FINANCE MODEL QUESTIONS AND ANSWERS Prepared by Professor Sujoy Kumar Dhar. Faculty Member, IBS Kolkata. 1.

What is the difference between Preference share and Equity share? Ans. Preference shareholder enjoys preference in case of distribution of dividend and repayment of capital when company goes on liquidation. All Preference shares are redeemable in India. Preference share holder has no voting right and it is not market traded. Therefore preference shareholders only can enjoy dividend gain. Equity share is not redeemable. Equity shareholders are owner of the company. Equity shareholder has voting right in selection of board of directors of company. Equity shares are market traded. Equity share holders will enjoy both dividend and capital gain. 2. What is the difference between NPV and IRR ? Ans. Net present value of a project is defined as excess of the sum total of present value of future inflow over and above the current outflow. If NPV of the project is positive, project is accepted. NPV follows additive rule. Multiple NPV is not possible for a project. NPV aims to maximize the wealth of the firm. Internal Rate of Return is the discounting rate for which sum total of present value of future inflows will be equal to current outflow. If IRR is greater than cost of capital, project is accepted. IRR does not follow additive rule. Multiple IRR is possible if direction of cash flow of the project changes more than once, so many times direction will be changed, so much number of IRR will be there. IRR maximizes the return from the project. 3. What is the difference between forward and future? Ans. Both forward and futures are derivative instrument. They are basically the agreement between buyers and sellers to deliver a particular asset at a predetermined future price at a predetermined future date. They are different due to following aspectsForward is not market traded but future is market traded. Default risk is high in forward but in future there is no default risk. Forward is highly illiquid but liquidity of future is high. Forward has no standardized format but future has standardized format. No margin money is required for forward as there is no clearing house between buyer and seller but both the buyer and seller has to deposit margin money in future to the clearing house. 4. What is the difference between future and option? Ans. Future is an agreement between buyers and sellers to deliver an instrument at a particular predetermined price at a predetermined future date.

Option is an agreement that gives the buyers right but no obligation to buy or sell any instrument at a particular price within or on a predetermined future date. Option seller is obliged to sell or buy the instrument when option buyer exercises its option. Option seller is enjoying premium from option buyer. The option that gives right to buy is called call option. The option that gives right to sell is called put option. In case of future , either trader has to take or make the delivery of the underlying asset on the delivery date or they have to square off their position before the maturity date. In case of option, buyer has the right but no obligation to exercise the contract. In future possible profit or loss can not be forecasted in advance unless and until trader squares of its position. In case of option, for the buyer maximum possible loss is limited to premium price. 5. What is the difference between systematic and unsystematic risk ? Ans. Systematic risk implies that risk which will affect the share of all sectors. Example of systematic risk is political risk, inflation risk, interest risk. Systematic risk can be reduced by hedging. Unsystematic risk is a sector specific risk which arises due to inefficient operation of a particular sector. Example of unsystematic risk is Government regulation, external risk, market risk, financial risk, corporate governance risk. If investor can invest in different stocks of diversified nature, unsystematic risk can be reduced to minimum. 6. What is the difference between CML and SML? Ans. Capital Market Line(CML) shows linear relationship between portfolio risk and portfolio return. Capital market line is efficient frontier when the individual diversifies their investment into risk free and risky asset. Security Market Line(SML) measures the required rate of return of an individual security. Required rate of return of a security is risk free rate of return plus risk premium multiplied by beta value of the security. If the expected return form the security is greater than the required rate of return, the asset is under priced or vice versa. Whether an asset is overpriced or under priced, it is determined by SML. If the asset is plotted above SML, it is underpriced and if the asset is plotted below SML , it is over priced. 7. What do you mean by hedger, speculator and arbitrageur? Ans. Hedger wants to minimize their risk by adopting appropriating investment strategy. Speculator wants to maximize its gain by using their speculation power. They are ready to take higher risk to get higher return. Arbitrageur wants to earn risk less profit by taking the advantage of price differentials.

firm can raise its earning per share. 12. by relying more and more on debt capital. It is the weighted average of the price of 30 securities. According to Technical analysis market price of the stock is determined by the free movement of market forces such as demand and supply.initial margin. variation margin. If Margin money falls below the maintenance margin. These demand and supply are influence by both fundamental and psychological factors. 11. It measures the change in the market price of the security due to change in market index.8. Beta value of the stock is calculated by the formula = Covariance between the return of market index and return of the particular stock /variance of the market index 10. The bottom line is that barring few exceptions. What do you mean by beta value of a security? How it is calculated? Ans. clearing house will compensate the other party with the help of the margin money. depending on appreciation or depreciation of the market price of future margin will increase or decrease. What is trading on Equity? Ans. how many types of margin an investor is required to keep? Ans. Beta is the measure of systematic risk. that a future trader is required to keep. Maintenance margin is the minimum necessary margin money that each party to has to keep in their account. This is known as variation margin. If return on capital employed of the firm is greater than cost of debt capital. Both the buyer and seller of the contract has to deposit a certain percentage (usually 10%) of total value of the contract in the clearing house as initial margin. stock prices are moving along a . Nifty is the index of National Stock exchange. Sensex is the index of Bombay Stock Exchange. What do you mean by Sensex and Nifty ? Ans. It is the weighted average of the price of 50 securities. party will get a call from the clearing house to deposit the money so that his margin balance will increase to initial margin level. 9. Beta value is the market sensitivity of a stock. There are three types of margin. It is called trading on equity. Since future is being traded daily. If any one of the party makes default. In future trading. What is the difference between Technical analysis and Fundamental analysis? Ans. maintenance margin.

Stock price movement can be explained with the help of graph and charts. secondary trend and day to day fluctuation. it is undervalued or vice versa. right issue. Market is governed by primary trend. no body can earn extraordinary profit if market is semi strong efficient. Free cash flow to equity Model. cyclical industry. industry analysis and company analysis. stock price is moving along a particular cyclical trend. Union Budget. On the basis of information of past period stock price and published information . Money supply. 13. Industry life cycle and nature of industry (Growth industry. inflation and interest rate. Free cash flow to firm model etc. Economic analysis takes into account different factors such as GDP of the nation.particular trend. Primary trend shows the the long range cycle which makes the entire market up or down. Secondary trend moves in opposite direction of primary trend. If the intrinsic value of the stock is less than the market price. bonus issue. dividend declaration. According to Dow theory of Technical Analysis. Market efficiency means to which extent current information are instantaneously reflected in the market price of the stock. merger acquisition news etc. Thus stock price will reflect publicly available information as well as internal information . Therefore current period stock price is reflecting the past period stock price. defensive industry). Semi strong form of efficiency implies market participants have information about the past period stock price movement as well as all published information about the company such as quarterly financial report. Thus current stock price reflects previous period stock price as well as all publicly available information. Therefore future stock price trend can be determined from the past movement of stock price. Secondary trend implies market correction that restraints the movement of primary trend. Fundamental analysis is used to determine the intrinsic value of the share. It includes economic analysis. Weak from of efficiency implies that all the market participants have the information of past period stock price. stock split. no body can earn extraordinary profit in weak form efficient market. Autocorrelation test and run tests are used to judge whether the market is following weak form efficiency or not. profitability position of the company which will be followed by valuation of the company by discounted cash flow method such as Dividend Discount Model. Saving and investment pattern. Day to Day fluctuation of stock price depends on . Insider trading also not possible if market is strong form efficient. What do you mean by weak. 14. On the basis on past period stock price information. solvency. Industry analysis incorporates Porter’s five factor model. balance of payment position etc. Strong form of efficiency implies market participants have the easy access to both internal and published information about the company. What is Dow theory ? Ans. semi strong and strong form of efficiency in the market? Ans. Company analysis includes analysis of liquidity.

A naked call strategy involves writing a call option on asset without buying the asset. What is the difference between the close ended and open ended mutual fund scheme? Ans. it is On the Money Call Option. What do you mean by protective put strategy ? Ans. A close ended scheme does not allow investors to with draw funds as and when they like. volume will increase when share prices are going down and volume will fall when share prices are going up. When RBI is borrowing from RBI. the commercial bank will receive the interest from the borrowers. they will purchase put option. It is called naked position because potential obligation to deliver the stock is not covered by the underlying stock in the portfolio. What is repo and reverse repo ? Ans. 19. The subscription to a close ended scheme is kept open only for a limited period. Often commercial banks borrow from RBI by selling their securities with an agreement to repurchase it after a certain period of time at a higher price . To hedge risk. RBI raises the repo rate. Open ended scheme permits investors to withdraw funds on a continuing basis under a repurchase agreement. If primary trend is bullish. A covered call strategy involves writing a call option on an asset along with buying the asset. What is covered call and naked call ? Ans. 18. 16. 15. 17. repo rate is reduced. Volume will also move along the primary trend.sentiments of the people. The rate commercial banks receive from the RBI is known as the reverse repo. If buyer of the call option has a net cash inflow as because market price is greater than the exercise price. During the inflationary period. On the contrary. In inflationary period. Current repo rate is 6%. An open ended scheme has no maturity period. When an investor purchases an under priced stock with the anticipation that its price will go up in the near future. The open ended scheme accepts funds from investors by offering its units on a continuous basis. The rate the commercial bank has to pay to RBI is called repo rate. it is In the Money call option. if primary trend is bearish. reverse repo rate is also increased and vice versa. Current reverse repo rate is 5%. It is known as protective put. A close ended fund has a fixed maturity period. It is called covered position because potential obligation to deliver the stock is covered by the underlying stock in portfolio. During the recession time. there is a risk that due to market risk price of the stock may fall. What is in the money and out of the money call option ? Ans. volume will increase when share prices are going up and volume will go down when share price decreases. If buyer of the call option has a net cash inflow as because market price is less than the exercise price. .

Under Systematic Investment plan . price reflects revealed demand and contemporary market conditions. An index based market wide circuit breaker system at three stages of index movement either way at 10%. The law in many countries require that the account of foreign subsidiaries and branches have to be consolidated with those of the parent company. It is a method of offering share to the people where issue price is not fixed in advance but is determined through a bidding process. What do you mean by Transaction. As an additional measure of safety. The essence of Operating Exposure is that exchange rate changes significantly alters the cost of a firm’s input and the price of its output and thereby influences . Therefore there is no reason of worry for individual investors. As the investment is made regularly. In a book building offer. Such risk exposure is referred as transaction exposure. assets and liabilities expressed in foreign currencies have to be translated into domestic currencies at the exchange rate prevailing on the consolidation date. 15% and 20%has been prescribed. Systematic Withdrawal plan allows the investor to withdraw a fixed amount every month. individual scrip wise price bands of 20% either way have been imposed for all scrip. What is Circuit Filter/Circuit Breaker ? Ans. The investor can opt for a fixed sum every month or a certain percentage of the capital appreciation in the NAV of the scheme. To curb excess volatility. 21. a change in exchange rate will alter the amount of local currency received or paid. The mutual fund sends the redemption proceeds to the investor every month automatically. the investor buys more units when the price is low and less units when the price is high. Stock market volatility is generally a cause of concern for both policy maker as well as investors. It implies SIP provides the opportunity of rupee cost averaging to the investor. For such considerations. What is Systematic Investment plan and Systematic Withdrawal plan ? Ans.Price bands or circuit breakers bring about a coordinated trading halt in all equity and equity derivative markets nation wide. SEBI has prescribed a system of price bands . 23. translation gain or loss will arise. What is Book Building Process? Ans. 22. Usually public companies go for Initial Public Offer with the help of Book Building process. When a firm has a receivable or payable in a foreign currency. Translation and Operating Exposure ? Ans.20. the investor can invest regular sums of money every month to buy units of a mutual fund scheme. If the value of foreign currency changes between two successive consolidation dates. The breakers are triggered by movement of either Nifty or Sensex whichever is beached earlier.

The instruments in the Money Market is Call Money. Investment Information and Credit Rating Agency(ICRA) and Credit Analysis and Research Limited(CARE) provide bond and other debt rating. Depository receipts are quoted and traded in the country in which they trade and are governed by trading and settlement procedure of the market. A depository receipt is a negotiable certificate that usually presents a company’s publicly traded equity or debt. These shares are physically held by domestic custodian banks nominated or appointed by Overseas Depositories Banks(ODB). Certificate of Deposits and Repo and Reverse Repo rate. 29. 27. What is difference between European an American option ? Ans. What is Short Selling ? Ans. Mention some names of Credit Rating Agencies. if speculation goes wrong. Bills of Exchange . the Credit Rating Information Services Limited CRISIL). Notice Money. he uses the strategy known as .the competitive position substantially. 26. If their speculation is correct. Therefore American option offers much flexibility than European option. What is straddle? Ans. Commercial bill. When investor is feeling that there will be a big suing in the market. What are the instruments in Money Market ? Ans. 25. It is possible when manufacturing takes place in one nation and selling takes place in another nation. not by the companies but by the oversea depositories bank which are authorized by the company in say India to issue them to non resident investors against their shares. Often investors sells the shares of a company in the first half of the day when they do not have the ownership of the share . Ans. What is Global Depository Receipt ? Ans. This is known as short selling which takes place specifically in intraday activity where traders have to buy the shares in the second half of the day. Treasury Bill. Money market is a mechanism when fund can be borrowed or lent for short term that is less than one year. they have to incur loss. but he is uncertain that it will take place in which direction. In India. 28. Depository receipts are created when a broker purchases the company’s share on the home stock market and deliver those to the depositories local custodian bank which then instructs the depository bank to issue a depository receipt. 24. On the contrary. All the depository receipts including GDR are essentially equity instrument created or issued abroad. they will earn lucrative profit. In the company’s book the ODBs’ name appear as the holder of their shares. They anticipate that price will go down in the second half of the day. A European option can be exercised only on the expiration date whereas an American option can be exercised on or before the expiration date.

In short butterfly. A basic value of decision tree lies in expressing all outcomes or events in quantitative terms which provide precision in decision making. If investor perceives that there will be bullish trend in the market but he is not very sure about it. To conclude regarding the firm’s liquidity position. Define Decision Tree and its uses Ans. it is possible to comprehend the true probability of a decision leading to results desired. Profit will be maximized if spot price falls below the exercise price of in the money of the call option and loss will be maximized when spot price is above the exercise price of out the money call option. In long butterfly. investor purchases two extreme call options and sell 2 units of intermediate call options. A decision tree is basically used to make decisions in complex situations when outcome of a later situation is dependent on the outcome of the former. 31. concept of ratio analysis is to be taken into account.100. What is Butterfly strategy? Ans. Investor purchases that call option whose exercise price is below than the spot price and sells that call option whose exercise price is greater than the spot price. Decision tree is graphical method for identifying alternative actions. in short butterfly. Straddle is a strategy to purchase/sell a call and a put option simultaneously with same exercise price and same expiration date.straddle. Short straddle is used when stock price is expected to be very close with exercise price. Bear spread strategy is used when investor anticipates there will be bearish trend in the market but he is not certain about the intensity of it. 32.150. How liquidity position of a company is judged ? Ans. Concept of decision tree is widely used in investment analysis. C whose exercise price are Rs. Ans. . he uses Bull spread strategy. profit will be maximized if spot price comes close to the exercise price of B. Another popular strategy is called butterfly strategy .200 respectively. B. cash in bank. estimating probabilities and indicating the resulting payoff. By incorporating the probabilities of various investment possibilities in the decision tree. in long butterfly investor will buy A and C and sell 2 units of B. profit will be maximized if spot price becomes either below the exercise price of A or above the exercise price of B. Explain the concept of Bull Spread and Bear Spread strategy. a) Current ratio= Current asset/Current liability Current assets are those assets which can be converted into cash within one year without any diminution in value such as cash in hand. Profit will be maximized if the spot price is above than out the money call option. Here investor buys one call option and sells another call option with same expiration date but with different exercise price. investor will sell A and C and buy 2 units of B. Here investor buys a call option whose exercise price is higher than spot price and sells a call option whose exercise price is less than spot price. Loss will be maximum if the spot price is below the in the money call option.In long butterfly. 30. 33. Long straddle is used when it is expected that spot price will move to the either direction from the exercise price. For example if there are 3 call options A.

bills receivables. 34. Debt Equity ratio= Long term debt/shareholder’s fund Long term debt includes long term loan from bank or financial institution. there is a risk of insolvency as the firm relying more and more on debt capital. provision for taxation. Sometimes it happens that current ratio is high but quick ratio is low. The ideal current ratio is 2 so that each rupee of current liability should be backed by 2 rupee of current asset. Average inventory holding period= 365/Inventory turn over . It shows majority of the current assets are in the form of stocks where there is no guarantee whether company will be able to offload the stock within one year or not. Shareholder’s fund= equity capital+ preference share capital+ reserve and surplus-fictitious asset if any . it implies that firm is depending more and more on equity capital instead of debt capital. bond and debenture. stocks. It is defined as current asset. 35. that there is no chance of payment default to the suppliers and creditors. Company has consolidated its position in such way. a) Debt Equity ratio= Debt equity ratio is an indicator of long term solvency position of the firm. So investor’s fund is almost safe. This describes the degree of efficiency in utilization of various assets deployed inthe firm. How solvency position of a company is judged ? Ans. sundry creditors.If firm has lower debt equity ratio. outstanding expenses. it interprets that long term solvency position of the firm is good. at first the solvency aspect of the company is to be judged. a) Inventory turn over ratio= Inventory turn over ratio is defined cost of goods sold/average inventory.sundry debtors. On the contrary if debt equity ratio is high. Majority of the assets are financed by shareholder’s fund. What do you mean by Efficiency or Turn Over analysis of a firm ? Ans. b) Proprietary ratio= By definition.stock/ current liability. Whenever an investor is willing to invest in a stock. Proprietary ratio= Shareholder’s/proprietor’s fund Total asset If proprietary ratio of the firm is high. Low proprietary ratio presents just reverse scenario that firm has a lot of debt burden. Higher quick ratio stands for sound liquidity position of the company. Current liability is the expenses those are to be incurred within one year such as bills payable.bank overdraft. prepaid expenses etc. provision for depreciation and proposed dividend etc. b) Quick ratio= Quick ratio is the ratio of quick asset to quick liability.

If net profit margin of a firm is high it implies that the firm is able to cope with all unfavorable circumstances whatever may take place in near future such as fall in the price of the product. difficulty of obtaining raw materials etc.Inventory turnover throws light at the degree of efficiency in inventory management. How profitability position of a firm is judged ? • Ans. the Return on Equity(ROE) is defined as ROE= PBIT/sales x sales/assets x PBT/PBIT x PAT/PBT x asset/net worth ROE=PBIT efficiency x asset turnover x interest burden x tax burden x leverage . If gross profit margin of a firm is high it indicates that firm has achieved excellence in curtailing the production/manufacturing cost. Gross profit margin = gross profit/sales x100.Net profit margin = net profit/sales x 100 . b) Net profit margin = Net profit is nothing but post tax profit of the company. High credit turn over ratio indicates firm is to pay its suppliers immediately after purchase. 36. its net profit is not up to the mark. A very high inventory turn over ratio should be examined cautiously.Net profit=operating income+ income from other sourcesdepreciation-interest-tax. A low inventory turnover ratio implies excessive inventory levels than warranted by volume of operation. c) Return on equity=The most important indicator of financial performance . A high level of idle or obsolete inventory means blockage or loss of capital. Usually profit is defined as the difference between total revenue and total cost. A low credit turn over ratio is apparently favourable as in that case firm enjoys lengthy credit period. Average payment period=365/creditors turn over ratio. Lower debt turn over ratio means longer average collection period. It may result the bad debt which may erode profitability. emergence of substitutes. It may be due to maintaining an inadequate level of inventory which may cause frequent stock out. Strain on working capital is low. A high inventory turnover ratio is the indicator of sound inventory management. Average collection period= 365/debtors turn over ratio Higher debtor turn over ratio means shorter average collection period. Vital parameter to measure the success of the company is its profitability. b) Debtors turn over ratio =It is defined as Credit sales/ average receivables. If gross profit margin is high but net profit margin is low. c) Creditors turnover ratio= It is explained as Annual Credit purchase/Average payable. it implies though firm has attained efficiency in manufacturing but due to higher office and administrative expense. Debtors are not allowed to linger their payment. It indicates efficiency in collection of debt. There are several measurements of profitabilitya) Gross profit margin=Gross profit is nothing but excess of sales over and above the cost of goods sold. This reflects inefficiency in collection of debt.

a) Operating Leverage= Operating leverage measures disproportionate change in profit due to proportionate change in sales. DFL will be higher. If fixed cost of a firm is higher. Higher DOL is preferable when demand for the product or service of the firm is more or less stable. What is Random Walk Theory ? Ans. industry or company. Higher financial leverage is favourable if the return on capital employed is higher than the cost of raising capital. firm will be in risky position because due to higher DFL there is a risk that earning per share will fall to a larger extent when profit falls. It is desirable that a company should have a higher EPS. Then the stock of the company will be lucrative option for the investor 37. Some methods of capital budgeting with risk and uncertainty is • Risk Adjusted Discount Rate • Certainty Equivalent method • Sensitivity Analysis . Earning per share=Earning per share is the ratio of firm’s total earnings. b) Financial leverage= Financial leverage measures disproportionate change in earning per share due to proportionate change in profit. earning per share can be enhanced which is known as Trading on Equity. it shows stock performance of the company is very good. 39. Therefore movement of stock price is at random rather than in a predicted pattern. Net worth of a company is Equity capital +Preference capital + Reserve and surplus.fictitious assets if any. Change in stock price occurs if there is a change in economy. Random Walk theory implies that stock price of today has no influence on stock price of tomorrow. What do you mean by Operating Leverage and Financial Leverage? Ans. Leverage analysis of firm is also very vital to get an idea about the firm. Degree of Financial leverage(DFL) is defined as Profit Before Interest and Tax(PBIT)/Profit Before Tax(PBT).In simple version Return on Equity is interpreted as PAT/Net worth. If interest burden of a firm is high. Break even point of output will be higher. profit will be reduced to large extent. by relying more and more on debt capital. net taxes minus preference dividend over the number of equity shares. Ans. In this case. That information is immediately and instantaneously reflected in the stock price. Mention some methods of capital budgeting where risk and uncertainty is incorporated.DFL=PBIT/PBIT-I. 38. Degree of Operating Leverage(DOL) is defined as contribution/ contribution-fixed cost. If return on equity is high. The firm will be in a risky position. There is a risk that due to reduction of small amount of sale. When firm depends more and more on borrowed capital. its DOL will be higher.

It shows the free cash flow available to equity shareholder after meeting all expenses. For example. r= cost of equity (determined by CAPM model) r= risk free rate of return + Beta value x risk premium g= expected growth rate Reinvestment rate calculation is done on the basis of FCFE model.• Decision Tree approach 40. What is the difference between Free Cash Flow to Equity and Free Cash Flow to Firm concept? Ans. the excess of face value acquirer company pays to the target company for its each share multiplied by number of outstanding shares of the target company is known as externally generated good will for the acquirer company and it will be shown as the asset side of the balance sheet. In case of equity valuation. What do you mean by intangible assets & fictitious asset ? Ans. There are some items which are placed in the asset side of balance sheet in accounting sense but they can not be considered as the asset of the company logically. Growth rate = Reinvestment rate x return on Equity Reinvestment rate= (Capital expenditure – depreciation. concept enjoys.amortization + change in non cash WC – debt issue+ debt redemption)/ Net Income Return on Equity= PAT/Net worth FCFF model shows cash flow available to the members of the firm that is both debt and equity holder. Intangible assets are those assets which are created through time and effort but they are not physically measurable. In case of fictitious assets. FCFF= PBIT(1-t) + R(1-t) + Depreciation+ Amortization.The example of official assets are patent. If a company incurs loss. Over the life company has to write off them. FCFE= Net Income.externally generated goodwill. Fictitious assets are those which have monetary value without backed by any physical asset. Paten and copy right has finite period of life. Net Income= Profit After tax Current Market price of the share= FCFE1/(r-g) FCFE1= Free cash flow equity shareholder after 1 year. Intangible assets are of two type’s such as official asset and fictitious asset .Capital expenditure – change in non cash working capital R = Interest payment by the company to creditor g= ROCE x Reinvestment rate ROCE= PBIT (1-t)/ ( book value of debt + book value of equity) .amortization )-Change in non cash working capital +Net cash inflow from debt issue. process. These are intellectual property right that the innovator of a new product. copy right. it will be shown in the asset side of the balance sheet though loss is not an asset for a company. 41. Preliminary expense and discount on issue of shares are also example of fictitious asset. When one company acquires another company.Depreciation. they have to be written off at a higher rate.( Capital expenditure. FCFE model is used as a modern equity valuation approach.

• For computation of EVA. According to Residual Income Method.Reinvestment rate= Capital expenditure – depreciation.operating expense). to specify the area where the investor’s fund has been invested in which proportion but in former case they don’t reveal their investment pattern.amortization + Change in Non cash working capital/ [ PBIT (1-t) + R(1-t)] Current price of the market share= FCFF1 /(k-g) K= weighted average cost of capital = (Book value of debt/ Book value) x cost of debt + (Book value of equity/ Book value ) x cost of equity 42. it implies return earned from investment is greater than cost of capital. EVA is the Economic Value Added which is considered as a performance evaluation for the company. Compare between EVA and MVA . EVA= {(NOPLAT/Total capital)-WACC}x total capital NOPLAT=Net Operating Profit Less Adjusted Tax WACC=Weighted Average Cost of Capital WACC= (Book Value of debt/Total book value)x cost of debt x (1-t) + (Book value of Equity/ total book value)x cost of equity According to refined earning method. What is hedge fund? Ans. 43. Provision of . it will able to enhance EPS. even if sales increased by Rs1. Ans. mutual fund company has to provide quarterly statement to the investors. EVA is calculated as EVA= ( sales. MVA is market value added which is defined as MVA= Market value of equity-( Book value of debt+ Book Value of Preference Share+ Book Value of equity) MVA of a company is the sum total of present value of future EVA. it implies company’s performance is satisfactory. MVA= EVA1/(1+WACC) + EVA2/(1+WACC)2+ EVA3/(1+WACC)3+-------EVAn/ (1+WACC)n If MVA of a company is positive . Therefore if sales is increased by 1 Rs. it will deteriorate the EPS. EVA can be computed by two methods – Residual Income method and Refined Earning method. EVA is better financial indicator for the financial organization because • It takes into account only operating profit.WACC x net assets If EVA of a company is positive. When EVA is negative. WACC is taken into consideration where both cost of equity and cost of debt are included. Hedge fund is a new concept which is different from mutual fund where in case mutual fund . Otherwise investors will think twice before investing in that company.

If a certain amount of fund(Y) is to be realized after certain period of time(n). In both the cases systematic risk has been hedged. all the banks are advised to main capital adequacy ratio at least 8%. Basel II is the second of the Basel Accords. profit is derived from under priced stock but loss will be incurred from short selling. n year) = Y x Capital recovery factor Capital recovery factor is the reciprocal of PVIFA. Xx PVIFA(r%.that is determined by sinking fund factor. subordinated debt etc. On the contrary when market becomes bearish . What is BASEL II and how it is different from BASEL I ? Ans. n year)= Y Or X = Yx 1/ PVIFA(r%. The excellence of Hedge fund is that it reduces the systematic risk or market risk of the investment. When Market becomes bullish. What do you mean by sinking fund factor and capital recovery factor? Ans. The . 44. So loss from short selling is counter balanced by gain from investment in under priced stock. profit is earned from short selling but there is a loss from under priced stock investment. Tier II capital includes hidden reserve. n year)=Y x sinking fund factor Sinking fund factor is reciprocal of FVIFA.that is determined by capital recovery factor. hybrid instruments. the equal amount of inflow (X)that project is expected to generate. Capital adequacy ratio= (Tier I capital + Tier II capital)/ risk weighted asset. RBI has instructed all Indian Commercial banks to hold capital adequacy ratio at least 9%. According to Basel I. n year) = Y Or X= Y x 1/FVIFA(r%. Generally the strategy adopted by Hedge fund company that they simultaneously invest in under priced stock as well as they are involved in short selling of the asset. Loss from investment in under priced stock is balanced by profit from short selling. 45. what equal amount(X) should be invested at the end of every year. revaluation reserve. Tier I capital includes equity capital and reserve & surplus. X x FVIFA( r%.hedge fund is mainly enjoyed by high Net worth Individual and hedge fund company charge both management fee as well as performance fee simultaneously. As a result both return and risk will moderate rather than abnormally high. If an investor invests a certain amount of fund(Y) in a project in the current period and willing to realize the fund within a certain period of time that is (n years). which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision.

. Considering Market risk and operation risk apart from credit risk 2.This rate that a sub prime borrower has to pay is known as sub prime rate. This will further worsening the situation.purpose of Basel II. But specifically in USA. In practice. which was initially published in June 2004. When market interest goes up. these rules mean that the greater risk to which the bank is exposed. the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability. Generally speaking. The cash realised by this way is immediately paid to the Bank. some financial institutes take loan from the banks in prime lending rate and they are providing the loan comparatively poorer section at a higher rate for example PLR+2%.After that the institution. real estate price started to fall rapidly.So borrowers make default in payment .Then Institutional investors make lien on the real estate property and try to sell it. Basel II attempts to accomplish this by setting up rigorous risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices. is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face. 46. he is not eligible to get the loan.this is known as subprime crysis. Usually commercial Banks provide loan to the borrowes depending on their credit history and financial capability.Therefore institutional Investor started to suffer from liquidity crysis. Continuous disclosure to the market . PLR+2% will also go up. The three main pillar of Basel II is 1. . What is securitisation and subprime crysis? Ans. But intermediate financial institution contnued their credit creation process as their credit history is always good as they are paying timely to the banks.Sometimes they are intentionally inflating the borrowers level of income so that Institutional Investors will be motivated to purchase the debt security. Advocates of Basel II believe that such an international standard can help to protect the international financial system from the types of problems that might arise due to a major bank or a series of banks collapse.As a result selling pressure in market has gone up.If a person’s credit history is poor or he has the irregularity in income.this is known as securtisation by which adequate liquidity can be provided to mortgage market of illuquid asset simultanously hedging can be done against default risk. immediately hedge their risk by selling the loan as a debt security to the Institutional Investors where those Institutional Investors are entitled to received Equated monthly installment. Minimum capital requirement depending on credit rating 3.

The only constraint is that. the person will continue to earn interest on the amount. Autonomous transactions includes all the transactions which are taking place for the sake of business for example current account and capital . 50. 48. The new inflation computation method with 2004-05 as base year has more 241 items than the old series with base year 1993-94 as the base year which only reflected the price rise in 435 articles. it is underpriced or vice versa. automatically fund will be block free. gold.Autonomous transaction and accommodating transaction.2010 came out with a new Wholesale Price Index (WPI) series that measured inflation in August 2010 is 8. In other words inflation implies excess of money supply over and above the available goods and services in the economy. microwave ovens.47 What do you mean by alpha value of an asset? Ans. It is a better way of applying for an IPO or FPO by simply blocking the fund in the bank account. Edible and non edible items widely used by middle class people like ice cream. BOP is defined as systematic record of financial transactions with the residents of the member country and the residents of rest of world for a particular period of time. The Government on 14th September. Characteristic line shows the relationship between stock price movement and the market index movement. ASBA is designed by SEBI to protect the Investor’s interest who are willing to apply for IPO but not at the expense of interest income loss. What do you mean by Balance of Payment of a nation? Ans. In WPI. washing machines. In this case. Inflation can be measured by WPI ( Wholesale Price Index Number) or CPI ( Consumer Price Index Number). In CPI. Inflation is the sustained rise in price. significant weight is given to manufactured article. ASBA is Application Supported by Blocked Amount. Balance of payment has two types of transactions. Amount will be debited only if share is allotted to the individual. What do you mean by inflation and its measurement? Ans. Alpha value of an asset implies risk free rate of return from risky security. What do you mean by ASBA ? Ans. Alpha value can be determined with the help of characteristic line. silver are reflected in new WPI series. mineral water. they can not withdraw the fund from the account. 49.5%. If the person is not allotted the share. The equation of the characteristic line can be expressed as Y= alpha + Beta X Y= Return from the particular stock X= Return form the market index If alpha value of the stock is positive.5% although in older system it was 9. it incorporates a basket of goods which consumers are usually use and significant weight is given to food articles.

If the sum total of credit side of current and capital account is greater than the sum total of debit side of current and capital account. What do you mean by consolidated balance sheet of a company? Ans. Any transaction which creates demand for home currency will be placed in credit side. Distinguish between reserve and provision of the company. furniture’s etc. If credit side in capital account is greater than debit side of the capital account. building.( barring the time of global recession in 2008-09. Similarly a certain portion of credit sales of the organization will never be realized which will become bad debt. 51. Capital account balance became adverse). Inflow of FDI and FII is posited in credit side of BOP and outflow of FDI and FII is posited in debit side of BOP. nation has current account surplus. change in gold reserve etc. Accommodating transaction are those transactions which are taking place to make the balance of payment always balanced. Capital account transaction includes inflow and outflow of FDI and FII. India is the popular destiny of FDI and FII. Ans. For example – change if foreign exchange reserve. any transaction which creates supply of home currency will be placed in supply side. 52. Therefore company makes provision for depreciation and bad debt in the profit and loss account and they are charged in the debit side of the P/L a/c so that net profit can be reduced and company has to pay . Export of goods and service will be posited in credit side and import of goods and services will be posited in debit side. Current account transaction includes export and import of goods and services and unilateral payment. If credit side of current account is greater that the debit side of current account. Characteristics of holding company is given as belowa) Good will or capital reserve has to be mentioned. b) Minority interest has to be mentioned.account transaction. nation is said to have a BOP surplus. Therefore Capital account of India remains always surplus to a such extent that it more than offset the current account deficit of the nation. When the asset and liability of the holding company as well as all of its subsidiaries are expressed in the currency of the parent company. BOP is computed as a double entry accounting system. it is known as consolidated balance sheet of the holding company. It is a known fact that there will be depreciation of the fixed asset of the company such as plant & machinery. nation has capital account surplus. India is always a current account deficit nation as its value of import is always higher than value of export. Any transaction which is used as a source of fund is placed in credit side and any transaction which is used as application of fund is placed in debit side. c) Adjustment of common debtor and common creditor has to be maintained. But due to being an emerging economy. due to huge withdrawal of funds by FII from Indian capital market.

. As a result demand for factors will go up and employment goes up. Among inflation and deflation which do you prefer & why? Ans. 55. But despite of its evils. Demand goes down further. a mild doze of inflation should be injected in the body of economy because it stimulates aggregate demand. Again price moves in the downward direction. Unemployment will go up. 53. income will go up. producer reduces production.revenue reserve and capital reserve. India Indian GAAP allows deferred revenue expenditure. Distinguish between Indian GAAP & USA GAAP . Demand for factors will go down. employment will move in downward spiral. As price goes down. dividend equalization reserve. Therefore inflation is bad but recession is worst. USA GAAP is liberal in related party transaction USA GAAP is more focused on minority interest. Capital reserve includes capital redemption reserve. Deflation means sustained fall in price. Ans. share premium account. If demand is higher. employment. installation. Therefore all variables such as output. delivery schedule. Producer will be willing to supply more to boo higher profit. Distinguish between financial lease & Operating lease. Inflation is sustained rise in price which reduces the purchasing power of money. price. 54. Emphasis is given on consolidation norm where goodwill or capital reserve has to be specified. Reserves are of two types. All economic variable such as output.lower corporate profit tax. Provision payment to the shareholder also. Related party transaction is strictly prohibited in India. can be made for proposed dividend When company earns profit certain amount will be paid to the shareholder a dividend and remaining amount will be kept as reserve and surplus. Revenue reserve includes reserve for bad debt and reserve for depreciation. A financial lease is structured to include the following characteristics• The lessee selects the equipment according to his requirement from manufacturer or distributor • The lessee negotiates and settles with the manufacturer or distributor the price. USA USA GAAP does not allow it. maintenance etc • Financial lease may provide the right or option to the lessee to purchase the equipment at a future date. price will go up.

57. Lease Hire purchase The lessor is the owner and lessee is Ownership of the asset passes on to the entitled to the economic use of the asset. Lessor is allowed to claim tax shield on Hirer is allowed to claim tax shield on depreciation and lessee is entitled to claim depreciation of the asset tax benefit on lease rental. insurance of the equipment rests with lessee. Cost of maintenance is borne by lessee in Cost of maintenance is borne by hirer. 58. A operating lease is structured as • Operating lease is generally for a period shorter than the economic life of the leased asset. The depreciation of the asset is charged on Hirer is entitled for depreciation shield. It is known as Interest Rate Parity theory (IRP). an independent regulator and allow them to launch option in the commodity market among a host of other changes. Commodity market regulator is finally get SEBI like status and power. the risk of obsolesces and liability for repair. • The responsibility of suitability of the equipment. The devaluation concept is applicable in fixed exchange rate regime. Currency with higher interest rate will depreciate. Distinguish between devaluation and depreciation. Devaluation is reduction of the value of home currency in terms of foreign currency. There is no intervention from the Government. rate is determined by demand and supply force of the market. the book of lessor. 56. Ans. hirer in case of hire purchase on payment of last installment. What is FMC ? Ans. case of financial lease and cost of maintenance is borne by lesser in case of operating lease. Depreciation is also reduction of home currency in terms of foreign currency but it is applicable in case of flexible exchange rate. both regulator . Currency with higher inflation rate will depreciate. Distinguish between lease and hire purchase.• The lease period spreads over the expected economic life of the asset. In flexible exchange rate. It is a policy measure to encourage export and discourage import. FMC will be at par with SEBI. It is known as Purchasing Power Parity(PPP) theory. • Operating lease normally includes maintenance clause requiring the lesser to maintain the leased asset. maintenance. The Union cabinet on 17th September 2010 approved long pending amendment to the Forward Contract (Regulation) Act and it will go for seeking Parliamentary approval to make the Forward Market Commission.

external debt such as External Commercial Borrowing (ECB) or FCCB ( Foreign Currency Convertible Bonds) and Internal debt that is collection of fund from domestic market by issuing treasury bills etc.60000 per annum for a male . It paves the way for commodity based exchange traded fund. sales tax etc. Tax revenue includes direct tax like income tax and indirect tax includes excise duty. Future and option together will give better liquidity in the market. hospital. Rs 1.8% of GDP which directly violated FRBM act. Pranab Mukherjee for the financial year 201011. highway. 60. Upto income Rs 1. In 2009 after the general election when UPA-II Government came into power. Mention the key features of Union budget placed by Honourable Finance Minister Mr. What do you mean by FRBM act? Ans: Fiscal Responsibility & Budget Management Act was passed In parliament in the year 2003 where it was clearly mentioned that by the financial year 2009-10. Capital payment includes expenditure to be incurred to construct or upgrade the infrastructure like road. Public debt are of two types. no tax will be paid. subsidy and defense.10% per annum . 59. When sum total of revenue payment and capital payment exceeds sum total of revenue income and capital income. The main emphasis of the union budget for 2010-11 is as follows – a) Income tax exemption has been increased. Fiscal deficit was excessively high due to a) Release of Sixth Pay commission which gives a huge hike to Central Government Employee b) Redemption of Rs 170 thousand crore farm loan c) Huge investment in social infrastructural sector for employment generation d) Declaration of bailout package for recession hit sectors. Revenue payment includes expenditure on salary. Fiscal deficit takes place. recovery from loan and advances by RBI and disinvestment proceed. Finance Minister Mr. Capital receipt includes public debt. trading on indices and weather based product. Farmer’s participation will increase through option route because they would not only become insurance in case market goes down but it will give the opportunity to the farmers to capture best possible price in case of a market rally.are likely to get place on each other’s board. Pranab Mukherjee tabled the budget where Fiscal deficit was excessively high 6. there will be no revenue deficit and fiscal deficit will be limited to 3. Indian Airlines and fee from selling licenses and earning of dividend from all PSUs.60000-Rs 500000.5% of GDP at most. interest. Revenue receipt includes tax and not tax revenue. custom duty. universities etc. non tax revenue includes earing from Indian Railway. Ans.

LIC premium. Before the SEBI regulation came into force . For senior citizen. As the commission amount was automatically deducted from the principal amount of investment. NSC etc.5% and that only the balance 97. what was the immediate impact? Ans. no tax will be paid. Today any investor seeking to buy an mutual fund through distributor has to mutually agree upon the commission payable to a distributor for his . Bihar. Partial rollback of fiscal stimulus given by Government during the recession time was done by increasing excise duty from 8% to 10% and enhancing Minimum Alternate Tax from 15% to 18%.Rs 500000-Rs 800000-20% per annum More than 800000. where the onus of collecting a fee from the investor fell on the distributor alone. 61. Additional Rs 200000 will be exempted if person invests in infrastructural bond. upto Rs 240000 per annum. b) c) d) e) f) Huge disinvestment target of PSU of Rs 400 billion is taken to meet the fiscal deficit. ELSS.5% was getting invested into the scheme Those who were aware of it would demand that their distributors repay a part of such commission usually 1 to 1.30% per annum For female. Budget has given more importance to agricultural sector where strategies were taken to increase the agricultural productivity by extending another green revolution in Bengal. Another Rs 100000 can be saved. Jharkhand . Eastern UP . MF housed used to pay commission to distributors in lieu of their services in reaching out . Rs 16500 crore is proposed to be injected to the PSU banks to increase their tier I capital to 8% by March 31. It was August 2009 that SEBI banned Entry loads for mutual fund investments. After abolition of entry load in mutual fund scheme. the mutual fund industry is yet to fully come to terms with changes which have transformed the industry.90000 per annum . target has been taken to provide the banking service to all villages where population is more than 2000. reduction in wastage of agricultural products & implements. marketing and selling MF products to the investor from the amount collected through entry loads. By 2012.2011. A year down the line .25% on the amount invested was charged by the fund houses from investors. few investors were aware of the fact that their initial investment would get automatically reduced by about 2. no tax will be paid. It was to curb this very practice and to make MF investments more transparent and customer friendly that SEBI introduced the no load regime last year. Financial inclusion is a major focus area of the budget. Extending credit Support to farmers and providing thrust to food processing sectors.5% to them in cash. Employee provided fund. upto 1. an entry load or an upfront commission of close to 2. if individual invests in PPF.

2010. therefore IRDA has the supreme authority in issuing ULIP and IRDA perceived that SEBI is unnecessarily encroaching into their area of autonomy. Insurance companies will face dilemma while issuing pension plan with a guaranteed return. A guarantee of minimum return would make it difficult for issuers to invest pension funds in riskier financial securities. therefore SEBI wants to control and regulate the ULIP to protect the investor’s interest. After abolition of entry load in mutual fund schemes. . Their only source of income is the commission paid to them by the MF houses. Soon all insurance companies will withdraw most of their unit linked insurance plans and will issuing a new set of such policies. it has been seen two market regulatory body were involved in conflict : the issue became so serious that matter reached to Supreme Court.services. This is to protect lifetime savings of pensioners and to differentiate pension from other investment products.Can you focus some light on it. the Return on Investment was dependent on the discretion of the insurers.2010. The matter went to Supreme court. The regulator has introduced a minimum guaranteed return 4. since convincing an investor to pay money for services rendered while investing in a financial product such as an MF is not easy. While the intention of the regulator were well meaning. In recent time. Earlier in case of policy surrender. as ULIP is Unit linked Insurance Product . new launches had managed to collect close to Rs 15000 crore. Ans. IRDA will control ULIP since it is an insurance product but it issued certain guidelines.5% on Unit Linked Pension Products . Industry observers feel that there will be very few such pension plans that will be on offer after September.For investors having long been used to getting a part of their investment as cash back from the distributor . Equities offer superior long term investment return but not without a risk of loss of capital. Supreme court gave the verdict. Immediate fall out of latest ULIP guidelines could be that Insurance companies may tend to go slow on issuing pension plans. Compared to the collections of nearly Rs 30000 to 40000 crore in the years 2006& 2007. 62. Another major step taken by IRDA was the standardization of surrender charges. SEBI Instructed for stop issuing ULIP to all insurance players as premium collected from ULIP are invested in to the market . These collections are worse considering that even during the financial meltdown of 2008. These charges will be applicable when a policy holder surrenders the policy before the predetermined lock in period. Many independent distributors offer their service free of charges to their investors. the year 2010 has so far witnessed collections of just about Rs 2000 crore through the sale of NFO. the industry is yet to reconcile itself to the changes which have been carried out. it will take a while for them to get used to this new regime. But IRDA did not take it positive spirit. The no load regime has forced many small distributors to shut shop.This is in response to ULIP guidelines issued by IRDA on June 28.

Ans. . The General Agreement of Tariff & Trade was born in 1948 as the result of International desire to liberalize the trade. it sought to resolve disagreements through consultation. Distinguish between TRIP & TRIM.The principle of non discrimination requires that no member country shall discriminate between the members of GATT in conduct of international trade. Trade Related Investment Measures (TRIM) refers to certain conditions or restrictions imposed by a Government in respect of foreign investment in the country. a) Local Content Requirement ( certain amount of local inputs be used in products) b) Trade balancing requirement( import should not exceed a certain amount of export) c) Trade and Foreign exchange balancing requirement d) Domestic sales requirement ( a company shall sell a certain portion of its output locally).. The agreement requires the notification of all WTO inconsistent TRIMS and their phasing out within two. developing and less developed countries. Trade Related Aspects of Intellectual Property Right (TRIP) is under the Uruguay round arrangement of GATT( Now WTO) TRIP cover seven Intellectual propertiesa) Copyright & related right b) Trademark c) Geographical Indications d) Industrial designs e) Patents f) Lay out design of integrated circuits g) Undisclosed information including trade secrets What is GATT & WTO? Ans. The preamble of GATT mentioned the following as its important objectivesa) Raising standard of life b) Ensuring full employment and large & steadily growing volume of real income & effective demand c) Developing full uses of resources of the world d) Expansion of production & international trade GATT adopted the following principles• Non discrimination. An agreement on TRIMs provide that no contracting party shall apply any TRIM which is inconsistent with the WTO articles . TRIMs were widely employed in developing countries. five. • Prohibitive of Quantitative Restrictions: It rules seek to prohibit quantitative restrictions as far as possible and limit restrictions on trade to the less rigid tariff • Consultation: By providing a forum for continuing consultation . 4. seven years by industrial.An illustrative list identifies that following TRIMs are inconsistent.3.

No person can receive otherwise through an authorized person . was conservation and proper utilization of the foreign exchange resources of the country.Following the Uruguay round. 1973. The FERA was widely described as draconian law. Any person may sell or draw foreign exchange to or from an authorized person for capital account transaction permitted by RBI in consultation with RBI. no person shall deal in any foreign exchange or foreign security other than authorized person.any payment by order or on behalf of any person resident outside India in any manner. Foreign Exchange transactions were regulated in India by Foreign Exchange Regulation Act (FERA). Venture capital is basically equity finance in relatively new companies when it is too early to go to the capital market to raise funds. The main objective of FERA framed against the background of severe foreign exchange problem and controlled economic regime . . • The WTO administers ‘Understanding on Roles & procedures governing the settlement of disputes. FEMA permits dealing in foreign exchange through authorized person for current account transaction. It can be also made in the form of loan finance/convertible debt to ensure a running yield on portfolio of venture capitalist. What is FERA & FEMA? Ans.1995. In the light of ongoing Economic liberalization of the country and improving foreign exchange reserve of the nation. What do you mean by venture capital? Ans. replaced the FERA.’ • The WTO administers ‘ Trade review Mechanism’ 65. no person can make any payment to or for the credit of any person resident outside of India in any manner. Except as provided in terms of the act. No person can enter into any financial transaction as consideration for or in association with the acquisition or creation or transfer of a right to acquire any asset outside India by any person. or with the general or special permission of RBI. The WTO has the following functions• The WTO will facilitate the implementation. However such investment is not exclusively equity investment. a new Foreign Exchange Management Act (FEMA) 1999. operation and further the objectives of Multilateral Trade Agreement • The WTO shall provide the forum for negotiations among its members concerning their multiple trade relations in matter dealt with under agreement. This act was sought to regulate certain aspects of conduct of business outside the country by Indian companies and in India by foreign companies. GATT was converted from a provisional agreement into a formal International Organization called World Trade Organisation (WTO) with effect from January 1. administration. Venture capital is a financial intermediary between investors looking for high potential return and entrepreneurs who need institutional capital as they are not ready or able to go to the market.

MSS are issued by the auctions to be conducted by RBI. Several sequential steps are to be followed such as establishing the time horizon. What do you mean by sterilization policy ? Ans. The Treasury bills or dated securities under MSS are have all the attributes of existing T bills and dated securities.67. ratios as well as qualitative information such as borrowers’ reputation. Loss Given Default (LGD) : Loss given default is the estimated percentage of an outstanding claim that can not be recovered in the event of a default. Conversely when it sells foreign exchange the domestic liquidity is absorbed from the system. it injects liquidity into the system through corresponding selling of domestic currency. The securities acquired by the banks with the intention to hold them till the maturity period will be classified as held to maturity. equity prices . LGD. Sensex etc are considered as eligible collaterals. critically reviewing the available information. When RBI intervenes in the foreign exchange market through purchases of foreign exchanges. As a result there is very marginal impact on market interest. analyzing the published default studies/ secondary data as well as successful use and implementation of transition matrices to look at the way PDs change over time. Cash on deposit. The amounts will be held in a separate identifiable cash account titled MSS account to be maintained & operated by RBI. Conceptually sterilization process involves decision of RBI to intervene by substituting foreign currency with domestic currency in case of excess capital inflow and decision to intervene further in the money or bond market to substitute domestic currency so released out of the intervention of foreign exchange market with bond or other eligible papers. The investments included under held to maturity should not exceed 25% of bank’s total investment. in which case premium will be amortized over the period remaining to maturity. 70. The Government in consultation with RBI will fix an annual aggregate ceiling for T bills or dated securities under MSS. Probability of Default (PD) : PD is the likelihood of a borrower defaulting on a contractual obligation. What do you mean by market stabilization scheme? Ans. The Government can issue Treasury bills or dated securities under MSS for absorbing liquidity from the system. Equities listed in major stock indices such as Dow Jones. Nikkei. What do you mean by held to maturity? Ans. Define PD. banks and corporate securities rated minimum at BBB-. To calculate the PD. Recovery rate and Loss given default are mutually exhaustive with each other as LGD= 1. Investments carried out under held to maturity are not marked to market and will be carried at acquisition cost unless it is more than the face value . EAD. Ans. Gold. The T bills and dated securities issued for MSS would be matched by an equivalent amount of cash balance held by the Government with RBI. Neutralizing part or whole of the monetary impact of foreign inflows are known as sterilization process. the time horizon must be long enough to be meaningful and short enough to be feasible given the data available. determining the measurement approach using the quantitative data such as financial statements.Recovery rate Usually collaterals reduce the risk of an exposure and hence collateralized loans carry lower risk weights than un-collateralized loans. securities by sovereigns & public sector entities carrying a minimum rate of BB-. Expected loss and unexpected loss. However the value of the collateral C is adjusted by applying so called Hair Cut (H) .

15% (gold) and 30% (eligible corporate securities). Expected Loss (EL) : Expected loss is the amount that a bank can expect to lose on average in the event of a default.these ‘Security receipts’ are considered as contingent liability. A person who has defaulted two EMI can be treated as 60 days DPD that is Days Passed Deal. 72. The main activity of the commercial bank is accepting deposits and credit creation in the economy. calling exercise should be done with a default script. Exposure At Default (EAD) : Exposure at default is the maximum amount that a bank can loose in the event of a default.CA= C/( 1+H) Where CA= Collateral Adjusted The value of H will depend on the value of collateral. Bank usually takes the help of Debt Reconstruction Company (DRC) when they have accumulated excessive NPA due to non recovery of loan. What is Para Banking activity? Ans. loss given default. is called factoring. Depending on that they sell certain amount of ‘Security Receipts’ to the bank. factoring services etc. insurance business. What is factoring? Ans. As the bank is selling their NPA to the DRC. Debt Reconstruction Company has to undergo a market research to analyze the extent of NPA. It varies from 0% (cash). underwriting. After default of 2nd EMI. submitting sales account to creditors . Security receipt acts almost like Collateral Debt Security where for the bank. it can be shown as 30 days DPD that is Days Passed Deal. after collection to return the reserve money to the seller and provide consultancy services to the customers in respect of marketing. The factor performs the functions of such as purchase of receivables. hire purchase business.It becomes a NPA (Non Performing Asset). marinating the sales or receivables ledgers . collection of debt on due dates. Banks undertake financial services such as credit card business. banks will be able to transfer the collection hazard from their shoulder to the DRC. Banks will be able to get the money against these security receipts provided the Debt Reconstruction Company is able to realize the receivables from NPA. finance & production. Debt Reconstruction company is a trust. They purchase the NPA of the banks by paying certain amount of cash which is much lesser than the value of NPA. Expected loss is the product of probability of default. EL= PD x LGD x EAD Unexpected Loss (UL) : Unexpected loss/ unanticipated loss is computed by subtracting expected loss from actual loss. The arrangement in which receivables created out of sales of goods or services are sold to an agency. These are called Para banking activities which can be taken up departmentally or by setting up subsidiaries. UL= Actual loss –Expected loss 71. A person who has defaulted consecutive three EMI can be shown as 90 days DPD . exposure at default . The way Debt Reconstruction Company is . Apart from that. 73. 4% (sovereign securities). it will be able to realize by applying different standard conventional techniques and tactics. What is NPA and what is the function of Debt Reconstruction company ? When debtor defaulted one Equated Monthly Installment (EMI). equipment leasing.

Usually as a common thumb rule. 74. loan will be available at a lower rate. • Helps in pricing the loan according to the risk.35% Amounts owed. According to FICO Scoring method. What do you mean by credit scoring model ? Ans. There are different credit scoring methodologies such as FICO. As it is a known fact that prevention is always better than cure.credit risk 63%.999T5 Zones of Discrimination: . ONICRA( Onida + Icra). operation risk 25-26% and market risk is 11-12%. Higher the score.2T1 + 1. total risk faced by a bank can be decomposed into three different categories.6T4 + . Credit score is nothing but numerical forecast of repayment of future loan.exercising pressure on the nerve of debtors that raises lots of dispute from the moral and ethical perspectives. FICO score ranges from 300 to 850. Z Altman’s score etc. ALTMAN Z SCORE MODEL T1 = Working Capital / Total Assets T2 = Retained Earnings / Total Assets T3 = Earnings Before Interest and Taxes / Total Assets T4 = Market Value of Equity / Total Liabilities T5 = Sales/ Total Assets Z Score Bankruptcy Model: Z = 1. Use of credit counseling services if reported by creditors may lower the credit score.bank specific.15% New credit-10% Account Mix (nature of loan)-10% Change of job frequently may lower score if no history of late payments.3T3 + 0.30% Length of history. Banking Sector has to use credit scoring model from 1998 onwards. banks are using credit scoring models to reduce the probability of piling up of bad debt or non performing assets.4T2 + 3. For credit scoring certain factors are taken into accountPayment history. Change of residence to negative area may lower score-bank specific. Inquiring for more credit may lower credit score. Reasons for using the scoring models are as follows• Determination of probability of default and expected loss • Ensures that good loan proposals are accepted and bad loan proposals are rejected.

The RBI's working committee had worked out illustrative base rate to be 8. margin pressures are expected as banks would be unable to lend below sub-base rate coupled with the fact that the rates charged for ‘other borrowers' such as SME lending agriculture and retail lending would see a decline as a result of this move. What is the difference between hypothecation & pledge? Ans. Pledgee may retain the goods until the payment of debt or performance of the promise is fulfilled. Hypothecation is an equitable charge where the borrower keeps the possession of the security on behalf of the creditor.Z > 2.55 per cent. All new loans and old loans that come for renewal are expected to be priced with reference to the base rate.80 -“Distress” Zone 75. If the borrower fails to return the advance against the hypothecation of the securities. the bank can take the possession of the securities with the consent of the borrower and becomes a pledgee. public sector banks and banks with high proportion of low-cost deposits may be less affected as they have low cost of funds (an important input in determining the base . as the banks are given free hand on deciding the base rate.99 -“Safe” Zone 1. the Reserve Bank of India has stipulated banks to migrate to base rate system for determining lending rates from the current benchmark prime lending rate (BPLR) system from April 1. the rate at which banks lend to prime borrowers. What is Benchmark Prime Lending Rate ? Ans. The move to discontinue BPLR came in the light of predatory pricing done by banks to gain market share (especially the teaser loans to housing sector).99 -“Grey” Zone Z < 1. the share of sub-BPLR lending to total loans stood at 70. In the banking space. As of September 2009. clearly suggesting that the PLR rate is no longer relevant as a reference rate. which is higher than the current home loan rates of 8 per cent. Pledge is bailment or delivery of goods as security for payment of a debt or performance of a promise. was earlier formulated to be the base rate. the bank can take the possession of the securities. 78. While the implications of this move are uncertain.BPLR.8 < Z < 2. he move is expected to reduce the proportion of sub-PLR loans.4 per cent.: In a move to increase transparency in credit pricing. Pledgee can sell the goods by giving a due notice to pledger in case pledger fails to make the payment of debt.

During the inflationary time. An adjustable-rate mortgage loan in which the borrower pays a very low initial interest rate. This leaves borrowers with increased monthly payments. most will not qualify for standard mortgages. This method of loaning is considered risky. Teaser loans are considered an aspect of sub prime lending. 80. RBI buys the securities from commercial banks to enhance the liquidity in the market. Often RBI buys and sells their securities to Commercial bank in their own initiative. claiming that borrowers should be able to refinance before the increases occur. What is an Open Market Operation ? Ans. Teaser loans try to entice borrowers by offering an artificially low rate and small down payments. Unfortunately. which increases after a few years. as default rates are high. In recession time. What is teaser Rate ? Ans.79. which many cannot afford. as they are usually offered to low-income home buyers. RBI sells their securities to Commercial banks as a result credit creating capacity of the commercial banks go down. . when these borrowers try to refinance the loan before the rate increases.

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