Pillai Institute of Management Studies and Research Course Syllabus & Study Notes

PILLAI INSTITUTE OF
MANAGEMENT
STUDIES AND
RESEARCH
Course Syllabus
&
Study Notes
1
MMS
Finance
Semester III
FINANCIAL MARKETS
AND INSTITUTIONS
Prof. D. C. Pai
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Syllabus
UNIT 1
INTRODUCTION TO FINANCIAL MARKETS
 MONEY MARKETS
 CAPITAL MARKETS
 ADVANTAGES OF FINANCIAL MARKETS TO INVESTORS/CORPORATES
UNIT 2
DETERMINANTS OF INTEREST RATE
 REAL AND NOMINAL INTERST RATES

 THEORY OF TERM STRUCTURE OF INTEREST RATES
 MONETORY POLICY AND THE ROLE PLAYED BY THE CENTRAL BANK
 MONEY SUPPLY AND DEMAND
 MEASURES OF MONEY SUPPLY (M1/M3)
 INFLUENCE OF INTEREST RATES IN OTHER ECONOMICS OF DOMESTIC INTEREST RATES
UNIT 3
MONEY MARKETS
 WHY MONEY MARKETS ARE NEEDED

 VARIOUS MONEY MARKET INSTRUMENTS
 HOW THE MONETORY POLICY OF THE CENTRAL BANK GETS PERCOLATED IN THE ECONOMY
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UNIT 4
FOREIGN EXCHANGE MARKETS
 PURPOSE SERVED BY THE MARKET

 SPOT RATE/FORWARD RATE – FOREIGN EXCHANGE MATHEMATICS
 FLOATING / FIXED RATES – ADVANTEGES/DISADVANTAGES
 DETERMINANTS OF CURRENCY MOVEMENTS OR EXCHANGE RATE
UNIT 5
DERIVATIVES AND RISK MANAGEMENT
 UNDERASTANDING BASIC PURPOSE OF DERIVATIVES

 RISK MANGEMANT / SPECULATIONS
 BASIC FEATURES OF FUTURES AND OPTIONS
 DIFFERENCE BETWEEN FORWARD AND FUTURE MARKET
 INTRODUCTION TO ARBITRAGE AND RISK NEUTRAL VALUATION
UNIT 6
COMMERCIAL BANKS
 UNDERSTANDING THE BALANCE SHEET

 CAPITAL ADEQUACY RATIO
 UNDERSTANDING VARIOUS RISKS FIXED BY BANKS
 HOW BANKS MANAGE THESE RISKS
 UNDERSTANDING THE PROFITABILITY DRIVERS OF THE BANKS
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UNIT 7
INVESTMENT BANKING
 ROLE OF MERCHANT BANKERS

 CAPTIAL STRUCTURING
 BUY BACK AND ITS RATIONALE
 IPO/RIGHTS ISSUE PROCESS
 ADR/GDR ISSUE
 IMPORTANT SEBI REGULATION
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UNIT 1
INTRODUCTION TO FINANCIAL MARKETS
Learning objectives:
After studying this unit, you should be able to:
 AN OVERVIEW ABOUT THE FINANCIAL SYSTEM

 ITS ROLE AND CONTITUENTS OF THE SYSTEM
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FINANCIAL SYSTEM
A financial system means the structure that is available in an economy to mobilize the capital from
various surplus sectors of the economy and allocate and distribute the same to the various needy
sectors. The transformation of ‘Savings’ into ‘Investments and Consumption’ is facilitated by the active
role played by the financial system. The process of transformation is aided by various types of financial
assets suiting the individual needs and demands of both the ‘investors’ and ‘spenders’. The offering of
these diverse types of financial assets is supported by the role of ‘financial intermediaries’ who
invariably intermediate between these two segments of investors and spenders. Examples of
intermediaries are banks, financial institutions, mutual funds, etc. The place where these activities take
place could be taken to connote the financial market.
Figure1 represents the various segments of the financial market.
The financial system comprises a mixture of intermediaries, markets and instruments that are related to
each other. It provides a system by which savings are transformed into investments. To simplify, the
overall financial system can be presented diagrammatically as shown in Figure 2.
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Roles and Functions in Brief of the Central Banking Authority
The Central Banking Authority (Reserve Bank of India) has two distinct roles; Monetary control including
controlling inflation and bank supervision. All major central banks other countries to look after these
two functions and carry the charge of ensuring that the overall financial health of banks is not impaired
This is ensured through off-site and on-site surveillance of banks. Monetary control is exercised through
Cash Reserve Ratio and Statutory Liquidity Ratio mechanism and Bank and Repo rates — main
instruments available to Central Banks to control Prime rates of leading banks. Central Banks do act as
lenders of last resort to banking system and are responsible for ensuring an efficient payment and
settlement system.
1. Monetary Control 1. Equity market and debt 1. Regulatory framework

2. Supervision over market supervision and including rules and
 Commercial control regulations for running
banks 2. Supervision over insurance business.
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3. Management of govt. institutional brokers including
debt investors (FII) agencies both
4. Banker to government  Custodians individuals and banks
5. Lender of last resort to  Depositories Pensions
banks  Mutual Funds 1. Framing rules for
6. Regulating money  Listed companies pension funds
markets through  Service providers 2. Regulating all pension
monetary instruments to capital markets funds
(CRR, SLR, Bank Rate, like registers
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REPO Rate)
FIGURE 2: Financial System — A Schematic Presentation
This schematic diagram illustrates the various constituents in a financial system and the broad
categories in which they can be categorized on the basis of activities that they perform.
Commercial Banks
Commercial banks include public sector banks, foreign banks, and private sector banks. Acceptance of
from the public for the purpose of lending or investment is the main area of activity.
Non-Banking Financial Companies (NBFCS)
NBFC’s are allowed to raise monies as deposits from the public and lend monies through various
Instruments including leasing hire purchase and bill discounting etc. These are licensed and supervised
by Central Banking Authority. Central Bank prescribes that no NBFC can operate without a valid license
from the Central Banking Authority.
Primary Dealers (PDs)
Primary- dealers also known as PDs, deal in government securities and deal in both the primary and
secondary markets, their basic responsibility is to provide markets for government securities and
strengthen the government securities market.
Financial Institutions (FIs)
FI’s are development financial institutions which provide long-term funds for industry and agriculture.
All these institutions are under off-site and on-site surveillance of the Central Banking Authority. FIs
raise their resources through long-term bonds from the financial system and borrowings from
international financial institutions.
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Cooperative Banks
These are allowed to raise deposits and give advances from and to the public. Urban Cooperative Banks
are controlled by State governments and RBI, while other cooperative banks are controlled by National
Bank for Agriculture and Rural Development (NABARD) and State Governments. Except for certain
exemptions in paying a higher interest on deposits, the Urban Cooperative Banks regulatory framework
is similar to the other banks.
Payment and Settlement System
An efficient and effective Payment and Settlement System is a necessary condition for a well running
Financial System. Maintenance of clearing houses at various centres, creation of currency holding chests
in different geographical areas and creation of the mechanism for electronic transfer of funds are vital
activities undertaken by the Central Banks.
Management of Government Debt
Most of the Central Banks manage the issue and servicing of government debt. This involves price
discovery, volumes to be raised, tenure of debt and matching it with the overall cash management of
the debts.
Bankers to Government
Most of the Central Banks maintain an account, Government deposit and carry out their cash
management through the issue of Bonds and Treasury Bills.
Lender of Last Resort to Banks
The Central Bank provides liquidity support on a temporary basis through the facility of repurchase
(REPO) of securities to banks to meet their short-term liquidity requirements.
Cash Reserve Ratio (CRR)
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Cash Reserve Ratio (CRR) is the mandatory deposit to be held by Banks with the requisite monetary
authority. It is a percentage of their Demand and Time liabilities. The increase or decrease can be
affected by the Central Bank to pump in or soak liquidity in the banking system.
Statutory Liquidity Ratio (SLR)
Statutory Liquidity Ratio (SLR) is the prescribed percentage of Demand and Time liabilities of a bank to
be held in prescribed securities, mostly government securities. The increase or decrease in the CRR &
SLR, contracts and enhances credit creation.
EQUITY AND DEBT MARKET
Marketability of corporate securities, i.e. bonds, debentures, and convertible debentures, enables
corporate to raise debt, while debenture holders enjoy very high liquidity. All securities quoted on stock
exchanges and freely bought and sold on these exchanges can be issued only after obtaining approval of
the capital market regulator viz., SEBI.
Stock Exchanges
A stock exchange is duly approved by the regulators to provide sale and purchase of securities on behalf
of investors. The stock exchanges provide clearing house facilities for netting of payments and securities
delivery. Clearing houses guarantee all payments and deliveries. Securities include equities, debt and
derivatives.
Brokers
Only brokers approved by the capital market regulator can operate on the stock exchange. Brokers
perform the job of intermediating between buyers and sellers of securities. They help build-up an order
book, carry out price discovery and are responsible for brokers’ contracts being honored. The services
are subject to brokerage.
Equity and Debt Raisers
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Companies wishing to raise equity or debt through stock exchanges have to approach a capital market
regulator with the prescribed applications and a Proforma prospectus for permission to raise equity and
debt and to get them listed on a stock exchange.
Investment Bankers (Merchant Bankers)
Merchant banks undertake a number of activities such as undertaking the issue of stocks, fund raising
and management. They also provide advisory services and counsel on mergers and acquisitions etc. They
are licensed by the capital market regulators.
Foreign Institutional Investors (FIIs)
FIIs are foreign-based funds authorized by the Capital Market Regulator to invest in the Indian equity
and debt market through stock exchanges.
Depositories
Depositories hold securities in demat form (as opposed to physical form), maintain accounts of
depository participants who, in turn, maintain sub-accounts of their customers. On instructions of the
stock exchange clearing house, supported by documentation, a depository transfers securities from the
buyers to seller’s accounts in electronic form.
Mutual Funds
A mutual fund is a form of Collective Investment that pools money from investors and invests in
Stocks, Debt and other Securities. It is a less risky investment option for an individual investor. Mutual
funds require the regulators’ approval to start an asset management company (the fund) and each
scheme has to be approved by the regulator before it is launched.
Registrars
Registrars maintain a register of share and debenture holders and process share and debenture
allocation, when issues are subscribed. Registrars too need regulators approval to do business.
INSURANCE REGULATORY AND DEVELOPMENT AUTHORITY (IRDA)
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Regulator for Insurance business, both general and life assurance. Regulates all aspects of insurance
business, including licensing of insurance companies, framing regulations about the conduct of business
and supervising all insurance activities in the country etc.
SUM UP
The financial system comprises a mixture of intermediaries, markets and instruments that are related to
each other. It provides a system by which savings are transformed into investments. The RBI (Reserve
Bank of India), being the Central Banking Authority, exercises monetary control and supervises the
banking institutions. Different institutions such as Cormnercial Banks, Non-Banking Finance Companies,
Mutual Funds, Insurance companies, primary dealers, brokers, depositories and insurance agents, also
different markets such as the capital market and the money market are part of the financial system. The
three regulatory authorities viz., RBI, SEBI and IRDA are controlling and supervising the banking, capital
market and insurance sectors respectively.
UNIT 2
DETERMINANTS OF INTEREST RATE
 REAL AND NOMINAL INTERST RATES

 THEORY OF TERM STRUCTURE OF INTEREST RATES
 MONETORY POLICY AND THE ROLE PLAYED BY THE CENTRAL BANK
 MONEY SUPPLY AND DEMAND
 MEASURES OF MONEY SUPPLY (M1/M3)
 INFLUENCE OF INTEREST RATES IN OTHER ECONOMICS OF DOMESTIC INTEREST RATES
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INTEREST RATES
This is defined as the cost of money, which is determined by the demand and supply of money. Demand
is generally related to industries and investment and supply pertain to savings (household, private
sector, and public sector). As in growth, there are two aspects of interest rates that are to be analyzed—
nominal interest rates and real interest rates. The latter is obtained by subtracting the expected inflation
from the nominal interest rate, which is the benefit of real saving that the investor gets for his savings.
Interest rates play a role in deciding the level of investment activity in a country. The nominal interest
rate is the contractual rate of interest when a business firm/individual borrows money from a bank or
financial institution. The real interest rate signifies the inflation adjusted interest rate (Real interest rate
= Nominal interest rate — inflation). Because Indian firms are made to compete with global players as a
part of our globalization strategy, the interest rates in India have declined during the last 3—7 years
(2002—2008) with the government implementing economic reforms in the banking industry. Recently,
there has been an upward shift in the rates in line with the global trends.
Real v/s Nominal Interest Rate
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A high nominal and real interest rate adversely affects the investment pattern as the cost of money and
of doing business is high. This is beneficial to the saver only as long as the expected inflation is kept low,
this act as a deterrent to investments. A high nominal interest rate and a low real interest rate (i.e. when
the expected inflation is high) however is a deterrent to both investments and savings, as both get the
worst of the world. A low nominal and real interest rate implies that there is no demand for money and
that the saver also does not benefit much by saving. This is a typical situation in times of recession. A
low nominal and a high real interest rate implies that there is less demand for money (due to the low
nominal interest rate), but that the saver gets relatively more as the expected inflation is also low. High
or low nominal interest rates need to be also seen in the light of expected growth rate, as the interest
rate signifies the cost of growth.
IMPLICATIONS OF REAL INTEREST RATES TURNING NEGATIVE
What is a negative real interest rate?
The real interest rate is the effective rate after adjusting for inflation and is considered a true measure of
the cost of funds for the borrower or the return to the lender. It is calculated approximately by
subtracting the rate of inflation from the nominal interest rate. When inflation is higher than the
interest rate, the real interest rate becomes negative. If the one year interest rate is 8% and average
inflation over this period is 10% then the real interest rate is negative 2%.
Implications of a negative real interest rate
Savers or lenders are losers in a negative real interest rate situation. Take the same example of bank
deposit rate for one year of 8% and the average rate of inflation over this period 10%. At the end of one
year, you are left with Rs 108. But what Rs 100 could purchase a year ago will now take Rs 110 to
purchase, so your interest earning has failed to protect your saving, because it earned a negative rate of
interest, the nominal rate of 8% was lower than the rate of inflation of 10%. However, the borrowers
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benefit in a negative real interest rate regime. The money used to repay loan will have lesser value than
the original amount borrowed because of the high inflation. In this case, the borrower should have been
paying back more than Rs 110 to give him a real return of money but he only paid Rs 108. This is how
the idea of inflating debt away has come.
What is the situation in India?
The widely followed measure of inflation in India, the wholesale price index, was 10.55% for June and is
expected to climb further. The rate of interest on a ten year benchmark government paper is about 8%.
This implies that the difference between the long-term interest rate and inflation is about 2.5
percentage point, or a negative real interest rate of that much.
Is the negative real interest rate a concern?
The real interest rates need to be seen over a longer period. The rate of inflation has been high in India
in recent months, causing the real rate of interest to be negative. However, over a longer period the
average inflation is likely to be much lower, even if we went by the wholesale price index. If the GDP
deflator, a more comprehensive measure of inflation, was considered the inflation for the year would be
lot less, which will give a positive real rate of interest.
MONETARY INDICATORS
MEASUSRES OF MONEY SUPPLY M1/M3
There are different measures of money supply, which are defined as M 1, M2, M3, and M4. Of these, in
India, M3 is widely used for indicating the true form of money supply. Figure indicate growth rate in
money supply M3.
The four money supply measures can be defined as follows:
M1 =Currency with public + demand deposits +other deposits with RBI
M2 = M1 + Post Office Savings Bank Deposits
M3 =M1 + Time deposits with banks
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M4 = M3 + Total post office deposits
(Total Post Office Deposits include 15-year PPF, 6-year NSC, SB Account, 6-year Post Office Monthly
Income Scheme, 5-year recurring deposit, NSS Account 1992, Kisan Vikas Patra, Time Deposit)
Growth Rate of M3
Domestic currency is issued by the central bank to fund investment activities. A higher than required
money supply may lead to inflation as more money chases fewer goods. The money issued by the
central bank is known as reserve money or high powered money. The banking system, through lending
and re-lending (referred to as the money multiplier factor), multiplies rue reserve money, and we
therefore have
Money Supply = (Real GDP x Income elasticity of money) + (Inflation x price elasticity of money)
Income elasticity of money is a measure of the change in the income per unit change of money, and the
price elasticity of money is a measure of the change in the price per unit change of money. Money
multiplier may be defined as the amount of money issued by the central bank multiplied by the
economy. The higher the multiplier, the higher is the flow of money into the economy. The banking
sector is the credit delivery channel into the investment needs of the economy, and it primarily receives
the money from the central bank and depositors. It lends money to the real economy investment needs.
In the interim, it also invests money for a short term. The growing credit to deposit (CD) ratio of the
banks indicates the requirement of funds by the economy.
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Monetary policy and role played by central bank
The RBI controls the money supply, volume of bank credit and also cost of bank credit (via the Bank
Rate) and there by the overall money supply in the economy. Money supply change is a technique of
controlling inflationary or deflationary situations in the economy. The RBI issues monetary policy for the
country as the Ministry of Finance issues fiscal policy and the Ministry of Commerce issues the EXIM
policy of the country from time to time. All these policies are among the important macroeconomic
policies that influence various businesses in the country. RBI issues monetary and credit policies
annually.
TOOLS OF MONETARY CONTROL
RBI uses its monetary policy for controlling inflationary or deflationary situations in the economy by
using one or more of the following tools of money control. These are discussed below.
Cash Reserve Ratio (CRR)
It refers to the cash that all banks (scheduled and non scheduled) are required to maintain with RBI as a
certain percentage of their demand and time liabilities DTL). As you know, demand liabilities of a bank
represents its deposits which are payable on demand of the depositors (viz., current and savings
deposits) and time liabilities refer to its time deposits which are repayable on the specified maturities. In
order to meet these liabilities in time (i.e. to keep liquidity) a bank has to keep a regulatory cash reserve
with the RBI (currently, it is 6.5 per cent for scheduled commercial banks). If a bank fails to maintain the
prescribed CRR at prescribed intervals, it has to penal interest on the shortfall by adjustment from the
interest receivable on the balances with RBI. A cut in the CRR enhances loanable funds with banks and
reduces their dependence on the call and turn money market. This will bring down the call rates and
increase in CRR will squeeze the liquidity in banking system and reduces their lending operations and the
call rate will tend to increase.
Statutory Liquidity Ratio (SLR)
It refers to the supplementary liquid reserve requirements of banks, in addition to CRR. SLR is
maintained by all banks (scheduled and non-scheduled) in the form of cash in hand (exclusive of
minimum CRR)current account balances with SBI and other public sector commercial banks,
unencumbered approved securities and gold. RBI can prescribe SLR from 0 per cent to 40 per cent of
bank’s DTL (presently it is 25 per cent). SLR has three objectives:
 To restrict expansion of banks’ credit,

 To increase banks’ investment in approved securities and
 To ensure solvency of banks.
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The effect of an increase in SLR by RBI is the reduction in the lending capacity of banks by preempting a
certain portion of their DTL for government or other approved securities. It has therefore a deflationary
impact on the economy, not only by reducing the supply of loanable funds of banks, but also by
increasing the lending rates in the face of an increasing demand for bank credit. The reverse
phenomenon happens in case of a cut in SLR.
Bank Rate
Bank Rate is the standard rate at which RBI is prepared to buy or rediscount bills of exchange or other
eligible commercial paper from banks. It is the basic cost of rediscounting and refinance facilities from
RBI. The Bank Rate is therefore used by RBI to affect the cost and availability of refinance and to change
the loanable resources of banks and other financial institutions. Change in the Bank Rate by RBI affects
the interest rates on loans and deposits in the banking system across the board in the same direction, if
not to the same extent. After deregulation and bank reforms since 1991, RBI has gradually and lending
rates and these are left to banks to decide through their boards, with only a few exceptions. However,
RBI can still affect the interest rates via changes in its Bank Rate, whenever the situation of the economy
warrants it.
Open Market Operations (OMOs)
This refers to sale or purchase of government securities (of Central or State governments or both) by RBI
in the open market with a view to increase or decrease the liquidity in the banking system and thereby
affect the loanable funds with banks. RBI can also alter the interest rate structure through its pricing
policy for open market sale/purchase.
Selective Credit Control (SCC)
The RBI issues directives, under Sections 21 and 35A of the Banking Regulation Act, stipulating certain
restrictions on bank advances against specified sensitive commodities as follows:
Pulses, other food grains (viz., coarse grains), oilseeds, oils including vanaspati, all imported oil seeds
and oils, sugar including imported sugar (excepting buffer stocks and unreleased stock of sugar with-
sugar mills), gur and Khandsari, Cotton and Kapas, Paddy/Rice and Wheat.
RBI’s objective in issuing Selective Credit Control (SCC) directives is to prevent speculative holding of
essential commodities and the resultant rise in their prices. RBI’s general guidelines on SCC are:
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1. Banks’ should not allow customers dealing in SCC commodities any credit facilities (including
against book debts/receivables or even collateral securities like insurance policies, shares, stocks
and real estate) that would directly or indirectly defeat the purpose of the SCC directives.
2. Credit limits against each commodity covered by SCC directives should be segregated and the
SCC restrictions be applied to each of such segregated limits.
Presently, only buffer stocks of sugar, unreleased stocks of sugar with sugar mills representing free sale
sugar and levy sugar are covered SCC directives.
UNIT 3
MONEY MARKETS
 WHY MONEY MARKETS ARE NEEDED

 VARIOUS MONEY MARKET INSTRUMENTS
o CALL MONEY
o RBI LAF – REPOS & REVERSE REPOS
o CBLO
o T – BILLS – MARKET STABILIZATION SCHEME
o COMMERCIAL PAPER (CP)
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o CERTIFICATE OF DEPOSITS
MONEY MARKET INSTRUMENTS
The term money market refers to the market for short-term requirement and deployment of funds
Instruments which have maturity period of less than one year are known as money market instruments.
The most active transactions of the money market are the market for overnight and term money
between banks and institutions (known as call money) and the market for Repo transactions. The former
deals with loans, whereas the latter with sale and buy-back agreements—both are obviously not traded.
Money market instruments have the following features:

1. Are completely unsecured
2. Have high liquidity and tradability
3. Can be transferred by endorsement and delivery, without any stamp duty or any other transfer
fee levied
4. Has no tax deduction at source from the interest component
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Call /Notice Market
Borrowing
Commercial Banks are allowed to invest in call markets based on an average fortnightly borrowing of
<100% of capital funds. Cooperative Banks’ call market limit is a daily borrowing of <2% of aggregate
deposits of the previous financial year. Primary Dealers are allowed to invest an average fortnightly
borrowing of <200% of net owned funds.
Lending
Commercial Banks have an average fortnightly lending of <25% of capital funds, and for Cooperative
Banks, there is no limit on lending. Primary dealers invest up to an average fortnightly borrowing of
<25% of net owned funds. Financial Institutions, Insurance Companies, and Mutual Funds are not
allowed to lend in call money markets.
Reserve Bank of India Liquidity Adjustment Facility (RBI LAF)
The Repo the Reverse repo is the two instruments used by the RBI as a part of the Liquidity Adjustment
Facility (LAF). On a daily basis, although the RBI borrows at a reverse Repo rate from the market. It lends
only at the Repo rate. Only Commercial Banks, Primary Dealers (PDs), and Financial Institutions can
participate in the RBI LAF.
Repos and Reverse Repos
A repurchase agreement (Repo) is an agreement between a seller and a buyer, and is usually associated
with debt securities, by which the seller irrevocably undertakes to repurchase the securities, and the
buyer sells them back at an agreed price on a specified date.
Thus, a Repo consists of a temporary sale of debt, involving full transfer of ownership of the securities,
that is. The assignment of voting and financial rights.
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In recent years, the RBI has been taking steps to activate Repo markets, Repo/reverse Repo transactions
among select institutions in all Central Government dated securities besides Treasury Bills (TBs) of all
maturities.
Non-bank entities, which hold an SGL with the RBI, are also allowed to enter reverse Repo (but not into
Repo) transactions with banks, primary dealers in T-bills of all maturities, and all Central Government
dated securities. With effect from June 26,. 2004, a non- bank participant’s limit on lending has been
reduced from 60% to 45%.
During the last decade, the use of the Repos as a money market instrument in developed markets has
undergone a tremendous change. The Repo is recognized as a very useful money market instrument in
enabling the smooth adjustment of short-term liquidity among varied categories of market participants
such as banks, Financial Institutions and securities, and investment firms. In all advanced financial
markets, the Repo is the most versatile and popular instrument, and Repo market transactions form a
part of security transactions. The Repo instrument is much safer compared with the pure
call/notice/term money and inter-corporate deposit markets which are non-collateralized as they are
backed up by securities and are fully collateralized. Thus, risks for the counterparty are minimal.
Globally, central banks have been using the Repo as a very powerful and flexible instrument for
absorbing or injecting short-term liquidity. As the Repo is a market-based instrument, it can be utilized
by central banks as an indirect instrument for monetary control, particularly in India, which is a
liberalizing financial market.
Concept and Mechanism
The Repo is a money market instrument, which enables collateralized short-term borrowing and lending
through sale/purchase operations of debt instruments. In a Repo transaction, a holder of securities sells
Repos to an investor with an agreement to repurchase them at predetermined, date and rate. For a
Repo, the forward clean price of the bonds is set in advance at a level which is different from the spot
clean price, which is obtained by adjusting the difference between the Repo interest and the coupon
earned on the security.
In the money market, this transaction amounts to collateralized lending as the terms of the transaction
are structured to compensate for the funds lent, and the cost of the transaction is equal to the Repo
rate. In other words, the inflow of cash from the transaction can be used to meet temporary liquidity
requirements in the short-term money market at a comparable cost.
The Repo rate refers to the annualized interest rate for the funds transferred by the lender to the
borrower. Because Repo transactions are collateralized and the credit worthiness of the issuer of the
security is often higher than that of the seller, the rate at which it is generally possible to borrow
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through a Repo is lower than that offered on an unsecured (or clean) inter-bank loan. Other factors
affecting the Repo rate include the credit worthiness of the borrower, liquidity of the collateralized
transactions, and comparable rates of other money market instruments.
A reverse Repo is the mirror image of a Repo in that in the former, securities are acquired with a
simultaneous commitment to re-sell.
Hence, whether a transaction is a repo or a reverse Repo is determined only based on who initiated the
first leg of the transaction. When the reverse repurchase transaction matures, the counterparty returns
the security to the entity concerned and receives its cash along with a profit spread. One factor which
encourages an organization to enter reverse Repo transactions is that it earns some extra income on its
otherwise idle cash.
A Repo is also sometimes known as a ready forward transaction, as it is a means of funding by selling a
security held on a spot (ready) basis and repurchasing the same on a forward basis.
A double ready forward transaction is said to take place when an entity sells a security to another entity
on a Repo basis and simultaneously purchases some other security from the same entity on a resell
basis.
Collateralized Borrowing and Lending Obligation (CBLO)
The borrower is under an obligation to return the money that he had borrowed, at a specified future
date, and the lender has the authority to receive the money lent, at a specified future date, with an
option/privilege to transfer the authority to another person for the value received. As an underlying
charge on securities is held in custody (with the Clearing Corporation of India Ltd) for the amount
borrowed/lent, it functions as an exchange traded Repo.
TREASURY BILLS (T-BILLs)
These are issued by the RBI on behalf of the Government of India, and are thus actually a class of
Government Securities.
Currently, T-Bills are issued for the following maturity periods:
 91 days
 182 days
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 364 days
The Market Stabilization Scheme MSS had been introduced on April 1, 2004 under an MOU between the
Government of India and the RBI. Treasury bills and dated securities of the central Government are
issued as an instrument of sterilization. The tenure, timing of issuances along with the amount will be
notified by the RBI as a calendar of issuances.
The RBI holds auctions for 364-day T-Bills on a fortnightly basis, whereas for 91 day T-Bills, it holds
auctions on a weekly basis. There is a notified value of bills available for the auction for 91-day T-Bills,
which is announced 2 days before the auction. There is no specified amount for the auction pertaining
to 364-day T-Bills. Thus, at any given point of time, it is possible to buy T-Bills to tailor one’s investment
requirements.
At specified times, potential investors have to put in competitive bids on a price/interest rate basis. The
auction is conducted on the same lines as French auctions, which are all bidders above the cut-off at the
interest rate/price which they bid while the bidders at the clearing/cut off price/rate get pro-rata
allotment at the cut off price/rate. The cut-off is determined by the RBl depending on the amount being
auctioned, the bidding pattern, etc. By and large, the cut-off is market determined, although sometimes
the RBI uses its discretion and decides on a cut-off level, which results in a partially successful auction,
with the balance amount devolving on it. This is done by the RBI to ensure that there is no undue
volatility in the interest rates.
Non-competitive bids are also allowed in auctions (only from specified entities such as State
Governments and their undertakings and statutory bodies) where the bidder is allotted T-Bills at the
cutoff price.
CORPORATE DEBT
Commercial Paper (CP)
These are issued by corporate entities in denominations of Rs 2.5mn and usually have a maturity period
of 90 days. Although CPs can also be issued for maturity periods of 180 days and one year, the most
active market is for 90-day CPs.
The two key regulations that govern the issuance of CPs are that CPs have to be compulsorily rated by a
recognized credit rating agency and only those companies which have a short-term rating of at least P1
can issue CPs. Secondly, funds raised through CPs do not represent fresh borrowing for the corporate
issuer, but instead they merely substitute a part of the banking limits available to it. Hence, a company
issues CPs almost always to save on interest costs, that is it will issue CPs only at rates lower than the
rate at which it borrows money from its banking consortium.
Certificates of Deposit (CD)
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These are issued by banks in denominations of Rs 0.5mn, and have a maturity period ranging from 30
days to 3 years. Banks are allowed to issue CDs with a maturity period of less than one year, whereas
financial institutions are allowed to issue CDs with a maturity period of at least one year. Usually, this
refers to 366-day CDs. The market is most active for the one-year maturity bracket; whereas longer
dated securities are not much in demand. One of the main reasons for there being an active market for
CDs is that their issuance does not attract reserve requirements as they are obligations issued by a bank.
UNIT 4
FOREIGN EXCHANGE MARKETS
 PURPOSE SERVED BY THE MARKET

 SPOT RATE/FORWARD RATE – FOREIGN EXCHANGE MATHEMATICS
 FLOATING / FIXED RATES – ADVANTEGES/DISADVANTAGES
 DETERMINANTS OF CURRENCY MOVEMENTS OR EXCHANGE RATE
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PURPOSE SERVED BY THE MARKET
FOREIGN EXCHANGE TURNOVER
It is easy to say that the foreign exchange market is the world’s most important financial market. The
rapid increase in world trade and investment that we have witnessed in recent years means that the
exchange of different currencies has accelerated. According to the Bank for International Settlements’
(BIS) April 2004 “Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity,”
average daily international foreign exchange trading volume was almost US$1.9 trillion. That foreign
exchange trading survey collected national foreign exchange and derivatives market data from 52
central banks and monetary authorities around the world. BIS said in its report: that the growth in
turnover was driven by all types of counterparties, with trading between banks and financial customers
rising most strongly. The report noted that foreign exchange turnover among banks and their financial
customers rose because of the increase in activity of hedge funds and commodity traders, as well as
robust growth in trading by asset managers. This contrasts with the period between 1998 and 2001,
when activity in this market segment had been driven mainly by asset managers, while the role of hedge
27
funds had reportedly declined. Foreign exchange turnover grew strongly between 1989 and 2001, and
then took a dip in 2001, before surging again in 2004. The decline in 2001 was partly attributed to the
advent of the euro in 1999, which saw the end of trading in important currencies like the Deutsche mark
and the French franc. Another reason cited was rationalization in the global banking sector in the wake
of the Asian financial crisis in 1997 and the bursting of the dot.com bubble in early 2000.
In 2006, the average daily turnover on the New York Stock Exchange was estimated at about US$90
billion, while the trading volume in foreign exchange, at US$1.9 trillion per day, was more than 10 times
the average daily turnover of all the world’s other stock markets. Considering that the free- floating
currency system, which is at the center of foreign exchange trading, only began in the 1970s, the daily
trading figure is staggering. And trading volumes are growing robustly. It is estimated that the average
daily volume in global foreign exchange could soon reach as high as US$3 trillion.
SPECULATION IS THE KEY DRIVER
The most important component of daily trading volume is speculative activity—this usually relates to
global capital seeking the most profitable return in the shortest period of time. It is estimated that 95%
of foreign exchange transactions are speculative. More than 40% of trades last less than two days, while
about 80% of trades last less than one week. In December 2004, the BIS published a follow-up report to
its triennial survey of April, titled “Why has FX trading surged? Explaining the 2004 Triennial Survey.”
The report confirmed that the surge of activity between banks and financial customers could reflect the
broad search for yield that has characterized financial markets in recent years. It noted that, in this
search, currency market players worldwide have followed two key strategies—one is based on interest
rate differentials and the other on trends in exchange rates. The report said: “The first strategy exploited
the forward bias by investing in high-yielding currencies. A popular form of this investment strategy
among leverage players and real money managers was the so-called carry trade.” In a “carry trade,” an
investor borrows in a low interest rate currency and, with these funds, takes a long position (buys) in a
higher interest-rate currency betting that the exchange rate will not change so as to offset the interest
rate differential between the two currencies. “While U.S. dollar depreciated and the interest rate
differential persisted, such investment strategies were profitable and a likely factor contributing to
turnover growth,” it said. The second strategy involved “momentum trading,” where investors took
large positions in currencies aimed at exploiting long swing or runs in exchange rates such trades added
weight to the underlying trends in exchange rates between countries. “Following the April 2001 survey,
there was a strong pattern of U.S. dollar depreciation as the price of a dollar in different major
currencies fell steadily until early spring 2004. U.S. dollar depreciation ranged from about 15% against
the Canadian dollar and Japanese yen, to more than 30% against the Australian dollar.” Beyond the
position-taking related to profit opportunities associated with exchange rate trends, the report said such
runs may also be associated with growth in hedging-related turnover. “Multinational firms face greater
incentives to hedge in the face of long swings in currencies in order to minimize losses associated with
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currency positions. For instance, the European exporter invoicing in dollars in the midst of a long run of
dollar depreciation has an incentive to hedge against further depreciation,” it added.
FOREIGN EXCHANGE MARKET CHARACTERISTICS
In recent years, the three major foreign exchange markets have been London, New York, and Tokyo.
According to the 2004 BIS survey the U.K. and U.S. accounted for more than 50% of daily turnover, while
Japan accounted for slightly more than 8%. Singapore was also an important player with about 5% of the
average daily turnover (see Figure below).
Although we identify the countries where foreign exchange trading takes place, this trading is distinct
from equities market or commodities market insofar as foreign exchange markets have no fixed
locations.
Foreign exchange markets are actually decentralized over the counter markets that cut across borders.
They are also the least regulated of all financial markets. Here are some of the commonly cited
characteristics of the foreign exchange markets:
 24-Hour Market: The currency market doesn’t sleep during the working week and players can
enter or exit trading positions at any time. There is no opening bell as the global trading day
starts in Wellington, New Zealand, moves westward via Sydney, Tokyo, and Singapore, then
Moscow, Frankfurt, London, and finally New York and San Francisco, before starting a new
global day in Wellington again. Traders can, therefore, effectively choose when they want to
trade morning, noon, or night.
 Liquidity: The foreign exchange market has better depth and breadth than any other capital
market. Financial instruments like stocks and commodities are all subject to what is available in
an order book and investors may not get all they want in one go. A foreign exchange order has
the potential to be filled instantaneously at one rate and in a good size.
 Easy Entry: Anyone who wishes to trade in currencies can do so by using any of a number of
companies to set up online trading accounts that operate around the clock.
 Simple Trading Decisions: Only a few of the world’s currencies represent the bulk of the average
daily turnover. This is in contrast to thousands of stocks to choose from in the world’s stock
markets. As such, the decision to buy or sell can be reached more quickly.
 Neutral Conditions: Currencies trade in pairs and typically one side of every currency pair
constantly moves relative to the other side. When you buy a currency, you are simultaneously
29
selling the other currency in the pair. So, if some currencies go up, others have to go down.
There’s no structural bias and profits can be made as currencies go up or down.
 High Leverage Possible: Participants can typically leverage their positions to as much as 100
times the cash they put up. This means that the foreign exchange market trader need only
deposit US$1,000 for each US$100,000 position traded. This makes currency trading accessible
to a wider range of traders because the initial funds requirement is very low relative to the size
of the trading positions they hold. But the risks are commensurate—if a bet goes wrong, they
can lose by a correspondingly high amount.
 Low Transaction Costs: Transaction costs are normally lower in the foreign exchange market and
currencies are cheaper to trade than stocks. Foreign exchange trading is typically commission-
free and there is no exchange or clearing fees. Thus, bottom line visibility is clearer for traders,
making decisions about taking new trading positions, or what to do with existing ones, quicker
and more efficient.
 Tight Bid-Ask Spreads: Because of the high liquidity within the currency market, bid-ask spreads
are generally tighter when compared with bonds, equities or futures. The spread reflects
transaction costs in the foreign exchange market.
 Real-Time Quotes, Instant Execution: Players in the foreign exchange market can execute their
trades directly off real-time bid-ask quotes. This means that trades can be executed with much
more certainty than, for example, transactions that have to be executed on an exchange floor.
Against this backdrop, the dynamic nature of the foreign exchange market is an attractive proposition to
many investors. As is the case with any type of investment vehicle, there are risks and rewards in
currency trading. These risks and rewards are amplified in the foreign exchange market because it is
relatively unregulated. For instance, a stock exchange is a highly regulated environment, with tight rules
placed on buying and selling. This helps to keep the playing field fair for everyone and takes away, for
example, the opportunity for companies to manipulate stocks for their own ends. While the potential
for a skilled investor to realize significant profits in the foreign exchange market is large, good investors
will also familiarize themselves with potential downside risks, which can be magnified by margin trading.
REGULATION
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Each foreign exchange transaction comes with its own associated risks, including volatility, exchange
rate risk, credit risk, monetary risk, and interest rate risk, as well as the possibility of central bank
intervention. Because the foreign exchange market is largely unregulated on an international scale,
trading activity is generally subjected to lows and customs of each participants home nations.
FOREIGN EXCHANGE MARKETS – SUM UP.
Foreign exchange markets comprise individuals, business entities, banks, investors, users and
arbitrageurs, across the globe, who buy or sell currencies. It is a communication system-based market,
with no boundaries, and operates round the clock, within a country or between countries. lt is not
bound by any four-walled marketplace, which is a common feature for commodity markets, say
vegetable market, or fish market.
Forex markets are dynamic and round the clock market, due to different time zones in which various
countries are located. Geographically, forex markets extend from Tokyo and Sydney in the east, through
Hong Kong, Singapore, Bahrain, London and New York in the west.
If we view the markets as per GMT, when the London and other European markets start the day it is
almost lunch time for the Indian markets, and when the Indian markets are about to close, the New York
market is about to begin its day. While the New York market operates for sometime alongside the
London and European markets, the markets in the east, Tokyo, Hong Kong and Singapore are ready to
start, before New York closes. Thus the clock has turned around, with Indian and Middle East markets
ready to start the day, before close of Singapore and Hong Kong markets.
The world currency markets are a very large market, with a large number of participants. Major
participants of forex markets are:
 Central Banks — managing their reserves and using currency markets to smoothen out the value
of their home currency.
 Commercial Banks — offering exchange of currencies to their retail clients and hedging and
investing their own assets and liabilities as also on behalf of their clients, as also speculating on
the movements in the markets.
 Investment funds/banks — moving funds from one country to another using exchange markets
as a vehicle as also hedging their investments in various countries/currencies.
 Forex brokers — acting as middleman, between other participants, and at times taking positions
on their books.
 Corporations— moving funds between different countries and currencies for investment or
trade transactions.
 Individual — ordinary or high net worth individuals using markets for their investment, trade,
personal, and travel and tourism needs.
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As seen above, the participants not only use the forex markets for trade or travel purposes, but also for
investments, hedging and speculative purposes, thus generating large volumes for the market. It may be
surprising for some of the readers that the global forex market handles total turnover of approx. US
dollar 1.90 trillion per day. This is against daily world trade turnover of approx. US dollar 750 billion per
day, thereby meaning that more than 98% of the global forex trading relates to investments, or
speculative trading. The Indian markets, trade US dollar 1.20 billion per day, mostly because of
regulatory exchange control regime and restrictive flow of foreign currency. The forex markets are
highly dynamic, that on an average the exchange rates of major currencies (say GBP/USD) fluctuate
every four seconds, which effectively means it registers 21,600 changes in a day (15x60x24). Forex
markets are usually Monday to Friday markets globally, except for Middle East or other Islamic countries
which function on Saturday and Sunday with restrictions, to cater to the local needs. The bulk of the
forex markets are OTC (over the counter) markets, meaning that the trades are effected through
telephone or other electronic systems (dealing systems of various news agencies, banks, brokers or
Internet-based solutions).
Banks in London quite commonly deal with banks in Paris, Frankfurt, Mumbai and New York and even in
Tokyo or Singapore, which are totally in a different time zone. Large dealing rooms operate round the
clock, to be with all major markets across the globe. For a few traders, systems are provided in
bedrooms too, to enable them to trade in any time zone. Major banks, which act as market makers
always quote two way quotes, (buy and sell), and leave upon the caller to either buy or sell as per his
needs. This generates market depth and volumes. Thus characteristics of foreign exchange market can
be listed as under:
 A 24 hour market
 An over the counter market
 A global market with no barriers/no specific location supports large capital and trade flows
 Highly liquid markets
 High fluctuations in currency rates (every 4 seconds)
 Settlements affected by time zone factor
 Markets affected by governmental policies and controls
LEADING CURRENCIES
The four most important currencies in foreign exchange markets in terms of trading volume, are the US
dollar, the euro, the Japanese yen, and UK pound sterling (see Figure 5.4).
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The International Organization for Standardization (ISO) has assigned the following codes to the four
main currencies: USD, EUR, JPY, and GBP respectively. Generally, the currency code is composed of the
country’s two- character country code plus an extra character to denote the currency unit. After the
USD, EUR, JPY, and GBP, the next most heavily traded currencies in the world are the Swiss franc (CHF),
the Canadian dollar (CAD), the Australian dollar (AUD), and the New Zealand dollar (NZD).
As we have noted, currencies trade in pairs in the foreign exchange market. This involves simultaneous
buying one currency and selling another currency. The most important currency pairs are EUR/USD,
USD/JPY, GBP/USD, and USD/CHF. USD/CAD, AUD/USD, and NZD/USD are known as the “dollar Bloc”
currencies. These currency pairs are referred to as “majors,” which distinguish them as the most liquid
and widely traded currency pairs in the world. Trades involving majors are estimated to make up about
90% of all trading in foreign exchange markets. EUR/USD is the most actively traded pair, accounting for
almost 30% of global average daily turnover. The next two most important pairs in terms of daily
turnover are USD/JPY and GBP/USD.
Note that there is a system to the way that currency pairs are quoted. The first currency in the pair is
considered the base currency and the second currency is the quote currency or counter currency. For
example, the euro is the base currency and the U.S. dollar is the quote currency in the EUR/USD pair. Or
for USD/JPY, the U.S. dollar is the base currency while the Japanese yen is the quote currency. Most of
the time the US dollar acts as the base currency. Quotes are expressed in units of US$1 per quote
currency.
CURRENCY TRADING TRENDS
The BIS triennial survey of 2004 revealed some interesting global trends, in terms of currency and
geographical share of turnover, compared to the previous survey in 2001. As mentioned, the EUR/USD
was the most widely traded currency pair, averaging US$501 billion per day or 28% of total turnover
(see Figure below). However, the share of the EUR/USD was slightly down from 30% in 2001. This was
attributed to factors including an investors’ drive for diversification into a wider range of currencies, to
seek better returns on their investments, and greater demand for hedging in a wider range of currencies
by companies exposed to different foreign currencies. The second most actively traded currency pair
was the USD/JPY, with 17% of turnover or US$296 billion per day.
In terms of individual currencies, the U.S. dollar was the most heavily traded with 88.7% of average daily
turnover followed by the euro at 37.2% (see Figure below). Both were a tad below their shares from the
2001 survey, which were 90.3% and 37.6% respectively.
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The share of the yen was also down, from 22.7% to 20.3%, with the pound taking up some of the slack
with a 16.9% share of turnover, up from 13% in 2001. The Swiss franc maintained its position from 2001
at 6.1%, while the Australian dollar’s share rose to 5.5% from 4.2% in 2001. (Note, the total share
exceeds 100% due to double counting or more on currency pairs.)
CURRENCY AS AN ASSET CLASS
The surge in foreign exchange trading signifies a growing recognition that currencies are an asset class in
their own right. In “Why has FX Trading Surged?” Explaining the 2004 triennial survey, authors Gabriele
Galati and Michael Melvin noted the attractiveness of currencies, compared to bonds and stocks, in
inventors’ search for yield. They said that interest in currencies as an asset class was reinforced by
disappointing yields in stock and bond markets at different times. As returns on stocks and bonds
waned, investors found currency strategies to be quite profitable over the 2001 to 2004 period.
Following the 2001 survey, there was a long run of dollar depreciation that was actively exploited by
investors. It can be seen that, in general, at that time equity markets were falling well into 2003 before
beginning an upward run that lasted less than a year. Bond yields were low and fairly flat over the
period. So, the strong trend in the foreign exchange market offered an attractive alternative to stocks
and bonds.
Thus, the major attraction of currencies as an asset class is for portfolio diversification since their
movements are often uncorrelated to other asset classes.
Summary
Foreign exchange trading volumes are collated once every three years by the Bank for International
Settlements. Its triennial survey for 2004 showed the staggering extent of the foreign exchange trading
—then at $1.9 trillion a day—and by most accounts trading volumes have grown since then. Growth has
been driven by hedge funds, central banks and other investors, adding to the liquidity already provided
by commercial and investment banks. It should be stressed that the most important component of daily
trading volume is speculative activity – this usually relates to global capital seeking the most profitable
return in the shortest period of time. It is estimated that 95% of foreign exchange transactions are
speculative. In recent years, the three major foreign exchange markets have been London, New York
and Tokyo. According to the Bank for International Settlements’ triennial survey for 2004, the U.K. and
U.S. accounted for more than 50% of the daily turnover, while Japan accounted for slightly more than
8%. Singapore was also an important player with about 5% of the average daily turnover. The major
34
attractions of foreign exchange markets include: (1) high liquidity levels; (2) high accessibility for many
different types of participants; and (3) efficiency. The U.S. dollar, the euro, the U.K. pound and the
Japanese yen continue to be the four most important currencies in the world and account for the
dominant share of foreign exchange trading. There is also a notion that currencies have become an asset
class in themselves as investors search for yield around the globe.
SPOT RATE/FORWARD RATE – FOREIGN EXCHANGE

MATHEMATICS
FLOATING / FIXED RATES – ADVANTAGES/DISADVANTAGES
Types and Calculation
Due to vastness of the market, operating in different time zones, most of the Forex deals are done on
SPOT basis, meaning thereby that the delivery of the funds takes place of the second working day
following the date of deal/Contract. The rate at which such deals are done is known as SPOT rates. Spot
rates are the base rates for other FX rates. The date of delivery of funds on the date on which the
exchange of currencies actually takes place, is also referred to as ‘value date’. The delivery of FX deals
can be settled in one or more of the following ways:
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Ready or Cash
Settlement of funds on the same day (date of deal), e.g. if the date of Ready/Cash deal is 25 October
2009 (Monday), settlement date will also be 25 October 2009.
TOM
Settlement of funds takes place on the next working day of the date of deal, e.g. if the date of TOM deal
25 October 2009 (Monday), settlement date would be 26 October 2009 (provided it is a working day for
the markets dealing as I as where currency is to be settled.).
SPOT
Settlement of funds takes place on the second working day after/following the date of contract/deal,
e.g. if the date of Spot deal is 25 October 2009 (Monday), settlement date will be 27 October 2009.
(Presuming all markets are working on 25, 26 and 27 October 2004.).
Value Date
This is the term used to define the date on which a payment of funds or entry to an account becomes
actually effective and/or subjected to interest. In the case of payments on Telegraphic Transfers (TT) the
value date is usually the same in both centers, i.e. payment of the respective currency in each centre
takes place on the same day, so that no gain or loss of interest accrues to either party. Such payments
are said to be valuer compensee, or, simply, here and there. If there is time lag between receipt of funds
at one centre and payment of funds at another centre, compensation should be paid to party, which is
out of funds. Normal mode of compensation is interest, which should be recovered/paid separately. This
may be done by adjusting the value date if acceptable to both the parties. Thus, the date of settlement
of funds is known as value date.
Forward
Delivery of funds takes place on any day after Spot date, e.g. if the date of forward deal is 25 October
2009 (Monday), for value settlement date 25 November 2009, it is a forward deal.
Spot and Forward Rates
As explained earlier, in the Forex market all rates are quoted are generally ‘Spot Rates’. The spot rates
are for delivery of currency or exchange of the streams of currencies dealt in, on the second day from
the date of deal/transaction. Say USD/INR quoted as 1 USD = 45.50 INR, or GBP/USD quoted as
1GBP=1.80USD
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When the delivery of the currencies is to take place at a date beyond the Spot date, then it is a forward
transaction, and the rate applied is called forward rate.
Forward Margins—Premium and Discounts
Forward rates are derived from spot rates, and are function of the spot rates and forward premium or
discount of the currency, being quoted.
Forward rate = Spot rate + Premium - Discount.
If the forward value of the currency is higher than (costlier) the spot (present) value, then the currency is
said to be at a Premium, say, if the spot GBP against USD is being quoted at 1.8350, and 1 month
forward as 1.8450, then GBP is dearer, value one month forward, and a premium of 100 pips is being
charged for the same.
Similarly, if the forward value of a currency is cheaper than the present value (spot), the currency is said
to be at a Discount. In the above example, where the spot GBP is quoted as 1.8350, against USD, and 1
month forward as 1.8450 (10O pips), while the GBP is at a premium, the USD, the other currency is at a
discount against the GBP
Let us take another example. Indian rupee spot being quoted as 45.50/52, against USD i.e. one USD is
being bought at 45.50 and sold at Rs 45.52. Now if the six-month premium being quoted is 40/42 paise,
it means that the USD is being quoted dearer in forward, and is being quoted as 45.90/94. Here the USD
is at a premium, while the INR at a discount.
Thus, a correlation is clearly established as the quotes are for a pair of currencies, where one is
exchanged for another, (GBP/USD, USD/INR, USD /SGD, Euro/USD, USD/JPY, etc.).
The forward premium and discount are based on the interest rate differentials of the two currencies
involved, as also on the demand and supply of forwards in the market. The demand and supply depends
upon various factors, e.g. movement of capital in normal times (flight of capital), trade and balance of
payment and their financing, labour problems, political speculative activities, etc.
The interest factor is the basic factor in arriving at the forward rate. If the rate of interest, say in US, for
three months prime bank bills is 2% p.a. while similar paper in London can be purchased at a rate of
interest of 4% p.a. there will be a flow of funds from USA to London to take advantage of higher yield
shown by UK bills. (Assuming there are no exchange controls and free movement of capital is allowed.)
The US investor will have to buy GBP by surrendering his USD (owned or borrowed) in the spot market
and the, GBP so obtained by him would be invested in the UK bills. This will lead to a demand for GBP in
the spot market. At the maturity of pound bills, the pounds received would be reconverted back to US
dollars. This will lead to a demand for US dollars in the forward.
37
This gain or sacrifice will be adjusted in the forward rate of currencies (as forward margin — premium or
discount), dealt in the foreign exchange market, to ensure a no-profit no-loss situation.
Therefore, the forward price of a currency against another can be worked out with the following factors:
1. Spot price of the currencies involved.

2. The interest rate differentials for the currencies.
3. The term, i.e. the future period for which the price is worked out.
It would be relevant to emphasize here that the forward rate so worked out is no indicator of the future
trend of the currency values.
Direct and Indirect Quotes
As given elsewhere, the price of the currency can be expressed either as one unit of home currency,
equal to so many units of foreign currency, or as one unit of foreign currency equal to so many units of
home currency.
Under direct quotes, the local currency is variable, say as in India, 1 USD = Rs 45.50. The rates are called
direct, as the rupee cost of foreign currency is known directly. These quotes are also called Home
currency or Price Quotations.
On the other hand under indirect method, the local currency remains fixed, while the number of units of
foreign currency varies. For example, Rs 100.00 = 2.10 USD.
It would be worthwhile to mention that globally a practice is being followed Where all currencies,
(except a few) are quoted as direct quotes, in terms of USD (1 USD = so many units of another currency).
Only in case of GBP (Great Britain Pound/British Pound), Euro, AUD Australian Dollars), and NZD (New
Zealand Dollars), the currencies are quoted as indirect rates, i.e. one GBP, Euro, AUD, or NZD = so many
units of USD.
Cross Rates
When, we deal in a market where rates for a particular currency pair are not directly available, the price
for the said currency pair is then obtained indirectly, with the help of cross rate mechanism. This can be
explained with the following example:
Suppose, we intend to get a quote for Euro/rupee and no one is prepared to quote Euro/Rs directly in
the market. We can work out a Euro/Rs quote through Euro/USD and USD/Rs quotes.
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Euro/USD quote would be available in the international markets and USD/RS would be available in the
domestic market. By crossing out USD in both the quotes, we can arrive at an effective Euro/Rs quote.
This is the basis for working out cross rates. Cross rate mechanism is possible solution for calculation of
rates for currency pairs which are not actively traded in the market.
For example, we need to quote GBP against INR, but in India, usually GBP is not quoted directly, as such
we need to take rates for USD/INR and GBP/ USD to compute GBP/INR rate.
if. USD/INR is 45.50/60, and GBP/USD is 1 .8340/50, then, to GBP/INR rate, we need to cross both the
given rates, which would give us GBP/INR rate as
83.2636/83.4925.
Chain Rule
It is used in attaining a comparison or ratio between two quantities which are linked together through
another or other quantities and consists of a series equations, commencing with a statement of the
problem in the form of a query and continuing the equation in the form of a chain so that each equation
must start in terms of the same quantity as that which concluded the previous equation.
Fixed vs. Floating Rates
The fixed exchange rate is official rate set by the monetary authorities for one or more currencies. It is
usually pegged to one or more currencies. While under floating exchange rate, the value of the currency
is decided by supply demand factors. In some cases, even fixed exchange rates are allowed to fluctuate
between definite upper and lower bands, as fixed by the monetary authority of the country.
Bid and Offered Rates
The buying rates and selling rates are also referred to as bid and offered rates. In a USD/INR quote, of
45.00/02, the quoting bank is bidding for USD at 45.00 and is offering to sell the USD at 45.02. On the
other hand, in a GBP/USD rate 1.8810/15, the quoting bank is willing to buy GBP at 1.8810 willing to sell
at 1.8815.
Exchange Arithmetic — Theoretical Overview
All foreign exchange calculations have to be worked out with extreme care and accuracy and also the
use of decimal point has to be correctly placed. Constant check is also required to minimize the risk of
39
mistake, as the markets work on very thin margins. An error in one quote may erode earnings from
several trades/transactions.
Per Cent and Per Mille
A percentage (%) is a proportion per hundred, e.g. 1% is one part in every hundred parts such as Rupee
1 per Rupees 100, while per mille means thousand, e.g. 1 per mille is one part in every thousand, such as
Rupee 1 per Rupees 1,000.
Percentage or per mille can also be used to advantage in checking roughly any calculations, such as
interest when allowed in a rate of exchange
Arbitrage in Exchange
Arbitrages consist in the simultaneous buying and selling of a commodity in two more markets to take
advantage of temporary discrepancies in prices. As applied to dealings in foreign exchange, arbitrage
consists of the purchase of one currency for another in one centre, accompanied by an almost
immediate resale against the same currency in another centre, or in operations conducted through
three or more centres and involving several currencies. A transaction conducted between two centres
only is known as simple or direct arbitrage. Where additional centres are involved, the operation is
known as compound or three (or more) point arbitrage. Such operations must be carried must be
carried out with the minimum of time delay if advantage is to be taken of temporary price differences,
and they require a high degree of technical skill. Speed in handling the deals would be the foremost
aspect in such deals, as markets usually tend to move towards such deals and the differences get wiped
out in no time.
Rates quoted to merchants, or for retail transactions are specified by the nature of transactions. By this,
the different rates could be applied for TT Bills transactions, Foreign Money or Cash transactions,
Travellers Checks transactions, or even personal checks buying. The rates would be different for buying
or selling transaction, levying different margins over the interbank rates, depending upon the nature of
transaction.
 Key learning:
o Authorized Dealers: banks / institutions authorized to deal in foreign exchange
o Value Date: The date of settlement of funds
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o Cross Rate: Price of a currency pair not directly quoted arrived from price of two other
currency pairs.
o Forward Contract: It is a binding contract for purchase / sale at a future date.
o Premium: A currency is said to be at a premium if it commands more units of another

currency at a future date.
o Discount: A currency is said to be at a discount if it commands less units of another

currency at future date.
o Premium / Discount: It represents interest rate differential in a forward contract
o Swap: It is an exchange of specific streams of payments over an agreed period of time.
o Fixed Exchange Rate: Official exchange rate fixed by the monetary authority
o Floating Exchange Rate: Market exchange rate decided by supply and demand factors
o Direct Exchange Rate: Exchange rate expressed in terms of home currency quotations.
o Indirect Exchange Rate: The exchange rate expressed in terms of foreign currency
quotations.
o Ready / Cash Rate: Value to be settled the same day – value today
o TOM Rate: Value to be settled tomorrow, next day.
o SPOT Rate: Value to be settled on the second working day from the date of transactions
o Forward Rate: Value to be settled beyond SPOT value
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DETERMINANTS OF CURRENCY MOVEMENTS OR EXCHANGE
RATE
FACTORS DETERMINING EXCHANGE RATES
The quotations in the Forex markets depend on the delivery type of the foreign currencies, i.e. exchange
of streams of the two currencies being exchanges. The spot rates, being the base quotes in the forex
markets, are more dynamic and are effected by varied reasons, a few of which are fundamental and
other technical. The main factors, which influence movement of exchange rates, can be summarized as
under:
a. Fundamental Reasons
These include all those causes or events, which effect the basic economic and fiscal policies of the
concerned government. The causes normally affect the long term exchange rates, while in the short-run,
many of these are found ineffective. In a long run, exchange rates of all currencies are linked to
fundamentals, as given under:
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 Balance of payment— generally a surplus leads to a stronger currency, while a deficit weakens a
currency.
 Economic growth rate — a high growth leads to a rise in imports and a fall in the value of
currency, and vice versa.
• Fiscal policy — an expansionary policy, e.g. lower taxes can lead to a higher economic growth.
• Monetary policy — the way, a central bank attempts to influence and control interest and
money supply.
• Interest rates — high domestic interest rates tend to attract overseas capital, thus the currency
appreciates in the short term. In the longer term, however high interest rates slow the economy
down, thus weakening the currency.
• Political issues — political stability is likely to lead the economic stability, and hence a steady
currency, while political instability would have the opposite effect.
b. Technical Reasons
Government controls can lead to an unrealistic value of a currency, resulting in violent exchange rates.
Freedom or restriction on capital movement, can affect exchange rates, to a larger extent. This is a
recent phenomenon, as seen in Indonesia, Korea, etc. Huge surpluses of petroleum exporting countries,
due to sudden spurt in petroleum prices, which could not be utilized in these countries, needs to be
invested in overseas centres, thus creating huge movement of capital to these countries and resultant
appreciation of the relative currency. Capital tends to move from lower yielding to higher yielding
currencies, and results, is movement in exchange rates
c. Speculation
Speculative forces can have a major effect on exchange rates. In an expectation, that a currency will be
devalued, the speculator will short sell the currency for buying it back at a later date at a cheaper rate.
This very act can lead to vast movements in the market, as the expectation for devaluation grows and
extends to other market participants.
Speculative deals provide depth and liquidity to the market and at times act as a cushion also, if the
views do not lead to a contagious effect.
CURRENCY MOVEMENT FACTORS
To date, there is no exchange rate model that can predict future currency prices with 100% accuracy. In
rapidly growing global foreign exchange markets, currency movements become harder to predict as
43
more participants enter the market on a daily basis, bringing with them all their research opinions,
emotions, and expectations about where currencies should be headed. Currency movements in the
short term can be influenced by publicly available information like the release of the country’s gross
domestic product data, the consumer price index, or employment data. The following publicly available
information can have immediate impact on currency movements:
• Local economic data releases and the anticipation of those releases.

• Economic data releases in foreign countries, especially of major trading partners, and the
anticipation of those releases.
• Central banks, such as the U.S. Federal Reserve or the European Central Bank, raising or
lowering interest rates.
• Central banks making public their thoughts on monetary policy.
• Expectation of central banks making public their views on local interest rates or monetary policy.
• Political developments, both globally and in individual countries.
• Natural disasters and perceptions about how they will impact economies.
• Changes in commodity prices, particularly oil and gold.
This list is not exhaustive, but these factors would be among the more important catalysts for currency
movements.
But there is also information that is not immediately publicly available, such as individual traders’ in-
house strategic analyses on currencies or buy and sell orders that come from customers, which can
affect the decision process of market participants. The activities of market participants such as central
banks, commercial banks, hedge funds, individual investors, and multinational corporations will be
influenced by a mixture of all these factors.
Central banks around the world such as the U.S. Federal Reserve, carry out actions called ”monetary
policy” to influence the availability and cost of money and credit. The do this to achieve certain national
economic goals such as lowering inflation or promoting growth. In 1913 the passage of the U.S. Federal
Reserve Act gave the monetary policy power to the Federal Reserve. There are three tools of monetary
policy that the Federal Reserve or “Fed” uses: (1) open market operations, (2) the discount rate and (3)
reserve requirements. While the FED’s board of Governors makes decisions regarding the discount rate
and reserve requirements, the Federal open market committee (FOMC) is responsible for so called open
market operations. By using those tools the Fed is able to influence the balances that banks and other
depository institutions hold at Federal Reserve banks and are thus able to alter the federal funds rate
which is the interest rate which banks lend to each other overnight. A change in the federal funds rate
influences a whole host of financial and economic events such as other short-term interest rates, foreign
exchange rates, long-term interest rates, the amount of money and credit, and such economic variables
44
such as employment, production output, and prices of various goods and services. The 12 members on
the FOMC; including various officials of the Federal Reserve System, hold eight annual meetings where
they determine monetary policy after they have reviewed economic and financial conditions and any
risks to price stability. The Federal Reserve’s commentary shown above illustrates how such variables as
natural disasters, energy prices, political uncertainties and interest rate changes can influence currencies
Currency strategists will look at such factors to forecast price targets for currencies. For example, if a
strategist was tasked to predict the expected performance of the Canadian dollar against the U.S. dollar
through 2007, he would probably factor in the expected performance of the U.S. dollar over the
previous period, as well as expectations of commodity prices that Canada exports such as oil, the
direction of interest rates in Canada, and the corresponding rate environment in the U.S. The strategist
is also likely to look at expectations of capital and trade flows associated with the Canadian economy,
and how Canada’s political landscape is likely to evolve over the period. Thus, in forecasting the
expected performance of the “loonie,” the strategist essentially conducts a fundamental analysis of a
country underlying economic conditions. To get a feel for these fundamental analyses, here are some
common scenarios that can have an impact on currencies:
• If a country’s stock market rallies, its currency could strengthen. A stock market rally provides an
ideal investment opportunity for individuals regardless of geographic location. As a result, there
is a positive correlation between a country’s equity market and its currency. If the stock market
is rising, funds will rush in to seize the opportunity. Alternatively, falling stock markets will see
investors selling their shares to seek opportunities elsewhere. The correlation between stocks
and currencies is strong enough to make currency trader’s watch stock market for cues on
performance of currencies.
• If oil prices surge to record highs, it can have a negative impact on some currencies. A country’s
dependence on oil is very important in determining how its currency will be hit by a spike in oil
prices. There will be a greater negative impact on countries that are net oil importers. For
example the U S is among the world’s largest net oil importers and thus its economy will be
more sensitive to changes in oil prices than many other countries. Countries with alternative
fuel sources, and other resources, have the ability to switch from strict oil dependence to other
energy sources, which helps to reduce their exposure and sensitivity.
• An increase in a country’s unemployment numbers can have a negative impact on its currency.
Currency prices reflect the balance of supply and demand for those currencies. A primary factor
affecting supply and demand is the overall strength of the economy. The unemployment rate is
a strong indicator of a country’s economic strength and therefore a contributor to the
underlying shifts in supply and demand for that currency. When unemployment is high, the
economy may be weak—and its currency may fall in value.
• If a country’s central bank makes a surprise decision to raise rates by more than expected, its
currency could rally. Currency traders look at data related to interest rates very closely as
45
interest rate differential are strong indicators of relative currency movements. If a country raises
its interest rates, its currency can strengthen in relation to those of other countries because high
interest rates help nations attract foreign investment. Economic indicators that have the biggest
impact on interest rates are the producer price index, consumer price index, and GDP.
Generally, the timing of an interest rate decision is known in advance. They take place after
regularly scheduled meetings by the Federal Reserve, ECB, BOJ, and other central banks.
THE IMPACT OF REAL INTEREST RATES
Traditional macroeconomic exchange rate models are based on fundamental analyses. In these models,
the basic force that drives exchange rates comes from the balance between supply and demand for
example if the demand for the U.S. dollar exceeds its supply at the current exchange rate against the
euro the price of US dollar in terms of the euro will rise. Conversely, if supply exceeds demand, the price
will fall. Demand and supply factors that govern exchange rates become much more complex than that
because people don’t use currencies just to purchase foreign goods and services, but also for activities
like cross-border investment and speculation. This opens up many other variables that must be
considered when addressing exchange rate movements, as underscored in the Federal Reserve Bank of
New York’s commentary cited previously. One of the most important factors, for example, is how
investors ride interest rate differentials between countries.
We know that interest is the price paid to entice people with funds to save rather than spend, or to
invest in long-term assets rather than hold cash. Therefore, interest rates reflect the interaction
between the supply of savings and the demand for capital, or between the demand for money and its
supply. A key determinant of these interest rates is inflationary expectations. Global investors broadly
desire a real return from their investments, and changes in forecasts over future inflation are
consequently reflected in current exchange rates. “Real return” here refers to the interest rate minus
the inflation rate.
Here is an example of how this works: If Australia’s interest rates are higher than Japan’s then Japanese
investors will for example, want to buy Australian bonds to take advantage of the higher rates and
corresponding returns. But to do so they must first sell Japanese yen and buy Australian dollar at the
current exchange rate between the two currencies. Next, Japanese investors are not likely to park their
money in Australian bonds indefinitely and, at some point in the future, will want to bring their proceeds
home and convert them back to yen. So they will also be interested in having an idea of what the
exchange rate between the yen and the Australian dollar will be in the future. The expected return for
these investors will have to factor in both the interest rate and the expected movement in exchange
rate between the two currencies. That is, the demand for yen will depend not only on, the current
exchange rate, but also on anticipation of future exchange rate movements against the Australian dollar.
The Japanese investors’ exchange rate predictions will, in turn, be influenced by their estimate of what
the inflation rates will be in each country. If inflation in Australia rises above the prevailing interest rates,
46
the Japanese investors will then expect a weakening of the Australian dollar. If Japanese inflation is
lower than the prevailing interest rates then the Japanese yen will become more attractive.
SPECULATION AND OTHER FACTORS
The demand for foreign exchange to support international trade is not as complex as interest rate
differential considerations since term trade patterns are reasonably predictable—for example, the
market will know roughly at which levels domestic importers will buy foreign currencies with their local
currency to pay for the goods they buy overseas, and they will also know where exporters will sell
foreign currencies which they receive for goods sold in their export markets. Speculative demand, on
the other hand, causes most of the short-term fluctuations in currency markets. Speculators have to
guess constantly where currencies are headed, and their guesses are often revised when their short-
term targets are reached or if currency movements run contrary to their initial guesses. As foreign
exchange speculators change their views about the future, their demand for currency changes, resulting
in exchange rate fluctuations.
In addition to all these drivers, central banks also intervene in foreign exchange markets for reasons that
can be quite different from the other participants. For instance, the Bank of Korea could easily decide to
sell Won in foreign exchange markets. The bank’s intention could be to keep the value of the won low so
that the country’s exports are more competitive. The greater demand for South Korea’s exports will feed
back positively into its economy.
The scenarios just described generate supply and demand drivers for currencies across the globe. The
accompanying foreign exchange transactions come on the back of thousands upon thousands of
decisions, made each day, to buy or sell currencies. To determine exchange rates, we would have to
consider the influence of these decisions on currencies, which is by no means an easy task. Different
empirical exchange rate models incorporate one or more of these variables—all of which can have an
impact on exchange rates.
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UNIT 5
DERIVATIVES AND RISK MANAGEMENT
 UNDERASTANDING BASIC PURPOSE OF DERIVATIVES

 RISK MANGEMANT
 BASIC FEATURES OF FORWARD, FUTURES AND OPTIONS
 DIFFERENCE BETWEEN FORWARD AND FUTURE MARKET
 INTRODUCTION TO SPECULATIONS AND ARBITRAGE
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UNDERSTANDING BASIC PURPOSE OF DERIVATIVES
WHAT ARE DERIVATIVES — HISTORY AND DEVELOPMENT
As explained in the beginning of this unit, derivatives refer to a variable, which has been derived from
another variable. Interest in derivative products may mostly arise out of Interest in the underlying
product, but it can also be without any interest in the underlying. Even if so, the values of derivatives
and the underlying are interrelated and irrespective of the fact that one has interest in both or only the
later, the two will affect each other prices.
The underlying can be any product, literally anything ranging from agricultural products, foreign
exchange, interest rates, oil, gas, gold or silver, stocks and stock indices, financial instruments (Treasury
Bills, Bonds, etc.) or anything in the world, which itself is traded. Thus derivatives are derived from
markets, products, risks or any underlying on which they are based.
Derivatives have been in use for hundreds of years, in the form of futures or options, when high seas
cargoes were bought and sold in future prices (or priced for future delivery) or rice produce sold for
future delivery by Japanese farmers. The future transactions were then done in various pockets, in
anticipation of future deliveries. The explosion of the market could be linked to or coincided with the
49
collapse of Bretton Woods fixed exchange rate regime (35 USD = 1 Ounce of Gold) and suspension of US
Dollars’ direct, links to gold in the 1970s. The delinking of US dollars to a fixed parity of gold, effected
volatiIity of exchange rates as also the interest rates. The increased volatility thus lead to the creation
and explosion of a financial derivatives market which has since than grown manifolds.
In early 1970s, the Chicago Mercantile Exchange introduced the world’s first exchange traded currency
future contract. Later in 1975, the first interest rate futures were introduced. Several exchanges then
introduced exchange rate and interest rate futures contracts. By 1983, the derivative markets saw
further growth with currency options trading in Philadelphia Stock Exchange.
Trading in Currency Futures and options gave the world a whole new range of risk management
techniques for managing exchange risk, which helped in growth of global trade, investments and cross-
border remittances.
This was the time (early 1980s) when interest rate swaps were also introduced. Interest rate swaps
helped borrowers and lenders to switch their borrowings/lendings from fixed to floating rate structures
are otherwise, as per their views on the interest rate movements.
Mid-1980s saw a boost in the derivatives market, with a host of exchange rate, interest rate as also
commodity price risk derivative tools/products being traded in various exchanges, which was evident
from the fact that Chicago exchange handled millions of derivatives contracts annually.
Initially, the derivative products were used mainly by the hedgers as actual users of the underlying
contracts, who used these products for managing their risks. The importers, exporters, financiers,
borrowers, buyers, etc., were the major users of these products.
Gradually, individuals and institutions tracked the prices of derivative products, much similar to
speculation in commodity prices or cross currency prices. They started speculation in futures, options
and swap prices. This gave depth and volumes to the derivative markets.
Further, there were people who would be always on a look out for, opportunities of mispricing and
uneven pricing on the markets, and arbitraged between market differences, until the differences
disappeared.
Thus, hedgers, speculations and arbitrages provided depth, volumes and initiative for newer derivative
products, so that a large number of exchanges offered these products with spurt in volumes by the day.
The derivative products in a short lifespan of 25 years, have seen tremendous growth, which can be
observed from the fact that in April 1988, the average daily turnover in derivatives was to the order of
USD 1.3 trillion while, the notional amounts outstanding for OTC contracts and exchange traded
contracts stood at USD 72 trillion and USD14 trillion respectively in June 1998. (BIS Data):
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The main reasons for this growth in derivatives market were increased volatility in the financial and
commodity assets during 1970 and 1980s, the oil shocks, in 1971 and thereafter, the need to insulate
exchange risk for incomes in different currencies, arising out of increased global investments,
technological advancements providing real-time information systems and 24-hour financial trading
platforms, also development of pricing models and instruments based on computer-generated work
sheets, the political developments and not the least but the most important would be increasing
professionalism amongst all market participants, be it banks, traders, actual users, companies, investors,
etc.
Derivatives in India — An Overview
Derivatives are not new for India, and have been practiced for several years, in commodities markets,
like oilseeds, jute, etc., as also as Badla system in the stock market. The use of modern financial
derivatives started in 1990s in forex, capital and commodities markets. While in 1992., Reserve Bank of
India had permitted banks to offer cross currency options to their clients, on back to back basis, in 1996
banks were allowed to offer to their corporate rest rate swaps, currency swaps, coupon swaps, interest
rate options, and FRAs. Further, banks are also allowed to use these derivatives to manage risks of their
assets and liabilities, and also for ALM purposes.
On, the other hand, derivative products were allowed for capital markets in 2001, with futures and
options being offered on BSE and NSE, for stock indices also for individual stocks.
Later on derivatives were also permitted in commodities market, with forming specific commodity
exchanges, NCDEX and MCDEX, offering derivatives of various commodities such as pepper, soya,
cotton, gold, silver, sugar, etc. Derivatives are picking up in the Indian markets, as market participants
get savvy in its understanding, use and deriving benefits out of the products on offer. The market in
India is slated to grow manifold, which can be judged from fact that the principal amount of IRS
outstanding has crossed a figure of over Rs 2,00,000 crore and the daily turnover in the stock exchanges
in derivative segments is almost equal to the cash segments, on several of the trading days.
DERIVATIVE INSTRUMENTS
Types and Classification
As made to understand earlier in this chapter, derivative instruments are management tools derived
from underlying exposure such as currency, commodities, shares, bonds or any of the indices, used to
reduce or neutralize the exposures on the underlying contracts. Derivatives help to hedge against the
uncertain movements in the prices of the underlying contracts.
51
Derivatives could be Over the Counter (OTC) i.e. made to order (suited to ones’ needs or requirements)
or Exchange Traded Facilities which are for fixed lots, periods/tenors, etc.
OTC products are customized for the amount, period, etc., and are flexible to suit the needs of the
customers. OTC derivatives are mainly offered by banks and Fls, exchange traded products are traded on
the floor of the exchanges and are standardized in terms of quantity, quality, start and ending dates.
Due to standardization of products, exchange traded derivatives are lesss expensive in comparison to
the OTC products.
RISK MANAGEMENT
RISKS IN FOREIGN EXCHANGE OPERATIONS
As explained earlier, forex operations and markets are somewhat different from other commodity
markets and peculiar in nature, due to the reasons that they are largely over the counter market, open
24 hour-a-day, without any single location and barriers, fluctuations registered almost every four
seconds, effect of other markets, effected by controls/policies of respective governments, delayed
settlements due to time differences, etc. These peculiarities expose the participants to various risks. The
participants, as such have to exercise extreme caution in managing forex operations. Any laxity on his
part may result in losses and exposures, ruining the whole business. Some of the very common risks
faced in foreign exchange operations are: exchange risk, settlement risk, liquidity risk, country risk,
sovereign risk, interest rate risk, operational risk, etc.
Let us check on these risks individually which have been discussed below:
A. Exchange Risk
52
Movements in exchange rates can adversely affect the value of our foreign exchange holdings, i.e.
receivables and payables (purchases and sales), if not covered at the appropriate time, with due watch
on the market moves. Normally, the dealer is expected to cover the transactions immediately (by
entering into matching and opposite transactions), without loss of time. In case this is not done, then he
is exposed to exchange risk. This is the most common and obvious risk in foreign exchange dealing
operations. The markets may move against him, resulting in loss. Thus the dealer has to immediately
cover his positions and keep constant watch on his positions and the market moves, so as to not to get
effected by adverse movements.
A position in a given currency arises when assets and outstanding contracts to purchase that currency
exceed the liabilities plus the outstanding contracts to selI that currency. In the former case, the bank
will have a long (overbought) position and would be exposed to a risk if the currency depreciates in
value. In the latter case, the bank will have a short (oversold) position and would stand to lose if the
currency appreciates in value. This overbought or oversold position is the open position for the dealer.
In the present world, when globe is literally wired, major currencies of the world viciously floating
against each other, the risk of open position assumes considerable significance.
As due to market lot requirements thin trading on select days, or other events, it may not be possible to
cover each and every transaction individually, this risk has to be controlled and managed by prescribing
suitable limits (daylight and overnight limit, single deal limit — trading position limit, volume limit,
overall overnight open position limit, stop loss limit, gap — forward mismatch limit, etc.). In fact, it is a
practice to accumulate and keep positions open, taking a view on the movement of exchange rates, like
possible depreciation/appreciation of currencies, etc., but all within the prescribed limits.
Reserve Bank of India has authorized the boards of respective banks to specify and approve limits
relating to forex operations. Banks, according to their merchant turnover requirements, trading skills
and volumes, as also considering the capital base, fix various limits for their forex dealing operation.
B. Settlement Risk (Pre-settlement and Settlement Risks)
The international financial system evolves around foreign exchange markets Forex markets facilitate
conversion of currencies, movement of funds, global investments, travel and tourism, all culminating
into a huge daily turnover, of over US$ 1.9 trillion. This volume is transacted between the market
participants worldwide without the use of one single central clearing house — it is truly over the counter
market.
In the absence, of such a single, global, centralized clearing house, each foreign exchange market
participant has to make and receive payments on an individual basis. This entails counter-party credit
risk for each transaction. Any disruption in the market due to sudden doubts about the solvency of one
53
of the market participants could have serious repercussions for the global trade and finance and for the
international banking system as a whole.
Thus credit risk in foreign exchange operations, is the risk of failure of counter party, whether a bank or
a customer, to meet obligation at maturity of the contract, which could result in the need for resultant
open position to be covered at an ongoing rate. This could happen prior to settlement by one of the
parties or subsequent to execution by one party but before execution by the other one. The risk is, thus,
classified into pre-settlement risk and settlement risk.
Pre-settlement risk is the risk of failure of the counter party, due to bankruptcy closure or any other
reason, before maturity of the contract thereby compelling the bank to cover the contract at the
ongoing market rates. This entails the risk of only market differences and is not an absolute loss for the
bank. Settlement risk is the risk of failure of the counter party during the course of settlement due to the
time zone differences between two currencies to exchanged. That is where the bank in earlier time zone
say Japan or Australia performs its part of the contract by delivering the currency to be delivered by it
but the counter party, in another time zone, say Germany, fails before delivering the currency to be
delivered by them, which may still be in a third time zone, say USA. Such an event means complete risk
and loss for the bank which is in the earlier time zone.
In other words, at its core, settlement of a foreign exchange trade requires the payment of on currency
and the receipt of another. In the absence of a settlement arrangement that ensures that the final
transfer of one currency will occur if and only the final transfer of the other currency also occurs, one
party to a foreign exchange transaction could pay out the currency it sold but not received the currency
it bought. This principal risk in the settlement of foreign exchange transaction is variously called foreign
exchange settlement risk or temporal risk or Herstatt risk (named after the 1974 failure of the Bankhaus
Herstatt in Germany). This can happen because banks operate in different time zones.
As the nature of trade and forex business does not make it possible to totally eliminate the settlement
risk, more particularly due to countries situated and operating in different time zones, the risk is
recognized by the market participants by applying credit lines (limits) to each counter party to reduce
the risk. The credit limits take the form of maximum outstanding limit as well as daily delivery limits for
each bank.
The settlement risk could be avoided, if only settlement systems, operating on a single time basis, as also
on a real-time gross settlement basis, are put in place. This would eliminate the time zone problems and
also would pay only on ‘if received’ basis. The time zone differences could be eliminated, if the global
books are linked to a single time zone, say GMT closing.
C. Liquidity Risk
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When a party to a foreign exchange transaction is unable to meet its funding requirement or execute a
transaction at a reasonable price, it creates Liquidity risk. It is also the risk of the party not being able to
exit or offset positions quickly at a reasonable price. Here, for whatever reason, the market turns illiquid
and positions cannot be covered or liquidated, except for high price.
For- example, in a deal of US dollar purchase against rupee, if the party selling US dollar is short of funds
in the Nostro account then it may not be possible for him generate/borrow or buy USD to fund the USD
account, then liquidity risk is said to have arisen. For this, proper funds and cash management practices
have to be followed by the dealers.
Therefore liquidity risk is, the potential for liabilities to drain from the bank at faster rate than assets.
The mismatches in the maturity patterns of assets and liabilities give rise to the liquidity risk. Liquidity
risk could also arise, in case the markets turn illiquid leading to higher bid offer spread or even market
makers getting out of the market. For protecting against the liquidity risk, the bank has to resort to
control the mismatches between maturities of assets and liabilities. This is done by fixing limits for
maturity mismatches and reduces open positions.
D. Country Risk
Country risk arises when a foreign entity or a counter party, private or sovereign, may be unwilling or
unable to fulfill its obligations for reasons, other than the usual reasons or risks which arise in relation to
all lending and investment.
Dealing in foreign currencies and with counter parties in another country will sometimes result in
country risk. Movements of fund across international borders create uncertainty with regard to their
receipts and payments and this uncertainty is defined as country risk. The foreign parties may be
unwilling or unable to fulfill their obligations for reasons, such as imposition of exchange or other
controls by the central bank or the government regulation, on which the parties do not have any control
(externalization). Country risk is considered very high in the case of countries which are facing problems
related to foreign exchange reserves, balance of payments, management of resources, liquidity etc.
Country risk is usually controlled by fixing country wise exposure limits and being dynamic, has to be
constantly monitored, more particularly in case difficult countries. The difficult countries, may give high
returns, as not too many countries, banks or parties wish to take exposure in such countries.
It would be worthwhile to mention that country risk is different from the usual credit and other risks
associated with lending decisions, like credit risk, settlement risks, liquidity risk, etc.
A country risk arises, when the counter party or the borrower or the buyer is a good credit risk and does
not have any desire to default but by local laws or directives, is forbidden by the government central
bank to honour commitment. A sovereign risk is larger, when the counter party is the foreign
55
government itself or any of its agencies, and enjoys sovereign immunity under the laws, with no legal
recourse to other party. Another dimension of sovereign risk could be a change in the government
policies, or the change in t government itself, which could invalidate the previous contracts and thus
forbid the parties concerned to complete or take recourse for the same.
While sovereign risk cannot be completely avoided, when dealing with another country, it can be
suitably reduced by inserting disclaimer clauses in the documentation and also making the contracts and
the sovereign counter parties subject to a third country jurisdiction.
E. Interest Rate Risk
Interest rate risk or GAP risk, as it is otherwise known, arises due to adverse movement of interest rates
or interest rate differentials. It also refers to the potential cost of the adverse movement of interest
rates that the bank faces on its deposits/borrowings/lending, or the currency swaps, forward contracts,
forward rate agreements, or other interest rate derivatives. The increasing capital flows in the global
financial markets by the day, the economic disparities between the nations increased use of interest
rates as a regulatory tool for macro-economic control to regulate global economies, have resulted in
significant volatility interest rates.
While, in the course of its business, the bank buys and sells currencies for spot and forward value,
borrows and lends foreign currencies, enters into swaps, futures or options relating to interest rates, it is
not practically always possible match its forward purchase and sales, borrowing and lending, creating a
mismatch between its assets and liabilities. This mismatch is referred to as GAP. These GAP’s are to be
filled by the bank by paying/receiving appropriate forward differentials or resorting to other interest
rate derivatives. The forward differentials are, thus a function of interest rates. Any adverse movement
in Interest rates would result in adverse movement of forward differentials thus affecting the cash flows
on the underlying open gaps or mismatches.
Besides, deployment of foreign currency resources is not exactly for matching maturities, exposing the
bank to an interest rate risk due to uneven cash inflows and outflows.
Interest rate risk also occurs when different bases of interest rates are applied to assets and
corresponding liabilities. If the degree of fluctuations in the two different interest rates is different,
affecting the spread originally envisaged, then, interest rate risk is said to have occurred.
With the integration of foreign exchange and money markets, the dealers manage interest rate risks
frequently by undertaking appropriate swaps, or matching funding actions or through appropriate risk
mitigating interest rate deriatives.
To reduce interest rate risks, individual and aggregate gap limits are fixed for the international banking
operations. Some banks adopt strategy to determine the interest rate scenario, undertake appropriate
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sensitivity exercises, for estimating the potential profit or losses based on interest rate projections and
devise suitable hedging strategy and adopt various risk assessing models like value at risk, interest rate
sensitivity test, etc., and use derivative products like interest rate swaps, currency swaps and forward
rate agreements for managing the interest rate risk.
F. Operational Risk
Being a critical area of operations, operational risk is another important risk that should be managed by
a dealing room. It may occur due to deficiencies in the information systems or internal control or human
errors or other infrastructures problems that could lead to unexpected losses. Factors like trouble in the
premises and location of the dealing room, the computer systems, hardware and software,
communication systems including telephone lines, etc., provided to the dealing room fail to function due
to some error or fault, the operations in the dealing room would come to a grinding halt and exposed to
various risks.
Operational risk can be controlled by providing state of art systems, specified contingency plans, disaster
control procedures, and sufficient back-up arrangements for man and machine, and a duplication
process at a different site (mirroring).
G. Legal Risk
Legal risk arises when it transpires that the counter party, with whom the transaction has been
undertaken, does not have the legal or regulatory authority to enter into such transaction. In other
words, the counter party is incapacitated for engaging in such a deal, resulting in non-enforceability of
contract. Legal risk also includes compliance and regulations related risks, arising out of non-compliance
of prescribed guidelines or breach o governmental rules, leading to wrong understanding of rules and
penalties by the enforcing agencies.
MANAGEMENT OF RISK AND GUIDELINES ON RISK MANAGEMENT
To manage risk, it is important to identify and appreciate the process of measurement of risks as a
prerequisite. Some risks, like exchange risk, interest rate risk, etc., are easy to be quantified, while some
other risks like country risk, operational risk, legal risk, etc., cannot be mathematically quantified and
can only be qualitatively compared and measured. Some risks like gap risk in foreign exchange
operations can be measured using modern mathematical and statistical tools like ‘value at risk’, etc.
Thus only after the risk is identified and assessed, question of management of risk arises.
We have seen that risk is an unforeseen event, and to avoid risk proactive measures could be taken so
as to either eliminate the same or reduce the same. Thus risk management is a process focusing upon
steps to contain or avoid risks and losses there from. Since certain risks may not be avoided totally, its
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management would depend upon the expected rewards, risk appetite as also profile of the risk portfolio
held.
A sound risk management process would start with a detailed policy, a specific limit structure for various
risks and operations, a sound management information system, and specified control, monitoring and
reporting process. Putting in place sound risk management policies, understood and laid down by the
top management/board, would be a prerequisite for determining the risk exposures being faced by the
bank. Measures to determine the market risks, credit or liquidity risks can be put in place in accordance
with the laid down policies.
Thus the risk management process starts from the TOP, i.e. the Board of Directors, which should
prescribe and approve a detailed policy for management of various risks being faced or expected to be
faced by the bank. This policy would also specify limits for various types of trades, functions as also
upper limits for exposures. All these limits would be based on the risk appetite of the bank in relation to
the expected rewards in taking the risks. (Risk-reward equilibrium)
After the benchmarks are set out by the board, the top management has to involve in implementation
of the plans, by putting in place required manpower, various infrastructure, tools, etc., to help the
dealing staff in better functioning so as to avoid risks as also to measure and contain risks. The top
management has not only to implement the policies approved by the board, but also ensure compliance
of regulatory requirements.
The risk policy framework should cover the goals and objectives, delegation of responsibilities, specify
activities to be undertaken and level of acceptable risks, besides the authority to undertake such
functions and a system of review.
While implementing the risk policies, the top management has also to take appropriate measures to
ensure proper and regular measuring and monitoring of the risks.
Risk management Policies require constant focus and attention and need to be reviewed on a regular
basis. The natures of risks keep on changing with the business portfolio, also market scenario as also the
tools, MIS, and risk containment measures. Risk management is dynamic and needs to remain in
constant focus of the users as well as the top management.
The Guidelines
The broad policy approved by the Board of Directors and the steps for implementation taken by the top
management would all be within the overall guidelines laid by the central bank of the country and/or
other regulatory authorities. Reserve Bank of India and FEDAI have issued guidelines for management of
risk in international trade and foreign exchange, which itself limit the risk in the forex operations.
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RBI has issued Internal Control Guidelines (ICG) for foreign exchange business, which covers various
aspects of dealing room operations, code of conduct for dealers and brokers and other aspects of risk
control guidelines, including set up of the dealing room, back office, and risk management structure.
Under ICG, banks are required to put in place various dealing limits for their forex operations, which can
be briefly summarized as under:
i. Overnight limit: Maximum amount a bank can keep overnight, when markets in its time zone are
closed.
ii. Daylight limit: Maximum amount the bank can expose itself at any time during the day, to meet
customers’ needs or for its trading operations.
iii. Gap limits: Maximum interperiod/month exposures which a bank can keep, are called gap limits.
iv. Counter party limit: Maximum amount that a bank can expose itself to a particular counter
party.
v. Country risk: Maximum exposure on a single country.
vi. Dealer limits: Maximum amount a dealer can keep exposure during the operating hours.
vii. Stop loss limit: Maximum movement of rates against the position held, so as to trigger the limit
— or say maximum loss limit for adverse movement of rates.
viii. Settlement risk: Maximum amount of exposure to any entity, maturing on a single day.
ix. Deal size limit: Highest amount of deal size a deal can be made, to restrict operational risk on
large deals.
Besides above limits, banks approve panel of brokers through whom deals could be undertaken, the
currencies in which the bank/dealers would deal in of Value of Risk limit, Nostro Balances limit,
Overdraft limits, etc.
Further, the master circular on Risk Management and Interbank Dealings, issued by Reserve Bank of
India, specifies risk management facilities that are available to residents and non-residents, to hedge
their forex exposures, as also for authorized dealers, for managing exposures on their foreign currency
assets and liabilities. The guidelines permit booking of forward contracts by customers on the strength
of underlying exposure/transaction or merely on the basis of past at turnover. Also guidelines on
interest rate swaps. Foreign currency and rupee options, etc., and the segments relating to Interbank
dealings, procedures, norms for position and gap limits, authority to undertake FEX derivatives, foreign
currency accounts, borrowing/lending in foreign currency and various reports to be submitted to the
Reserve Bank of India are prescribed in the guidelines. Thus, while the RBI has prescribed the broad
guidelines on operations and risk management aspects of FEX dealing room, detailed guidelines have
been issued by FEDAI on certain aspects, while most of the guidelines and risk management framework
is to be finalized and approved by the board of the bank, to be implemented by the top management,
treasury head and the MID office functionaries.
 Key learning
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o Risk: Uncertainty
o Exchange Risk: It arises mainly on account of fluctuations in exchange rates and/ or

when mismatches occur in assets / liabilities and receivables / payables
o Credit Risk: It is a risk of loss which arises due to inability or unwillingness of the counter
party to meet the obligations at maturity of the underlying transaction.
o Settlement Risk: it is the risk of the failure of the counter party during the course of
settlement due to the time zone differences between the two currencies to be
exchanged.
o Liquidity Risk: It is a risk which may arise due a party to foreign exchange transaction
unable to meet its funding requirements or execute transaction at a reasonable price.
o Interest Rate Risk: Risk arising out of adverse movements in implied interest rates or
actual interest rate differentials.
o Market Risk: It is a risk which arises due to a party to a foreign exchange transaction
unable to exit or offset a position quickly at a reasonable price.
o Operational Risk: It is risk on account of human errors, technical faults, infrastructure

breakdown, faulty systems and procedures or lack of internal controls.
o Legal Risk: It is a risk arising on account of non enforceability of contract against a

counter party.
o Systemic Risk: This risk is possibility of a major bank failing and the resultant losses to
counter party reverberating into a banking crises.
o Country Risk: It is the risk of the counter party situated in a different country unable to
perform its part of the contractual obligations despite its willingness to do so due to
local government regulations or political or economic instability in that country.
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o Sovereign Risk: It is a sub category of country risk and arises on account of sovereign
entities.
BASIC FEATURES OF FORWARD, FUTURES AND OPTIONS

DIFFERENCE BETWEEN FORWARD AND FUTURE MARKET
Forward Contracts
Forward contracts are typical OTC derivatives involving the fixation of rates (Exchange rate, commodity
price, etc.) in advance for deliveries in future. In a forward contract a seller agrees to deliver goods to
the buyer on some future date at a fixed rate. Forward contracts has a long history with the earliest
forward contract reported to have undertaken at Chicago Board of Trade in 1851 for delivery of maize
corn.
Under forward contract, since the price of commodity or foreign currency is fixed today for delivery on a
future date, the risk of any adverse price movements is removed on covered.
Thus forward contracts are a firm and binding contracts entered into by two parties (usually the user
and bank/institution/exchange), for purchase or sale a specified quantity of foreign currency or
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commodity. (Gold, silver, metal, etc.) at an agreed price for delivery and payment at a future date or in
certain cases during a period of specified time.
The rate specified for the forward contract is called forward rate, it is generally quoted as premium or
discount over the cash/spot rates.
The forward premium/discount applicable for the forward rate/price is merely the cost of carry of the
commodity or the currency price, and includes say the storage cost, insurance cost, interest cost, etc.
The forward rate/price is a function of spot price plus cost of carry.
In currency/exchange forwards, the cost of carry would depend upon the interest rate differential of
both the currencies being exchanged.
The forward exchange rate may be equal to, higher/costlier or lower/cheaper than the spot rate of the
currency, based- on the interest rate of one currency in relation to another.
The currency with lower interest rate would be at a premium in future, while the currency with a higher
interest rate would be at a discount in future. The forward exchange rate would thus be a function of
spot rate plus or minus premium/discount as the case may be.
Forward contracts could be fixed date forward contracts or option period forward contracts. In
international foreign exchange market, all forward contracts are usually on fixed date delivery basis, say,
one month, 3 months, 6 months forwards, from spot date and forward date of delivery is fixed at the
time of entering into the contract itself.
Let us now see how forward exchange rates are calculated:
A forward rate is the price the market sets for the currency today for the delivery on a future date.
In forex markets, the forward rate is a function of spot rate and premium/discount of the currency. The
premium/discount would depend upon mainly on interest rate differential of the two currencies, but
also on the demand/ supply of the currency for future deliveries, the perception, the political, fiscal and
other trade-related conditions in the country and for the currency.
In a pure market, the forward differentials should be almost equal to the interest rate differentials of the
two currencies being dealt with.
Futures
Another most popular and widely used derivatives product is futures, which was evolved out of forward
contracts. Futures could be called another version of exchange traded forward contracts, which is based
upon an agreement to buy or sell an asset at a price at certain time in future. Futures are standardized
contracts as far as the quantity (amounts) and delivery dates (period) of the contracts.
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A future contract conveys an agreement to buy a specific amount of a commodity or financial
instruments at a particular price on a stipulated future date. It is an obligation on the buyer to purchase
the underlying instrument and the seller to sell it, unless the contract is sold to another person/entity in
order to take profit or book/limit the loss.
Let us now see the key features of the future contracts.
1. It standardizes the quality of underlying asset per contract, known as contract size. It is also
called Notional Principal Amount.
2. It standardizes the minimum price movement for the contract known as tick size, say for
GBP/USD one basis point.
3. The-period of contract is also standardized — say three months starting/ending in calendar
quarter month of March, June, September and December.
4. Futures are exchange traded contracts and hence the buy/sells contracts are between the
futures exchange and the buyer or seller and not directly between buyers and sellers. The
exchanges are in the middle of each contracts.
5. Futures exchange maintains creditworthiness, by way of margin on buyer and sellers, which is
adjusted each day.
6. The delivery under future contract is not a must, and the buyer/seller can set off the contract by
packing the difference amount at the current rate/price of the underlying.
The Futures are thus a type of forward contract, but differ from forwards in several ways. The difference
between the two can be listed as under:
Futures Forwards
1. An exchange traded contract An OTC product
2. Standardized amount of contract Can be made for any odd amount based on need
3. Standardized time period, say three months, six Can be made for any odd periods, say one and a
months, etc. half month or 100 days etc.
4. Delivery of underlying not essential Delivery is essential
5. Contract risk on exchanges, i.e. performance Credit risk on counter parties, i.e. buyers and
guaranteed by Exchanges sellers.
6. Works on margin requirements, and are marked Margins not compulsory. Not marked i.e.to market
to market every day. Every day.
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The Margin Process: From the above, it can be seen that the backbone and creditworthiness and
capacity of exchanges to settle the contracts is based on margin mechanism. Future contracts are
marked to marked on daily basis and are thus similar to daily settled forward contracts. Three types of
margins are levied in a futures contract.
1. Initial margin: At the start of each new contract initial margin is to be paid to the Exchange in
the form of cash or another approved liquid security (i.e. treasury bills, bonds, bank
guarantees). It is usually a small margin, which enables the buyers as seller to command and
play in a large value of contract. For example, in London International Financial Futures
Exchange (LIFFE) initial margin for a Euro/Dollar Contract size of USD 1 million is USD 500 only.
Thus any person with only USD 500 can play/enter into a large value future contract of USD 1.00
million.
2. Variable margin: It is calculated on daily basis, by marking to market the contract at the end of
each day. This margin is normally to be deposited in cash only. Any adverse movement in the
value of the underlying asset is thus to be deposited in cash to cover the increased credit risk.
The exchange makes the margin call, upon erosion in value of the contract which is normally to
be deposited and made available in the margin account with the exchange by next morning. In
case of appreciation in value of the contract, the difference occurs to the buyer and the same is
credited by the exchange to this margin account.
3. Maintenance margin: This margin is similar to minimum balance stipulation for undertaking and
trades in the Exchange and has to be maintained by the buyer/seller in the margin account with
the exchange. The exchange is also authorized to debit/credit the variable margin to this
amount as such the party needs to constantly fund the account in case of continuous erosion in
the value of contract.
Let us now see an example of a future contract in euro dollar to see the movment of margins in a
futures contract
Euro—Dollar Contract for Notional Principal amount of Euro 1 million
tick size 1 basis point, period 3 months
Tick size of 0.0001 would be equivalent to Euro 25.00 as under:
Notional principal x tick size x Period (annualized)
1000,000 x 0.0001 x 3/12 = Euro 25.00 in per tick movement
Say the contract was BOT on 1.404 at EURO/USD base spot price of 1.2700 and future rate of 1.3000
value 30.6.04.
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The buyer has deposited Euro 500 as initial margin and Euro 2000 as maintenance margin with the
exchange. (Minimum balance).
Say on 2.4.04, the spot price moves to 1.2690 (movement of 10 pips) against the buyer his maintenance
account will be debited by Euro 250.00 (10 pips x 25.00) which he has to replenish to maintain the
minimum balance.
The spot price moves to 1.2710 on 3.4.04 the exchange will credit (20 x 25) Euro 500.00 to his margin
A/c and he can now withdraw Euro 250.00 in excess of the minimum margin in his account.
Futures contracts can mainly be of four major types:
— Commodity futures
— Financial futures, including interest rate futures
— Currency futures
— Index futures
The futures contracts were first traded in 1972 Chicago Mercantile Exchange and the future market has
seen tremendous growth over the past decades, both in terms of usage, number of instruments as also
geographically.
Options
Under the forward contract or the futures, delivery of contracts or its reversal at the prevailing price, is
essential and as such any favourable movement of price index would not be beneficial to the
purchaser/corporate. To overcome this essential feature, options were invented, where the buyer had
an option to buy or sell the underlying without any obligation.
The options convey the right to buy or sell an agreed quantity of currency commodity on index value, at
an agreed price, without any obligation to do so.
Thus option is a right not an obligation.
The option holder or buyer would exercise the option (buy or sell) in case the market price moves
adversely and would allow the option contract to lapse in case the market price is favourable than the
option price.
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On the other hand, the option seller, usually a bank or financial institution or an exchange is under
obligation to deliver the contract, if exercised at the agreed price, but has no right to revoke/cancel the
same.
Options are traded in exchanges, where the counter party is the Option Exchange.
Options conferring a right to buy at a fixed price on or before a fixed date are called Call option, while
options conferring a right to sell at a fixed price or before a fixed date are called Put Option.
The price at which the option may be exercised and the underlying asset bought or sold is called Strike
Price or Exercise Price.
The cost of the option, usually levied upfront on the buyer of the option, called premium. This is the fees
to buy the option contract (akin to insurance premium). The final day on which option may be exercised,
is called Maturity date or expiration date.
In the money: When the strike price is below the spot price, in case of a call option or when the strike
price is above the spot price in case of a Put Option, the option is in the money, giving gain to the buyer
of the option to exercise the same.
At the money: When strike price is equal to the spot price, the option is said be at the money leaving no
gain or loss to utilize the option.
Out of the money: The strike price is below the spot price in case of put option and above the spot price
in case of call option, the option is said to be out of the money. It is better to let the option expire
without use, in case the option is out of the money.
Options are of two types, when seen from delivery/expiry angle:
1. American option: can be exercised on any date before and including (the expiry date).
2. European option: can be exercised only at maturity date (fixed date).
The option contract insures the buyer against worst case scenario and allows him to take advantage of
any favourable movement in the spot rate. Options are both OTC products as well as exchange traded,
most popular being currency options, which are traded on many exchanges of the world. Other options
are stock options, commodity options, index options, etc. We may now see the working of an option, in
the example of currency on as under:
Example
Say in case of USD/Re on 1.10.09 an exporter has a receivable of USD 1million value 6 months, i.e. 1. 4 .
10. The spot USD/Re is 45.00.
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Now due to uncertain market, he feels that the rupee may weaken six months down the lane, and he
does not deem it fit to lock his chance of any upside, by booking forward contract. On the other hand,
the market could go other way, if large inflows continue. He is able to get a Put Option for USD at 45.50
value 1. 4. 10 at a premium of 0.05 paise per USD. Due to this contradiction in views, he feels that it is
prudent to buy a Put Option at a strike price of 45.50, at a premium of 5 paise per USD, instead of
booking forward contract at 45.50.
On the expiry date, i.e. 1. 4.10 the spot USD/Re is 46.05, he allows the option to expire and sell his USD
in the market at 46.05 getting 50 paise (after adjustment of premium cost).
He has thus taken a chance to avail upside by bearing a small cost in the form of premium, and thus
insured the value of his USD earning at 45.45(45.50 — 0.05) on one hand and on the other hand,
retained right to avail the advantage of any market move in his favour beyond the strike rate.
The pricing of option premium is based on several factors. There are several methods an approaches of
pricing of options such as Binomial theory, Cox-Rubentstein, Garman and Kohlagen theory, and the
Block Scholes model which e most popular of all.
Option pricing would depend upon the following aspects:
 Call and Put Option

 Amount (Whether market lot or small lot)
 Strike price
 Type — American or European
 Spot rate
 Interest rate differentials
 Swap rate (forward differentials)
 Volatility in the price of the underlying.
The tricky issue of option pricing is complicated due to effect of several factors listed above, as such
computation of the option price is done normally on the basis of computer models.
However, volatility in price of underlying is the most important feature and the option price is directly
affected by the same, i.e. higher the volatility, higher would be the price.
Options are widely used in foreign exchange markets, where both OTC and exchange traded options are
available. Equity and commodity linked options are usually exchange traded only. Options are also
available on various exchanges for hedging interest rate risk.
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Options are also available on futures contracts, giving a double edged sword in the hands of the buyer.
The buyer has an option to exercise the rate fixed in the futures constant, thereby allowing flexibility in
the futures contract.
 Key learning
o Derivatives: They are hedging instruments
o Forward Contract: It is binding contract for purchase / sale at a future date.
o Premium / Discount: It represents interest rate differential in a forward contract.
o Futures: It is a contract traded on an exchange to make or take delivery of a commodity.
o Option: Contracts confer upon the holder the right without the obligation to take up the
contract.
o Premium: In an option contract represents the fee charged by the option writer
o Call Option: Option conferring a right to buy at a fixed price on or before a fixed date is
called call option.
o Put Option: Option conferring a right to sell at a fixed price on or before a fixed date is
called put option.
o Strike Price: The price at which the option may be exercised and the underlying asset
bought or sold is called strike price or exercise price.
o In The Money: When the strike price is below the spot price, in case of call option or
when the strike price is above the spot price in case of a put option the option is in the
money, giving gain to the buyer of the option to exercise the sale.
o At The Money: When the strike price is equal the spot price, the option is said to be at
the money leaving no gain or loss to utilize the option.
o Out Of The Money: The strike price is below the spot price in case of put option and
above the spot price in case of call option the option is said to be out of the money.
o American Option: Can be exercised on any date before and including the expiry date.
o European Option: Can be exercised only at maturity date (fixed date).
INTRODUCTION TO SPECULATION AND ARBITRAGE

SPECULATION
Acceptance of foreign exchange risk is speculation. It is the opposite of hedging. Speculation is a difficult
trading technique because one has to identify, with a high degree of reliability, the movement in
exchange rate so that one can benefit from this trading.
Speculation refers to deliberate creation of a position in order to profit from exchange rate fluctuations,
accepting the added risk. This is a deliberate attempt to benefit from the exchange rate movement.
Consequently, an open foreign exchange position is based on speculation. These positions may be long
or short, but they involve risk and hence the possibility of speculative gains.
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Speculators are those investors who willingly take price risks to profit from price changes in the
underlying asset. Speculators do not have any position in the underlying cash market on which they
enter into futures and options market. They just have a view or belief about a commodity, currency,
stock index, interest rate, etc., that is based on policy announcements by the government, international
events or any other development.
They may be either bullish or bearish on any currency. Their outlook is said to be bullish when they buy
futures or call (sell put options) options and wait for the prices to rise in future. It is said to be bearish
when they take an opposite view, i.e. they sell futures or call options (buy put options) and hope for
prices to fall so that they can buy the currency and deliver.
Speculators are essential to foreign exchange markets as they provide volume and liquidity. They act as
a counter party to the hedgers. Internationally, speculation in currency trading is quite large. Large
fluctuations in currency widen the scope for speculators.
Speculation may be conducted through either the spot or forward exchange markets and involves the
establishment of short positions in weak currencies, which are expected to depreciate or be devalued,
and long positions in strong currencies, which are expected to appreciate or be revalued.
By far, the largest proportion of currency exchange transactions in the international forex markets is
speculative in nature. That is, currencies are bought and sold in the hope of profiting from price
movements. Indian exchange control allows banks in India to undertake currency trading within
approved limits. Recent relaxations in exchange control in India permit non-bank entities in India also to
speculate on currency movements. This is done in three ways:
1. By canceling and re-booking of forward contracts: To be sure, the initial booking of a forward
contract to sell or purchase a currency against the dollar or rupee can be done only to hedge a
commercial exposure. Consider a euro payable. You buy Euros in the forward market against
dollars as a trading position at USD 1.2695. Your expectation that the euro is likely to appreciate
proves right and you cancel the contract at USD 1.2750. This difference is not a profit, as you still
have to buy Euros to honor the payable. There will be profit only if you succeed in re-buying
Euros at a rate better than USD 1.2750, perhaps USD 1.2725. Remember that under the strategy
of canceling and rebooking forward contracts, the profit is not the gain on cancellation of the
original contract; it is the difference between the cancellation and re-booking rates.
2. By booking a forward contract in a currency other than the actual exposure: For example, a
dollar payable can be hedged by buying dollars against Euros. As a careful reading of the earlier
discussion shows, this is not a hedge at all. The dollar exposure against rupee has been changed
to a euro exposure against the rupee.
3. By locking into the forward premium when it is attractive, but the spot rate is not.
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ARBITRAGE
The act of purchasing a currency security or commodity in one market and selling it immediately in
another at a higher price is termed arbitrage, or specifically, deterministic arbitrage. It means taking
advantage of discrepancies in the prices of currencies or commodities existing in various markets at the
same or at different times.
However, the meaning of arbitrage has been expanded to include any activity wherein the difference of
pricing is exploited. Arbitrage is popularly applied in trading options and futures. Risk-free profits
continue until market correction occurs.
UNIT 6
COMMERCIAL BANKS
 COMPONENTS OF A BANKS BALANCE SHEET

 UNDERSTANDING PROFITABILITY DRIVERS OF THE BANKS
 UNDERSTANDING THE VARIOUS RISKS FIXED BY THE BANK
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 HOW BANKS MANAGE THESE RISKS?
COMPONENTS OF A BANK’S BALANCE SHEET

O COMPONENTS OF LIABILITIES
O COMPONENTS OF ASSETS
O BANKS PROFIT AND LOSS ACCOUNT
O SIGNIFICANCE OF ASSET LIABILITY MANAGEMENT
O PURPOSE AND OBJECTIVE OF ASSET LIABILITY MANAGEMENT
 NET INTEREST INCOME (NII)
 NET INTEREST MARGIN (NIM)
 ECONOMIC EQUITY RATIO
Like any balance sheet of any other firm, the bank’s balance sheet also comprises of sources and uses of
funds Liabilities and net worth form the sources of the bank funds, whereas assets represent uses of
funds to generate revenue for the bank.
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Bank’s Liabilities
The sources of funds for the lending and investment activities constitute the liabilities side of the bank’s
balance sheet. The various sources through which the bank raises funds for its business are broadly
classified into the following:
1. Capital
2. Reserves and Surplus
3. Deposits
4. Borrowings
5. Other Liabilities and Provisions
6. Contingent liabilities
Bank’s Assets
The funds mobilized by the bank, through various sources are deployed into various assets. The assets
side of a bank’s balance sheet consists of various items that fall into the following broad categories:
1. Cash and Balances with Reserve Bank of India

2. Balances with Banks and Money at Call and Short Notice
3. Investments
4. Advances
5. Fixed Assets
6. Other Assets
A brief description of various balance sheet components under liabilities and assets is narrated below:
 Components of Liabilities
Capital
Capital represents the owner’s stake in the bank and it serves as a cushion for depositors and creditors
to fall back in case of losses. It is considered to be a long term source of funds. Minimum capital
requirement for the domestic and foreign banks is prescribed by Reserve Bank of India.
Reserve and Surplus
The components under this item include statutory reserves, capital reserves, share premium, revenue
and other reserves and balance in profit and loss account.
Deposits
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Main source of funds for the banks is the deposits. The deposits are broadly classified as deposits
payable on demand which includes current deposits, overdue deposits, call deposits, etc. Second
category is savings bank deposits and lastly the term deposits which are repayable after a specified
period, known as fixed deposits, short deposits and recurring deposits.
Borrowings
Borrowings in India consist of borrowings/refinance obtained from the RBI other commercial banks and
other institutions and agencies like EXIM bank of India, NABARD, etc
Other Liabilities and Provisions: The other liabilities of the bank are grouped into the following
categories:
o Bills payable: This includes drafts, telegraphic transfers, travelers cheques, mail transfers
payable, pay slips, bankers’ cheques and other miscellaneous items
o Inter-office adjustments: The credit balance of the net inter-office adjustments.
o Interest accrued: The interest accrued but not due on deposits and borrowings.
o Others: All other liability items like provision for income tax, tax deducted at source, interest
tax, provisions, etc.
 Components of Assets
Cash and Balances with RBI
All cash assets of the banks are listed under this account and it forms the most liquid account held by
any bank. The cash assets consist of the following:
o Cash in hand: This asset item includes cash in hand including foreign currency notes and
cash balances in the overseas branches of the bank.
o Balances with RBI: Cash account also includes the balances held by each hank with RBI in
order to meet statutory cash reserve requirements (CRR).
o Balances with banks and money at call and short notice: The bank balances include the
amount held by the bank in the current accounts and term deposit accounts with other
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banks. Money at Call and Short Notice includes all loans made in the interbank call money
market that are repayable within 15 days notice.
Investments
A major asset item in the balance sheet of a bank is investments in various kinds of securities. These
include, Government Securities, Approved Securities, Shares, Debentures and Bonds, Subsidiaries
and/or Joint Ventures, Other Investments.
Advances
The most important of the asset items on the bank’s balance sheet are advances. These advances which
represent the credit extended by the bank to its customers, forms a major part of the assets for all the
banks.
o Cash credits, overdrafts and loans repayable on demand: Items under this category
represent advances — which are repayable on demand though they may have a specific due
date.
o Term loans: All term loans extended by the bank are included here. These advances also
have a specific due date, but they will not become payable on demand.
o Bills purchased and discounted: This item includes the bills discounted/ purchased by banks
from the client irrespective of whether they are clean/documentary or domestic/foreign.
o Secured/unsecured advances: Based on the underlying security, advances are classified into
the following categories:
o Secured by tangible assets: All advances or part of advances, within/outside India, which are
secured by tangible assets will be considered as secured assets.
o Covered by bank/government guarantees: Advances in India and outside India to the extent
they are covered by guarantees of Indian and foreign governments/banks and DICGC and
ECGC will be included here.
o Unsecured advances: All advances that do not have any security and which do not appear in
the above two categories will come under this category.
Fixed assets
All fixed assets of the bank, e.g. immovable properties, premises, furniture’s and fixtures, hardware,
motor vehicles are classified into fixed assets.
Other assets
The remainder of the items on the asset side of the bank’s balance sheet is categorized as Other Assets.
The miscellaneous assets that appear are:
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o Inter-office adjustments: Debit balance of the net position or the interoffice accounts,
domestic as well as overseas.
o Interest accrued: This will be the interest accrued, but not due on investments and advances
and interest due, but not collected on investments.
o Tax paid in advance/tax deducted at source: This includes amount of tax deducted at source
on securities and the advance tax paid to the extent that they are not set-off against relative
tax provisions.
o Stationery and stamps: Stock on hand of stationery is considered under this head of
account.
o Non-banking assets acquired in satisfaction of claims: Items under this account include
immovable properties/tangible assets which are acquired by the bank in satisfaction of
bank’s claims on others.
o Others: Other items primarily include claims that are in the form of clearing items,
unadjusted debit balances representing additions to assets and deductions from liabilities
and advances provided to the employees of the bank.
Contingent Liabilities
Bank’s obligations under issuance of letter of credit, guarantees and acceptance on behalf of
constituents and bills accepted by the bank on behalf of its customers are reflected under contingent
liabilities. Other contingent liabilities include claims against the bank not acknowledged as debts, liability
for partly paid-up investments, liability on account of outstanding forward exchange contracts and other
items like arrears of cumulative dividends, bills rediscounted, underwriting, commitments, and
estimated amount of contracts remaining to be executed on capital account and not provided for, etc.
 Bank’s Profit and Loss Account
A bank’s profit and loss account has following components:
o Income: which includes Interest income and Other income, and

o Expenses: which includes Interest expended, Operating expenses and Provisions and
Contingencies.
These components are explained hereunder:
a) Income
The bank’s income is broadly classified as interest income and other income. A detailed break up is
provided below:
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Interest income
Interest income forms the major and most important revenue for the bank. The bank thrives on this
income as spreads are essentially generated out of this income.
o Interest/discount on advances/bills: This item includes interest and discount on all types of
loans and advances like, cash credit demand loans, overdraft, term loans, export advances,
domestic and foreign bills purchased and discounted/rediscounted, overdue interest and
interest subsidy, if any relating to such advances/bills.
o Income on investments: The dividend and interest income earned on investment portfolio of
the bank is entered under this head.
o Interest on balances with RBI and other interbank funds: This item includes the interest
earned by the bank on balances with RBI and other banks, call loans, money market
placements, etc.
o Others: All other types of interest discount income that not included above will appear in
this head of income.
Other income
Apart from the interest income, banks have certain income in the form of fees, commission, exchange,
etc., derived in the following ways:
o Commission, exchange and brokerage: Charges of services such as commission on

collections, letters of credit and guarantees, government business and other permitted
agency business including consultancy and, other services. It also includes rent on lockers,
commission/ exchange on remittances and transfers, brokerage, etc., on securities:
o Profit on sale or investments: The items that are included here are profit/ loss on sale of
securities, furniture, land and buildings, motor, vehicles, gold, silver, etc.
o Profit on revaluation of investment: The net position that appears after the revaluation of
investments will be considered here. In case there is a loss after netting the profits against
the losses, it will be shown as a deduction.
o Profit on sale of land, building and other assets: The net profit-loss on revaluation of assets
will also be included under this head.
o Profit on exchange transactions: This includes profit/loss on dealings in foreign exchange, all
income earned by way of foreign exchange, commission and charges on foreign exchange
transactions, excluding interest which will be shown under interest income.
o Income earned by way of dividends, etc.: This will include the dividends from
subsidiaries/companies and/or joint ventures abroad or in India.
o Miscellaneous income: The miscellaneous income comprises of recoveries from constituents
for godown rents, income from bank’s properties, security charges, insurance, etc.
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b) Expenses
The expenses of the bank can be broadly classified into interest expenses, other operating expenses and
provisions and contingencies. The detailed breakup of these expenses is provided below.
Interest expended
Since banks will have to mobilize funds regularly to meet the credit demands, the major expenses of the
bank arise from the interest expended on deposits and borrowings.
o Interest on deposits: Interest paid on all types of deposits raised by the bank, from banks,
institutions and others will appear under this head.
o Interest on RBI/interbank borrowings: This includes the discount/interest on all
borrowings/refinance from RBI and other banks.
o Others: Discount/Interest on all borrowings/refinance from Fls and other payments like
interest on participation certificates, penal interest, etc., are included here.
Operating expenses
The operating expenses will generally include the cost of running the bank. Components of operating
expenses are listed below.
o Payments to and provisions for employees: Staff salaries/wages, allowances, plus, other
staff benefits like provident fund, gratuity, liveries to staff, leave fare concession, staff
welfare, medical and house rent allowance to staff, etc.
o Rent, taxes and lighting: Rent paid by the bank on building and vehicles, municipal taxes and
other taxes (excluding income tax and interest tax) and other charges on electricity, etc.
o Printing and stationery: Books and forms and stationery used by the bank and other printing
charges which are not incurred by way of publicity expenditure are included here.
o Advertisement and publicity: All expenditures incurred by a bank for advertisement and
publicity and the related printing charges. Depreciation on bank’s property: Includes
depreciation on bank’s own property, motor cars and other vehicles, furniture, electric
fittings, vaults, lifts, leasehold properties, non-banking assets, etc.
o Director’s fees, allowances and expenses: Expenses relating to sitting fees and all other
expenditure incurred on behalf of directors
o Auditors’ fees and expenses: Fees paid to the statutory/branch auditors for their
professional services and all expenses incurred in this regard.
o Law charges: All legal expenses and reimbursement of related expenses are reflected under
this heading
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o Postage, etc.: Postal charges like stamps, telegrams, telephones, etc., will be the expenses
appearing under this head.
o Repairs and Maintenance: Repairs to bank’s property, their maintenance charges, etc, are
included here
o Insurance: This includes insurance charges on bank’s property, insurance premium paid, to
Deposit Insurance and Credit Guarantee Corporation (DICGC), etc.
o Other expenditure: Other expenses like License fees, donations, subscriptions to papers,
periodicals, entertainment expenses travel expenses etc, are all included here
Provisions and contingencies
Provisions made for bad and doubtful debts, taxation, diminution in the value of investments, transfers
to contingencies and other similar items will appear under this category of expenses
WHAT IS ASSET LIABILITY MANAGEMENT
Because the business of banking involves the identifying, measuring, accepting and managing the risk,
the heart of bank financial management is risk management. One of the most important risk-
management functions in banking is Asset Liability Management (ALM).
Asset Liability Management (ALM) is the act of planning, acquiring, and directing the flow of funds
through an organisation. The ultimate objective of this process is to generate adequate/stable earnings
and to steadily build an organization’s equity overtime, while taking reasonable and measured business
risks.
SIGNIFICANCE OF ASSET LIABILITY MANAGEMENT
Why do we need asset liability management? In simple terms — a financial institution may have enough
assets to pay off its liabilities. But what if 50% of the liabilities are maturing within 1 year but only 10% of
the assets are maturing within the same period. Though the financial institution has enough assets, it
way become temporarily insolvent due to a severe liquidity crisis. Thus, ALM is required to match the
assets and liabilities and minimize liquidity as well as market risk. Asset-liability management can be
performed on a per liability basis by matching a specific asset to support each liability. Here you ensure
that for every liability, there is an equivalent tenure and amount matching asset. Again even if the assets
and liabilities maturity is matched to a large extent the interest rates can change during the period
thereby affecting the interest income from assets and interest expenses on liabilities. Depending upon
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the movement of interest rates the net interest margin may increase or decrease resulting in
corresponding increase or decrease in profit during a certain period.
PURPOSE AND OBJECTIVES OF ASSET LIABILITY MANAGEMENT
An effective Asset Liability Management technique aims to manage the volume, mix, maturity, rate
sensitivity, quality and liquidity of assets and liabilities as a whole so as to attain a predetermined
acceptable risk/reward ratio. Thus, purpose of Asset Liability Management is to enhance the asset
quality; quantify risks associated with the assets and liabilities and further manage them.
The parameters that are selected for the purpose of stabilizing Asset Liability Management of banks are:
 Net Interest Income (Nil)

 Net Interest Margin (NIM)
 Economic Equity Ratio
A brief description of these parameters is given below:
1. Net Interest Income (Nil)
The impact of volatility on the short-term profit is measured by Net Interest income
Net Interest Income = Interest Income — Interest Expenses.
In order to stabilize short-term profits; banks have to minimize fluctuation in the NII.
2. Net Interest Margin (NIM)
Net Interest Margin is defined as net interest income divided by average total assets.
Net Interest Margin (NIM) = Net Interest Income/Average total Assets. Net Interest Margin can be
viewed as the ‘Spread’ on earning assets.
The net income of banks comes mostly from the spreads maintained between total interest income and
total interest expense. The higher the spread the more will be the NIM. There exists a direct correlation
between risks and return. As result, greater spreads only imply enhanced risk exposure. But since any
business is conducted with the objective of making profits and achieving higher profitability is the target,
it is the management of risks that holds key to success and not risk elimination.
3. Economic Equity Ratio
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The ratio of the shareholders funds to the total assets measures the shifts in the ratio of owned funds to
total funds. This fact assesses the sustenance capacity of the bank
Sum Up
 The bank’s balance sheet comprises of sources and uses of funds. Liabilities and net worth form
the sources of the bank funds, whereas assets represent uses of funds to generate revenue for
the bank. Asset Liability Management (ALM) is the act of planning, acquiring, and directing the
flow of funds through an organisation. The ultimate objective of this process is to generate
adequate/stable earnings and to steadily build an organization’s equity over time, while taking
reasonable and measured business risks.
 It is an integrated approach to. Bank Financial Management requiring, simultaneous decision
about the types and amount of financial assets and liabilities it holds or its mix and volume.
 ALM involves balance sheet restructuring wherein bank managers make efforts to adjust and
readjust their portfolios in response to corporate objectives, economic conditions and future
interest rate scenario to prevent undesirable imbalance between asset and liability maturities.
 Some of the reasons for growing significance of Asset Liability Management are:
o Volatility due to deregulation of financial system, interest rates and price levels.
o Rapid innovation of financial products of banks.
o Requirement under the Regulatory Environment.
o Increasing awareness among the Top Management.
 At macro-level, Asset Liability Management involves the formulation of critical business policies,
efficient allocation of capital and designing of products with appropriate pricing strategies.
 At micro-level the Asset Liability Management aims at achieving profitability through price
matching while ensuring liquidity by means of maturity matching.
 The Asset Liability Management technique so designed to manage various risks will primarily
aim to stabilize the short-term profits, long-term earnings and long-term substance of the bank.
The parameter that is selected for the purpose of stabilizing are:
o Net Interest Income (Nil)
o Net Interest Margin (NIM)
o Economic Equity Ratio
Keywords
Asset liability management: The act of planning, acquiring and directing the flow of funds through an
organisation.
Net interest income (NII): Net Interest income = interest income — interest Expenses.
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Net interest margin (NIM): Net interest Margin (NIM) = Net Interest income/ Average total Assets
Economic equity ratio: The ratio of the shareholders funds to the total assets measures the shifts in the
ratio of owned funds to total funds.
UNDERSTANDING THE PROFITABILITY DRIVERS OF BANK

O VARIOUS COMPONENTS OF INCOME AND EXPENDITURE OF A BANK
O HOW DIFFERENT MIX OF ASSET PORTFOLIO AFFECT PROFITABILITY AND CAPITAL
REQUIREMENT FOR A BANK
O HOW NPA’S AFFECT THE PROFITABILITY?
PROFIT PLANNING
Banks are commercial organizations. They are there to earn profits and provide good returns on the
equity. However, they have the role of a financial intermediary. Banks accept deposits and lend monies
to industry, trade, agriculture, consumption, housing etc. They are the trustees for the deposits kept
with them and have to perform the sacred duty of protecting the depositor’s funds. They are also
expected to give some fixed returns to the depositors. In this capacity as a trustee for the depositors, a
Banks role may have variance with its responsibility to maximize the profits for its owners. Banks are,
therefore, required to be cautious in their dealings and manage the risks in a prudent manner.
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Profit planning in a bank essentially involves balance sheet management; covering credit, investment
and non fund based income. Banks’ income arises from three sources viz. interest income, fee based
income and treasury income. Interest income is derived from lending as well as investments in securities
bonds etc. In most of the countries, there are norms that a certain percentage of deposits is mandatorily
required to be kept n government securities. In our country, statutory liquidity ratio (SLR) takes care of
this aspect. Though, the investments in government securities are practically risk free, the yield on such
investments is lower. Similarly, the interest income on highly rated corporates is much lower as
compared to the income on lower rated corporate. Banks are required to have a proper blending of
investment in government securities and credit portfolio to maximize the profits for a given level of risk
appetite.
The risk would increase for lending to lower rated customers resulting in an increased need for capital
and also improved yield on the assets. Banks need to optimize the investment and lending portfolio to
earn the best possible returns for a given capital level.
Banks have to take into account the effect of NPA on the interest income and thereby on the
profitability. NPAs do not generate income and therefore bring down the yield on advances Also; under
BASEL-II regime the risk weight age of such assets is higher, thereby forcing a bank to maintain higher
capital. Thus NPAs have two fold effect reduction income and need for additional capital. Hence return
on capital or profitability gets further deteriorated.
The second major source of income is derived from fee based activities. The traditional activities such as
demand drafts, remittances, safe custody, guarantees, letters of credits, bills etc. continue to be
prevalent. However, with technological changes, some of the services such as demand drafts,
remittances, bills handling may reduce drastically. Some new services like depository services, internet
banking, and e-commerce have appeared on the scene. These services have given a boost to the fee
Income or else have resulted in higher minimum balance requirements. The banks have been
introducing several innovative products and services with the advent of technology. Banks have also
ventured into cross selling of other financial products such as insurance policies; mutual funds etc. with
established network and position of trusted entity for its customers, a bank can make logical and natural
entry in the selling of such third party products. Banks thus tend to become financial super markets and
such measures help - increase the fee based income. Banks are required to keep in mind the operational
risks associated with these new services.
The last and most important component of income is treasury income, which is derived by trading in
securities, foreign exchange, equities, bullion commodities and derivatives-This is largely a speculative
activity which banks undertake with stringent internal controls and checks in place. Regulators also
prescribe various measures in this regard. Banks put in place several risk management measures such as
caps on open positions, mark to market valuations capital provisioning based on value of risk etc
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Trading activities may provide large incomes to banks. This has been the case with many Indian banks
during the last three years. These activities may result in large amounts of losses as well. If a bank is not
adequately capitalized, such losses can cause serious problems for it. In the 90s, Barings Bank, a very old
British Bank, collapsed due to very large losses on the Exchange. It is important to undertake trading
activity within one’s means an exploit-the potential to earn more income for a bank.
We have so far seen the income side. On the expenses side, there are two major expenses viz. interest
expenses and operating expenses. There are three major parts of the deposit portfolio. Current deposits
which are interest free, Savings Deposits — which get a regulated interest rate of 3.5% in our country
and Term (short & long) Deposits — for which interest rates are deregulated in India. Thus, a bank has to
find ways and means to improve the share of low cost deposits such as Current and Savings Bank. This
helps them to lower interest costs. Interest rates of term deposits are largely decided by market forces.
A bank keeps such interest rates at a level, at which it can garner requisite deposits in competition with
other banks. These interest rates are also influenced by other instruments such as debentures, postal
deposits, Government securities, provident fund etc.
The second factor of expenditure is operating costs which consist of staff costs and other costs. Banks
try to improve productivity and also link up some of the staff costs to productivity by providing incentive
based packages. Thus, every effort is made to maintain and reduce the percentage of staff costs to the
income level. Other cost comprises depreciation, rent, utilities legal expenses, travelling expenses
postages, telecommunication charges, stationery etc. Banks like any other commercial organizations
would ensure that wasteful expenditures are avoided, and best possible deals are achieved wherever
possible. Cost benefit aspects are looked into and alternatives are explored. Thus, every effort to
rationalize this segment of expenditure is made. In a nut shell, profitability is a function of six variables,
viz.
1. Interest income,
2. Fee based income,
3. Trading income,
4. Interest expenses,
5. Staff expenses, and
6. Other operating expenses.
Maximization of the first three variables and minimization of the last three variables are the requisites
to maximize profitability. All the six factors are dependent on each other and achieving the optimum
level is the requirement here.
PROFITABILITY IN INDIAN BANKS
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The past decade or so has been historically momentous for the banking industry in India. Starting with
Narsimham committee report of 1991, Indian banking has seen a total change in the scenario during the
last 19 years. The process of deregulation which was set in motion has brought in sea change in Indian
banking. Regulated interest rates, directed investment/credit have become thing of the past. The
Reserve Bank of India has been more concerned about prudential & norms, and disclosure
requirements.
During the last decade, several new private sector banks have come into existence. They have diverse
ownership patterns. Similarly foreign banks have been given clearances for expansion. These measures
have resulted in a keen competition in the banking sector. The new entrants have brought modem
technology, new products, and aggressive marketing. Public sector banks and old private sector banks
had to take cognizance of these developments and change their ways. Profitability has become the most
important parameter in banks functioning.
Indian banks have shown that they are alive to the changing environment and have geared up to face
the new challenges. They have realized that the bottom line is very critical and demonstrated their will
and skill in changing colors.
Sum Up
We have dealt with the most important issue viz. profitability. Profitability for banks depend on six
factors viz. interest income, fee based income, trading income, interest expenses, staff expenses and
other operating expenses. The banks also need to take care of capital adequacy. Basel committee norms
have brought in standardization in the norms for capital adequacy and provided benchmarks in this
area. Banks have to keep the balance of capital requirement and profitability.
Banks have to optimize the allocation of funds amongst securities, credit portfolios, forex/bullion
positions to achieve the best possible results in terms of profitability and capital adequacy. Fee based
income areas have to be reworked with the introduction of new products and phasing out of outdated
processes, if any.
Banking in India has changed considerably over the last 18/19 years. Competition, technology, and
deregulation have brought out fundamental changes in the banking scenario. Profitability and capital
adequacy have become the most important parameters for banks. Risk management processes have
attained a key position in the banking arena.
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UNDERSTANDING THE VARIOUS RISKS FIXED BY THE BANK
 CONCEPT OF RISK
 RISK IN BANKING BUSINESS
 BANKING BOOK AND TRADEING BOOK
 OFF BALANCE SHEET EXPOSER
 BANKING RISKS
O LIQUIDITY RISK
O INTEREST RATE RISK
O MARKET RISK
O DEFAULT OR CREDIT RISK
O OPERATIONAL RISK
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Banking business lines are many and varied. Commercial banking, corporate finance, retail banking,
trading and investment banking and various financial services form the main business lines of banks.
Within each lines of business there are sub-groups and each sub-group contains variety of financial
activities. Bank’s clients may vary from retail consumer segment to mid-market corporate to large
corporate to financial institutions. Banking may differ appreciably for each segment even for the similar
services. For example, lending activities may extend from retail banking to specialized finance. Again
specialized finance may extend from specific fields. With standard practices, such as exports and
commodities financing, to structured financing implying specific structuring and customization for
making large and risky transactions feasible, such as project financing or corporate acquisitions. Banks
also assemble financial products and derivatives and deliver them as a package to its clients as a part of
specialized financing commensurate with the needs of its clients.
Product lines also vary across client segments. Standard lending products include short-term and long-
term loans with specified repayments, demand loans and various other lines of credit such as bill
purchase and bills discounting facilities, cash credit etc. In the retail segments banks have variety of
consumer loans such as auto loans, house-building loans etc. Banks also offer guarantees letters of
credit etc., which are in the nature of off-balance sheet transactions. There are various deposit products
that vary for different segments and different needs. Banks also offer market products such as fixed
income securities, shares, foreign exchange trading and derivatives like standard swaps and options.
The key driver in managing all the business lines are enhancing risk adjusted expected return. This is the
common factor for all business lines. But, management practices vary across business lines and sub-
groups and activities within each business lines as profitability of various business lines /activities differ
and so does the risk factors associated with them. From the risk management point of view banking
business lines may be grouped broadly under the following major heads.
 The Banking Book

 The Trading portfolio
 Off-Balance Sheet Exposures
Risks associated with each of them are discussed below.
The Banking Book
The banking book includes all advances deposits and borrowings, which usually arise from commercial
and retail banking, operations. All assets and liabilities in banking book have following characteristics
1. They are normally held until maturity, and

2. Accrual system of accounting is applied
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Since, all assets and liabilities in the banking book are held until maturity, maturity mismatch between
assets and liabilities results in excess or shortage of liquidity due to mismatches in the maturities of
assets and liabilities. This is commonly known as liquidity risk. In addition interest rates changes takes
place during the period such assets and liabilities are held in the banking book. Therefore interest rates
on assets as well as liabilities change on their maturity. This affects net interest margin i.e., interest
received net of interest paid. This is called ‘Interest Rate Risk’. Further, the asset side of the banking
book generates credit risk arising from defaults in payments of principal and/or interest by the
borrowers. This is called ‘Default Risk’ or ‘Credit Risk’. Since, banking book is not open to market price; it
is not exposed to market risk. In addition to all these risks, exposures under banking book suffer from
what is termed as ‘Operational Risk’. These arise due to human failures of omission or commission,
deficiencies in information system and system failure, inadequacy or non-adherence to internal
processes, external events etc. The banking book is mainly exposed to liquidity risk interest rate risk,
default or credit risk and operational risk.
Summary
All assets and liabilities in the banking book are normally held until maturity and accrual system of
accounting is applied on them. The banking book is mainly exposed to liquidity risk, interest rate risk,
default or credit risk and operational risks.
The Trading Book
The trading book includes all the assets that are marketable i.e., they can be traded in the market.
Contrary to the characteristics of assets and liabilities held in banking book, trading book assets have
following characteristics:
1. They are normally not held until maturity and positions are liquidated in the market after
holding it for a period, and
2. Mark to Market system is followed and the difference between market price and book value is
taken to profit and loss account.
Trading book mostly comprises of fixed income securities, equities, foreign exchange holdings,
commodities, etc., held by the bank on its own account. Derivatives that are held for trading in the
market or over the counter (OTC) and for hedging exposures under trading book would also form the
part of trading book. Trading book is subject to adverse movement in market prices until they are
liquidated. This is termed as ‘Market Risk’. Trading book may have market overseas as well if it is so
permitted by laws of the land. This adds to the demand and hence adds to the market liquidity.
Instruments having lower demand i.e., have lower trading volume are exposed to liquidation risk where
trading may trigger of adverse price movement. Trading book is also exposed to Credit Risk or Default
Risk which arises due to failure on the part of the counter party to keep its commitment. Trading book is
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also exposed to operational risks that arise human failures of omission or commission deficiencies in
information system and system failure, inadequacy or non- adherence to internal processes, external
events etc.
Trading book is mainly exposed to market risk including liquidation risk, default or credit risk and
operational risk.
Summary
The positions in the trading book are normally held for liquidating them in the market after holding it for
a period. The difference between market price realized and book value is accounted for as profit/loss.
Trading book is mainly exposed to market risk, market liquidity risk, default or credit risk and operational
risk.
Off-Balance Sheet Exposures
Off-balance sheet exposures are contingent in nature. Where banks issue guarantees, committed or
backup credit lines, letters of credit etc., banks face payment obligations contingent up on some event
such as failure to meet payment obligations. These contingencies add to the revenue generation of
banks. Banks may also have contingencies receivables. Here banks are the beneficiaries subject to
certain contingencies. Derivatives are off-balance sheet market exposures. They are swaps, futures,
forward contracts, foreign change contracts, options etc.
Contingent exposure may become fund-based exposure. Such exposures may become a part of the
banking book or trading book depending upon the nature of off-balance sheet exposure. Therefore, off-
balance sheet exposures may have liquidity risk, interest rate risk, market risk, default or credit risk and
operational risk.
Summary
Off balance sheet exposures may become funds exposure-based on certain contingencies. Both
contingencies given (where bank provides benefit) contingencies receivable (where bank is the
beneficiary) may form off balance sheet exposure. Off-balance sheet exposures may have liquidity risk,
interest rate risk, market risk, default or credit risk and operational risk.
BANKING RISK
From the discussion above, we may summarize the major risks in banking business or ‘Banking Risks’.
They are listed below.
 Liquidity Risk
 Interest Rate Risk
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 Market Risk
 Default or Credit Risk, and
 Operational Risks
The risks mentioned above defined in the following paragraphs. It is to be mentioned here that each of
these risks manifests in different dimension. They are outlined and explained below in brief.
Liquidity risk
The liquidity risk of banks arises from funding of long-term assets by short term liabilities, thereby
making the liabilities subject to rollover or refinancing risk. Funding Liquidity Risk is defined as the
inability to obtain funds to meet cash flow obligations. For banks, funding liquidity is crucial. The
liquidity risk in banks manifest in different dimensions.
Funding Risk: This arises from the need to replace net outflows due to unanticipated withdrawal/non-
renewal of deposits (wholesale and retail);
Time Risk: This arises from the need to compensate for non-receipt of expected inflows of funds i.e.
performing assets turning into non-performing assets; and
Call Risk: This arises due to crystallization of contingent liabilities. This may also arise when a bank may
not be able to undertake profitable business opportunities when it arises.
Interest Rate Risk
Interest Rate Risk (IRR) is the exposure of a Bank’s financial condition to adverse movements in interest
rates. Interest Rate Risk (IRR) refers to potential impact on Net Interest Income or Net Interest Margin or
Market Value of Equity (MVE), caused by unexpected changes in market interest rates. Interest Rate Risk
can take different forms. IRR can be viewed in two ways: Its impact is on the earnings of the bank or its
impact on the economic value of the bank’s assets, liabilities and CBS positions.
Gap or Mismatch Risk
A gap of mismatch risk arises from holding assets and liabilities and off balance sheet items with
different principal amounts, maturity dates or repricing dates, thereby creating exposure to unexpected
changes in the level of market interest rates.
An example of this risk would be where an asset maturing in two years at a fixed rate of interest have
been funded by a liability maturing in six months. The interest margin would undergo a change after six
months, as liability would be reprised up on maturity causing variation in net interest income.
Basis Risk
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The risk that the interest rate of different assets, liabilities and off-balance sheet items may change in
different magnitude is termed as basis risk. An example of basis risk would be say in a rising interest rate
scenario asset interest rate may rise in different magnitude than the interest rate on corresponding
liability creating variation in net interest income.
The degree of basis risk is fairly high in respect of banks that create composite assets out of composite
liabilities. The Loan book in India is funded out of a composite liability portfolio and is exposed to a
considerable degree of basis risk. The basis risk is quite visible in volatile interest rate scenarios. When
the variation in market interest rate causes the NII to expand, the banks have experienced favorable
basis shifts and if the interest rate movement causes NII to contract, the basis has moved against the
banks.
Embedded Option Risk
Significant changes in market interest rates create the source of risk to banks profitability by
encouraging prepayment of cash credit demand loans, term loans and exercise of call/put options on
bonds/debentures and/or premature withdrawal of term deposits before their stated maturities. The
embedded option risk is becoming a reality in India and is experienced in volatile situations. The faster
and higher the magnitude of changes in interest rate the greater will be the embedded option risk to the
banks NII. The result is reduction of projected cash flow and income for the bank.
Reinvestment risk
Uncertainty with regard to interest rate at which the future cash flows could be invested is called
reinvestment risk. Any mismatches in cash flows would expose the banks to variations in NII as the
market interest rates move in different directions.
Market Risk
Market risk is the risk of adverse deviations of the mark-to-market value of the trading portfolio, due to
market movements, during the period required to liquidate the transactions. This results from adverse
movements in the level of volatility of the market prices of interest rate instruments, equities,
commodities and currencies. Market Risk is also referred to as Price risk.
Price risk occurs when assets are sold before their stated maturities. In the financial market, bond prices
and yields are inversely related. The price risk is closely associated with the trading book, which is
created for making profit out of short-term movements in interest rates.
The term Market Risk applies to
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1. That part of IRR which affects the price of interest rate instruments,
2. Pricing Risk for all other assets/portfolio that are held in the trading book of the bank and
3. Foreign Currency Risk.
Forex Risk
Forex risk is the risk that a bank may suffer losses as a result of adverse exchange rate movements
during a period in which it has an open position, either spot or forward, or a combination of the two, in
an individual foreign currency.
Market Liquidity Risk
Market liquidity risk arises when a bank is unable to conclude a large transaction in a particular
instrument near the current market price.
Default or Credit Risk
Credit Risk is most simply defined as the potential of a bank borrower or counterparty to fail to meet its
obligations in accordance with agreed terms. For most banks, loans are the largest and most obvious
source of credit risk.
Counterparty Risk
This is a variant of credit risk and is related to non-performance of the trading partners due to
counterparty’s refusal and or inability to perform. The counterparty risk is generally viewed as a
transient financial risk associated with trading rather than standard credit risk.
Country Risk
This is also a type of credit risk where non-performance by a borrower or counter-party arises due to
constraints or restrictions imposed by a country. Here reason for non-performance is external factors on
which the borrower or the counterparty has no control
Operational Risks
Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and
systems or from external events. Strategic risk and reputation risk are not a part of operational risk.
Operational risk may loosely be comprehended as any risk which is not categorized as market or credit
risk. Scope of operational risk is very wide. It includes Fraud risk, Communication risk, Documentation
risk, Competence risk, Model risk, Cultural risk, External events risk, Legal risk, Regulatory risk,
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Compliance risk, System risk and so on. Two of these, which are frequently used namely, transaction and
compliance risk has been defined below, which form the part of operational risk.
Transaction Risk
Transaction risk is the risk arising from fraud, both internal and external, failed business processes and
the inability to maintain business continuity and manage information.
Compliance Risk
Compliance risk is the risk of legal or regulatory sanction, financial loss or reputation loss that a bank
may suffer as a result of its failure to comply with any or all of the applicable laws, regulations, and
codes of conduct and standards good practice. It is also called integrity risk since a bank’s reputation is
closely linked to its adherence to principles of integrity and fair dealing.
Strategic Risk
Strategic Risk is the risk arising from adverse business decisions, improper implementation of decisions,
or lack of responsiveness to industry changes. This risk is a function of the compatibility of organisation s
strategic goals, the business strategies developed to achieve those goals, the resources deployed against
these goals and the quality of implementation.
Reputation Risk
Reputation Risk is the risk arising from negative public opinion. This risk may expose the institution to
litigation, financial loss, or a decline in customer base.
Risk faced by banking and financial services may be summarized as shown in the Figure below
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HOW BANKS MANAGE THESE RISKS?
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 RISK IDENTIFICATION
 RISK MEASUREMENT
 RISK PRICEING
 RISK MONITORING AND CONTROL
 RISK MITIGATION
Management of risks begins with identification and its quantification. It is only after risks are identified
and measured we may decide to accept the risk or to accept the risk at a reduced level by undertaking
steps to mitigate the risk, either fully or partially. In addition pricing of the transaction should be in
accordance with the risk content of the transaction. Hence management of risks may be sub-divided
into following five processes.
• Risk Identification
• Risk Measurement
• Risk Pricing
• Risk Monitoring and Control
• Risk Mitigation
Further, approach to manage risks at transaction level — i.e. at branch level where business transactions
are undertaken — and at aggregate level i.e., sum total of all transactions undertaken at all the branches
— differs. This is because of risk diversification that takes place at aggregate level. Aggregated risk of the
organisation as whole is called ‘Portfolio Risk’.
The same point can be elaborated further. We take a little closer look at the profit and loss statement of
a bank. The cash inflows in case of banking business arise from interest earnings (from advances,
investment and various forms of market lending), exchange/commission/fees earned and profit on sale
of assets/investments etc. Now let us take the item interest earnings from advances. This, we know, is
the sum total of interest earnings from all the advance accounts that are performing. Typically, the
number of advance accounts in case of banks could be in millions. In other words, cash inflow arising
from interest income on advances is the sum total of cash inflows arising from millions of advance
accounts. This is true for other items of cash inflows. Therefore, total cash inflow of a bank is the sum
total of all cash inflows that arise from millions of individual transactions. The cash outflows arise from
interest payment (on deposits, borrowings etc.) and operating expenses. And, as in case of cash inflows,
this is the sum of cash outflows that arises from millions of individual transactions.
The net cash flow of the bank, which is the total cash inflows net of total cash outflows, arises from
millions of transactions. Cash flow that arises from each transaction has risks associated with it albeit a
few exceptions. Since, individual cash flows impacts total cash flow, risk at the transaction level needs to
be managed.
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Like in case of any other business, risks in banking business would depend upon the variability of its net
cash flow at the aggregate level. Therefore, managing variability in aggregate cash flow is equally
important and portfolio risks also need to be managed. Therefore, risk management in banking business
is directed at transaction level and as well as at aggregate level.
RISK IDENTIFICATION
Nearly all transactions undertaken would have one or more of the major risks i.e., liquidity risk, interest
rate risk, market risk, default or credit risk and operational risk with their manifestations in different
dimensions. Although all these risks are contracted at the transaction level, certain risks such as liquidity
risk and interest rate risk are managed at the aggregate or portfolio level. Risk such as credit risk,
operational risk and market risk arising from individual transactions are taken cognizance of at
transaction level as well as at the portfolio level.
Aggregated risk determines capital needs. Performance of bank at the aggregated level in terms of risk-
adjusted return that it generates is the key corporate issue. Therefore, risk preference as well as total
enterprise-wide risks is a corporate level issue Guidance for risk taking therefore, at the transaction level
has to emanate from the corporate level.
Products approved at corporate level with due screening procedures and appropriate safeguards and a
limit on exposure, product wise as also amount- wise, provide for necessary guidelines in risk taking. In
fact, the guidelines help in standardizing risk content in the business undertaken at the transaction level.
Any new product or any deviation from the directed procedures and safeguards add to the risk content
of the exposure and needs a clearance at the corporate level where risk return characteristics and risk
quantification forms the basis of decision-making. Impact of risk taking at transaction level on the
portfolio risk is critical issue here.
In essence, risk identification consists of identifying various risks associated. With the risk taking at the
transaction level and examining its impact on the portfolio and capital requirement. As we would see
later risk content of a transaction is also instrumental in pricing the exposure as risk adjusted returns is
the key driving force in management of banks.
Risk identification is best explained by taking an example. Say a Branch B has extended a loan of Rs 1
crore in accordance with the corporate policy and guidelines for a period of 5 years at a rate of interest
1% over BPLR (Base Prime Lending Rate) of the Bank, BPLR being 10%. The loan is to be repaid in equal
quarterly installments with one-year moratorium. Funding of the loan is to be done from a deposit of
three years of the same amount, interest rate on it being 6%. What are the risks associated with the
transaction without taking into account CRR/SLR requirements?
The deposit would become payable at the end of three years whereas the loan would stand repaid to
the extent of 50% only (assuming that there is no default). At the end of three years it will face Funding
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Risk. In case there is default, Time Risk would also arise. These would be liquidity risks associated with
the transaction.
The interest on loan is linked to BPLR of the Bank whereas the deposit is carrying a fixed rate of interest.
If BPLR were reduced during the first three- year period, Basis Risk would arise. After the three-year
period, when the question of funding the loan would arise, deposit rate may not remain same. So the
transaction would face Gap or Mismatch Risk at the end of three-year period. As the loans get repaid,
the repayment proceeds have to be deployed elsewhere. The rate at which this may be done may not
be at par with the interest rate being charged on the loan amount. As a result the bank would face
Reinvestment Risk. There would always be a possibility that the loan amount is prepaid or the deposit
amount is withdrawn prematurely adding to the risk as Embedded Option Risk. These would be Interest
Rate Risks associated with the transaction. In addition, there would be Default or Credit Risk and
Operational Risks in the transaction.
This transaction would also impact risks at the aggregate level, but it may be noted that, the incremental
risk in the portfolio may also be less than the risks taken at the transaction level
RISK MEASUREMENT
Risk management relies on quantitative measures of risk. The risk measures seek to capture variations in
earnings, market value, losses due to default etc. (referred to as target variables), arising out of
uncertainties associated with various risk elements. Quantitative measures of risks can be classified into
three categories.
 Based on Sensitivity
 Based on Volatility
 Based on Downside Potential
RISK PRICING
Risks in banking transactions impact banks in two ways Firstly, banks have to maintain necessary capital,
at least as per regulatory requirements. The capital required is not without cost. The cost of capital
arises from the need to pay investors in Banks equity and internal generation of capital necessary for
business growth. Each banking transaction should be able to generate necessary surplus to meet this
costs. The pricing of transaction must take that ii to account.
Secondly, there is a probability of loss associated with all risks. This also needs to be factored into
pricing. To explain this, let us take the case of a bank that has 100 credit accounts with say level 2 risks
according to some measure. Say, historical observation indicates that there is an average loss of 2% on
level 2 accounts. This loss is the cost associated with such risk. This is to be factored into in pricing. The
intention is to defray the possible losses across similar transactions. In this case risk premium of 2% may
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be added in pricing. Risk pricing implies factoring risks into pricing through capital charge and loss
probabilities. This would be in addition to the actual costs incurred in the transaction. The actual costs
incurred are cost of funds that has gone into the Transaction and costs incurred in giving the services,
which are incurred by way of maintaining the infrastructure, employees and other relevant expenses.
Pricing, therefore, should take in to account the following:
1. Cost of Deployable Funds

2. Operating Expenses
3. Loss Probabilities
4. Capital Charge
It should also be mentioned here that cost of funds should correspond to the term for which it is
deployed. This is because five-year funds may have a different cost than one-year fund due to time value
of money.
It may be noted that pricing is transaction based. This is one of the key reasons for risk measurement at
transaction level.
RISK MONITORING AND CONTROL
The key driver in managing a business is seeking enhancement in risk-adjusted return on capital
(RAROC). Therefore, approach to risk management cannot be in isolation or in stand-alone mode. The
approach to risk management centers on facilitating implementation of risk and business policies
simultaneously in a consistent manner. Modern best practices consist of setting risk limits based on
economic measures of risk while ensuring best risk adjusted return keeping in view the capital that has
been invested in the business. It is a question of taking a balanced view on risks and returns and that
within the constraints of available capital.
In order to achieve the above objective, banks put in place the following:
1. An organizational structure.
2. Comprehensive risk measurement approach.
3. Risk Management Policies adopted at the corporate level, which is consistent with the broader
business strategies, capital strength, and management expertise and risk appetite.
4. Guidelines and other parameters used to govern risk taking including detailed structure of
prudential limits, discretionary limits and risk taking functions.
It is not enough to put in place a structure for the purpose. It is equally important to ensure that the
organization functions in a manner it has been planned. A feedback of the actual functioning is therefore
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necessary for the purpose of control. In addition to that the feedback received on the actual
performance requires monitoring also to endure that the divergence between the planned performance
and actual performance is kept at the level that is acceptable. This requires the following:
1. Strong Management Information System for reporting, monitoring and controlling risk.
2. Well laid out procedures, effective control and comprehensive risk reporting framework.
3. Separate risk management framework independent of operational departments with clear
delineation of responsibility for management of risk; and
4. Periodical review and evaluation.
The banks establish an adequate system for monitoring and reporting risk exposures and assessing the
bank’s changing risk profile. The bank’s senior management or board of directors should, on a regular
basis, receive reports on the bank’s risk profile and capital needs. These reports should allow senior
management to:
 Evaluate the level and trend of material risks and their effect on capital levels;
 Evaluate the sensitivity and reasonableness of key assumptions;
 Assess bank’s risk profile on a continuous basis and make necessary adjustments to the bank’s
strategic plan accordingly.
The bank’s internal control structure is essential to the process. Effective control of the process includes
an independent review and, where appropriate, the involvement of internal or external audits. The
bank’s board of directors has a responsibility to ensure that management establishes a system for
accessing the various risks develops a system to relate risk to the bank’s capital level, and establishes a
method for monitoring compliance with internal policies. The board should regularly verify whether its
system of internal controls is adequate to ensure well-ordered and prudent conduct of business.
The banks conduct periodic reviews of its risk management process to ensure its integrity accuracy, and
reasonableness. Identification of large exposures and risk concentrations, accuracy and completeness of
data inputs into the bank’s assessment process and stress testing and analysis of f assumptions and
inputs are all a part of control and monitoring processes.
RISK MITIGATION
Since risks arise from uncertainties associated with the risk elements, risk reduction is achieved by
adopting strategies that eliminate or reduce the uncertainties associated with the risk elements. This is
called ‘Risk Mitigation’;
In banking, we come across a variety of financial instruments and number of techniques that can be
used to mitigate risks. The techniques to mitigate different types of risk are different. For mitigating
credit risk banks have been using traditional techniques such as collateralizations by first priority claims
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with cash or securities or landed properties, third party guarantees etc. Banks may buy credit derivatives
to offset various forms of credit risk. For mitigating interest rate risk banks use interest rate swaps,
forward rate agreements or financial future. Similarly, for mitigating forex risks banks use forex forward
contract, forex options or futures and for mitigating equity price risk, equity options.
Risk mitigation measures aim to reduce downside variability in net cash flow but it also reduces upside
potential simultaneously. In fact, risk mitigation measures reduce the variability in net cash flow. In
addition risk mitigation would involve counterparty and it will always be associated with counter party
risk. It may also be stated here that markets have responded to the counterparty risk by establishing
‘Exchanges’ such as stock exchange, commodity exchange future and option exchanges. Such
‘Exchanges’ take up the role of counterparty and have established rules for risk minimization. As a
result, when we enter in to a contract with exchange as counterparty, counterparty risk remains but
gets reduced very substantially. In OTC deals, counterparty risk would depend upon the risk level
associated with party to the contract
Sum Up
1. Risk is defined as uncertainties resulting, in adverse outcome, adverse in relation to planned

objective or expectations. ‘Financial Risks’ are uncertainties resulting in adverse variation of
profitability or outright losses
2. Uncertainties associated with risk elements impact the net cash flow of any business or
investment. Under the impact of uncertainties, variations in net cash flow take place. This could
be favorable as well as unfavorable. The possible unfavorable Impact is the “RISK” of the
business.
3. Lower risks imply lower variability in net cash flow with lower upside and downside potential.
Higher risk would imply higher upside and downside potential Zero Risk would imply no
variation in net cash flow. Return on zero risk investment would be low as compared to other
opportunities available in the market.
4. The key driver in managing a business is seeking enhancement in risk-adjusted return on capital
(RAROC). Capital and RAROC, both are risk dependent. Hence, Risk management is critical in the
management processes of an organisation.
5. From the risk management point of view banking business lines may be grouped broadly under
the following major heads.
 The Banking Book
 The Trading portfolio
 Off-Balance Sheet Exposures
6. All assets and liabilities in the banking book are normally held until maturity and accrual system
of accounting is applied on them. The banking book is mainly exposed to liquidity risk, interest
rate risk, default or credit risk and operational risks.
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7. The positions in the trading book are normally held for liquidating them in the market after
holding it for a period. The difference between market price realized and book value is
accounted for as profit/loss. Trading book is mainly exposed to market risk, market liquidity risk,
default or credit risk and operational risk.
8. Off-balance sheet exposures may become fund-based exposure based on certain contingencies.
Both, contingencies given (where bank provides benefit) and contingencies receivable (where
bank is the beneficiary) may form off-balance sheet exposure. Off-balance sheet exposures may
have liquidity risk, interest rate risk, market risk, default or credit risk and operational risk.
9. The portfolio risk level would have a lower risk level than the individual risks that constitute the
portfolio. This would be due to effect of diversification as all portfolio constituents will not
behave in a unidirectional manner. This would be true for all types of risk.
10. Management of risks may be sub-divided into following five processes
• Risk Identification
• Risk Measurement
• Risk Pricing
• Risk Monitoring and Control
• Risk Mitigation
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UNIT 7
INVESTMENT BANKING
 ROLE OF MERCHANT BANKERS

 CAPTIAL STRUCTURING
 BUY BACK AND ITS RATIONALE
 IPO/RIGHTS ISSUE PROCESS
 ADR/GDR ISSUE
 IMPORTANT SEBI REGULATION
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IPO/RIGHTS ISSUE PROCESS
Types of Capital Issues in the Primary Market
In the primary market, issues can be classified as a public, rights or preferential issues (also known a
private placement). While public and rights issues involve a detailed procedure, private placements or
preferential issues are relatively simpler.
Public issues can be further classified into Initial Public Offerings (IPO) and Further Public Offerings
(FPOs). In a public offering, the issuer makes an offer for the new investors to enter its shareholding
family. The issuer company makes detailed disclosures as per the Disclosure and Investor Protection
(DIP) guidelines in its offer document and offers it for subscription.
An IPO is the offering that is made when an unlisted company makes either a fresh issue of security &
offer for sale of its existing securities or both for the first time to the public. This paves way for listing
and trading of the issuer’s securities.
An FPO is made when an already listed company makes either a fresh issue of securities to the public or
an offer for sale to the public, through an offer document. An offer for sale in such a scenario is allowed
only if it is made to satisfy listing or continuous listing obligations.
Rights Issue (RI) is when a listed company proposes to issue fresh securities to its existing shareholders
as on a recorded date. The rights are normally offered in a particular ratio to the number of securities
held prior to the issues. This route is best suited for companies who would like to raise capital without
diluting the stake of its existing shareholders, unless they do not intend to subscribe to their
entitlements
A private placement is an issue of shares or of convertible securities by a company to a select group of

persons under section 81 of the Companies Act, 1956, which is neither a rights issue nor a public issue.
This is a faster way for a company to raise equity capital.
A Qualified Institutional Placement (QIP) is a private placement of equity shares or securities convertible
into equity shares by a listed company to Qualified Institutional Buyers (QIB) only, in terms of provisions
of Chapter XIIIA of SEBI (DIP) guidelines.
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Eligibility Norms for Making Capital Issues
SEBI has laid down eligibility norms for entities accessing the primary market through public issues.
There are no eligibility norms for a listed company that is making a rights issue as it is an offer made to
the existing shareholders who are expected to know their company. There are also no eligibility norms
for a listed company making a preferential issue. However for a QIP, only those companies whose shares
are listed in NSE or BSE and those who are having a minimum public float as required in terms of the
listing agreement, are eligible.
Any company making public issue a listed company making right issue of a value of more than Rs. 50
lakh is required to file a draft offer document with SEBI for its observations. The validity period of SEBI’s
observation letter is only three months, i.e. the company has to open its issue within a period of three
months. There is no requirement of filing any offer document/notice to SEBI in the case of preferential
allotment and QIP. In QIP, the merchant banker handling the issue has to file a copy of the placement
document with SEBI post-allotment, for record purposes.
The merchant banks are the specialized intermediaries who are required to display due diligence and
ensure that all the requirements of DIP are complied with, while submitting the draft offer document to
SEBI. Any non-compliance on their part attracts penal action from SEBI in terms of SEBI (Merchant
Bankers) Regulations. The draft offer document filed by the merchant banker is also placed on the
website for public comments. Officials of SEBI, at various levels, examine the compliance with DIP
guidelines and ensure that all necessary material information is disclosed in the draft offer documents.
Offer Document means prospectus in case of a public issue, or offer for sale and Letter of Offer in case of
a rights issue which are filed with Registrar of companies (ROC) and stock exchanges. An offer document
covers all the relevant information to help an investor to make his/her investment decision.
A Draft Offer Document means the offer document in a draft stage. The draft offer documents are filed
with SEBI, at least twenty-one days prior to the filing of the offer document with ROC/SEs. SEBI may
specify changes, if any, in the draft offer document and the issuer or the lead merchant banker (LM)
shall carry out such changes in the draft offer document before filing the offer documents with the ROC/
SEs. The draft offer document will be available on the SEBI website for public comments for a period of
twenty-one days from the filing of the draft offer document with SEBI.
Red Herring Prospectus (RHP) is a prospectus which does not have details of either price or number of
shares being offered or the amount of issue. This means that in case the price is not disclosed, the
number of shares and the upper and the lower price bands are disclosed. On the other hand, an issuer
can state the issue size, and the numbers of shares are determined later. An RHP for an FPO can be filed
with the ROC without the price band. In such a case, the floor price or the price band will be notified by
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way of an advertisement one day prior to the opening of the issue. In the case of book-built issues, it is a
process of price discovery and the price cannot be determined until the bidding process is completed.
Such details are thus not shown in the RHP filed with ROC in terms of the provisions of the Companies
act. Only on completion of the bidding process, the details of the final price are included in the offer
document. The offer document filed thereafter with ROC is called a prospectus.
Pricing of the Issue
Indian primary market ushered in an era of free pricing in 1992. Following this, the guidelines have
provided that the issuer, in consultation with the merchant banker shall decide the price. There is no
price formula stipulated by SEBI. SEBI does not play any role in the price fixation. The company and
merchant banker are however required to give full disclosures of the parameters which they had
considered while deciding the issue rice. There are two types of issues, one where company and Lead
Manager (LM) fix a price (called fixed price) and other, where the company and LM stipulate a floor price
or, price band and leave it to market forces to determine the final price (price discovery through book
building process).
An issuer company is allowed to freely price the issue. The basis of issue price is disclosed in the offer
document where the issuer discloses in detail about the qualitative and quantitative factors justifying
the issue price. The issuer company can mention a price band of 20 per cent (cap in the price band
should not be more than 20 per cent of the floor price) in the draft offer documents filed with SEBI and
actual price can be determined at a later date before filing of the final offer document with SEBI/ROCs.
Book Building means a process undertaken, by which a demand for the securities proposed to be issued
by a corporate body is elicited and built up and the price for the securities is assessed on the basis of the
bids obtained for the quantum of securities offered for subscription by the issuer. This method provides
an opportunity to the market to discover the price for securities.
In a book built issue allocation, Retail Individual Investors (RIIs), Non-Institutional Investors (NIIs) and
QIBs are in the ratio of 35:15:50 respectively. In case the book built issues are made pursuant to the
requirement of mandatory allocation of 60 per cent to QIBs in terms of Rule 19(2)(b) of SCRR, the
respective figures are 30 per cent for RIIs and 10 per cent for NIIs.
Retail Individual Investor means an investor who applies or bids for securities of or for a value not more
than Rs. 1, 00,000,
Intermediaries in an Issue in the Primary Market
Merchant bankers to the issue or Book Running Lead Managers (BRLM), syndicate members, registrars
to the issue, bankers to the issue, auditors of the company, underwriters to the issue, solicitors, etc., are
the intermediaries to an issue in the primary market.
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Book Running Lead Managers (BRLM): A merchant banker possessing a valid SEBI registration in
accordance with the SEBI (Merchant Bankers) Regulations, 1992 is eligible to act as a BRLM to an issue.
Safety Net: Any safety net scheme or buy-back arrangements of the shares proposed in any public issue
shall be finalized by an issuer company with the lead merchant banker in advance and disclosed in the
prospectus. Such a buy-back or safety net arrangement shall be made available only to original resident
individual allottees limited to a maximum of 1000 shares per allottee and the offer is kept open for a
period of six months from the last date of dispatch of securities.
Cut Off Price: In a book-building issue, the issuer is required to indicate either the price band or a floor
price in the RHP. The actual discovered issue price can be any price in the price band or any price above
the floor price. This issue price is called the Cut Off Price. This is decided by the issuer and LM after
considering the ‘book and investors’ appetite for the stock. SEBI (DIP) guidelines permit only, retail
individual investors to have an option of applying at the cut off price.
105
IMPORTANT SECURITIES AND EXCHANGE BOARD OF INDIA (SEBI) FUNCTIONS/ REGULATIONS
The Government of India enacted the SEBI Act, 1992, on 4 April 1992 to provide for the establishment of
a board, called the Securities and Exchange Board of India (SEBI) to protect the interests of investors in
securities and to promote the development of and to regulate, the securities market and for matters
connected therewith or incidental thereto (Prior to the formation of SEBI, some of the control functions
were carried on by the controller of Capital Issues and the Company Law Board.).
Functions/Regulations of the Board
1. Subject to the provisions of this Act, it shall be the duty of the board to protect the interests of
investors in securities and to promote the development of and to regulate the securities market,
by:
a) Regulating the business in stock exchanges and any other securities markets;
b)
I. registering and regulating the working of stock brokers, sub-brokers, share
transfer agents, bankers to an issue, trustees of trust deeds, registrars to an
issue, merchant bankers, underwriters, portfolio managers, investment
advisers and such other intermediaries who may be associated with the
securities market in any manner;
II. registering and regulating the working of the depositories, participants,
custodians of securities, foreign institutional investors, credit rating
agencies.
c) registering and regulating the working of venture capital funds and collective
investment schemes, including mutual funds;
d) promoting and regulating self-regulatory organisations;
e) prohibiting fraudulent and unfair trade practices relating to the securities markets;
f) promoting investors’ education and training of intermediaries of security markets;
g) prohibiting insider trading in securities;
h) regulating substantial acquisition of shares and takeover of companies;
i) calling for information from, undertaking inspection, conducting inquiries and audits
of the stock exchanges, mutual funds, other persons associated with the securities
market, intermediaries and self-regulatory organisations in the securities market;
j)
I. calling for information and records from any bank or any other authority or
board or corporation established or constituted by or under any Central,
State or Provincial Act in respect of any transaction in securities, which is
under investigation or inquiry by the Board;
106
II. performing such functions and exercising such powers under the provisions
of the Securities Contracts (Regulation) Act, 1956 (42 of 1956), as may be
delegated to it by the Central Government;
k) levying fees or other charges for carrying out the purposes of this section;
l) conducting research for the above purposes;
I. calling from or furnishing to any such agencies, as may be specified by the
board, such information as may be considered necessary by it for the
efficient discharge of its functions;
II. performing such other functions as may be prescribed.
2. The board may take measures to undertake inspection of any book, or register or other
document or record of any listed public company or a public company (not being
intermediaries), which intends to get its securities listed on any recognised stock exchange,
where the board has reasonable grounds to believe that such a company has been indulging in
insider trading or fraudulent and unfair trade practices relating to the securities market.
3. The board shall have the same powers as are vested in a civil court under the Code of Civil
Procedure, 1908 (5 of 1908), while trying a suit in respect of the following matters, namely:
a) the discovery and production of books of account and other documents, at such a place
and time as may be specified by the board;
b) summoning and enforcing the attendance of persons and examining them on oath;
c) inspection of any books, registers and other documents of any person at any place;
d) inspection of any book or register, or other documents or record of the company;
e) issuing commissions for the examination of witnesses or documents.
4. The board may, by an order, for reasons to be recorded in writing, in the interests of investors
or the securities market, take any of the following measures, either pending investigation or
inquiry or on completion of such investigation or inquiry, namely:
a) suspend the trading of any security in a recognised stock exchange;
b) restrain persons from accessing the securities market and prohibit any person
associated with the securities market to buy, sell or deal in securities;
c) suspend any office bearer of any stock exchange or self-regulatory organisation from
holding such position;
d) impound and retain the proceeds or securities in respect of any transaction which is
under investigation;
e) attach, after passing of an order on an application made for approval by the Judicial
Magistrate of the first class having jurisdiction, for a period not exceeding one month,
one or more bank account or accounts of any intermediary or any person associated
with the securities market in any manner involved in violation of any of the provisions of
this Act or the rules or the regulations made there under. This provided that only the
bank account or accounts or any transaction entered therein, so far as it relates to the
107
proceeds actually involved in violation of any of the provisions of this Act, or the rules or
the regulations made there under shall be allowed to be attached;
f) direct any intermediary or any person associated with the securities market in any
manner not to dispose of or alienate an asset, forming part of any transaction which is
under investigation.
Powers of SEBI to Regulate or Prohibit Issue of Prospectus, Offer Document or Advertisement Soliciting
Money for Issue of Securities: Without prejudice to the provisions of the Companies Act, 1956, (1 of
1956), SEBI may, for the protection of investors,
a) specify, by regulations:
I. the matters relating to issue of capital, transfer of securities and other matters
incidental thereto; and
II. the manner in which such matters shall be disclosed by the companies;
b) by general or special orders:
I. prohibit any company from issuing prospectus, any offer document or advertisement
soliciting money from the public for the issue of securities;
II. specify the conditions subject to which, the prospectus, such offer document or
advertisement, if not prohibited, may be issued.
Without prejudice to the provisions of Section 21 of the Securities Contracts (Regulation) Act, 1956 (42
of 1956), SEBI may specify the requirements for listing and transfer of securities and other matters
incidental thereto.
Power to Investigate
When SEBI has reasonable ground to believe that:
a) the transactions in securities are being dealt with in a manner detrimental to the investors or
the securities market; or
b) any intermediary or any person associated with the securities market has violated any of the
provisions of this Act or the rules or the regulations made or directions issued by SEBI there
under, it may, at any time by order in writing, direct any person (specified in the order to
investigate the affairs of such intermediary or persons associated with the securities market) to
report thereon to the board, for taking suitable action.
Cease and Desist Proceedings
If SEBI finds, after causing an inquiry to be made, that any person has violated, or is likely to violate, any
provisions of this Act, or any rules or regulations made there under, it may pass an order requiring such
person(s) to cease and desist from committing or causing such violation.
108
REGISTRATION OF STOCK BROKERS, SUB-BROKERS, SHARE TRANSFER AGENTS, ETC.
1. No stock broker, sub-broker, share transfer agent, banker to an issue, trustee of trust deed,
registrar to an issue, merchant banker, underwriter, portfolio manager, investment adviser and
such other intermediary who may be associated with the securities market shall buy, sell or deal
in securities except under and in accordance with, the conditions of a certificate of registration
obtained from SEBI in accordance with the regulations made under this Act.
2. No depository, participant, custodian of securities, foreign institutional investor, credit rating
agency or any other intermediary associated with the securities market as the Board may, by
notification in this behalf specify, shall buy or sell or deal in securities except under and in
accordance with the conditions of a certificate of registration obtained from SEBI in accordance
with the regulations made under this Act.
3. No person shall sponsor or cause to be sponsored or carry on or cause to be carried on any
venture capital funds or collective investment schemes including mutual funds, unless he
obtains a certificate of registration from SEBI in accordance with the regulations.
4. Every application for registration shall be in such a manner and on payment of such fees as may
be determined by the regulations.
5. SEBI may, by order, suspend or cancel a certificate of registration in such manner as may be
determined by regulations. Provided that no order under this sub-section shall be made unless
the person concerned has been given a reasonable opportunity of being heard;
109
Buy Back And its Rational
A buyback can be seen as a method for company to invest in itself by buying shares from other investors in the
market. Buybacks reduce the number of shares outstanding in the market. Buy back is done by the company with the
purpose to improve the liquidity in its shares and enhance the shareholders’ wealth. Under the SEBI (Buy Back of
Securities) Regulation, 1998, a company is permitted to buy back its share from:
a. Existing shareholders on a proportionate basis through the offer document.

b. Open market through stock exchanges using book building process.
c. Shareholders holding odd lot shares.
The company has to disclose the pre and post-buyback holding of the promoters. To ensure completion of the
buyback process speedily, the regulations have stipulated time limit for each step. For example, in the cases of
purchases through stock exchanges, an offer for buy back should not remain open for more than 30 days. The
verification of shares received in buy back has to be completed within 15 days of the closure of the offer. The
payments for accepted securities has to be made within 7 days of the completion of verification and bought back
shares have to be extinguished within 7 days of the date of the payment.
110
ADR/GDR ISSUES
Global Depository Receipts (GDRs)
A GDR is a dollar denominated instrument, tradable on a stock exchange in Europe or private placement
in USA representing one or more shares of the issuing company. The shares are acquired by a bank in
Europe, which then issues its own “receipts” or “certificates” to the investors. This bank is called a
“depositories” and such certificates are called “Global Depository Receipts” in short, GDRs. These GDRs
can be traded on the European exchange.
A holder of a GDR can at any time convert it into the shares that it represents. However, till conversion,
the GDRs do not carry any voting rights. The company, which has issued GDRs has no commitment to
pay any amount in foreign exchange, and thus has no exposure in foreign exchange. As a result, it has no
foreign exchange risk. The dividend paid by the company is in local currency. The holder of the GDR has
to get the amount converted in US dollars at the prevailing exchange rate. As the GDR represents shares
there is no redemption involved. The company doesn’t have to make any payment either in foreign
exchange or in local currency for the repayment of GDRs. This arrangement thus, works to the
advantage to the company as also is convenient for the holder of the GDRs, as it can be traded on a
foreign stock exchange where they are listed alternatively the holder can convert the GDR into its
underlying shares, sell these on the local stock exchange, and then convert proceeds into US Dollars at
the prevailing exchange rate.
The main features of GDRs are as under:
1. GDR has a distinct identity from the underlying shares.

2. GDRs do not appear in the books of the issuing company. However, the underlying
shares appear in its books.
3. The issuing company collects the GDR proceeds in foreign currency. It may then use
these proceeds for meeting the foreign exchange component of its project cost,
repayment of foreign loans, or for its domestic expenditure.
4. A GDR holder has the option to convert the GDR and hold the underlying equity shares.
5. GDRs are normally listed on Luxembourg exchange and traded at two other places
besides the place of listing-OTC market in London and private placement market in USA.
6. GDR does not entitle the holder any voting rights. However, the holder gets the voting
rights, when he prefers to convert GDRs into, underlying shares.
7. GDR is an instrument governed by international law.
8. Pricing of GDR would generally be in line with the pricing of underlying shares. However,
based on international market conditions and perceptions about domestic currency, the
GDR may be at discount or at premium compared to domestic share prices.
111
9. The GDR market is a global one. It is therefore exposed to international influences, like
prices of other securities in the financial market or interest rates in the US Market.
Currency markets also have impact on GDR prices.
American Depository Receipts (ADRs)
ADR is an instrument similar to GDR and is issued in the capital markets of USA alone. Generally, far
more stringent rules and regulations prevail for bringing out an ADR issue.
An American Depository Receipt is a receipt or a certificate issued by a US bank, representing title to a

specified number of shares of a non-US-company. The US bank is a depository in this case. ADR is the
evidence of ownership of underlying shares. ADRs are freely traded in the USA, without actual delivery
of underlying non-US-shares.
ADRs can be created in two ways:
1. Unsponsored ADRs
One way to create ADR is by an arrangement which is not initiated by the company concerned, but is
generally set up by one or more US brokers, when it is observed that a large number of American
investors are interested in dealing in the shares of a non-US-company. The brokers then ask a US
depository bank to create ADRs. The depository has to register the ADRs with the Securities and
Exchange Commission (SEC), which is the main securities regulator in USA. However, as the ADRs are not
initiated by the company concerned, the depository may not be able to fulfill the reporting
requirements of the SEC. Therefore, the depository asks exemption from these.
The depository bank receives the compensation or the income from issuance of certificates and from
cancellation fees. It also deducts fees from dividend payments. The company, whose shares are linked to
this kind ADRs, is not required to pay any costs to the depository.
The trading of ADRs takes place in some of the stock exchanges in USA as NASDAQ or NY stock
exchange.
2. Sponsored ADRs
In this case the issuing company actively promotes the company’s ADRs in USA, choosing a single
depository bank, which assumes sole responsibility for administration and dividend payment. In this
case, the administrative costs involved in issuing the ADRs are borne by the issuing company. The
proceeds of the ADR issue are also received by the company.
The registration of ADRs with SEC (Securities Exchange Commission) is not compulsory. The company
needs to submit its annual reports to SEC.
112
Unregistered ADRs are not eligible for listing on any of the American stock exchanges. However, trading
in such ADRs may take place on the NASDAQ’s bulletin board.
If the ADRs are to be registered with the SEC, the financial statements of the company need to be
prepared in accordance with US Generally Accepted accounting Principles (US GAAP) and fulfill listing
requirements of at least one the US stock exchanges.
The size of ADR can expand or reduce depending upon demand, as depository banks can issue or
withdraw corresponding shares in the local market. Generally, raising forex funds through ADR/GDR
route is preferred to external commercial borrowing route. Commercial borrowing adds to the country’s
external debt burden, which is not the case with ADR/GDRs.
113

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Pillai Institute of Management Studies and Research Course Syllabus & Study Notes

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PILLAI INSTITUTE OF

INTRODUCTION TO FINANCIAL MARKETS

DETERMINANTS OF INTEREST RATE

 REAL AND NOMINAL INTERST RATES

 WHY MONEY MARKETS ARE NEEDED

FOREIGN EXCHANGE MARKETS

 PURPOSE SERVED BY THE MARKET

DERIVATIVES AND RISK MANAGEMENT

 UNDERASTANDING BASIC PURPOSE OF DERIVATIVES

 UNDERSTANDING THE BALANCE SHEET

 ROLE OF MERCHANT BANKERS

 AN OVERVIEW ABOUT THE FINANCIAL SYSTEM

Figure1 represents the various segments of the financial market.

1. Monetary Control 1. Equity market and debt 1. Regulatory framework

FIGURE 2: Financial System — A Schematic Presentation

Non-Banking Financial Companies (NBFCS)

Primary Dealers (PDs)

Financial Institutions (FIs)

Payment and Settlement System

Management of Government Debt

Lender of Last Resort to Banks

Cash Reserve Ratio (CRR)

Statutory Liquidity Ratio (SLR)

EQUITY AND DEBT MARKET

Equity and Debt Raisers

Investment Bankers (Merchant Bankers)

Foreign Institutional Investors (FIIs)

INSURANCE REGULATORY AND DEVELOPMENT AUTHORITY (IRDA)

 REAL AND NOMINAL INTERST RATES

Real v/s Nominal Interest Rate

IMPLICATIONS OF REAL INTEREST RATES TURNING NEGATIVE

What is a negative real interest rate?

Implications of a negative real interest rate

What is the situation in India?

Is the negative real interest rate a concern?

MEASUSRES OF MONEY SUPPLY M1/M3

The four money supply measures can be defined as follows:

M1 =Currency with public + demand deposits +other deposits with RBI

M2 = M1 + Post Office Savings Bank Deposits

M3 =M1 + Time deposits with banks

TOOLS OF MONETARY CONTROL

Cash Reserve Ratio (CRR)

Statutory Liquidity Ratio (SLR)

 To restrict expansion of banks’ credit,

Open Market Operations (OMOs)

Selective Credit Control (SCC)

 WHY MONEY MARKETS ARE NEEDED

MONEY MARKET INSTRUMENTS

Money market instruments have the following features:

Reserve Bank of India Liquidity Adjustment Facility (RBI LAF)

Repos and Reverse Repos

Concept and Mechanism

Collateralized Borrowing and Lending Obligation (CBLO)

TREASURY BILLS (T-BILLs)

Commercial Paper (CP)

Certificates of Deposit (CD)

 PURPOSE SERVED BY THE MARKET

SPECULATION IS THE KEY DRIVER

FOREIGN EXCHANGE MARKET CHARACTERISTICS

FOREIGN EXCHANGE MARKETS – SUM UP.

CURRENCY TRADING TRENDS

CURRENCY AS AN ASSET CLASS

SPOT RATE/FORWARD RATE – FOREIGN EXCHANGE