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INDEX
S. No Topic Page No
Week 1
1 Introduction to Financial System 1
2 Equilibrium in Financial Markets 17
3 Efficiency of Financial Markets 32
4 Measures of Financial Development 47
5 Financial Development and Economic Growth 61

Week 2
6 Systematic risks in financial system 77
7 Unsystematic risks in financial system 93
8 Return concepts in financial system 108
9 Fundamental analysis of financial assets 122
10 Technical analysis of financial assets 137

Week 3
11 Theories of interest rate determination-I 154
12 Theories of interest rate determination-II 170
13 Term structure theories of interest rate-I 187
14 Term structure theories of interest rate-II 200
15 Term structure theories of interest rate-III 215

Week 4
16 Financial market regulation 231
17 RBI- structure and objective functions 247
18 Monetary policy instruments 263
19 Challenges and reforms in monetary policy and central bank autonomy 279
20 SEBI, IROA and PFRDA structure and function 295

Week 5
21 Commercial banks Role and Services 313
22 Commercial banks Financial statements 328
23 Commercial bank performance 342
24 Basel Accords 357
25 Measure of risk in commercial banks 373
Week 6
26 Provident fund and pension fund 391
27 Insurance companies 410
28 Mutual funds-I 428
29 Mutual funds-II 444
30 NBFCs-I 459
Week 7
31 NBFCs-II 475
32 Venture capital 490
33 Merchant banks 508
34 Credit Rating Agencies 525
35 Non-banking statutory financial organization 542
Week 8
36 Call Money Market-I 563
37 Call Money Market-II 578
38 Treasury Bills Market 593
39 Miscellaneous short-term money market-I 609
40 Miscellaneous short-term money market-II 624
Week 9
41 Bond Analysis-I 639
42 Bond Analysis-II 658
43 Bond Analysis-III 675
44 Bond Analysis-IV 693
45 Bond market in India 711

Week 10
46 Stock market-I 729
47 Stock market-II 744
48 Stock market-III 764
49 Stock market-IV 782
50 Stock market-V 799

Week 11
51 Derivatives Market-I 817
52 Derivatives Market-II 832
53 Derivatives Market-III 851
54 Derivatives Market-IV 866
55 Derivatives Market-V 884

Week 12
56 Foreign Exchange Market-I 900
57 Foreign Exchange Market-II 915
58 Foreign Exchange Market-III 929
59 Foreign Exchange Market-IV 946
60 Foreign Exchange Market-V 965

Financial Institutions and Markets
Prof. Jitendra Mahakud
Department of Humanities and Social Science
Indian Institute of Technology, Kharagpur
Lecture – 01
Introduction to Financial System
Good morning, welcome to the course on Financial Institutions and Markets. Today we
will be discussing about the introduction part, where you will have the idea that how to
define this financial system or financial institutions and markets and what are those
functions of this particular system and how the financial markets are structured or how
the financial system in general structured into different financial institutions and markets.
(Refer Slide Time: 00:51)
So, if you see that what exactly the financial system is, the financial system basically
deals with the financial transactions and the exchange of money between savers,
investors, lenders and borrowers.
If you see each word, what does this particular word define? Savers means the
household sector or the corporate sector mostly the household sectors are the savers who
wants to save their money for specific reasons and the investors are those people who
wants to use that particular savings to generate certain profits mostly the corporate
sectors are responsible for that. Then we have lenders the lenders are basically the
financial institutions or the banks who lends the money for specific reasons that reason
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includes maybe buying the house or maybe investing the money in the market or buying
any other kind of consumable products.
So, for any other thing always the lenders or the banks or financial institutions provide
the loan to the different stakeholders and the borrowers are basically the individuals and
as well as some other financial institutions who wants to borrow the money from the
financial system. So, the financial system in general tries to integrate these stakeholders
for the transaction purpose and also to exchange the money between them. So, in general
overall if you see the basic job of the financial system is to make a relationship between
the different stakeholders like the savers, investors, lenders for borrowers and other
market participants who are existing in this particular system.
So, in general now we can define that what exactly it does. So, in this context the basic
job of the financial system is to provide the financial services and financial services
means it basically tries to provide certain kind of service to the different stakeholders to
maximize their return or to fulfill their requirements in terms of the financial
requirements or the requirements are mostly related to the financial aspects. So,
therefore, now we can define it this way the financial systems are made of different
integrate and complex models that link the financial institutions and markets to provide
the financial services for various stakeholders operating in the financial system like
depositors, lenders, borrowers, government and others.
So, here we are depositing the money and the commercial borrowers or the corporate
sector tries to take that particular loan and uses it for some specific investments and
finally, some return is realized and by that the maximum amount of return can be
generated from the market and finally, the money can be circulated and as well as the
flow of the particular money comes to the system which helps in the different kind of
growth activities in the economy at a large. So, therefore, the financial system basically
tries to make an integration between the different stakeholder or make them together by
that the money can come to the market in a systematic way and finally, the services or
the financial services can be realized from this.
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(Refer Slide Time: 04:59).
So, in this context there are three words people always use whenever they try to discuss
about or they try to relate about the financial system, one is money, second one is credit
and third one is the finance. So, these are the terms which are largely or mostly used by
the people or by the different participants in the financial system.
So, if you see in a layman point of view money means the rupee or the particular
currency would people use it for different reasons. But if you try to find out a proper
definition of the money the money is nothing, but the medium of exchange it is a means
of payment. If anybody wants to define the money in a very systematic or maybe
standard way, then we can say that money is particular instrument or money is basically
a particular medium of exchange or a means of payment whenever we transact in the
financial system or any other market which exists in this particular economy.
So, therefore, money refers to the current medium of exchange or the means of payment.
So, that is the way money in aggregate sense or in real sense can be defined. Whenever
you talk about the credit all of you might have already aware about that we have two
things that is a bank passbook n which some money is credited some money is debited.
So, whenever we talk about the credit it is basically whenever we expecting something to
be realized from that and if you have some kind of credit that is basically always used as
a positive sense which can generate certain revenue in the future.
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So, whenever you talk about credit in an aggregate sense in a larger sense it is basically
the commercial banks provide the credit to the different kind of other companies or
corporate sector and also individuals expecting certain interest from that. And mostly in
a true sense credit is nothing, but the loan which is given by the commercial banks to the
different stakeholder which are participating in the financial market by that the
commercial bank can generate certain revenue out of this and as well as the particular
person who takes that loan, they can utilize that particular resources, utilize that
particular finance for the specific purposes for what purpose they have taken that loan
that loan is basically can be utilized for that specific purpose. And finally, in the end they
have to pay certain interest to the commercial banks.
So, therefore, if anybody has taken a loan we consider this is a debt for them or if it is for
us it is a liability if any individual takes a loan, we consider this is the liability for the
individual. But however, we talk about the commercial bank prospective or any other
financial institutions who provide the loan to us for them it is basically an asset because
from this particular kind of loans they generate certain revenue, they generate certain
interest which basically helps them to run their business and finally, because they do the
financial business and we get this particular money from them to fulfill our requirements
and also to utilize that particular money for specific reasons.
So, that is the way the credit in a financial sense we use in the financial system. Then we
have the finance that is another word people always use. What is exactly the finance?
The finance is basically nothing, but it is a monetary resources comprising depth and the
ownership of the funds of the company or person. I can give an example in this case. For
example, a company wants to do the business and how the company do the business.
Company basically generate certain revenue by selling the products or maybe they
basically produce certain products sell them in the goods market and generate certain
kind of income from this and whatever cost they have incurred to produce that product
and if you take a difference between the income what they generate and what are the cost
they have incurred the rest of the money basically we call it profit.
But whenever we talk about the finance, how the particular company generate or maybe
invest that particular money or how the particular company can generate the funds to
produce that product? So, either company can start the business with certain kind of
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resources already they have or they can borrow the money from the commercial banks or
any other financial institutions or already you might have the idea that they can raise the
money from the market in terms of equity or the stock from the public, they can generate
the money from the public. So, therefore, the people who are invested the money in that
particular stock which is issued by that particular company, they become the owner
because they are the stakeholder of that particular company. So, that is why they become
the owner.
So, they are entitled to get certain kind of share of the profit what the company basically
generates. So, in this context what we can say the total finance or the financial capital in
aggregate sense we use that is nothing, but whatever money the company have generated
in terms of debt and in terms of the equity which is basically the owners fund. So, that
basically takes care of the financing activities of the company and that particular
financial capital is utilized for the investment in the future.
So, therefore, the money credit and capital these are the different terms which are mostly
used in the finance literature or in the financial market to define certain issues. So, that is
why we should know that how these particular things are different and how these
particular things are used in the financial market by the different stakeholders.
Then we can come to the, what exactly the financial system does, why we need a
financial system. Already you have the idea that financial system is nothing, but it is a
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particular system which tries to aggregate try to integrate all the stakeholders, who are
trying to participate in the market with certain objectives like the maximization of the
return or getting certain kind of loans or provide certain kind of loans. All kinds of
stakeholders are basically getting certain kind of benefits from this particular system.
But in a very systematic sense, on in a very we can say that not in a layman prospective,
but from a economics prospective and from a systematic way of understanding if you see
that what are those functions of the financial system. Then if you see one by one first one
basically it provides the payment system for exchange of goods and services in the
economy.
Already you have the idea that any kind of exchange or any kind of transactions which
takes place in the system that is through banks or any other financial institutions.
Wherever you want to put your money, you put your money in the bank, you put your
money in the stock market, you put your money any other market whatever stakeholder
whatever markets we have what kind of stakeholder you are does not matter, but any
medium of exchange for any kind of exchange if you want to do, then you have to take
the help of the financial system because financial system is only helpful for kind of
exchanging the goods and services from one particular sector to another sector.
So, all the payments are basically made through the banking if you take the example of
India and also there are other financial institutions which help them for this payment
mechanism. So, because of that it provides the kind of services to exchange the goods
and services in the economy at a large. Then another thing you see that if anybody wants
to whatever income you have and whatever consumption you are making whatever
money is surplus basically were keeping with you. If you are keeping with you at home it
has no use.
So, financial system basically helps that if the money the surplus money of the household
sector can go to the financial system and that money can be utilized in the market that
money can be utilized by the another corporate who takes it as a loan, it can be taken as
another individual for housing purpose, it can be taken as an individual for business
purpose. So, therefore, it provides certain mechanism to pull the funds in terms of the
household savings for the corporate investments. Finally, in general sense we always call
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household sector are basically the savers household sector or the individual are the savers
and the business or the corporate sectors are basically the investors.
So, once the money has been pulled out then that money can be utilized in the market by
the corporate sector and it generates certain kind of revenue. Another thing also if you
see, once we are making the small savings somebody could have 500, somebody could
have 5000 does not matter, but end of the day whenever that particular money is
accumulated in a bank or any other financial institutions which are existing in that
particular system, then that particular money helps to create the long term capital
formation for the government and the corporate sector or the business organization.
That money can go to the government, that money can go to the other private entities and
they create certain kind of capital formation in terms of the fixed assets. The money can
be utilized to generate certain assets, infrastructure, which can be further again utilized to
generate profit, revenue for the business unit, which indirectly again helps the
individuals or helps the aggregate economy to maximize or increase the growth rate in a
larger way. So, therefore, it basically helps for the capital formation in that sense we can
say.
Already you know that it also provides kind of infrastructure it provides certain platform
or it facilitates the process by which the investors and other market participants can
liquidate their investment alternatives like stocks and bonds. For example, somebody
wants to invest in the stock. How they can invest without the help of the financial
system? They cannot invest without the help of the financial market in the stock. If they
want to sell the stock, then they want an infrastructure from the financial market also to
sell the stock.
So, like that whether it is stock or bond or any other gold in any other instruments
nowadays you have for various financial alternatives which are available. So, those kind
of assets or those kind of instruments can bought and sold through financial system only.
So, therefore, it has lot of implications for generation of the resources as well as provides
the services in terms of the different instruments and finally, that services or that
instruments can be liquidated to generate the cash at the time of requirements. So,
therefore, what we can say it helps to provides very larger financial services to the
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system, which can help the participants to liquidate whatever financial alternatives they
are holding. There are enough financial alternatives which are available.
So, they are able to or the market participants are able to minimize the risk because they
can diversify the risk because enough alternatives are available in the market. So,
therefore, what we can say that it also helps for minimization of the risk because all of
you know that if you are holding more assets in your portfolio, then the unsystematic risk
can be minimized. We will elaborately discuss about systematic, unsystematic our
different type of risk, what the investors face or the market participants trades in the
coming sessions.
But now we can say that if you are holding more assets or more type of assets in your
portfolio then in one case you are losing that is the possibility that the other asset can
perform better then you make in. So, because of that it can say that it provides the
avenues for managing the risk because all type of funds which are coming to the market
and it does not have any kind of very biased kind of requirements or biased kind of term
to maturity involves in that it caters the demand for both short term and long term needs
of the market participants; somebody wants money for 3 months, somebody wants
money for 5 years somebody wants money for 20 years.
So, the financial system is the only system who is able to cater the demand for all type of
stakeholders on the different maturity. So, therefore, we can say it takes care of both
short term and long term needs of the market participants. Already I have told you it
provides the financial capital to the government for the public expenditure on the
different infrastructure projects and that infrastructure projects in the future can generate
excess revenue and also maximize the welfare of the people in the economy at a large.
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Another thing that if you see the market, financial market provides the price information
at what price we should buy the particular stock, at what price the bond price should be
issued and also it can give you an idea that whether whatever price I am paying for some
kind of asset whether it is the price is a fair price or not or whether the price is really
price which is in equilibrium or not.
So, that basically we can get it whenever we have a definite financial system and
financial system is able to only provide that kind of information to us and it also helps in
the reduction of a symmetric information and moral hazard problem which in turn
facilitates in reducing the transaction cost. I will just little bit elaborate on this.
Whenever we are investing in the market or we want to participate in the market always
we should ensure the cost what we are bearing in the markets should be less.
But how the cost can be minimized? The cost can be minimized whenever you have all
the informations. I can give an example if somebody is selling the car somebody is
buying the car particularly the old car, then you will find the person who is basically
selling the car this old car he has all the information about the car what the person who is
buying the car they have less information. So, in that context what happens the buyer
always says that they always feels that he should pay less, but the seller always feels that
feels that I should get more.
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So, then that particular thing creates certain kind of risky situation in the market because
of there is a symmetric information and finally, what will happen that the price what they
will get that price may not be actual fair price for this investor can or the particular buyer
and seller can finally, decide upon. But if there is a system, which is there are so many
participants are available and as well as the financial system can integrate all of them can
bring them together then what will happen that finally, the price what basically will be
decided that prices can be a fair price can be equilibrium price in the system at a large.
It creates the investment opportunities to maximize the return that is related to the
portfolio part that already I have shared with you. Then, it also helps in efficient
allocation of the resources because there are so many stakeholders and it caters the
demand for all the needs in that context whoever needs and whatever purpose the
financial system is able to cater this demand for this particular investors or the market
participants.
So, therefore, it plays a significant role for economic growth it creates a demand supply
of the funds and we can say that because the change in the demand and supply have the
impact on the interest rate in the market then it basically affects the total money supply
inflation and the foreign investments. All those details in general we will be discussing in
a very elaborate way or elaborate manner in the upcoming sessions.
But this is the way the financial system basically helps. That is why we can say these are
the major functions of the financial system.
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Then coming back to the structure of the financial system how exactly the financial
system is and how it is defined if you see. In general the financial system is divided into
two parts as already you know from that particular title of the course that we have
financial institutions we have the financial markets.
And if you talk about the financial institutions there are different kind of institutions
basically work in the system some institutions are regulatory like if you talk about India,
we have Reserve Bank of India we have Security and exchange board of India, we have
Pension Fund Regulatory Development Authority, we have IRDA that is Insurance
Regulated Development Authority. There is RBI regulates banks the SEBI regulates, the
stock market and the pension funds are regulated by PFRDA or pension funds
development authority, then we have the IRDA which regulates the insurance companies
and we have intermediaries and we have some non intermediaries. Intermediaries are
basically the banks and others and who are those non intermediaries we will discuss
these things little bit in more elaborate in this session.
Then we have some other organizations; there are notable, there are specialized
organizations which are also exist in the market and if you talk about this financial
market there are two types of market; we have organized we have unorganized market,
but this course mostly we will concentrate upon the organized market because
unorganized markets are many where there is no formal kind of mechanism or a
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functional system operational system exists for them. So, because of that we will little bit
more focus on the organized financial markets.
So, the organized financial markets again can be divided into two parts, one is your
money market second one is the capital market and we have another segment we have
the foreign market foreign exchange market. So, here if you talk about the money market
there are different type of money markets. The markets are basically classified on the
basis of the term to maturity or the instrument which are available.
Within the money market, we have call money market, we have treasury bills, we have
certificate of deposits, commercial papers, and etcetera. In terms of capital market where
basically the long term securities are traded we have stock market, we have debt market,
we have the derivatives market. Debt market means I am referring to the bond market
then already I told there is another segment another market that is foreign exchange
market. Then every market has two segments, one is primary another one is secondary.
Then if you see that how you can classify the financial institutions? There is banking and
non banking and why there is a difference because banks provide transaction services; it
creates the deposit or the credit what are other financial institutions cannot do it subject
to some reserve requirement like they have to fulfill certain requirements or regulations
what is impose by RBI like they have to maintain the CRR, SLR and all kinds of thing
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that we will discuss further. And also they can give more loan whatever deposits they
have because they can create the money.
And if you talk about the non banking institutions, we have like LIC, you have the
mutual funds, you have the NBFC says other non-banking financial companies. So, these
are basically takes the money from us, but they are not able to create the money in the
system. So, they are basically the user of the money or purveyors of the credit, but they
are not the creator of the credit, but commercial banks are able to create the credit in the
system. So, that is the way the classification can be made.
Other classification we can make in this way like intermediaries and non intermediaries.
Intermediaries basically intermediate between the savers and the investors like we are the
servers and the corporate sector are the investors, then they basically try to bring them
together. They lend money and as well as mobilize the savings, their liabilities are
towards the ultimate savers while their assets are from the investors or the borrowers. All
banking institutions LIC, GIC they are basically a form of the financial intermediaries,
but whenever you talk about the non intermediary although they do the loan business
where the resources are not directly from the savers.
For example, if you talk about NABARD. NABARD is an organization who provide the
services to the particular group of the people in the country and mostly the money comes
from the other financial assistance from the government.
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So, because of that we can say that they are basically this non intermediary because they
do not directly interact with the savers or the investors. But whenever we talk about the
banks or LIC they take the money directly from the individuals or the savers entitled to
utilize that money and also they provide the loan at the time of requirements.
Then already I told you that we have two types of markets broadly one is money and
capital market the conventional distinction is basically based upon the maturity period.
Almost all the financial market provides certain instruments, certain services in detail we
will discuss throughout this particular course.
But if you see the actual with formal definition, the formal definition is the money
market deals with the short term claims with a period of maturity one or less one year.
Some people argue that the money market can deal with up to the maturity 3 years.
Although this is a formal definition, but sometimes the maturity period can go up to 3
years and the capital market basically deals with the longer term maturity. Here we have
given a definition that the period should be more than one year, but in some cases you
can say that the period can more than 3 years also.
So, in aggregate I can say that the you can take the short term period up to 3years
maturity and if the period of maturity is more than 3 years, then we can call them the
long term market or there the instruments are basically traded in the capital market. So,
that is the way this is defined and mostly this money market like call money market
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reserve money market, certificate of deposits market, commercial papers market these
are basically called as the money market, the capital market, stock market, and corporate
market etcetera.
Then already I told you that every market has two segments, one is primary and
secondary. The primary market basically deals with the new financial claims or new
securities which are coming to the market; that means, this is the new addition to the
system and how the securities are issued what is the process of issuing that security and
all these things that we will discuss in detail. And the secondary market means once in
the primary market the money comes or the particular securities comes to the system
then depending upon the demand and supply it basically always traded in the market and
depending upon the demand and supply the price basically fluctuates for that security.
So, these are basically we call them the instruments of the secondary market. For
example, somebody first time issue the share we call it the IPOS i.e. initial public
offerings and once it is listed in the stock exchange traded in the market, we call them
they are the instruments of the secondary market. That is why the secondary market deals
with the securities which are there and the price fluctuation happens because of the
demand and supply of the security in that particular system.
So, overall I have given you this idea that what this financial system is then how the
financial system is helpful for the economic growth process and which are the different
major kind of financial institutions and the financial market exists in the system and how
the structure looks like and then in the following session will be discussing about how
the equilibrium in the financial market is established and what do mean by the
equilibrium in the financial system and as well as in general how the particular concept is
helpful for this.
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Please go through these particular references for this particular session.
Thank you very much.
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Department of Humanities and Social Sciences
Lecture – 02
Equilibrium is Financial Markets
Good morning, in the previous class we discussed about the financial system as a whole
and what are those functions of the financial system and also the structure of the
financial system.
So, today we will be discussing about the equilibrium in the Financial Market. So, why
basically we are discussing this equilibrium; if you see that whenever we are using the
financial market for some specific reasons, either to maximize the return or to participate
in the market in a useful manner. So, in that context we have to see whether really the
market is in the equilibrium or not; if the market is not in the equilibrium then what
happens? Whatever observations or whatever pricing we get it from the market; that
may not be the actual reflection of the demand and supply forces what basically we
should expect.
So, therefore we should ensure that the financial market should be equilibrium and if the
market is in equilibrium then what will happen? Whatever things we are going to use in
the market that will be better useful whenever practically we take the positions in the
market and as well as we are using the market for some specific objective.
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So, let us see that what exactly this equilibrium is and how this equilibrium can be
defined. If you see the definition equilibrium is established when the expected demand
for funds for short term and long term investment matches with the supply of the funds
generated out of savings and credit creation.
If you remember, in the previous class we are discussing about certain issues related to
the depositors or the savers and the investors; you see basically what here we are trying
to see that the demand for funds is basically coming from the investors or the business
community or the corporate sector and why they demand? They demand either for the
short term reason or for the long term reason. So, the investment can be both ways; it can
be a short term investment or it can be a long term investment.
So, therefore this business sector demand for the funds and who is basically supplying
the funds? The supply basically coming from the depositors in terms of the savings and
already I told you that the banks are able to create the credit also even if the much
deposits are not available with them. So, we should ensure that the total demand for
funds and total supply of the funds should be equal.
So, if there is an equality between these two then we can say the market is in the
equilibrium. Therefore, in general we can say that whenever we need money who is
basically supplying and who is basically demanding. So, we should ensure the demand
and supply should be equal and after you get that the demand and supply is equal;
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whatever pricing is determined in that market that is basically a useful signal or useful
indicator for signaling that the market is now useful or the price what would get it from
the market is useful for our investment.
So, therefore, we should always ensure that those things are very much important to
understand what exactly the equilibrium is.
So, then the question arises whether the equilibrium is always happening in all
conditions or for the market equilibrium we should have a certain kind of condition or
certain kind of idealistic condition where the equilibrium basically operates. So, how
basically we can get it or what exactly that means?
You see whenever we talk about equilibrium we have to ensure that there should be a
perfect market. If you see we are talking about the perfect market; so here if you ensure
that is the perfect market or perfect competition. If there is a perfect competition then we
should ensure that the market is now fit enough to arrive a particularly equilibrium point
and whatever price we are getting it from that particular point that will be useful for the
investor or the market participants.
So, as usual whenever we define this concept of the perfect competition; what do we
have to do? There are certain kind of assumptions we have to ensure. So, what are those
assumptions? We should ensure whenever the market is in the perfect condition or there
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is a perfect competition prevails in the market? The first one basically you see this large
number of savers and investors. Why we say that large number of savers and investors?
You see you take one example if in a market a few amount of the players are there, only
one bank which is there to supply the funds and very few investors are there who can
invest the funds in the market to generate to get some kind of returns.
So, in that context the bank will have the monopoly; the bank can decide that what kind
of interest rate they can charge on them. And here this particular investors also has the
monopoly to say that whether in that particular interest rate; they should get particular
loan or not, but that does not prevail because the investor needs the money. So, whatever
price this particular bank decides or whatever interest rate the bank basically suggests;
the investor has to borrow the money in that particular interest rate and in that particular
condition whatever interest rate or whatever price we get it from that particular market
that is not an idealistic price.
So, therefore if there are more number of savers or let me give you another example
whenever any product is sold in the market if there is a single seller; then whatever price
they charge we are bound to pay that particular price. So, therefore the price what we get
it from that particular point of time, the price is reasonably high and the producer or the
seller always gets very high amount of the profit. But that is not the idealistic condition,
but if there are more number of sellers for that particular product then what will happen?
Whatever price they will charge that price is basically reasonably is a profitable price,
but it is not creating that much supernormal profit for them and for others who are
basically using that product they get a fair price for that. So, you should ensure that
therefore, in the financial market we should have large number of savers and large
number of investors. And another thing you see the savers and investors are rational.
What do you mean by the rationality? Whenever you talk about the concept of
rationality; rationality means that in financial market we consider everybody wants to
take less risk or everybody wants to maximize the return and all the investors of the
market participants are risk averse.
That means, it is basically in general you can say if a is greater than b, b is greater than c;
then a will be always greater than c, but the concept basically does not prevail in an
idealistic condition or in the real market condition. But whenever we talk about the
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equilibrium we are ensuring that all the savers and investors are rational and everybody
is risk averse, everybody does not want to take more risk, but they always want to
maximize the return.
So, the savers think in a homogenous way and the investors also always feel that
whatever thing basically we are going to get it from the market that will be idealistic or
beneficial for me. So, therefore, savers and investors are rational that is very important in
this case. And the third one is very important that all operators in the market are well
informed and information is freely available to all of them.
I can little bit highlight on this. Why we say that for example, anybody wants to invest in
a particular stock or in a particular company? So, whether that investor gets all the
information about the company freely or some informations are free and some
informations are not free; they have to pay for that or who are those market investors or
market participants for that company; some of them are the big investors, some of them
are the small investors; whether the information available to the small investors and big
investors are same?
Or the big investor get more information than the small investor or some of the
informations the companies are hiding. So, all kind of issues comes into our mind or
comes into the picture whenever we talk about the information aspects for the particular
market. So, here what we are ensuring? To make this market perfect or we can say that
there is an equilibrium in the perfect market condition in that context we are saying that
all participants are well informed and the information is freely available and we do not
have to pay anything for that or whatever payment will be there that will be basically
available to everybody.
There should not be any kind of discrepancy; irrespective of the investor, irrespective of
the market participants who are existing in the market at that particular point of time.
Another the next assumption is basically the little bit unrealistic assumption; no
transaction cost which does not prevail in the ideal market condition or the real market
condition, but that is the assumption basically always we consider; we take whenever we
talk about the assumptions in the perfect market.
And the financial assets are infinitely divisible what does it mean? That the assets which
are available in the financial market; those assets should be available in different
21
maturity. If somebody wants some assets which should be long term in nature, some
assets should be short term in nature. So, here what we are assuming? Whatever assets
are available; those assets basically can be divisible in the different maturity period.
So, the requirement of the investor can be fulfilled in terms of the time to maturity. So,
that is another assumption that may not be practically sometimes feasible, but that is the
assumption always we take to ensure that the market is perfectly competitive. Then the
participants in the market have the homogeneous expectations; everybody’s expectations
about the market is homogeneous; there should not be any kind of heterogeneity in terms
of the expectations level of the investor; everybody feels in the same way that how the
market what kind of return they are expecting and how they are going to participate in
the market all kinds of things is basically coming from.
That is why this market participants are homogenous that is the assumption we consider.
And the last assumption what if you see there are no taxes; which again practically not
feasible in the market context because always we have the tax which is available in the
market. So, therefore, those assumptions cannot be considered in the realistic market
condition, but that is the assumption what always we consider whenever we talk about
the perfect market and the equilibrium conditions in the perfect market.
22
Then how we can define this? If you see; you see this is the basically the figure which
talks about the equilibrium. And already I told you that the equilibrium in the financial
market is nothing, but the interest rate.
So, in the X axis we are showing the demand and supply of the funds and in the Y axis
basically we have the interest rate. So, if you see this is your demand curve this is your
supply curve. Then obviously, the question can arise that why the demand curve is
downward sloping and why the supply curve is upward sloping?.
You might have the idea about this, but if you understand why this demand and supply
curve shape is look like this? The supply curve slopes upward from left to right which
means that once the interest rate increases then more funds should be available in the
financial system. Why? You see if your interest rate will increase, then the supply will
increase if you see, but if the interest rate will decline then your supply will decline.
Then why it happens? Because the interest rate if the interest rate will increase, more
people will ready for savings; more people will go for the savings because they are going
to get more interest rate or interest income from this.
So, because of that what happens? They are trying to put the money in the bank in terms
of the deposits and by that the amount of for the supply basically will go up. But
whenever we talk about the demand side; if the interest rate increases then what will
happen? The people who are if you see this one; if this is the interest rate then maybe the
demand is this, but if the interest rate goes down this demand goes up. Then why it
happens? This happens because in the lower interest rate if the loan rate loan interest rate
goes down, then more people will be ready to take the loan.
But if the interest rate goes up then the demand for loans comes down and the basic
source of basically investment is from the loan which is given by the financial
institutions that already we know. That whenever; that is why the demand curve
basically is going downward from left to right, the reason is are the interest rate
increases; the demand for finance would decline.
Demand for finance means what do you mean? The demand is coming from the business
units we need the some of the household units who wants to take the loan from the bank.
So, here we are talking about the demand for finance which is basically given by the
banks for specific uses. So, the supply side here the interest rate goes up; more people
23
who wants to deposit the money in the bank because they are going to get more interest,
but if the interest rate goes up in that particular point of time the investors or the business
units may not be interested to take more loan because it will be costlier for them.
So, the cost factor will decide whether they should go for more loan or not. So, then what
will happen even if the supply is there the demand goes down. So, therefore, we can
ensure that the demand and supply curve basically looks in this in this particular shape;
that is why this supply curve is upward sloping and the demand curve is downward
sloping. So, then the next thing is basically what we are trying to see; is there any
possibility that the supply curve and demand curve can move? For some specific reason
and the supply and demand curve also can be shift.
So, if you see if the supply and demand curve will shift then a new equilibrium point is
established that is affecting the price level.
So, if you see this the panel the figure B; the first diagram in this particular slide, you
will find that late the supply curve shifts down; right ward. If the supply curve moves,
the supply curve basically moves from this to this then what has happened? You see this
once the supply of the point increases; if you keep the demand curve remain constant
then what has happened? That the interest rate which was there in the r which has
become r prime; the interest rate goes down; why the interest rate goes down?
24
So, now, the supply has increased, but nobody is going to take that particular money for
the investment. If nobody is going to take that money for investment then what will
happen? That will affect the interest rate then; obviously, they have to reduce the interest
rate; if the interest rate will reduce then automatically what will happen? That will
change the scenario and more people will be interested to take the loan and by that what
will happen? That a new equilibrium point can be established and accordingly your
interest rate will go down.
So, therefore logically if you see those; those things basically work in this direction. But
another thing if you see that whenever we talk about the next diagram; if you see here we
have kept the supply curve remain same and we have shifted the demand curve in this
direction. Now here if you see what basically here we are trying to see? The demand
curve shift leftward; what does it mean? The demand for funds decline, if the demand for
funds declined why the demand for funds decline?
Because the investor or the people who wants to demand the money they basically find
that the interest rate is higher for them. It is good for the supply side; that is what the
supply curve is there; there is no change in the supply curve, but if the people feel that
the interest rate is already high then the demand is basically not much so obviously, the
demand will go down.
If the demand curve will go down then it will move leftward and whenever it has moved
leftward; what has happened? If you keep your supply curve remain constant then you
will have an equilibrium point which is r prime, then automatically the interest rate will
go down. So, here what we have seen? If there is some kind of changes for some reason
in terms of the demand and supply and interest rate which is nothing, but the price of that
particular instrument in that particular market then what has happened? That is basically
changing.
So, either you can keep your demand curve remain constant changing the supply or you
can keep your supply curve remain constant and changing the demand curve; then
accordingly what we have observed that the interest rate is going to be fluctuating; in
both the cases the interest has gone down. But there are also certain conditions where the
demand and supply curve can both change.
25
If the demand and supply curve both will change then what will happen? That the
interest rate may interact or the interest rate may decline or interest rate may increase
depending upon the relative change of the supply curve and the relative change of the
demand curve. So, because of that either the interest rate will be kept in that particular
equilibrium point or there is a movement in terms of the equilibrium condition that will
be basically decided by the relative shift of the demand and supply curve in the market.
Then already I told you the demands basically coming from the people who needs money
for the investments. Basically mostly the business units or the corporate sector and the
supply is basically nothing, but the savings what the household sector does and whatever
deposits we will have in the banks and banks basically supply that particular money for
the investments.
So, if the interest rate will increase; the demand for funds will go down, if the interest
rate will increase then the supply of fund will go up because the depositor will feel that
they can maximize the return out of this. So, then what basically we can see that now we
can move into the factors which decide that demand and supply of the funds in the
market.
What are those factors? That why they demand for and supply of the funds changes in
the market? If you see already I told you that the major supply of the funds is basically
the household sector and the demand for funds coming from the business sector or the
26
corporate sector. And business sector also saves and there are some government also is
responsible for the savings.
So, the first most important factor which affect the supply of the fund is the aggregate
savings by the household sector, business sector and the government sector. But the
question here is you see the major source of the supply is coming from the household
sector; business sector contributes to some extent, the government also contributes
certain to some extent, but the major contributor for the supply of the fund basically
comes from the household sector.
So, if there is some changes in the supply side the behavior of the consumer changes, the
behavior of the depositor changes then obviously, that will affect the supply of the funds
from the market. Supply of the funds to the market will be changed in accordance with in
the changing behavior of the depositors or the market participants.
Then another thing is then what factor determines that? Why this saving behavior can
change? The saving behavior can change due to the change in the income therefore, we
have here the second point if you observe the second point basically we are talking about
that is your current and expected income. So, the current income means whatever income
you are earning and the expected income is basically how much income you can generate
in the future.
So, if you are expecting that you can generate more income in the future also your
savings behavior may change. And if your current income has increase or decrease, your
savings behavior may change. And sometimes also the income can change due to the
cyclical behavior or cyclical variations of that particular income because in some period
the income is more and some period the income is less; so, that is why cyclical changes
is another factor.
Income also changes in accordance with the age, life cycle theory and the changes in the
economy; distribution of income in the economy in terms of the different sectors and the
degree of certainty of the income that how far what is the probability that income will be
maintained. Then another factor also which affect that is your wealth what can be
inherited and also you can generate in terms of the house, in terms of the buildings, in
terms of the other real assets if you have.
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Change in the inflation in the economy which affects the purchasing power; then what
we you can also your saving behavior may change if you want to keep more money for
the old age. And also for the precautionary motive you can keep some money for family
members and some kind of contingencies can happen at any point of time; that will
changes this deposit base of the particular individuals, change in the interest rate;
obviously, that is the most important factor.
Then what are those other savings media; what are those other different alternatives
which are available to save the money? And even if this last factor is important the
reason is even if you want to save; you do not have the major organizations, where the
money can be saved. So, the banks and other financial institutions also play the role
whether the savings should be made or not. So, these are the major factor which basically
affect the savings behavior which accordingly affect the supply of the funds.
And the demand for funds whenever you talk about; the first factor is investment in
fixed and working capital which is the measure to investment basically the corporate
sector does.
So, what are those factors basically determined this investment in the fixed and working
capital? How much already capital you will have; that is the capital we are talking about
the capital stock the first factor is the capital stock? How much utilization capacity you
have to utilize the capital? Whether even if you have the capital whether you are able to
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utilize it or not? Then what about the future demand for the goods, what is the prospect
of the business whether the business will grow up in the future or not and what is the
price of the product how the price is going to be behaved?
Then you have the what kind of government policies which is basically nothing, but
tariffs, quotas, duties, taxation and all these things which are also important. Then
another factor you have the profitability. If the company profit goes up, the demand for
fund also will goes up because they want to invest more money to maximize the return.
How much internal funds you will have? Internal fund means we are talking about the
internal cash flow the return earnings.
And for investment they want to raise the capital from the market; so, what is the cost
they are bearing? We will discuss more about the cost of the funds; how it is measured
and all in the future sessions; then we have the technological changes, technology also
affect the investments in the fixed and working capital.
Then finally, this you can also come to the demand for consumer durables. Peoples tastes
and preference can be changed; new product they want to always use, fashion; the new
cloths and everything which is coming to the market depending upon the fashion also
they can change their consumer behavior or their investment or the spending behavior.
Demonstration effect means if my neighbor is doing something; I may do that that also
affect your consumption pattern as well as the saving pattern and; obviously, again for
the cost of the funds.
So, these are the major factor, which change my behavior towards buying the
consumable products. And finally, it will affect my savings behavior and finally, the
demand for funds and the last one is another factor we have the investment in the
housing. So, these are the major factor; which are basically affecting the demand for
funds.
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So, if so we want to conclude these things; we can have some observations related to
this. Already in the real sense the financial markets are characterized by many
imperfections restrictive practices and externalities. There is an existence of transaction
cost that is taxation, there is information gap, there are also in some market; there are
limited number of operators and the instruments used by the different regulatory bodies
can be direct and indirect.
So, depending upon that the interest rate in the practical sense may not be only
determined by these factors; there are some other issues also is playing the role whenever
we talk about the determination of the price or determination of interest rate in the
market. So, these are the different ways the equilibrium is defined, but in the practical
sense you may not get to the equilibrium, but there is a chance of deviation from the
equilibrium due to the different market imperfectness.
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31
Financial Institutions And Markets
Lecture – 03
Efficiency of Financial Markets
So, in the previous class, we discussed about the Equilibrium in the Financial Market.
But another thing you should know that if you really work in the financial market or if
you want to participate in the financial market as an investor or as a depositor then we
should ensure that how far the market is efficient.
Though efficiency of the financial market is a very important concept, whenever any
market participants participate in the markets for some whatever reasons they have.
Either they want to participate to deposit the money or they want to participate to invest
in the stock market or they want to participate as a broker or they want to participate as a
regulator does not matter, but everybody’s concerns should be to know that whether the
market is efficient or not. So, even if it is efficient or inefficient, how far this is efficient,
how far this is inefficient all kind of basic questions comes to the market or comes to the
mind in the market point of view.
So, let us see that what do mean by the efficiency, how the market efficiency can be
defined. So, whenever you to talk about the market efficiency if you see that there are
there are some broad definitions and there are some narrow definitions.
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And the narrow definitions basically deal with the things related to a particular market
and there are some definitions which link to the aggregate economy or at aggregate sense
to the financial system as a whole. So, here if you see that the first point the ultimate
focus of the efficiency of the financial market is on the non-wastefulness of the factor
use.
And the allocation of the factors to the most socially productive purposes, what does it
mean? You know that the every resources or whatever we have these are scarce. So, we
have to utilize those resources in such a way that we can maximize the revenue out of
this, and whatever revenue we are basically maximizing, it should have some social
implications.
That mean, socially the product should be used in such a way where the maximum
welfare can be generated out of this. So, if you can maximize the welfare we can say that
the system is efficient using this scarce resources, but if you are not able to maximize the
resources then we can say that the particular system is not efficient. So, the first part is
basically a broad meaning of the concept of market efficiency, so which talks about the
efficiency and the productivity of the resources whatever we have.
But little bit in a deeper sense if you understand that what exactly the market efficiency
is. The second point is that market is efficient when the price of any security efficiently
represent the expected net present value of all future profits. You see whenever you talk
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about the market the market as basically we get a price for any kind of product which is
available in that particular market. So, whenever we get this particular price we saw that
particular price or we observe that particular price we should ensure that price basically
reflects all kind of cash flows what can be generated from that particular asset over a
period of time.
So, if we feel that whatever prices basically we are getting that from that particular asset
that should be if you discount it with respect to a particular discount rate, then the net
present value of that particular cash flow should be equal to that price what we are
observing from the market. So, that is very important you see. The price should reflect
all available effective cash flows what you are getting from that particular asset if that is
happening then what we can say the market is fundamentally efficient.
The third point is the buying and selling of the stock on an average should return a fair
measure of return for the associated rate of risk.Little bit I can elaborate this thing that, if
the market is efficient, then if anybody or all the participants who are investing in the
market on an average they should get some amount of return that does not mean that
some investor will get very high return.
And some investor will lose in the market, because what is happening whatever
informations are available about the market that is available to everybody. So, because of
that we should expect that a fair amount of return can be realized by all the market
participants which are existing in this particular system. So, if that is happening then we
can say the market is efficient, if that is not happening then we can say market is
inefficient. You see these are the two things which are basically market specific. And
here the broad definition what basically we have discussed that is related to the aggregate
economy or in a country sense.
So, to make this market efficient what we should ensure that there are some conditions
has to be satisfied. What are those conditions? The same thing to go back to the
equilibrium part also we have discussed a large number of competing profit maximizing
participants, but market participants should be more because everybody’s expectations,
everybody’s opinions, everybody’s positions, should be considered whenever we are
deciding the price. And this should be actively participating in the market. Somebody has
started investing in the stock market after buying the stocks they has forgotten that
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whether he is taking the positions or not. So, that is what this require some active
participation in some places they can buy, and some days they can sale and some kind of
activation of that particular investment position should be there, if that is not there then
that particular participants should be ideal. So, the active participants in the market is
very much essential.
Any particular individual cannot affect the price. If anybody feels that, there is a rumor
about a particular stock. Let due to this talk the price of the stock is going to be down
then if that particular person or particular individual will sell the stocks then the stock
price should not be fluctuating. And that can happen whenever the market is basically
full of more participants that actually have to be ensured.
And the information must be free, whatever informations we are getting about the stock
and about any other instrument that should be free and the free entry and exit by the
market players. And whenever the participant wants they can exit the market, whenever
the participant wants they can enter the market. So, that is the major condition and that
condition should be satisfied to analyze the concept of the market efficiency. So, these
are the different conditions we have to keep in the mind that what basically the market
efficiency is.
35
So, in aggregate sense the efficiency can be defined by 5 ways which is given by Tobin.
If you see that we are talking about the name is James Tobin, the Tobin is a Nobel
Laureate who was given this concept of market of is a concept of market efficiency.
And Tobin has explained these things in 5 ways; one is the information arbitrage
efficiency already I told you repeatedly. This is the degree of gain possible by the use of
commonly available information, if one can make large gains by using commonly
available information then the financial markets are said to be inefficient. That means, if
the availability of the information is equal to all the market participants, then one group
of the individuals one group of the investors cannot get more return. And some group
will not get any return that basically should not happen. If it is happening then the market
is inefficient. If it is not happening or if it does not happen the market is efficient. So,
from that point we can say the market is efficient from the information point of view.
Second one is basically I told you about the fundamental valuation efficiency. In the
fundamental valuation efficiency what we say the intrinsic value of the asset should be
equal to the market value. You see for any price there is a market value or the market
price of the asset and another one is the intrinsic value. The intrinsic value is basically
calculated by discounting the cash flow with respect to a particular discount rate. So,
here it is the cash flow what in a particular t is equal to the time, in a particular time
period, and r is equal to your discount rate which is sometimes we consider. If you are
going for stock valuation it is our return from the stock if you are talking about the bond
valuation it is nothing but the market interest rate, etcetera, etcetera. Then we are
ensuring whatever price you are getting from this that should be equal to the market
price. So, then we can say the particular market is fundamentally efficient.
If that does not prevail then we can say the market is not efficient from the fundamental
point of view. So, therefore, the intensive value of an asset is the present value of the
future stream of the cash flow that is what basically I have shown you here, and when the
cash flows are discounted at an appropriate rate of discount that is the discount rate
which is r. So, if you discount it the cash flow will be discounted with respect to r that
we can get the intrinsic value, and that intrinsic value should be equal to the market
value. If that is happening then the market is fundamentally efficient.
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Then the full insurance efficiency, what does it mean? It means that whenever you take a
position in the financial market you are exposed to certain risk, certain kind of problem.
So, how your risk or the probability of loss is going to be hedged by the financial
market? If really you can hedge that particular position in the financial market we can
say that the market is efficient from the insurance point of view, but it is not possible in
the real sense we cannot hedge the complete risk in the market, because we do not have
that kind of alternative investment. Although we have the derivatives instrument, other
instrument which can be used as for the hedging purpose but in general sense it is not
possible to hedge the complete risk what we are going to get it from the market.
So, because of that what we can say that the market cannot be fully insured or the market
cannot be efficient from fully insurance point of view, but to some extent that efficiency
is also important because that also decides that whether the market participant should
have invested or will be interested to invest in the market or not. So, that is another thing.
And another thing is the functional or the operational efficiency. You see what do mean
by the operational efficiency, whenever we do any kind of investments we do any kind
of decisions we should ensure that whatever cost, I am incurring to make that investment
that should be minimum. So, lower the minimum cost the basically the positions will be
more and the market will be more competitive if market will be more competitive then
that leads to a perfectly competitive market.
Then the price what you are getting from the market that is basically a fair price or the
price which is basically is useful for concluding any kind of things from the market or
maybe you can say that that price is a real indicator of the market developments. But
here the question is that we have to ensure that the transaction cost in the market should
be minimum. If higher the transaction cost the market is inefficient lower the transaction
cost market is efficient.
So, therefore, we have to ensure that it because that basically makes this investor, the
market participants more comfortable and convenient to participate in the market in a
larger way. So, therefore, the market can be efficient if the transaction cost is list or you
can say in a clear cut way market can be personally efficient if the transaction cost is
least.
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And the last one is the allocation efficiency because from the beginning we talked about
that is the resources are scarce, and because of that you have to utilize the resources in
such a way by that it can give you the maximum benefits or maximum welfare. So, even
if you see that how we can define this allocative efficiency or allocation efficiency here
if the marginal efficiency of the capital are adjusted for the risk differences is the highest.
So, what do mean by the marginal efficiency of capital?
The marginal efficiency of the capital is nothing but whenever you are producing any
kind of product if you are adding one extra unit of the capital to the production that is
MEC. The MEC is basically nothing but whenever you add one extra unit of the capital
or how this particular capital is going to increase the amount of the production, addition
of one extra unit to the capital how much extra output can be produced.
So, here what we are telling that whenever you are putting one extra unit of or extra
rupee on a particular investment, how much extra return, I am going to get adjusted to
the risk what I am facing. Wherever the particular value of that 1 rupee gives me the
maximum return then basically we can say that the market is efficient from the allocation
point of view. So, that is another concept which always we discussed in this regard.
Then, we can move into the different issues which are happening to the efficient market
you see that another thing is how well do markets respond to new information, any new
38
information comes to the market let Reserve Bank of India governor has announced
something.
Any policy measures has taken by the finance ministry or anything which has happened
or anything any crisis has happened in the US market because financial markets are
highly integrated with the global market. So, anything which has happened in the global
community any particular information, which comes to the market; how well the market
is well equipped to respond to that information. Whether the market is so mature, market
is so conducive to capture that information in a positive way or in a larger way or there is
some kind of loophole, some kind of gaps is existing in the market to capture that
information which is, if it is negative information market perceive it negatively, if it is a
positive information market perceives it positively.
What you see sometimes people also consider rumor as an information. So, that creates
the disturbance in the market, market become unstable, market become volatile, but we
should ensure that those things should not be there in the system and those kind of things
should not change the price away from the equilibrium price. So, because of that we
should ensure that our system should be so efficient that any news which is coming to
the market that particular news should be reflected in the price immediately and the
market should be efficient enough to capture that information efficiently. So, therefore,
we have to ensure that how well do the market respond to the new information.
And second one is, should it be possible to decide between a profitable and unprofitable
investment given current information? There should not be any kind of gap between the
different stakeholder to ensure that which one is good for them, which one is bad for
them; which investment they should make to maximize the return, which investment they
should not make. So, those kind of thing basically is very important whenever we talk
about the efficiency of the market.
39
Over the period of time if you see that the informational arbitrary efficiency has gained
maximum attention and therefore, mostly the literature on efficient market is
concentrated on the issues related to the information. How far the market is efficient
from the information point of view; whether really the market is efficient or there should
not be an information gap between the different market participants, or we can say that
what level of information gap they have and how the investors or market participants in
the market is going to use that information for their investment activities. So, these are
the some of the things always we should ensure or we should know.
And in this context the hypothesis was created that that is called the efficient market
hypothesis which was given by Eugene Fama long back in 1960s or 1970s, 1962 mostly
he has given this concept. That the concept of efficient market hypothesis is quite
popular after that, and lot of research lot of work has been carried out in this particular
area. We will just discuss.
There are certain methods to analyze those things in a technical way, but here I will be
discussing the concepts related to the efficient market hypothesis. And further maybe
other courses like equity resource and investment, and portfolio manager analysis and
portfolio management you will know more about this particular concept.
So, here if you see the efficient market hypothesis what does it mean, according to Fama
the efficient market hypothesis is the current prices of securities reflect all information
40
about the security. Why? Whenever we see the price of a particular stock or a particular
bond we should ensure that the particular price reflects all available information that
means, the information which is coming to the market that is basically captured through
that particular stock. The stock price has been determined on the basis of all the
information which have come to the market that we should always keep in the mind. We
should ensure that.
Why it happens? What Fama said, this can happen because the new information
regarding the securities which is come into the market that comes in the random fashion.
Nobody knows what information will come in the next day or tomorrow. If I do not
know that what information will come in the next day then obviously, that particular
information when ever comes in the next day that if everybody is aware about that
information then the price will behave in the different way.
But if I know what information will come in the next day and you do not know what
information will come in the next day then what will happen, I can use that information
to get some return and my return will be much higher than the return what you are going
to get. So, because of that what happens that creates the inefficiency in the market.
So, if the market prices follow a random walk, random walk in the sense randomly all
the news all the informations are coming to the market then what happens that not a
single group of the people are going to get very high return and some of the people or
some group of the people who lose in the market. That basically should not happen in the
market in the true sense.
So, in this context what we are trying to say if all the informations about the securities
come to the market in a random fashion, then we can say that the stock prices follows a
random walk. And, the information which is reflected in the stock price that captures all
type of news all type of things which are related to that particular stock.
And the profit maximizing investors rapidly reflect the effect of new information. The
expected returns implicit in the current price of a security should reflect its risk. So, even
if there is some new information is coming then the investor basically the demand and
supply of that for a particular stock a particular asset will change accordingly.
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If that particular thing will change accordingly, then what will happen? That the price
what the equilibrium price will be established frequently or very fast, and in that context
what happens if anybody gets that particular price he or she should ensure that the price
is able to reflect all type of information which is coming to the market about that
particular security. So that means, market is so conducive to gather all this information
and as well as that is reflected in the prices so fast and it should be adjusted to the risk.
So, then Fama has said there are 3 types of efficient market, 3 levels of the market
efficiency. So, here already I told you to what extent do securities market quickly and
fully reflect different available information that is the basic theme of this hypothesis.
And here Fama has talked about the 3 levels; one is weak form, semi strong form, and
strong form. I will discuss with you about how to define this weak form of the efficiency
or the semi strong form of efficiency and strong form of efficiency.
Already in the first part if you see that the weak form basically tells that prices reflect all
security market information. Semi strong form tells that price reflects all publicly
available information. Strong form says it reflects all public and private information.
So, if you see that now we can see that what exactly it means. You see that weak form of
efficient market hypothesis. What does it mean? According to the definition what it tells
that the current price reflect all security market information including the historical
sequence of the prices, rates of return, trading volume, and other markets generated
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information. What does it mean? If the current price reflects all available information,
then what will happen then analyzing the past data you cannot predict the future.
So, the past rates of return and other market data should have no relationship with future
rates of return. Why? Because the news is coming randomly, the information is coming
randomly, if the information is coming randomly I do not know what is going to happen
tomorrow and if some trend was happening 3 days back or 4 days back or 4 months back
if I analyze that 4 months back data or 3 months back data, how that particular data is
going to help me to say that whether the price of that particular security is going to offer
down in the next day or the next month, that is very difficult to predict difficult to say.
If the market informations are coming randomly and the informations are already
captured through the price of the particular security that we have to keep in the mind. If
it is captured through that what all the informations are captured in the prices, and
informations are coming randomly then the analysis of the past data cannot help you that
whether the particular security price will be up in the next day or next month or not, that
actually we have to keep in the mind.
And the second one is the semi strong form of efficient market hypothesis. What it tells?
Already told you that the security prices reflect all publicly available information giving
example, what does it mean.
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Let talk about a bond or about anything whenever any publicly available information
comes like whether the company pays a dividend or not, whether there is any merger
acquisition is related to that or not, whether this is interested as change in the market or
not, what kind of balance sheet the company has. All kind of informations are available
to everybody, then for any event for example, today company has paid to the announced
that the company will pay the dividend.
So, once the today’s company has announced maybe if you consider the today’s return
and once the dividend is paid on that day returned, and as well as the return what they are
getting before and what they are getting after the payment of the dividend if you
calculate the excess average return for that particular stock, on an average this particular
excess of the average returns would be close to 0.
So, how you can get this excess return? Excess return is nothing but the actual return
what you are getting minus the expected return. I will discuss more on expected return in
the future sessions. So, therefore, what we can see that if all informations are available to
everybody then that already reflected in the prices, then at any particular point of time
once this information comes to the public in and around that event the excess average
return should be close to 0, if it is not close to 0 that means, somebody has used the
information and somebody has not used it.
So, because of that some group have got very high return in a particular after this event
and some group basically could not use that information because of that they get less
return. Therefore, if all the information which are coming publicly and everybody is able
to use that then in no sense at any point of time that we cannot get very high return from
the market or any group of the people cannot get a very high return from the market. So,
that is what basically the basic notion of this semi strong form of efficient market
hypothesis.
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And the last one is the strong form of efficient market hypothesis which talks about the
public and private both the informations because the prices fully reflect both stock bond
or any other asset that reflect all information which is available publicly or privately.
That means, there should not be any gap between public information private information,
because in the practical sense it does not happen. Because the CEOs have more
information, bigger investors have more information, hedge fund managers are more
information regulators have more information.
So, if anybody have used that more information obviously, those group of people can get
more return than the common retail investor like us. So, in that context what we can say
that any point of time if you have categorized that one group of the people who have the
private information, another group they do not have the private information you see that
whether the return differences exist between them or not. So, if the return differences are
there then we can say that the market is inefficient.
So, either if it is return differences is not there the market is strongly efficient, if return
differences are there then we can say that the market is the market is inefficient. There is
no concept of weakly inefficient strongly inefficient, we can say that weakly efficient
semi strongly efficient or strongly efficient or in aggregate we can say market is
inefficient. But I can give you one information that the Indian market is weakly efficient,
US market is semi strongly efficient and no market is strongly efficient.
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Next class will be discussing about how the financial market development is measured
and how it is related to the economic development at a larger extent.
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Lecture – 04
Measures of Financial Development
So, after discussing about the Financial Market Efficiency, today we will be discussing
certain issues related to the Financial Market Development. Already in the beginning we
also discussed that financial sector has lot of role for the different activities. Like it
provides the medium of exchange, it also helps to bring this particular finance and other
alternatives for investment etcetera.
So, in this context today we will be discussing about how basically we can measure the
financial development in an aggregate and as well as in a particular market. Because, the
financial development is very much required in the economy growth process what are the
channel, through which the financial market helps to achieve economic development or
economy growth that will be discussing in the next session. But, first of all today let us
discuss certain issues related to the measures of the financial development.
So what we will do today let us discuss certain indicators which measures the financial
development in the aggregate sense. That means, we are talking aggregates sense in this
sense I am referring to the aggregate economy, then we can move into the how the
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financial development can be measured from a particular market perspective or as well
as from an institutional perspective.
So, whenever we talk about the financial development in the aggregate sense or whole
economic sense, there are different quantitative measures and there are different
qualitative measures. So, we will be discussing certain quantitative measures first then
we will move into the qualitative measures.
So, whenever we talk about the quantitative measure, the first point which basically
comes to our mind that is basically your finance ratio or the first measure which always
used by the researchers and the academicians and as well as the policy makers to know
that whether the financial market is developed or not that is basically your finance ratio.
Then what is finance ratio? The finance ratio is the ratio of total issues of primary and
secondary claims to the national income.
If you remember in the beginning in the introductory session we discussed about the
market can be broadly defined into two ways, one is your we can say the primary market
and other one is the secondary market. So, whenever we talk about the primary market
and secondary market that means, whenever the particular security comes to the market
in the first time we call it due to the instrument of the primary market. And once it is
listed and it comes to the secondary market then automatically the price and demand and
supply of that security depends upon supply and demand of that particular issue by the
different market participants.
So, here that means it talks about the total primary market issuance then as well as we
have the secondary market issuance divided by the national income. So, what exactly this
national income means? You might have known about the GDP the Gross Domestic
Product and here the gross domestic product can be measured in different ways some
people use it NNP at a factor cost as a proxy for the GDP. But you can take also the GDP
as a measure which is as a variable here in this case which is popularly or maybe very
popular term used by the different people.
So, how many securities or flows how much amount of the flows come to the market, in
terms of the primary issue, in terms of the secondary issue divided by the total national
income that is basically give you an indicator. That means, remember that here we are
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referring to primary market and secondary market issuance with respect to the financial
markets.
How many securities are issued in terms of the primary issues in the financial market
itself that includes the money market includes the capital market or the stock market that
also includes the bond market. So, it is we are basically confined our discussion with
respect to the financial markets only. So, therefore, this is the first major which is a very
broad measure people used. So, to define the concept of the finance ratio and which is
popularly used as one of the broad indicators for financial development.
Then next one is the financial interrelation ratio which is basically nothing, but relatively
how the financial market is developed with reference to the other markets or other
sectors in the economy. So, therefore, it is the ratio of the financial assets with respect to
the physical asset.
So, you see physical assets which we mean these are the instruments in the real sector
economy like all kind of manufacturing sector it includes also the particular sector which
produces some tangible products and those products also are demanded by the market
participants or the consumers for certain requirements. So, if you see if the ratio is high
that means, the financial assets percentages high with respect to the physical asset we can
say relatively the financial asset is performing better in comparison to the physical assets
existing in that particular economy. So, that is that ratio is used as kind of relative
measure which measures the financial development for that particular system.
Then another one you have the new issue ratio because some people argue that the
development of the new issue market or the primary market is more important in the
sense that it provides the real value addition to the economy. That means, it basically it
give some addition to the economy in the sense the secondary market valuations depends
upon the demand and supply of that existing securities. But, whenever we talk about the
new issue this particular issuance or particular securities, which is come to the market for
the first time that means, it gives the addition to the system as a whole. So, because of
that what basically you can say that the new issue is very important from the
development perspective.
So, here if you see that the new issue ratio is nothing but it is the ratio of primary issues
to physical capital formation. That means, what basically it gives that whenever we are
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providing the savings or any kind of capital to the economy final is the capital is
basically used for the investment. So, the investment already we have discussed about
that the investment is basically a function of the savings or the new capital which are or
new saving or new kind of instrument which is coming to the market.
So, here if the primary issues are more that means, what you can say those kind of capital
are mostly used by the investor for the investment which gives the value addition to the
system. So, therefore, how far the investment has been financed by the direct issues to
the savers by the investing sectors? That means, directly whatever savings is coming to
the market in the first time how that particulars money or particular kind of resources
financial resources are used to create the physical capital in the market or capital
formation.
In the market that gives the idea that how the new issues are utilized in the market to
generate certain kind of for revenue or the resources and finally, it has the implication of
the total output and economy at a large. Therefore, that is another indicator for the
measuring the financial development. The next one is intermediation ratio. The
intermediation ratio is basically again it is a relative measure. It is basically measures
with respect to secondary issues what is the development happening with respect to the
primary issues.
So, therefore, it is the ratio of secondary issues to primary issues, how much secondary
instruments are available, how much is the value of total money available in the
secondary market and what are the value available in the primary market. So, if you take
the ratio that basically gives you the intermediation ratio which indicates that the extent
of development of the financial institutions as mobilizers of the funds related to real
sector as direct mobilizers of the funds. It indicates the how the financial activity in the
economy has been utilized or financial development how it is activity basically character
by the mobilized. So, this is the way the intermediate ratio is defined.
And another broad measure if you see everybody uses that is money to the national
income. Total amount of the money available to the economy, then the national income. I
hope you must have known that the money can be defined in various ways. The
definition of the money can be in terms of narrow way, in terms of the broadways. So,
you have the measures like M 1, you have the measures like M 2, like M 3 and M 4 so,
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these are the different measures what RBI uses in terms in the context of India which
defines the different measures of money supply. And this particular ratio or this
particular indicators can be used the that how the money can be or how much money is
flown to the system and what is the ratio of money to the total national income in the
particular market or particular economy.
It indicates that the extent of monetization and the size of exchange economy in that
country. More the money is circulated in the system we say that the behavior or the
consumption behavior investment behavior of that system is basically increasing and
finally, the flow or the exchange size of the exchange economy has been increasing. So,
that also is one of the indicator which uses in the system in a larger sense.
Then, we are coming to the next part that what are the other indicators. You see the
another indicator we have the proportion of current account deficit, you know what do
you mean by current account deficit we have the different kind of deficit already we have
in terms of the balance of payments. So, we have a system where the always the asset
should be equal to liabilities. Whenever you talk about the balance of payment there are
different type of deficit we face, one is current account deficit another one is the capital
account deficit. One is your current account and second one is your current account and
another one is your capital account.
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The current account basically nothing, but it is a difference between your export and
import. But, whenever you talk about the capital account the capital account is basically
nothing, but the difference between or how much inflow and outflow is there in terms of
the capital. Capital means we are talking about the FDI and FII. So, the inflow and
outflow differences in terms of FDI and FII is a part of capital account and export and
import differences that is basically a we basically we will say that that is the current
account.
So, in this context what we are trying to say that if there is a current account deficit then
how the deficit is basically filled up? So, whether the deficit is filled up by the certain
kind of government policy measures or by borrowing the money or by depreciating the
money. If it is done by the government then it does not give you that idea that the market
is developed and market is taking care of the particular system itself.
So, another way of a making this current account filling this current account deficit is
basically development of the economic development of market related factors. May be
the currency, fluctuations, the market basically responsible for the current fluctuations,
and demand and supply factors which is affecting the export and demand activities, that
takes care of that current account deficit. That means, we can say the market is matured
enough, the market is developed enough to take care of the problems or the deficit what
is happening in that system in that particular point of time.
So, therefore, if market mechanism itself is taking care of the deficit part or the
proportion of current account deficit is financed by the market related flows then we can
say that the market is developed. But, if the government has to intervene and
governments has to take certain measures to fill that particular gap then we can say the
market is not that matured, market is not that developed to take care of the whatever
deficits they are facing in the system as a whole.
Another indicator is developed financial sector is fully integrated that means, there are
different type of market which exist in the particular domestic economy like your debt
market, equity market, money market that already again and again we have discussed.
So, we should ensure that if the market is developed then there must be a proper
integration and all the markets are highly integrated anything, anything goes wrong with
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the one market then generally that can spill over to another market, but one market if
does well that also have the positive impact in another market.
So, because of that if the markets are integrated that is also good sign that the market is
developed it can be domestically it can be internationally. Indian stock market can be
integrated with US stock markets or any other emerging market stock market. So, if there
is a integration happening within the domestic market within the market we call that also
the market is developed. And we should ensure that our market also in this globalized
economy or market should be also integrated with international market. So, the financial
integration also can be used as a indicator for the developed or the indicator of the
financial market development.
And again and again I am repeating that lower the transaction cost and information cost.
That means whatever information we are getting from the market that information should
be free and if this there is some cost basically involved in the information then it should
be a minimal and that cost basically should be borne by all the market participants.
So, if you talk about the stock market. For example, whenever we talk about stock
market the transaction cost is always reflected thorough the bid ask spread the
transaction cost is always measures through the bid ask spread. So, here the bid ask
spread is also measure of the liquidity. If the liquidity is high that means, this spread is
low that means, which implies that the transaction cost in the market is low.
The transaction cost includes all type of cost it includes brokerage cost, it includes the
cost for participating in the market in terms of a taking the positions in the stock market
or bond market. So, whenever your whenever you transact anything, whenever you are
opening the account, whenever you are basically making the insurance policy or you are
going to invest in the stock market or you are going to invest in the bond market.
Whatever cost you are bearing to take the position in that market that is basically
nothing, but the transaction cost or the cost of the investment in the market. So, lower the
transaction cost, lower the information cost higher the development.
So, we should ensure that transaction cost incurring in the market should be as much low
as possible by that the more participation or more investors or more savers more kind of
market participants should come to the market. And once more participation will be there
the market will be more competitive and then the price will be highly competitive also.
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And the price what we will get it that basically actual the reflection of the true value of
that particular security in the system. So, therefore, transaction cost is very important.
Then another thing is whenever we have a banking system we should ensure that with
the public sector bank private banking also should be developed. That means, the
government should not basically own all the blanks which are operating in the system, all
the banks should not be owned by the government, there must be some kind of private
banking system to minimize risk in the particular system.
So, more the participation of the private banks you should ensure that the market
become more transparent, the corporate governance system will be more robust. In that
contest the investors or the market participants should create the confidence in the
market which automatically ensure that the market is developed or the system is
developed.
So, the private banking should be predominant, we should encourage or any developed
financial system should always encourage that how the development in the private
banking can take place. So, in that context we should ensure that the development of the
private banking is also indicator of the financial development in that particular system.
Then, obviously, it is the next point you should have a strong and effective system of
supervision, inspection, auditing and regulation.
To create the confidence in the mind of the market participants the supervision is very
much required and periodically it should be audited and regular regulatory norm should
be very strong and very stringent. And all kind of grievances what the investor investors
are all other market participants have that should be addressed also periodically in a
better manner. So, are also periodic manner.
So, in that contest what we can say we should have a strong effective system for the
supervision that is why we have a regulatory bodies like RBI, we have the bodies like a
SEBI, we have the body is like PFRDA, the Pension Fund Regulatory Development
Authority, then we have IRDA, Insurance Regulatory Development Authority. Whose
job is basically to ensure that the market is well enough or market provides all kind of
information to the system or information to the all the market participate in such a way
that, the investor can use that information for their participation in the market and there
is time to time the regulation has been taken for betterment of the system.
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And as well as all the grievances have been addressed by the different regulatory bodies.
So, that is why this industries confidence or the market participants confidence increases
in that particular part. So, this is what basically we have in terms of the finance and
development indicators.
Then, we can of other some other indicators like presence of strong active large size non-
banking financial sector which comprising the stock market, debt market, insurance
companies, pension fund, mutual fund etcetera.
Then, we have should have a high level of current and capital account convertibility or
the openness that mean market should be more open. And the restriction should be
minimum these participation of the foreign investors basically should be minimum,
foreign minimum restrictions should be there. The effective and quick enforcement of
financial contracts and recovery of the loan should be there in the market.
We have a strong system to recover the loans and as well as we should have a effective
and quick enforcement of the financial contracts. So, whatever contracts are there that
contracts should come to the operations in an effective manner, in the quick manner. All
the positions which are taken that should be liquid that should be that should converted
into the liquid instruments and as well as at the time of requirement the market
participants should be able to utilize the money whatever they have invest they have
invested in the system and as well as the money can be easily converted into cash.
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So, these are the things we should ensure that is why we say that it should be effective
and quick enforcement of the financial contracts and the recovery of the loans. The
recovery of loan process also should be effective and quick. We should ensure that the
loans which we are giving they should follow the proper credit appraisal project policy.
And the commercial banks should follow their actually issues or actual process by which
the moral hazard problem should not be there, and the adverse selection problem should
not be there because that problem basic finally, leads to the bankruptcy and liquidation of
the system as a whole.
Then another point interesting point is we should a we should see that how this policy
makers are using or RBI in terms of India are using their instruments monetary policy
instrument to make the system stable or to increase the growth rate of the economy or to
control inflation. So, you have direct instruments we have indirect instruments. So,
according to the notion more the indirect instruments are used like your interest rate.
For example, we can take Repo what RBI following nowadays. So, Repo is basically
indirect instrument. So, here what I am we are basically discussing if repo rate is increase
it will have the impact upon the call money rate. And once the call money rate will
increase it will have the impact upon other market interest rate and lending rate of the
commercial banks. Then your money supply gets affected, then if money supply gets
affected then investment gets affected this the investment the call money market rate will
increase, then the money supply will basically decline, then investment will decline like
that it can take a reverse trend.
So, here our objective is if you change the Repo rate; Repo rate is basically indirect
instrument and like that you have many other indirect instrument like CRR is also
indirect instrument, then other instruments. So, instead of directly changing the money
supply if the RBI try to use or for the regulator basically try to use some indirect
instrument to control the money supply and their effectiveness also to reach that outcome
variables like your growth and inflation control or stability of the price then what we can
say that system is better system to ensure that the market is highly developed. So,
therefore, that also we can keep in the mind that how this whether the monetary policy
instruments are direct or indirect.
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So, coming to this financial sector development if you see the specific kind of system
specific kind of market or institutions. There are different dimensions we have depth, we
have access, we have efficiency, we have stability and of the different parts. So, what the
World Bank has given this guideline, that the development of that particular system
should be measured in terms of all type of dimensions whether it is banking or whether it
is the stock market and bond market etcetera. So, it should be considered from all 4
dimensions point of view.
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So, there are certain indicators they have given that how this depth, access, efficiency
and stability of the financial system or financial institutions and markets can be
considered whenever we measure the total index of a financial development in the
country has a whole.
If you see we have if you talk about the debt for the financial institutions, we have the
like private sector credit to GDP ratio, mutual fund assets, pension fund assets, non-
banking financial attribute. These are all the measures which measures the depth of the
financial institutions, you can consider any of the institutions. If you talk about the
access then how many branches for 1 lakh adults, ATM’s for 1 lakh adults, working
capital, short term capital, finance by the banks.
Then, if you talk about the efficiency for the financial institutions part interest margin we
will discuss more on banking part, lending deposit spread net investment income to total
income, return on asset which is a measure of the profitability net income upon the total
assets, return on equity this again net income upon the total equity, bank cost to income
ratio bank z score, non-performing loans to total loans these are the measure of the
stability. You remember those all those aspects will be extensibility we will discuss
whenever we will specifically talk about the banking and as well as the efficiency
measure or performance measure of that particular system in the respective sessions.
Then, if you talk about the depth, if it is in terms of the market, then you have the market
capitalization to GDP. Market means price of the particular asset multiplied by the total
number of stocks outstanding, traded value which is measure of liquidity, debt issue to
the GDP, outstanding private debt security to GDP, domestic public debt security to
GDP, etcetera.
Turnover ratio is a measure of a efficiency which is the liquidity measure and volatility is
a measure of the stability of any market. Then we have the access market capitalization
excluding 10, that means 10 top largest companies is to that means, the particular market
should not be highly only concentrated there must be some access to the largest
stakeholder, non-financial corporate bonds to total bonds, investment financed by the
equity and the stock sales. So, these are the different proxies which are used to measure
the development of the financial system or more particularly financial institutions and
the markets.
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Then, if you see then there are some subjective indicators that already I told you that
subjective indicators are given by the IMF. It is in the question form that what basically
research are basically has raised the question whether institutions find the most
productive investments. Do institutions revalue their assets and liabilities in response to
changed circumstances? How feasible they have, but how comfortable they are for the
changes whether they are adaptive towards the changes or not?
Do investors and financial institutions accept to be bend out of the mistakes and what
price? If there is any problem, how easily or how feasibly they are basically coming out
of this. Whether institutions facilitate the management of risk by making available the
means to ensure headge and diversify risk? whether this kind of whether they are capable
enough to manage the risk or not and all hedging activities diversifying activities are
properly done or not?
Do institutions effectively monitor the performance of their users and discipline that
means, regulation part whether they are properly monitoring them or not? And how they
are they should monitor that how the particular resources are properly and effectively
utilized by them? How effective is the legal regulatory, supervisory and judiciary
structure in that particular country? And whether the financial institutions publish
consistent transparent information, because information is quite important and that
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should be free of cost and are the information available to the all the in participates in the
market also should be same and there should be uniformity among them.
So, these are the different indicators different kind of questions was raised by him. So, if
you access all these things or if you are going to access them in a effective manner then
it will be also give you the overall picture that how the finance and development market
has been developed in that particular country. And whether it is we can say that the
market is developed in that sense or not.
Please go through this particular references for this particular session. Then next we will
be talking about how the development is affecting the growth process.
Thank you.
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Lecture – 05
Financial Development and Economic Growth
So, in the previous class we discussed about that how the financial development can be
measured and what those different indicators of the financial development are. So, today
I will be discussing certain issues or certain things which are related to or makes the
relationship between the financial development and economic growth. Because, the basic
objective is to know that what kind of relationship can exist or can be established
between the financial development and economic growth as a whole.
So, in this context if you see that there are certain issues related to the importance of the
financial development for economic growth. Already we have discussed to some extent
about this I am just going to summarize this thing. As you know that with money, with
other materials, other instruments, money is also crucial input in production activities,
money is very important for all type of production activities in the economy. And, if you
ask that how the financial development is affecting growth process the basic notion or
basic question is the financial development can affect the growth process through the
changes in the savings behavior.
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Once the savings and investment behavior changes, once the development process
change it will have the impact on the savings, it will have the impact on the investments.
And finally, if the savings and investment behavior gets changed then it will have the
impact on the growth process or economic development process. So, what basically here
we are trying to see, the financial development who provides the savings and that savings
is automatically invested in the market either the investment is done in the financial
assets or the investment is done in the physical assets or any kind of assets which are
used by the consumer for different reasons. So, for everything the money basically flows
from financial sector and money flows through the financial sector.
So, here what we are trying to say that once the savings and investment gets affected
then automatically it will have the impact on the different investment process and
automatically that will have the impact on the growth process. And, financial system or
financial development also enhances the efficiency of the function of the medium of
exchange. How fast your money can be transacted, you already know nowadays we are
using credit card, we are using debit card, we have online banking system and all kinds
of things which are happening that is basically increasing the efficiency of the function
of the medium of exchange. So, once the efficiency of the medium of exchange changes
then the trading activities gets affected then; obviously, the transaction activities gets
affected, then automatically it will have the impact upon the growth process.
So therefore, we should know that how the efficiency level in terms of the medium of
exchange is has been enhanced. And, you know that enhancement can be possible
through a developed financial system as a whole. So, because of that we can have a link
between the financial development and economic growth.
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So, here we are discussing certain theories which relates the financial development with
economic development through savings and investment. How the savings and
investments play the central role? Saving and investment are basically considered as the
central factors which contributes to economic growth process. And, financial
development is basically the responsible sector who affects the savings and investment
behavior in that particular system.
So, overall we have five theories: we have classical theory which is called it prior
voluntary saving theory, we have a credit creation theory, we have a forced saving theory
or inflationary financing theory. Then we have the financial repression theory, then we
have the financial liberalization theory. So, you remember these five theories tries to
establish the link between the financial sector or financial development with savings and
investment. And finally, once the savings and investment gets affected the economic
growth process gets affected.
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So, one by one we can discuss that what these theories basically talks about and what this
theory tells. You know if you talk about the prior savings theory which is given by the
classical economists, the prior saving theory tells that saving is a prerequisite or
determinants of investment. That means, here what basically I am trying to say that
whenever you talk about the prior saving theory here the investment is a function of the
savings.
Savings which is the most important factor which affected the investment; that means,
whatever surplus amount we have; that means, savings is nothing, but
Saving= Total income- Consumption
Then whatever money is basically saved that is going to be invested in the market. So,
that is what basically the concept of prior saving theory and prior saving theory does not
advocate the inflation. He said that inflation is not required, it is not a desired concept,
desired phenomena in the system, more the inflation it will have the adverse impact on
everything. So therefore, there should not be any inflation in the system. It advocate the
control of inflation any kind of policies should be taken by that the inflation can be
controlled.
And another very interesting feature what the prior saving theory tells the real interest
rate should be always high, high and positive real interest rate to encourage savings by
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the public. You remember that if interest rate will be more it will have the impact upon
the supply side in a positive way, because more people will be interested to deposit their
money in the banks because they will be getting more interest. But, in other sense the
banks will charge very high interest rate on the borrowers or the lending rate will be
higher. So, because of that the demand for money will go down.
So, because of that the investment gets affected, but still the prior saving theory
advocates that the real interest rate should be higher, real interest rate means we are
basically defining in this way your nominal interest rate minus the inflation that is
basically your real interest rate. So, the nominal and real concept will be extensively
discussed in the coming sessions, but remember
Real Interest Rate= Nominal Interest Rate- Inflation Rate.
So, it says that high positive real interest rate affects the savings behavior and once the
savings comes to the market or comes to the banks it goes to the market, then this
investment will automatically takes place. So therefore, saving is most important factor
which affects the investment.
So, here if you see this theory basically tries to analyze what kind of services these
financial development or financial institutions offer in terms of the different aspects.
What are those aspect if you see, we will discuss one by one. How they have really
contributes in terms of the growth process through savings and investment behavior and
as well as the other aspects also, which is basically the services side. What kind of
services the financial development of the financial institutions provide by that those
services increases the efficiency. And finally, this there is an investment takes place in
the system and the growth can be possible. Then what are those, if you see that first one
is liability asset transformation.
I will give you example: how this basically liability asset transformation takes place.
Whenever we give the money in the bank this is an asset for me, but this is a liability for
the bank. Whenever I am depositing the money in the bank this is an asset for me,
because I am getting some return out of this. But whenever bank provides that interest to
us by keeping that money with them that become the liability for the bank, but still bank
takes that why. Bank can creates the asset out of that, but how the bank creates asset out
of that, from that deposit base only the bank can provide the loans. If the bank will
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provide the loan now that particular liability whatever the bank has that has been
converted into assets for them.
Because once they have given the loan they get some return out of these and out of that
return they provide certain interest to us, because we are depositing the money with
them. So finally, what is happening the assets and liability are transformed. There is a
transformation which is happening with one stakeholder it considered as an asset with
another stakeholder it becomes a liability. And in the next period those things can be
converted into liability and the reverse basically asset and liability from liability to asset
from asset to liability. So, what organization can do? That can only be done by the
financial institutions. So, in that process it contributes to growth process.
Second one size transformation, how the money comes to the market unless the financial
system is not there it is not possible for the circulation of the money to a larger extent in
the financial system as a whole. Now you can observe that the banking sector has
developed like anything. We have there is so many bank branches and that is why
because of the accessibility the people can save their money. Once the money is saved
then what is happening that transformation can takes place and the small savings can be
accumulated and that small savings can be converted into the long loans or large loans.
So, in that context the whole system works and those things can be only given by can be
contributed by financial system.
So, through that the savings is increasing finally, it is helping in the investment process
of the particular system. Therefore, the size transformation is done by the financial sector
only. Risk transformation, you know how this risk is transformed by the financial sector
or financial develop; the financial sector is developed then what is happening some
people are the risk takers, some people are the risk averse. So, if you are taking some
positions or you are trying to invest your money in the market you are taking some risk
and that risk can be diversified. The risk can be transferred by the financial institutions
only, you know the risk can be managed by various ways. Risk can be diversified, risk
can be hedged and risk can be transferred.
So, whenever we talk about the hedging we are taking the help of derivatives instrument,
we have different positions. If one market does well another market may fall, if one
market basically falls another market may go up. So, whatever loss you are making in
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one market that can be a gain in another market, because you are taking a reverse
position. One market you are buying position to another market or selling position and
buying selling position can be depending upon the market fluctuations you can hedge
your risk. Diversification means the assets what you are holding can be invested in
various available alternative through the financial sector. You have the bonds, you have
the stocks, you have the derivatives instrument, you have the bank deposits, there are
different instruments which are available.
So, in that context what you can do, if you can have the positions in the different markets
then, if there is problem in one market maybe another market can take care of your
problem and the risk can be diversified, risk can be reduced. Transformation by the
insurance policies maybe everybody is paying the insurance premium, but everybody
may not be using it. So, what is happening to your money? It can be utilized to provide
the insurance to somebody else. So, in that context basically you are also transforming
the risk. So, overall if you see that financial organizations or financial institutions
provide the risk management services or risk transformation is happening through the
different financial instruments. Maturity transformation, why basically what do you
mean by the maturity transformation.
The maturity transformation is what? The maturity transformation is that we are

depositing the money for maybe 20 days or there is no maturity period. Because, those
moneys can be converted into the long term loans. Now, whenever you are taking a
house loan that is 20 years, but nobody have a fixed deposit of 20 years. The maximum
fixed deposit can be 3 years or 4 years or a kinds of thing, but the banks are able to
provide that long term loans out of the short term deposits; that is the beauty of that
particular system. By that what we can say that the instrument which are kept that
basically that instrument with the different maturity can be transferred or transformation
can be possible by the financial system. And, which is helping to all the different market
participants on the basis of their requirements.
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Then what we can do, we can move into another theory that is credit creation theory.
What do you mean by credit creation theory? Here in the previous discussion we have
said that investment is a function of the savings, savings affects the investment. But, here
according to credit creation theory financial system can also create the credit in
anticipation of the savings. You might have known, you might have the idea that the
bank's credit can be more than their deposits that is possible. Because why the bank can
do, because bank has the ability to create the deposits of the savings because of their
economies of scale and economies of scope. Economies of scale means in the larger
scale this particular organization is existing and economies of scope means they are
providing the different kind of services by that somewhere they can manage the risk in
such a way that the total risk of that particular system can be minimized.
So, only organization so if you ensure that the financial system is the only system which
can create the credit in anticipation of the savings that basically what we can ensure in
this particular context. So, then if you see that in that context this theory does not argue
that always the saving is affecting investments only; unless that theory tells even if there
is no savings to some extent the investment can take place because the financial sector
can create the credit. So, that is another argument that is why in this theory argues that
there is a independence of saving from saving the independence of investment from
saving in a given period of time; that is may not be possible always that always saving
affects unless there is savings investment cannot be possible.
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The equality in savings and investment is a question mark that always savings may not
be equal to investment, that is basically savings may be lesser than investments and that
is possible because the credit creation is possible in this case, because the bank can
create money. The investment out of created credit results in a prompt income
generation. Once the credit is created and that goes to the market for investment and
obviously, the production increases and if the production increases that leads to the more
income of the economy at a large.
So, credit creation overall if you summarize that credit creation does not subscribe the
concept that savings is the only factor which affects the investment. And, without
savings also investment can be possible by the creation of the credit and once the credit
is created then it can generate certain kind of income because, of the productive uses of
that particular credit in the system as a whole.
Then we can come to the next one the theory of forced saving which believes that
inflation is required for the development. Some amount of inflation is very much desired
whenever you talk about the growth or the development in a particular system. So
therefore, it is little bit interesting in the sense it is says that investment is not determined
by the savings. Savings may be determined by the investments. So, the policymakers can
take certain policies by that the investment can grow up, the investment can go up or can
be grown then finally, what will happen the total profit in the system will grow up. And,
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if the total profit will go up then it will leads to the more savings. The corporate sector
can generate more revenue whenever the total productivity or the production of the
system base increases.
So, in this sense what we can say that this theory does not subscribe that investment is
always determined by the savings. Otherwise it says also saving can be determined by
the investment itself, saving can be changed once the investment in the system changes.
So, how the investment can change? The investment can change autonomously through
monetary expansion; that means, because this theory was given by Keynes and Tobin.
And, they believe that the money supply can be exogenous, money supply can be
determined by the regulators or by the monetary authority exogenously outside the
system.
So, if you expand the money, if money supply increases then it will have the positive
impact on investment. So, the investment will go up, then the output will go up, if the
output will go up then the income will go up, if income will go up then; obviously, the
savings will go up. So, that is the argument what it gives; that means, we can
exogenously change the money supply. Then if you exogenously change the money
supply, then what will happen. It will have the impact on the investment behavior at
large and finally, the savings also gets affected that is what basically this saving in this
particular theory argues.
And, how the monetary expansion affect the economy growth they have given certain
channels. There are certain ways, certain concepts has been given by this economist by
which if there is a monetary expansion then how it affects the economy growth process.
If you see that according to Keynes the particular economy is not always in the full
employment level, there is some kind of resources which are available which are
unemployed. So, if the resources are unemployed then what will happen? If you increase
the money supply already there is a capacity the economy has; all the capacity has not
been utilized. If the still there are some resources which should be utilized then what will
happen whenever you increase the money supply it will increase the demand, because
still the resources are unutilized. If it will increase the aggregate demand then; obviously,
it will increase the investment; because the demand is there then people over your
producer will be ready to produce the product.
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Then by default the output will increase, if the output will increase then already I told
you that; obviously, your total income or corporate income corporate sector or producer
only will produce the thing, because they are investing the money. If they are investing
the money, the money which is flow to the market can be utilized by the producers and
they create this output. Because, why they can create the output because there is
aggregate demand, the demand is there in the system. Then what will happen their
income will increase, if their income will increase then automatically the profit will
increase. If the profit will increase then that will be coming into the corporate savings
form and the savings also can increase.
So, in that context if that happen and that also does not lead to inflation and it will not
lead to inflation because there are some resources which are unemployed. But, you
assume that the resources are fully employed in the system, there is another condition.
The first condition here we have discussed that the resources are unemployed. But let me
take another condition, the resources are not fully employed. Now, the capacity is not
there whatever resources are existing in the system that is completely employed. And,
now if it is completely employed then how the growth can take place because then the
argument was what Tobin has given this concept of portfolio shift effect. What Tobin
said, Tobin has given this concept that if there is a full employment then still we are
going to increase the money supply.
Then let whenever there is if you increase the money supply, the money supply has
increased so; obviously, it will creates the inflation. So, if it will create the inflation then
what will happen that the real interest rate or real return or real return from the financial
sector will go down. So, the real return in the financial sector will go down, but people
have the money because money is available in the system. Then what they will do, they
will shift to spend their money in the physical sector or physical goods. Why they will
spend their money on the physical good? They will spend their money on the physical
good, the reason is in anticipation that the expected inflation may go up.
So, now already the inflation is high, if they have any kind of requirements they try to
put their money in that particular asset. Because, if the inflation has already increased to
some extent they will expect that inflation may further go up. If the inflation may further
go up then again it will be more expensive for them to buy the product in the next period.
So, because of that they will go for more physical goods. Then if they go for more
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physical goods then the consumption will increase. The consumption will increase then;
obviously, the producer will go for more output or produce more. If the output will
increase then automatically what will happen that, that will have the impact upon the
growth process. And finally, your savings gets affected; that means, in the second point
if you see that this is called the income distribution effect.
Now, what this income distribution effect; the income is basically coming from the
financial sector to the physical sector and the physical sector basically increases the
savings or the producer basically increases the profit. If the profit increases then
automatically saving increases and the once the corporates have been increases the
money again comes to the market for the investment. Then finally, again the output or
the growth process can take place. So, that is what that is why it is called the portfolio
shift effect mean the shifting the money or investment from the financial sector to the
real sector or the physical goods sector. And, once the physical goods sector goes up or
the development of the physical sector goes up then the profit of that sector goes up, that
is why there is an income distribution between these two sectors.
And finally, this total profit leads to the total savings then finally, the output can be
enhanced. So, that is there is another that is the way basically this thing basically comes.
Then another thing also can happen there, if their profit increases; obviously, they will
pay more tax. If they will pay more tax then the tax revenue can be used for the public
expenditure. The government can use their tax as a public expenditure so, which is called
the inflation tax.
Why profit will increase, because already inflation is a little bit higher, the price of the
product is a little bit higher then the profit level of the producer will be more. Then once
the profit is more they will pay more tax and the once the tax is coming to the
government, the government can use it for the public expenditure. Then automatically
their total growth process, it also contributes the growth process at a larger extent. So, in
this process there are different channels through which the monetary expansion can
affect the growth process at a large.
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Then we have the financial regulation theory which does not subscribe the everything
should be market determined; that means, government intervention is very much
required. Why the government intervention is important? Some economists have argued
the financial markets are prone to market failure, there is a problem may happen in the
market. So, only government can so government intervention is very much required to
control that. And, the lowering of interest rates through government intervention improve
the average quality of the pool of the loan applications and improve the efficiency with
which the capital is allotted. Direct credit programs can encourage lending to sectors
which are usually shown by the market.
You see there are some times if the government does not intervene then the private sector
lending will not be there. The agricultural sector or small scale industries they may not
get the loans by the commercial banks and others and finally, the wholesome
development of the system may not be possible. So, because of that some kind of
regulations in the financial sector is required for the welfare of the society at a large
which ultimately also can affect the growth process in the economy. So therefore, that
direct credit programs can encourage the lending to the sectors which are usually done
by the market.
When government intervention provides that everything is a public good so, therefore the
public good in the sense any instrument which is coming to the market that money that
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can be utilized by everybody. And, everybody has the right on that particular thing, that
particular signal can be given by the government only. If everything is market
determined so those kind of things may not be possible whenever we talk about that
particular system. And, government also in the responsible to create a stable payment
system because government can get into that. So, that is another kind of argument we can
see which in the believer of the financial regulation theory.
Then we have the financial liberalization theory which believes that government
intervention is not required, because everything should be adjusted in terms of the
market forces both demand and supply. So, increase in interest rate on a variety of
financial asset as they would adjust to their competitive free market equilibrium. Increase
in savings financial liberalization leads to increase in savings, reduction in the holding of
the real assets and increase in the financial deepening; that means, the financial growth
financial development growth. It more be, more it is expansive and as well as the
development in terms of the instrument development in terms of operations that can
grow up.
So therefore, liberalization can bring all kind of efficiency to the market as a larger
extent that is everybody believes that the market should be fully liberalized. Expansion
in the supply of the credit, because it is integrated and market mechanism takes care of
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everything there is a possibility that supply of credit can grow up from the different
sources.
It helps in increase in investment, the once then if the investment get grows up because
of the more participation, more number of instruments, more types of instruments and
more different type of investors like FII foreign institutional investor, Foreign
Institutional Investors, this FDI FII. All kinds of investors are there in the system then it
will increase the efficiency of the market. And finally, the investment grows up and
increase in average productivity of that is why the average productivity of investment
can go up. Then finally, what will happen because of more participation as they are there
and more people are involved in the production process then it can also increase the
efficiency, the allocation or the marginal efficiency of the capital which is spent on that
particular market can go up which we call it the allocative efficiency.
By that the more number of participation and more, market participants make the market
more competitive and all those things can be captured through the market dynamics. By
that the possibility of the equilibrium always the exists in the market and if market takes
care of everything then there is no possibility that any kind of disturbances can happen in
that particular system that is the argument what the financial liberalization theory tells.
So, here these are the different five theories which highlights about how the financial
development affects the savings and investment. And finally, the savings and investment
changes or behavior of the change in the behavior of the savings and investment finally,
affects the economic growth.
So, in directly or indirectly what we can say that development in the financial sector,
financial development always lead to the growth process in the larger extent. Therefore,
the importance of the financial sector is very much important. And, then in the next
sessions will be discussing certain concepts a certain kind of we can say that major issues
which are used in the financial system at a large and then we can move ahead to the
specific institutions and the markets.
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So, here I can show you the result that this is the way the financial development affects
the economic growth that is the result for India. We say that the financial development
affects the economic growth largely. This is the empirical result, I will explain more on
whenever we talk about the empirical validation of this in the coming sessions.
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Lecture – 06
Systematic Risks in Financial System
So, after discussing about the basic role of financial system and how it is related to the
economy growth; we can start the discussion on certain concepts, which are linked to this
particular financial system. And this particular concepts will be used across the different type
of Financial Institutions and Market what we are going to discuss in the coming sessions.
So, as you know that the most important thing in the financial system is the management of
the risk. Because every participants come to the market knowing that they are going to
exports certain amount of risk, and accordingly they want to maximize the return in such a
way that whatever risk, they will face, the risk can be adjusted and as well as they can get
certain return for their benefits and as well as the maximization of the wealth.
So, keeping those things in the mind, we can start some discussion related to different type of
risk what always we observe in the financial system as a whole. Then those type of risk will
be discussed more elaborately, whenever we go and discover whenever we are going to
discuss these particular market and institution specifically in the following sessions.
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So, let us first see that what do you mean by the risk, how the risk is defined. So, you might
have known that the risk and uncertainty, these are the two words, which are popularly used
in the financial literature. And there are some kinds of theoretical differences between them.
So, I will give you these basic differences between them little bit later.
But, let us first analyze or try to understand, what exactly the risk is. The risk is basically a
situation, where the objective probability distribution of the values a variable is known, even
though the exact value it would take are not known. What exactly it means? It means that
whenever we are going to predict something in the market or we are going to say that, how
this particular stock or particular bond is going to perform, and what is the probability that we
are going to 5 percent, 10 percent, 15 percent return, we can have different scenarios.
For example, you say that let the particular market has three scenarios. One is a normal
condition, there is a normal condition, there is a recession, and there is boom, the market is
growing up. So, in these two condition, let we can assign different probability. There is a
probability that if there is a 40 percent chance that there will be a boom. So, if there is a
boom, the return will be let 10 percent.
And there is a 30 percent chance maybe the market will be in the normal condition, the return
will be 80 percent. And if there is a recession, and a 30 percent probability that is recession,
and you can get let 5 percent return. So, here what you are trying to say that whenever we are
talking about the return what you are going to observe from the market, we are defining a
certain probability distribution.
And we are assigning that if something is going to happen, then what is the probability that
we are going to get this amount of return? But exactly we do not know, whether really this
returns can be realized or not, but still we are thinking there is a probability that this kind of
return can be achieved from the market. So that is why, we are saying that the exact values
basically is not known here. But, we can go for a probability distribution of that particular
variable, which is our outcome variable or the focused variable.
And how the probability distribution is made? The probability distribution is made on the
basis of the theory, and the past experience, and as well as the laws of chance. What basically
this, we have the data about that particular variable, which is available for may be last 10
years or 15 years. And we have observed that how this data behaved in the last periods. And
accordingly, we can decide that if the data is behaving in this way historically, then how this
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particular data is going to behave in the future also. So, the probability distribution can be
derived from the past observations, whatever we have. And accordingly, we can assign
certain probability with respect to this. And finally, this expected return, what we are going to
get from this that can be calculated.
So, therefore here what we say, what is the risk here? The risk here is for example, you are
expecting if there is a boom, you are going to get 10 percent return, but it is not necessary
that you are going to get this 10 percent return. The reason is maybe you may get 12 percent
or you may get also 8 percent. So, what is trying to say? If there is a deviation, if there is a
deviation from the actual expectations whatever you have, it is not actual, basically you are
expecting something.
So, if you are expecting something, but you are getting something that means, there is a
probability that whatever thing you are expecting that may not be realized. So, if it is not
going to be realized or it is not going to be materialized, then we are facing certain amount of
risk in the market that means, we are saying that investment or positioning in the market is
risky, because whatever way we are expecting that particular thing may not be received by
us.
So, then what basically, we are trying to say? If the variation is more, then the risk will be
more. You are expecting 10 percent, you are getting 1 percent, somebody else is expecting it
possible 10 percent, getting 8 percent. So, there is a differences. If somebody is getting 2
percent or 3 percent, we are expecting 10 percent and somebody is getting 8 percent, but he
was expecting 10 percent. So, there is a deviation. The deviation there is a variation in the
deviations, so that variation or the variability basically measures the risk. How the actual
value is deviated from the expected value?
So, in the statistical sense, the expected value is nothing but the mean value of that particular
series that is what in the simplistic way we can say. Although there are different ways the
expectations of that particular distribution can be calculated. But, in general, we can say that
the mean value of that particular series can be used as the expectations or expected value of
that particular data, so that is why more the variation, the risk will be more.
And obviously, if the broader the range of the possible outcomes, the greater is the risk. So,
more the variation more is the risk that is what basically, what we can conclude. So, the risk
what we are going to face that is not basically related to the actual return, what you are
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getting that is related to the we always calculate the risk with respect to the variation of the
return of that particular data with respect to the expected return, what we are expecting or we
are calculating before, so that is why the variability or the dispersion in the possible
outcomes, basically measures the risk of that particular series or risk of that particular
distribution. So, this is the basic concept of the risk, what always we observe in the market or
we always use it in our analysis.
Then let us see that how this what are the popular measures of risk, how the risk is basically
measured? Whenever we measure the risk all of you might have known, that the basic way of
measuring the risk is the variance, the basic way of the measuring the risk is basically what,
we can say that is the standard deviation.
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So, variance or standard deviation, these are the basic measures of the risk. All of you know
that how the variance can be calculated that it is the deviation from the mean of that actual
series. If you take those square of that divided by the degrees of freedom that is n minus 2, so
that basically measures the standard deviation of that variance of that series and if you take
the square root of the variance, then we can measure the standard deviation. So, this variance
and standard deviation, these are the two things basically what we always use for measuring
the risk in the market.
So, then another thing is basically you see, you can also use the co-variance. The co-variance
basically measures the risk of the security, they related to the other security in the portfolio.
And whenever we are comparing the different type of alternatives whatever we have, if you
are comparing the alternatives of the choosing the assets in the market, then what basically
we are trying to do? We are using the concept of the covariance between x and y and that
covariance between x and y is basically measures the risk factor of that particular variable or
how that particular variable is risky, and whether this particular variable or particular
alternative can be taken for investment or not.
And another thing also we have that is called the coefficient of variation. The coefficient of
variation, we use it basically whenever we are comparing the two alternatives. For example,
in one alternative you have A, in another alternative you have the B. If A is giving 10
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percent return and giving a risk of 8 percent and B is giving a return of 12 percent, and you
are facing a risk of 9 percent.
Then here if there is a dilemma that which alternative should be chosen, so in that particular
point of time, basically we use the coefficient of variation. And the coefficient of variance is
nothing but that for one unit of the risk, how much extra return you are getting? It is basically
the ratio between the mean return what you are getting, and the standard deviation, so that
particular measure is used whenever we have the different alternatives. And we are going to
use that alternatives in the market for the investment or choosing the investment from the
varieties of alternatives, which are available.
Then another type of measure, we have popularly used that is called the value-at-risk. So,
what this value-at-risk means? The value at risk is basically a statistical measure. The value-
at-risk is statistical measure of the riskiness of the financial asset; it is a statistical measure or
the riskiness of the financial asset or portfolio of the assets. What it defines? How we can
define this value-at-risk?
The value-at-risk is nothing but the maximum amount expected to be lost over a given time
horizon, at a pre-defined confidence level. In the statistics, you might have known about the
confidence level and the significance level. And whenever we measure the value-at-risk, we
basically consider at what significance level or at what confidence level, we are basically
measuring this value- at-risk.
So, if you have the 95 percent confidence level, then that means significance level is 100
percent minus 95 percent that is 5 percent. If it is a 90 percent confidence level, then the
significance level is 10 percent like that. So, here what we are trying to say? If you see this
example, if 95 percent one-month VAR is rupees 5 million that means, if you want to
interpret it what basically the interpretation is the interpretation is that is 95 confidence that
over the next month the portfolio will not last more than 5 million.
What basically it means, it means that what is the maximum loss or the worst loss somebody
can make in a particular time period at a particular confidence level that is basically is
defined as the value-at-risk. The value-at-risk is basically a measure, which tried to tell you
that, what is the maximum loss this particular investor or particular company is going to
make if he or she wants to invest in the market, that is basically the measure of the value-at-
risk; or this is the way the value- at-risk can be defined.
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Then if you see that there are different types of risk, broadly the risk can be defined in two
ways. One is your systematic risk, and another one is the unsystematic risk. What do you
mean by the systematic risk? The systematic risk is a risk, which is basically everybody is
basically suffering from that. All the entities are exposed to the systematic risk, because that
is basically related to the macroeconomic fundamentals.
And if the general market or macroeconomic fundamentals like interest rate, inflation all
these things became volatile, so in that sense we can say that we are exposed to the
systematic risk of particular market that means, whether any company operates or any
individual operates in the market. So, if there is a change in the inflation, there is a change in
the interest rate everything, so then what will happen that everybody will be going to face
that particular risk in the system. So, therefore it is called systematic.
So, any kind of investment strategy if you want to make so that particular risk cannot be
diversified. So, this systematic risk cannot be diversified that is why, the other name of the
systematic risk is also on diversifiable risk. This particular risk cannot be diversified in the
system. So, whatever way you want to make your portfolio strategy or investment strategy
that is not going to help the participants to the investor to reduce or to diversify that risk in
the market.
Then another type of risk is the unsystematic risk. So, this unsystematic risk is basically
nothing but this risk is specific to the particular entity, either it is maybe with respect to
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individual or with respect to a company. So, any fluctuations within the company like if the
sales is fluctuating or if there is some kind of uneven situations, which have occurred in the
company, but that is not applicable to another company.
So, those kind of events, those kind of incidents can also create certain kind of risk for the
particular investment alternatives or for that particular entity. So, those risk can be
diversified, but in the sense what we are trying to say? If any kind of investor wants to invest
in the stock market, if they are holding 50 stocks, 20 stocks or 30 stocks, so in that context
what happens that if all those 30 stocks if you are chosen, and if one stock is do not doing
well, another stock can do well. At one sector particularly may not perform well, but another
sector may perform well.
So, in that context what they trying to do, they are trying to minimize the risk, so that is why,
what we can say? The unsystematic risk is also known as it is called the idiosyncratic risk.
The idiosyncratic risk is nothing but it is specific to the individuals. And those kind of risk
can be diversified, if you are holding more number of assets or more number of investment
alternatives in the system or your investment portfolio that is why, we can say that this is a
diversifiable risk. So, if you are holding more assets in your portfolio, then this particular risk
can be diversified. So, this is basically another thing, what we can say.
Now, let us discuss that, what are those different types of systematic risk, major type of
systematic risk, what we face in the market. So, the 1st one is the beta. The market risk,
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which is defined as beta and another one is interest rate risk, inflation risk, exchange rate or
the currency risk. These are the major risk, which are driven by the changes in the
macroeconomic fundamentals, and because of changes in the macroeconomic fundamentals
this every market participants are exposed to this type of risk in the market. So, let us see that
how this particular type of risk can be find, and what basic how we can measure this.
So, then we can come to first to the market risk, which is popularly known as beta. So, what
this beta indicates, the beta indicates the extent to which the risk of a given asset is non-
diversifiable, and it is basically measured as a coefficient, which measures the security’s
relative volatility with respect to the market volatility.
So, how this beta is calculated, so if you in the sense let me explain you that how the beta is
calculated. The beta is calculated in this way that beta is equal to the covariance between the
individual assets return of the individual assets with the market return divided by the variance
of the market. So, this is the covariance between i represents the individual return from the
asset, it may be stock, it may be bond, it can be anything. And this m represents the market
return.
So, for example, if you take the stock market, in the stock market the m is basically what. Let
you can take the proxy BSE Sensex, this is an index. And people consider this as a market
portfolio. So, the return from the BSE can be consider as the market return. Let you are using
a stock A, the stock A is returned is basically represented as i. So, we are talking about the
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covariance between the return of the individual asset or the individual stock, and the return
from the market divided by the variance of the market that will give you the value of the beta.
Cov i , m
β= 2
σm
So, here what we are telling that if you little bit expand it,
σ i σ m ρ i ,m σ i ρi , m
Covi ,m = =
σ
2
m
σm
then your covariance i and m is nothing but the standard deviation of i into the standard
deviation of m into the correlation between i and m divided by the variance of m. So, one
standard deviation and one standard deviation can be cancelled out. So, you will end up with
the standard deviation of the i multiplied by the correlation between i return of the individual
security in the market divided by the standard deviation of the market.
So, in general we can represent it that your covariance i, m is equal to or the beta is equal to
basically this one. Then beta is equal to covariance is equal to this, standard deviation of i and
the standard deviation m into the correlation between i and m divided by the variance of m.
So, then what has happened. Finally, one standard deviation of m can be cancelled out,
because the standard deviation variance of m is nothing but standard deviation of m into
standard deviation of m.
Then finally, we have your final
σi
β= ρ
σ m i,m
This i represents already I told you, this is the return from the individual stock or individual
security, and this is the return from the market, and this is the standard deviation of the
market, and this is the standard deviation of the return of the particular security, so that is
why, this is basically what, this is basically the calculation of the beta. So, this is the actual
calculation of the beta, but the beta also can be calculated in other way.
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If you regress if you can run the regression line, let R i= β ( R m ), this is the simplistic way of
calculation. The beta is the coefficient, R m is the market return, then what you can do, you
can take two columns. One column you can take the return from this individual asset, and
another column you can take the return from the market run the regression, where Ri is the
dependent variable Rm is the independent variable.
And whatever coefficient, you will find that coefficient also this beta, this is basically the also
the market risk, this is the way also the market risk can be calculated. So, therefore the
security the this is a slope, and the security with the higher beta is more volatile than the
market, and the asset with a lower beta would rise or fall more slowly than the how the
market is volatile that is the way the beta can be defined.
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Then we can come to the other type of risk that is basically you have interest rate risk. So,
what this interest rate risk is basically talk about the interest rate risk is basically nothing but
the variability of the return on security due to changes in the level of market interest rate. If
you go back generally if there is a change in the interest rate, then the value of this particular
asset gets changed. However it basically happens?
For example, if you talk about the bond the price of the bond is what, if you write this price
of the bond, the price of the bond works in this way write
CF i
v0 = t
( 1+r )
v 0= Price of the bond, CF i= cash flow and this r is nothing but the interest rate or the discount
rate. So, here if you see, if your r changes, then V 0 changes if r increases, the value of the
bond goes down. If r declines, then value of the bond goes up, because it is a discount factor,
which is taken in the denominator.
And here the price is increasing, for example somebody has invested in the bond. And in the
bond if they get the coupon, so the coupon is nothing but the regular cash flow right and as
well as in the principal amount, whenever in the end we get it. So, in that context what we
say, if the interest rate increases the value of the bond goes down, but whatever coupon they
get, if the coupon amount can be reinvested in the market, they get more return that is why,
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whenever the value of the bond goes down, we say that increase the interest rates declines the
value of the bond that is why the price risk increases, which is called the price risk.
And whatever money we get it from the coupon, like if we have bond value of the par value
of the bond is 1000 rupees, your coupon is 10 percent, then every year you will be getting
100 rupees. If that 100 rupees again you are reinvesting in the market, then if your interest
rate goes up, maybe you can get some more return. So, therefore the price risk and
reinvestment risk work in the opposite direction.
Then we can come to the other type of risk like inflation that everybody knows. Inflation is
basically nothing but the purchasing power. If the inflation goes up, the purchasing power of
the consumer goes down. And that is always if the inflation increases, the real value of that
particular asset goes down, because it affects or it negatively affects the purchasing power.
So, therefore always we should expect that inflation should be low, because the real addition
or the real return from that particular asset can be increasing. Always you remember
whenever we compare or we try to analyze the inflation risk, we are not talking about the
actual inflation, which is happening now, we also consider the uncertain inflation or the
expected inflation. The expected inflation is very much so important, whenever we talk about
the inflation risk in the market, so that is basically we have to keep in the mind.
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Then we have another one that is called the exchange rate or the currency risk. So, the
currency risk all of you much very much aware about if there is a change in the exchange
rate, then the value of that particular currency changes. And that affects every type of
international transactions or anybody who are doing this international business across this
basically, it effects mostly the multinational companies and who are doing the foreign
exchange business.
So, therefore the exchange rate risk is defined as the cash-flow variability experienced by the
economic units engaged in the international business or international exchange. And there is
no exchange rate if you see that we have different type of exchange rate system like India
adopt a managed exchange rate system, China adopts a fixed exchange rate system, because
the government decide what should be the exchange rate of that particular currency with
respect to another currency.
So, if that is the fixed exchange rate system, we are not exposed to exchange rate risk. If there
is a floating exchange rate system, market determines how much should be the exchange rate
of that particular currency with respect to another currency, then what will happen that we are
much more exposed to the exchange rate risk and accordingly the value of the set can go
down. So, therefore these are the different one of the major risk, which is affecting the value.
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Then finally, the country risk. The country risk is basically what, the particular risk which to
which the political and the economic unrest affect value of the securities. If there is the
probability that there is an unstable instability in the political scenario or there is no political
instability exist in the system. Then what will happen that basically affects the balance of
payment.
Mostly it affects the buyer’s country, who are basically doing this foreign exchange business
or any kind of business, whatever anybody any company is doing or any individual is doing.
And that is why it is the probability of loss due to political instability in the buyer’s country
resulting in inability to pay for imports, because there is a political instability.
That sometimes affects the whole economic system and generally if it is adversely affecting
the balance of payment, and finally the value of the total assets can be affected, so that is the
way the currents the country risk can be defined. So, these are the major type of systematic
risk. And we will be discussing the unsystematic risk in the next session.
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Thank you.
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Lecture – 07
Unsystematic Risks in Financial System
So, we are discussing about the different type of Risk in the Financial System. So, in the
previous class we discussed about the different type of systemic risk what the system
always faces and what are those different type of systemic risk we have like your market
risk, you have interest rate risk, you have inflation risk, you have the exchange rate risk
you have currency risk etcetera. Then today, in this session we will be discussing about
the different type of unsystematic risk and already I discussed with you that unsystematic
risk is nothing but the particular risk which is specific to the particular individual or
particular entity. It may be an individual, it may be a corporate sector or it may be
anything.
But it may be related to any kind of organization, any kind of entity who are participating
in the system, but mostly this risk is confined to that particular entity and it does not
affect the others. To some extent, we are telling that this particular risk are defined as the
unsystematic risk and other name of unsystematic risk is it can be diversified. Already, I
explained to you that if any investor can have the varieties of assets or varieties of kind
of instruments in their portfolio then they can diversify the total risk. Because, if one
particular asset or one particular instrument is not doing well, then the other instruments
can basically make up the loss what they are making by creating certain kind of profit or
certain kind of return with respect to that individual asset.
So, therefore, unsystematic risk is a very important concept which is used in the
investment of the portfolio management process. And, as well as it is also plays a
significant role in the financial system participation as a whole.
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So, then let us see that what are those different type of major unsystematic risk always
we have in the financial system we have business risk we have financial risk. We have
default risk we have liquidity risk, we have the maturity risk, we have the call risk.
Here, I have given a list of the different type of major unsystematic risk what the
financial system witnessed always or what we always find these kind of risk prevails in
the system as a whole but there may be other type of unsystematic risk which is specific
to the individual company or individual entity but here, if you see that these are the
major type of unsystematic risk always we face. So, one by one if you discussed that
what exactly those type of unsystematic risk are defined and how this particular risk are
playing the role for the investor to maximize the return or minimize the risk.
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So, let us see what you mean by the business risk. The business risk is nothing but it is
the uncertainty of income flows that is caused by the nature of a firms business. In a very
raw sense, I can tell that business risk is nothing but the fluctuations of the sales income
of that particular company. If the sales income is fluctuating highly, then we can say that
particular company is exposed to more business risk and if the fluctuations of the sales is
relatively less or the deviation of the expected sales and actual sales are less, then we can
say that the business risk of that particular company is less.
So, here what we are trying to say that business risk is nothing but the volatility or the
standard deviation of the sales income of that particular company in a crude sense or in a
quantitative sense; that is the way we can define. So, that is why the major income flow
what the company gets that is basically from the sales. Actual definition is business risk
is the uncertainty of income flows that is caused by the nature of your firms business. So,
how this business is getting fluctuated, how the business is getting affected, that is
basically always a derived from the fluctuations of the sales income of that particular
company or particular firm.
So, it has two components; one is internal, another one is the external. So, here that
means, what you are trying to say there are some internal factors which basically plays
the role for deviation of the sales or fluctuation of the sales. And, another factor there are
some external factors also which contribute to the fluctuations of the sales of the
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company. Then what are those internal factors? The internal factors related to the
operating efficiency of the company, how the company operates what kind of business
strategy they adopt and how the sales basically or sales maximization strategy the
company is going to follow. And what kind of structure they have, what kind of strategy
they are making to cell their product in a better way, what kind of advertisement strategy
they have and how they can make their customer base, how they can make their product
differentiation in such a way, they can beat their competitors etcetera etcetera.
These are coming under the internal factors, but whenever we are coming to the external
factors, the external factors can be the cyclic conditions, the seasonal conditions. For
example, if one particular company which is selling this cold products like cold drinks,
ice creams and etcetera; obviously, there sales income is highly fluctuated by the
seasonal factors because in some seasons the sales figure basically is quite high and
some seasons this sales decline. So, because of that, there are some external factors
which contribute their fluctuations of the sales. So, that is nothing but related to the
strategy which they adopted internally, but mostly those places the factors are mostly
determined by the external factors.
But, mostly if the company’s internal policy is affecting the sales income then the
company is more exposed to the business risk because, this seasonal factor and the
cyclical factors can be predicted to some extent. Because this is a periodical occurring or
periodical things which is happening to that particular company, but whenever
something is going wrong to the company, because of that the sales is declining and
which is happening in internally then that is a more worry some matter for the company
in comparison to the other external factors which contribute to the fluctuations of the
sales. The external factors are not in the control of the company but, the internal factors
can be controlled by the company in a larger extent and it is affecting the company. The
internal company should be controlled by that the business risks should not arise from
that.
So, that is the basic objective the company should always have. So, this is already told
you that business risk is measured by the distribution of firms operating income which is
firms earnings before interest and tax that already you know as EBIT. And, here I have
talked about the sales in a crude way, but EBIT is basically whatever profit the company
earns and how the profit gets affected and profit is obviously dependent upon the income
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what the company generating out of the selling of that particular product what the
company is producing. So, this is what basically the business risk talks about.
Then, we can see another risk which is called the financial risk. You see, whenever any
company tries to invest in the market, what do they do, the company want basically
money. If the company wants money for that or capital for that, what is the source of
capital, the source of capital is either they can raise it in terms of debt or they can raise it
in terms of equity.
So, that is every company has a debt component and the company has also equity
component but here in the finance literature, the financial risk is measured through the
debt financing; that means, what here we are trying to say if the companies debt is more,
then companies exposed to more risk if companies debt is less; companies exposed to
less risk in terms of which is defined as the financial risk; that means, what is the
percentage of the capital that is financed through debt and what is the percentage of
capital which is financed through equity. If the percentage of the capital financed
through debt is quite high in comparison to the percentage of the capital finance through
equity, then we can say that the financial risk of the company is quite high.
So, therefore, we say that the debt to equity or debt to total capital is high, then the
company is exposed to more financial risk. why, we are saying that if the company’s
debt is more they are exposed to more financial risk or the financial risk of the
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company’s more? Why that particular thing basically always we assume? The reason is
basically, you see whenever any company has taken the loan or company has received
the debt or the bonds. So, in that particular point of time, the first basic obligation of the
companies whenever they get the profit they have to pay them and it is fixed you cannot
avoid that.
You see already I told you that your capital is debt and you have the equity means
whenever you have raise the money from the public in terms of the stocks. And, if you
have taken the loan or you have issued that bond against that particular issuance
whatever or money whatever you have raised from the market, then in every periodical
basis a certain amount of interest has to be paid, interest payments has to be made.
So, whenever the company has related total profit once company gets the profit first of
all the company has to pay the interest because for the loan for the bond and everything
interest payment has to be made first, then total profit and after that company will pay
the tax then after that if company wants they can pay the dividend. Then whatever
remaining will be there that is called a return earnings, but here the issue is company
may not pay the dividend for the equity holder. Most of the company also do not pay that
dividend but if they have the debt component then; obviously, there is a fixed obligation
for them to pay the interest regularly.
So, that is why the earnings of the firm may not be sufficient to meet the obligations
toward the creditors. For example, the firm does not have much profit to pay the interest
whatever the interest payments they have to make the company generates certain profit,
but that is not sufficient, then the financial risk increases heavily. So, whenever you talk
about these things, another thing is here if the company does not have much profit to pay
the interest but still they are generating some profit which should be given to the equity
holder, but a company is not able to, even it is not sufficient to pay the debt holder then
the what the company does whatever remaining money will be there they will pay to the
debt holder and equity holder does not get anything.
So, therefore, it increases also the conflict between the managers and the equity holder
and that conflict again increases the cost of the company which again increases the risk
of the company. What we are trying to say; first of all it is not sufficient because of that
the company is exposed to more risk number 1; number 2 whenever the equity holder
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feels that the company is generating certain profit, but that profit first of all they have to
pay to the debt holders. Once the equity holder does not get any money. So, they are also
basically annoyed or they must not be very happy with the company that is why conflict
arises between the managers of the company and the equity holder that again further
increases the risk of the company. Because, equity holders may not be interested to
invest in that particular stock in the future and to attract them the company again has to
give some more premium.
So, in both ways, the composition of more debt in the company increases the financial
risk level of the company and as well as the investors are relatively less reluctant.
Because, they will reluctant in the sense what we are talking about, the investors will be
reluctant to invest in equity but the company also will be always feeling that I have some
fixed obligations that is why my risk is more and I have some binding role and that role
basically declines my operating efficiency.
So, that is why the financial risk basically increases if the debt to equity ratio is high.
Already I told you that higher the ratio higher the variability of the return and obviously,
the financial risk is relatively higher for them. So, this is about your financial risk.
Then, we can have another risk which we call it the default risk or the credit risk. What
exactly the credit risk or the default risk is? The default risk arises from the failure on the
part of the borrower or the debtor to pay the specified amount of interest or to repay the
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principal both are the time specified in the debt contract. What exactly it means? For
example, somebody has taken a loan and in the loan agreement what has been
mentioned, you have to pay the interest periodically and as well as you have to pay the
principal at a particular time, but you assume if the particular entity or particular
individual or particular corporate could not pay the interest or could not pay the
principal, then what will happen that it will increase the risk for that particular
organization who has given that particular loan.
So, here what the credit risk or the default risk is trying to measure the default risks
basically measures the probability of default. If I have given you the loan, then what is
the probability that you may not refund that loan in terms of interest or the principal
which will increase the risk level of that particular company because that particular
default payment or default in terms of the payment will affect the performance of that
particular company or profitability of that particular company.
So, because of that, default risk is quite important mostly it is very important from the
banking point of view because banks are mostly doing the loan business and profit
scenario totally depends upon the amount of credit whatever they are given or amount of
loans whatever they have given. So, therefore, what we can say that the default risk is
quite important from the financial institutions point of view because it basically
measures that, what is the probability the money can be repaid, the repayment can be
made. So, that is basically we measure, the default risk has two components; one is
capital risk and the income risk because it means not only the complete failure to pay,
but also the delay in payment. Even if somebody is not paying, then the organization is
prone to the default risk.
If somebody is paying also, but they are delaying in payment, then also the default risk
or the credit risk of that particular organization increases. So, because of that we have to
be very much concerned, the financial organizations mostly banks are very much
concerned about the minimization of the credit risk and that is what they want to choose
the customers in such a way that where the probability of default for the repayment will
be less and by that they can minimize their credit risk in the system.
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Then, we can come to another risk which is called the liquidity risk. In the true sense
what do you mean by the liquidity? The liquidity is basically how fast this particular
asset can be converted into cash if the it is very easily and cheaply can be converted into
cash we can say that that asset is more liquid; for example, if you say there is a cheque
and there is a draft.
Whether, the cheque is more liquid or draft is more liquid? If you are holding that
particular asset which can be easily convertible into cash that is obviously, more liquid.
You have a savings deposit at any point of time, you can withdraw your money. So, that
is a liquid instrument, but whenever you are investing in the stock that may not be liquid
instrument but you need certain process certain kind of mechanism to liquidate that
particular asset.
So, because of that, there are certain kind of liquidity issues what always the financial
institutions face in the system. Therefore, if you define the liquidity risk the liquidity risk
basically refers to a situation where it may not be possible to dispose of or sell the asset
or it may be possible to do so only at the great inconvenience and cost in terms of the
money in time. You cancel the process, you can liquidate, but it takes lot of time and as
well as you are going to incur lot of cost in terms of the transaction cost of the
administrative cost.
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So, because of that we can say that this particular asset is less liquid. So, that is why
liquidity is very important in terms of the investment or the financial market or financial
system. So, the greater the uncertainty about time, price concession and transaction cost
greater the liquidity risk. Liquidity is a concern for the companies the reason is or for this
any financial institutions. The reason is if the company or the financial institutions are
not liquid, then what will happen it is not liquid in the sense the transaction cost in the
market is quite high. So, more the transaction cost, the liquidity will be less; less the
transaction cost, liquidity will be high so; that means, the cost or investment or
participation in the market is very costly. So, to if you have to make your market more
liquid in that sense it implies that the there is a reduction in the transaction cost or
reduction in the administrative cost.
So, this is what basically always we observe in the market whenever we define the
liquidity risk in the system. So, here if you see that liquidity risk from a market
prospective and liquidity risk from a bank prospective other financial institution
prospective is little bit different; why it is different, because already I told you that how
liquidity risk is defined from the market prospective. The liquidity risk is nothing, but
how easily that asset can be converted into cash number 1; number 2, how you can
minimize your cost to participate or to invest in the market if your cost is very low for
participation then; obviously, the liquidity risk is less if the administrative cost or maybe
this your transaction cost is quite high, then we can say the market is highly illiquid in
that sense the liquidity risk is more.
But whenever to talk about the banks; why the banks or any financial institutions need
liquidity because they have to satisfy the customers demand. The customers demand is
for example, I have deposit I have deposited my money in the bank. So, whenever I need
I should withdraw my money at the time of requirements, but for example, I went to the
bank and I could not withdraw my money because bank has no cash available with them.
Then what we can say, the bank is suffering from liquidity; that means, bank has not
enough cash which can cater the demand for the customers. So, in that context we can
say the bank is illiquid.
So, that creates some kind of disturbances in the market you feel that the bank is going to
be insolvent, then that leads to a liquidation and end of the day there is a failure, but here
the question is that from the financial institution point of view, the liquidity means how
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the particular organizations are able to cater the demand for the depositors and whether
the depositors are able to withdraw the money at the time of their requirement or not, but
you remember liquidity and profitability do not go together if you want to keep more
liquidity, profitability maybe hamper. So, that thing we will be discussing more
whenever it is discuss more on about commercial banks.
Then, another type of risk we have the maturity risk what do you mean by maturity risk
in financial system we have the different type of assets some assets are short term
maturity, some assets of long term maturity, but the question here is as you know that if
you are holding asset let there are two bonds; one bonds maturity period is two years,
another bonds maturity period is 20 years. If somebody has invested in the 20 years
bond, then obviously, they are exposed to more risk because they do not know what is
going to happen in the long run what should be the interest rate scenario, how the interest
rate is going to be changed, how the policy is going to be changed what kind of a
political stability.
We can observe then all kinds of things will affect the discount rate and if all these things
will affect the discount rate automatically what will happen the price of the bond will be
highly fluctuating. So, if the price of the bond will be highly fluctuating, then you are
exposed to more price risk or there is investment risk. In that context, what you are
trying to say. Because the future is uncertain the prediction of the economic
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fundamentals are relatively uncertain in that context, if somebody is investing for the
long run and somebody is investing in the short run the person who invest for the long
run they are exposed to more risk why because the forecasting and envisioning the
environment conditions and situations becomes more difficult in the long run.
So, if the forecasting is not possible for 20 years and how can I say that how the interest
rates scenario will be there after 20 years, the interest rate may go up, the interest rate
may go down and the interest rate is also again depends upon certain other policy
measures what these regulators on the monetary authorities are taking. So, all kind of
things are going to affect my pricing of that particular asset. So, if the pricing of that
asset gets affected due to the change in the discount rate, cash flow etcetera etcetera, then
what will happen and I am exposed to more risk, but if somebody is investing for a short
run basis maybe 6 months, 1 year it may be to some extent possible, how this interest
rate scenario is going to be.
And how this particular market is going to behave in the next year? So, in that context
what will happen it will be relatively easier for them or for any investor to say that how
much risk they are going to be exposed and what kind of return they are going to get and
what should be the price of that particular asset in that particular context. So, therefore,
maturity risk is also important, we have to see that whenever you are investing or
holding any kind of asset whether the maturity period is longer or maturity period is
short. So, because of that the longer maturity assets of the yield of long term maturity
assets more than the short term maturity assets, that is what basically we observe, but
that yield may not be sufficient enough if you are exposed to more risk from the market
point of view and as well as individual or unsystematic risk point of view.
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Then, we have another type of risk which is called the call risk. You know what do we
mean by the call risk. Let there is a bond, the bond has the maturity period for 10 years is
a simple example. But, whenever you have issued the bond let the coupon is 10 percent
and the par value of the bond is rupees 1000, but generally what happens there are
certain bonds which are callable or the callable bonds or call bonds.
So, in that case what we say, may be there is a provision, whenever the bond was issued
there is a provision after 5 years, the company or the issuer who has issued this bond to
you, they can call back the bond, they can call back the bond and there is a price fixed
for that from the beginning. But, you assume whenever the bond is called back by the
issuer from you, let the interest rate in that particular point of time in the market is very
low then if you could have sold the bond in the market on your own then you would have
got a better price than whatever price the issuer is giving you.
So, then what is happening for example, that time you could have sold the bond in the
market you would have got 1200 rupees, but now the issuer is giving you 1100 rupees
that is fixed you are bound because there is a provision in that. So, because of that, you
are exposed to that kind of risk. So, you cannot do anything with that. So, therefore, the
call risk is associated with the corporate bonds which are issued with callback provisions
or option wherever the issuer has the right of redeeming the bonds before their maturity.
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Even if the bond has the maturity period of 10 years, but the bond can be called back
after 5 years at any point of time. So, that time the particular investor or bond holder who
is investing in that bond they may be exposed to more risk if the interest rate in the
market is relatively low and if the interest rate is relatively low, then he could have got a
better price he would have sold the bond in the market instead of giving back that bond
to the issuer in that price which is already mentioned.
That is why in case of such bond holders face the risk of giving up higher coupon bonds
reinvesting profits only at lower interest rates and incurring the cost and inconvenience
of the reinvestment and also the price. There are two things what they are going to be
exposed. So, either that time again if they are reusing the bond the coupon may be low or
again if the interest rate is low they could have sold the bond in the higher price and they
could not get the actual high return what they should be getting. So, because of that the
call risk is also one important type of risk always we face mostly in the bond market or
other financial derivatives market etcetera. So, these are the different type of
unsystematic risk always we face and the investor always try to minimize this on
systemic risk to maximize the return.
So, in the next class, we will be talking about the different return concept that how this
return is basically calculated what are the different concepts related to the return. Please
go through these particular references for this particular system.
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Lecture – 08
Return Concepts in Financial System
So, after discussion on the different type of risk what we face in the financial system, today
we are going to discuss about the different type of return concepts or different type of returns
which are always popularly used in the system or we try to calculate different type of
concepts whenever we go to the financial markets for our investments. So, today we will be
discussing about the different type of returns, what we are always use in the system or
financial system as a whole.
So, before going to analyze the different types of return or different type of concepts
associated with a return, let us first understand what do mean by the return. In a layman
prospective, always we talk about the return. Whenever you talk about the return, always we
expect that we are going to get something else, something better.
That means whenever we are putting some money or we are putting our effort for certain
things, we are respecting that we are putting our time, we are putting the wealth we are
putting the money into that because we are going to get certain benefits out of this, we are
going to gain something from that. So, whenever we are going to gain something from that;
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that is basically we call it the return. In a layman prospective, the return is nothing but the
reward of investment, whenever we are investing something in the market we are expecting
that that particular investment will give some extra return to us or extra benefit to us in terms
of the monetary term or non monetary term. There are some investments are done to get some
return in terms of real addition and there are some kind of investments are done to get some
additions which are basically in terms of the monetary part.
So, therefore, return is nothing but that a gain or a profit what we always try to get by putting
certain extra amount of the money into the market or into the system as a whole. So, in a
clear cut way, we are defining the return is the amount or the rate of produce or the proceeds
or the gain or the profit which acquires to an economic agent from an investment. We spent
certain money, whenever we spent certain money we may not get any return out of this but
whenever we are investing certain money, we are expecting that that particular investment
will give us some kind of extra return to us or some extra benefit we can withdraw from this.
So, therefore, it is a reward for a motivating force behind the investment. People invest
because they want to get some extra benefit out of this, that is why they put some money on
the different type of investments in the financial market or the financial system as a whole.
So, the basic objective of the investor is usually to maximize the return. Already again and
again we are using it that whenever we are putting some money; obviously, we are taking
some risk because we may get return, we may not get the return that is the uncertainty or the
probability of not getting the return that basically always we face but still we put the money
where we invest in the market because we are expecting that there is a probability that we can
get some extra benefit out of this or extra kind of return out of this. So, that is why the basic
objective of the investor is always to maximize the return with a minimum amount of
investment what they can take.
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So, whenever you talk about the return in the financial market particularly, the return has
different components, but mostly if you observe the return has two components, what are
those two components? One is your periodic cash or the income what you get and second one
is basically the capital gain or the capital loss depending upon the value of that particular
asset at the time of redemption or at the time of selling that particular asset in the market. Let
us take the example of a stock, whenever we are investing in a stock.
So, let you have bought the stock of a company A. So, then what has happened any quarter
after one quarter or after one up to six months or one year the company can give some
dividend to you. So, on the basis of the amount of stocks what you are holding you get some
dividend out of this stocks. Then, every period you can get it or that is basically income what
you can get in between; then, another thing if you see for example, you have bought that
particular stock at rupees 500 then after a certain period you want to sell that particular stock
at a price of 750.
So, basically this is your buying price of that particular stock, this is your selling price for
that particular stock. So, in this particular period there is the appreciation of 250 rupees. So, if
you are going to calculate the return, in terms of the capital gain the capital gain is 250, but in
terms of the percentage if you can calculate that is basically
250
×100=50 %
500
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that is basically nothing but how much around 50 percent. So, the 50 percent basically is our
capital gain or the capital gain from that particular stock. If the stock value has gone down let
you have bought it at 500, then the price has gone down to 400 then; obviously, there will be
a loss for this then accordingly you can calculate that particular kind of capital gain or the
capital loss what you are going to get from this.
But the periodic cash if you are receiving out of that particular stock that is always positive.
The periodic cash or the income what you are receiving that is basically positive, if it is a
stock then it is dividend or if it is a bond then it is basically the interest. And another one is
depends upon the appreciation or depreciation in the price of the value of the asset that is
basically called the capital gain or the loss that already have explained to you. So, this is the
way the particular return has two components, one is your income or the periodic income of
the cash what you are getting and another; one in the capital appreciation or the depreciation
on the basis of the price of the stocks in the market which is determined by the demand and
supply forces in the market.
But one thing remember, that income you may get or you may not get because some
companies pay dividend some company do not pay the dividend. So, the periodic income
may be possible may not be possible in terms of the bond it is mandatory but because the
coupon has to be paid periodically but if you talk about the stock, dividend may not be paid
or the company may not pay the dividend periodically; some companies pay the dividend,
some companies do not pay the dividend. So, although in general term there are two
components but not necessarily that income component exists with all type of assets or even
if that income component exists with some type of assets that may be paid or may not be
paid. So, that is what basically always we observe whenever we talk about the return
components of the financial assets. Already, I have explained the third one the capital gain or
the loss the difference between the purchase price of the asset and the price at which it is
bought or sold.
So, the total return on an investment thus can be defined as income plus or minus price
depreciation or appreciation. So, the question here is that if there is no income component,
then the total return depends upon the appreciation of that particular asset. If the return
component may be depending upon the both the components. Return component may depend
upon the income component mostly, if there is a particular asset is depreciated. So, therefore,
in general what basically we have seen we have to consider both the part into our analysis or
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both the components into our analysis because these two things are important for calculation
of the exact return from the stock or exact return from any financial asset.
So, if you see the finance literature, the different ways the returns are defined. Whenever we
discuss about the specific instruments throughout this particular scores it will be more
elaborate. We will discuss more concepts related to different type of instruments like the
different kind of return concepts related to bond, different type of return concepts related to
stock, different kind of return concepts related to derivatives instruments, etcetera, etcetera,
but here I will just give you the brief idea about the overall idea about what kind of general
return concepts are used in the market. So, whenever you talk about the return concepts what
basically we have seen one of the most popular use term in the financial system as a whole
always we use that the expected return. Expected return means it is anticipated, predicted,
desired and it is subject to certain kind of uncertainty or the risky. Expected means we are
telling that whenever there is a probability you may get, there is a probability you may not
get.
So, in this context for example, if I will give you a very small example in this case, let there
are two conditions in the market, there is recession and there is boom. So, there is 50 percent
chance you will have recession, there is 50 percent chance you will you can have the boom or
the recovery. If there is a boom, there is a 50 percent chance there is a boom you may get a
return of 10 percent. If there is a boom, then you may get a return of 15 percent. So,
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effectively the average return or expected return what you can get that 0.5 multiplied by your
10 percent plus 0.5 multiplied by the 15 percent.
If 0.5 is the 50 percent, 50 percent chance. So; that means, on an average this is 5 percent
plus 7.5 percent, then you can have the 12.5 percent, your expected return in that particular
point of time is 12.5 percent. But the question here is there are certain factors which are
basically playing the role for the expected return or for a calculation of expected return.
Whenever you can calculate the expected return already that is why you can note down here
it is subject to uncertainty. There is a probability, there is some uncertainty that particular
thing may be realized or it may not be realized. So, whenever you talk about the expected
part, expected thing or expected return always that is subject to certain kind of risk and there
is a probability distribution involved in that particular process.
So, here another thing if you see, but another concept we have that is called the realized
return. Realized return means what exactly we got. Let we are expecting 12.5 percent in this
example we may get 12.5. We are expecting we may not get 12.5, we may get 10 percent, we
may get also 15 percent or we may get also 13 percent. So, here the 12.5 percent is expected,
but actual how much we are going to get that is not basically clear or we can predict or we
can estimate from the beginning. So, whatever estimation we are making, whatever
prediction we are making that is related to the only some kind of probabilistic distributions.
And another concept in the market we use that is called the holding period return the holding
period return is nothing but it is the total return from an investment during a given or
designated time period in which the asset is held by the investor.
So, if you talk about this, there are two things; one is holding period yield and another one is
holding period return and the holding period return is nothing but the
Holding Period Return = Holding Period Yield + 1
So, holding period yield is basically what
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So, any cash or any kind of appreciation which or depreciation which has taken place that is
basically the price sense, then what basically we are talking about you see any cash payment
any kind of appreciation depreciation that is nothing but the price change.
Then total value how much you got then at what price you have first basically bought that
particular asset in the beginning, then that if you take the ratio between these two, you can
find out the holding period yield. Then if you add one into that then that will give you the
holding period return. So, that is another concept always we also use in the financial market
and other most important concept or important issue always discuss that the nominal versus
real return.
Nominal return means what; the nominal return is the return what exactly we are getting; for
example, if you see that let the return you have bought the particular stock at a price of 500.
And whenever you are selling the price was late 700, then the actual return percentage is
700−500 200 2
= = =0.4
500 500 5
that is 40 percent, but the question here is that this 40 percent is nothing but the nominal
return, this is basically the nominal return and how we can calculate the real return there is
another concept real return. The real return is basically the return adjusted for changes in the
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price level, all of you know that is called the inflation; that means, the nominal return has to
be adjusted with respect to the price level or inflation rate in the market.
So, for example, in that particular period of time, the inflation rate is 7 percent, then your real
return will be
40 %−7 %=33 %
the actual real return from that particular investment what do you got that is basically your 33
percent. But one thing you remember this is basically the approximate way we calculate, but
according to the research equation, the nominal return in real return relationship is explained
here; that means, it is basically your
(1 + Nominal Return) = (1+ Real Return) (1+ Inflation Rate)
that is already I have written here. You can see that one. So, from this we have derived that
one which is approximated way we can calculate. So, that is why in general we call it
Real Return= Nominal Return- Inflation Rate
Your real return is equal to your nominal return minus inflation rate that will give you the
real return; that means, the real return should be adjusted to the inflation rate. This is the way
the nominal and real return is calculated, then we have another concept we use that is called
the required rate of return.
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So, the required rate of return is more or less the similar with the expected return. So, the
required rate of return of a particular security is defined as the minimum expected rate of
return needed to induce or pursue the investor to purchase the security given its risk.
Whenever any investor or any individual come to the market, what is the minimum return
they are expecting to take the risk in the market or to put their money in the system so, that is
basically the required rate of return. The required rate of return is a concept which basically
motivates the investor to participate in the financial system or to invest in the financial
system. So, therefore, whenever you talk about the required rate of return, so required rate of
return has two components; one is the risk free rate of return and another one is the risk
premium. The risk premium means the premium what they are expecting because they are
going to take some risk and another one is the risk free rate.
Here the risk free rate is nothing but that particular instrument which give certain kind of
return without any risk and here the risk free rate is what for example, if you say that the risk
free rate is the treasury bills, government treasury bills, you have the government bonds. So,
whatever returns you are going to get because those kind of instruments are free from default
risk and obviously, the default risk is 0 and therefore, those kind of instrument whatever
return they give, we call it the risk free and risk premium is basically what the risk premium
means the extra risk or return what we are going to expect from this because we are taking
certain kind of risk in the market.
And why that risk because the risk can arise there is a change in the macroeconomic
fundamentals like inflation like growth of GDP like change in the monetary policy, I can take
example if the change in the monetary policy, let this reserve bank of India has gone for a
change in the interest, the repo rate has increased. If the repo rate has increased, then what
will happen? The repo rate will basically affect the call money rate. If the call money rate will
change, then the banks’ lending rate will change. If the banks’ lending rate will change, then
obviously, in the market interest rate will be changed. If the market interest rate will be
changed, then obviously, the money supply in the system will be changed; then obviously,
what will happen, it will have the impact of on the total investment then finally, the output.
So, it will have the impact upon the price of the security and as well as the other instruments.
So, therefore, what we are trying to say that any kind of change in the macroeconomic
system, macroeconomic measures will have the impact upon the risk, it may increase the risk,
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it may decrease the risk depending upon the policy, then accordingly what will happen that
we are expecting the premium accordingly.
That extracting that there is a change in the macroeconomic fundamentals, we are expecting
that the rate this particular return also should be compensated for that because we are going to
take more risk for this industry variables because you see the price of a stock or the return of
a stock is a function of three sets of the variables, your macroeconomic fundamentals, you
have the industry specific variables and company specific variables. So, any change in the
industry fundamentals, there is some industry or cyclical some industries are seasonal
industries, some industries are in the boom, some industries the probability of growth is less,
some industries probability of growth is more. So, like that there are different ways basically
the industries behave whenever there is any change in the macroeconomic fundamentals.
So, in this particular context also, we are prone to certain risk in which industry while
choosing for the investment. So, because of that we have to ensure that how the industry
variables are going to be changed and because of that I am going to exposed towards more
risk and that particular rate should be compensated by that. And company specific variables
which we call it the idiosyncratic risk always we face if there is a change in the company
fundamentals, the sales figure maybe change ourselves may be affected largely may be there
are some other factors, some non financial factors also may change, there are some
organizational changes may happen. So, all those things will have the impact upon the risk
and therefore, my return also should be compensated by that. So, combining all, the investor
always expect that this should get some risk premium whenever they invest in a particular
financial asset or a particular instrument.
So, therefore, we call it the premium that that extra return what we are going to get because
they are going to exposed or they are going to be exposed towards more risk in the future. So,
that is basically we call it the required rate of return and now we are coming back to there are
how to calculate this required rate of return.
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So, if you see there are different type of models in the system are existing. If you will see that
there are so many models but the most popular model are like capital asset pricing model,
then you have arbitrage pricing model, you have 3 factor model, you have 4 factor model,
there are different type of models we have seen that which is used to calculate the required
rate of return from the asset particularly from the stock or from anything. But the question
here is that you see that all those things are little bit more complex in nature that is basically
you can study more on whenever you go for the portfolio management and other things
which are popularly called as the alternative asset pricing models but I can give you idea that
most popular model which is used since 1960s that is basically the capital asset pricing
model.
So, here what basically capital asset pricing model tells that whenever, we are going to
calculate the required rate of return we are holding basically a portfolio and when we are
holding a portfolio, the basic objective of the holding portfolio each minute to minimize the
idiosyncratic risk. Instead of investing in one stock or a one asset if you are investing in many
stocks or many asset what basically happens that you can diversify the individual risk what
particular stock is facing and once you are diversifying that risk, then whatever remaining
risk is there that is basically a systematic risk already we have explained that because
systematic risks cannot be diversified.
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So, a capital asset pricing model therefore, tells that how the systematic risk is basically
going to compensated by the return what we are going to expect from that particular
portfolio. So, therefore, this model takes into account the asset sensitivity asset sensitivity to
non diversifiable risk; that means, here what we were telling if your market risk or beta which
is called in our language, we call it the beta if a beta is increasing then your return from that
particular stock or from the portfolio also should increase. So, more the beta, more the return.
So, that is what the basic notion of this and overall if you conclude that asset pricing model or
the capital asset pricing model tells what should be the required rate of return or expected
return from that particular stock and by calculating that expected return maybe investor will
be inclined to invest in that particular stock that is number 1. And number 2, it also says that
the beta is the sole factor or market risk is the sole factor which is affecting or which is
determining the expected return from that stock. So, other that means, it is assumes that other
risk which are diversifiable or which are called the idiosyncratic risk that can be eliminated
and only beta is a factor which cannot be diversified. So, therefore, those beta should be
considered always for calculation of the required rate of return or expected rate of return from
that particular asset.
So, how it is basically calculated that is why the equation basically talks about this, that your
expected return from that particular asset or from that particular portfolio is a risk free rate of
return. Already I told you that
E ( R i )=R f + β ( R m −R f )
wh
ich is the market risk premium. So, here the Rm is basically return from the market. The return
from the market means any market portfolio in Indian context we have the return from the
BSE Sensex, there is returned from the NSE nifty. These are the market portfolios and here
we are basically saying that the beta is the factor which is determining that how much return
some body will expect if he or she will invest in that particular stock or on that particular
portfolio.
Cov i , m
And the beta can be calculated already I told you the β= 2
σm
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Covi ,m = covariance between the individual stock or the portfolio with the market
σ m = the variance of the market

2
if you run a regression with R i= β R m, then if in one column you take a market return, in one
column you take the historical data from your individual stock or individual portfolio. Then
run the regression whatever coefficient you will find that coefficient is basically the beta,
values in this particular case. So, beta can be calculated in both ways. You can calculate the
beta in this way; beta also can be calculated in this way. So, this is the way, the required rate
of return can be calculated using the capital asset pricing model.
Then, if you see that the next one is if you want to test whether capital asset pricing model
works in your system or not then you can see, then what you can do first run the regression
takes the data.
Let fifty companies, let you have the 50 companies, let you have the 50 companies data for
let 200 months then what you can run for a first company, take the data for 200 months find
out the beta, 1 like that up to 250 companies, you can calculate the beta 50. The 50 betas you
have, then next step what you can do for first company you would average out the data for
this 200 months return data, then you take 50 return data points for 50 companies, then you
have the 50 beta, then you again regression first regression you run to calculate the beta
which is called the time series regression.
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Ŕ i=α + λ ( β )
In this equation then you got this thing in the average return that Ŕ i means the average return
throughout the period α + λ ( β ) , then the lambda is the premium if a beta is statistically
significant, then what we can conclude beta gives the premium and the capital asset pricing
model can be used for that particular market to calculate the required rate of return from the
stocks. So, this is the way basically the CAPM can be tested and this is the way the required
rate of return can be calculated. So, this is what basically the different type of broad return
concepts which are used in the financial system and now we have covered off the different
type of broader risk concept, different kind of return concept which will be regularly using
throughout this particular subject in the different kind of instrument what we will be
discussing. So, next will be discussing that, what are those common factors which affect or
which basically always look upon whenever we participate in the financial system or we try
to invest in the financial market as a whole.
Please go through this particular references for this particular session.
Thank you.
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Lecture – 09
Fundamental Analysis of Financial Assets
So, in the previous class we discussed about the different return concepts. So, today we will
be analyzing that what kind of fundamental factors both from the market point of view from
the aggregate economy point of view, from the industry point of view or from the individual
stock point of view always we should see or we should analyze whenever you try to choose
one alternative assets for the investments and also the alternative within the assets also which
kind of stocks should be chosen, which kind of bonds should be chosen.
So, those things basically we should discuss, to see that overview what kind of fundamental
factors drive us to decide what kind of investment we should undertake in the system to
maximize our return or what to choose what not to choose.
In this concept, in this context if you see what exactly the fundamental analysis is. The
fundamental analysis is basically examination of the underlying forces that affect the well
being of the economy industry groups and the companies.
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So, we have to see that how the economic factors is linked to the different financial
instruments or any changes in the economic factor how they are going to drive the financial
factors or financial assets return or financial choosing the financial asset. And as well as it
also related to in the industry point of view that which industry has more scope which
industry has less scope, which industry is prone to more risk which industry is potential;
growth potential is high which industry growth potential is less? All kind of questions
basically tries to always answer through this fundamental analysis.
So, at a company level the fundamental analysis may involve the examination of the financial
data, the management part, the business concept, computation, the different kind of financial
parameters, how the company is doing, what is the profitability, what is the growth
opportunity, what is the size of the company, whether is there what kind of for risk the
company is facing in terms of the sales, what is the business risk, what is the financial risk,
what is the structure of the financial structure of the company etcetera etcetera.
There are different ways the fundamental analysis can be defined. So, the fundamental
analysis is comprised of the three parts; one is your economic part or economic fundamentals,
industry fundamentals then you have the company fundamentals.
There are three types of fundamentals always we consider whenever we go for fundamental
analysis in the system or for the financial market as a whole. So, that is why if you observe
that the last point here that fundamental analysis combines economic, industry and company
analysis to derive assets current fair value and forecast the future value. If you see that
whenever we talk about the fundamental valuation of a particular company; what we do? If
you go back our previous discussion you might have remember the price of a particular asset
is nothing, but the future value of the cash flows; you are discounting the future value of the
cash flows with respect to some discount rate.
And you remember if you want to relate this particular thing with respect to this analysis, the
cash flow gets affected due to the change of anything economic, industry or the company.
The discount rate also may change with respect to economic, industry and the company. So,
once the cash flow gets changed, the discount rate gets changed then obviously, the price of
that particular asset gets changed.
So, therefore, fundamental analysis is quite important to understand what the intrinsic value
of that particular company is or what the intrinsic price of that particular company is. And
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once you get this intrinsic value, then it will be easier for you to decide whether you want to
invest in that particular asset or not by comparing it with the market price or to forecast that
how this particular asset or particular financial alternatives is going to behave in the future.
So, that is what basically always we try to see from this fundamental analysis; that is why it is
quite important from the investment prospective. Let us see one by one how this what do you
mean by the economic analysis, what do mean by the industry analysis, what do mean by the
company analysis. Although the scope of this particular terms are quite large; I will just
introduce you this particular thing, but if anybody wanted to study more; then they can go
through any investment analysis portfolio management books like Relent round like this
books like Jones to understand more.
But here I will be introducing that what do you mean by the economic analysis, what do
mean by this industry analysis, what do you mean by the company analysis? We are not
going into the detail of that because the scope of this particular paper or particular subject is
not in that direction.
Then we can go to understand this economic analysis; what do mean by this economic
analysis? Already I told you that the cash flow already I have written that particular one that
your cash flow basically gets affected, your discount rate gets affected.
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So, this is the price and once the economic factors which can affect the cash flow and can
affect the discount rate, then price gets affected by that. You see the economic factors affect
the value of the stock or value of any asset as due to change in the macroeconomic factors
like business cycle, monetary policy, fiscal policy, inflation both the expected cash flow and
the discount rate get affected. Just now I was telling you how it is done for example, you see
let there is a change in the monetary policy.
What RBI has done? RBI increased the repo rate; if you refer it has increased then it will
have the impact upon the market interest rate. Market interest rate will increase; then market
interest rate is nothing, but the discount rate right. So, then what will happen for the bond
market and for the stock market again accordingly they return, this discount rate is nothing,
but the required rate of return from the stock.
So, once the market interest rate gets in the required rate of return from the stock also gets
changed, but anyway if the market interest rate will increase then this r will increase if the r
will increase then; obviously, the value is going down. And here the cash flow is basically
also gets affected because if the money supply will go down then; obviously, the interest rate
will increase, the money supply will go down, the availability of the money into the market
will be less.
If the availability the money in the market will be less then; obviously, it will have the impact
upon the cash flow; the cash flow also will go down. The rate of return or the discount rate
will go up; here it will have the impact upon this there r will go up; cash flow will go down
then; obviously, the price will be drastically affected and the price gets affected due to the
change in the monetary policy. So, here if you want to summarize it what basically happens?
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You see this interest rate has gone up, policy rate has gone up. The policy rate will go up,
interest rate will go up; and then money supply will go down. Then if the money supply will
go down; it will have impact upon the cash flow and the cash flow (CF) will go down, but
change in the interest rate will basically increase the discount rate; which is r.
Then what will happen? Your CF will go down, but your r will go up then what will happen?
That the price will go down. So, in this context what here we are trying to say that here I have
given the example of a money supply. You can take any example if there is a change in the
interest rate; it gets affected, if there is a change in the inflation rate it gets affected. If the
growth rate of the economy also gets change then what will happen? It will have also the
impact upon the cash flow and as well as the discount rate and end of the day what will
happen? The price of that particular asset gets changed.
So, any variable which is macroeconomic fundamentals; any fluctuations any change in that
will have the impact upon the price of the intrinsic value of any asset. Because both the inputs
for the calculation of intrinsic value may get change; due to the change in the economic
fundamentals that is what basically what here we are trying to discuss. Here we have given
you for example, a restrictive monetary policy which reduces the growth rate of the money
supply; reduces the supply of the funds for expansion of business and due to increase the
interest rate and the cost of capital increases.
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If the cost of capital increases means the discount rate increases and; obviously, the value of
that particular asset goes down. Apart from this there are some other typical factors that also
will increase the risk and accordingly the discount rate also gets affected by that. What are
those? Political instability, war, international market fluctuations all these things for example,
there is something has happened in the US market.
You remember this 2007; financial crisis right, you have the Southeast Asian crisis in 1996-
97, you have the crisis which are in the Greek in the year 2012. So, all kinds of things once
anymore because there is a globalized market every market is highly integrated with another
market; both domestically and as well as globally. So, any changes anything which happens
in one market that can transmit that can spill over to another market. So, therefore any kind of
disturbances which are happening internationally that will have also the implications on the
domestic market.
And once the domestic market get restored then; obviously, the discount rate and cash flow
gets affected, then automatic the price get affected and the valuation of that particular asset
get changed; that is what basically the economic analysis talks about. So, therefore it can be
policy, it can be any kind of instability, it can be basically this inflation, it can be kind of
growth rate anything; any kind of disturbances with respect to any macroeconomic
fundamentals can influence the price of asset because the discount rate and the cash flow may
get affected due to this kind of changes.
So, this kind of analysis is basically we define as the economic analysis, but whenever we
talk about the industry analysis how the industry analysis is basically defined?
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The industry analysis the basic objective of the industry analysis is to identify which industry
will prosper or suffer in different macroeconomic conditions. When there is a change in
macroeconomic condition we basically go for a scenario building; a scenario building
analysis we do.
And through this scenario building what we are trying to basically find out that at the adverse
economic conditions how the industry is going to behave whether the industry will suffer or
the industry which basically prosper depending upon the changes in the macroeconomic
condition we try to explain that.
So, therefore, the industry analysis answers certain questions what basically I questions they
are trying to answer is there any difference between the return for alternative industries
during specific time periods? If you see these questions that will give you the clear cut idea is
there any difference between the returns for alternative industries during specific time period.
That means what? That in a particular time period is it possible that different industry will
give the different type of returns or difference prospects are available in the different
industries; is there any possibility? Is the performance of the industries consistent over time;
that means, whenever there is a change in the system or change in the economic fundamentals
or macroeconomic fundamentals is it that the performance of the industry is totally not
affected by that or the industry also gets affected once the economic fundamental gets
changed. So, those thing or is there any difference in the risk of alternative industries; is it
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that every industries risk level is same or prospects are same growth are same. So, what kind
of industries profitable for me?
In which industry I should choose? What kind of industry basically always we should
consider? For example, if I say some of the industries are totally not affected by the business
cycle, any kind of problems in the market happens they are not affected. If you consider for
example, like pharmaceutical industry. At any point of time the people will the health issues
will be there; then product or the sells is not going to be affected by the business cycle,
whenever you compare it or you are trying to discuss about the pharmaceutical industry.
So, these are a highly defensive industries they are not getting affected by any kind of
cyclically fluctuations. There are certain industries they do well in all kind of seasons like
your referencite; referencite companies do better or always perform better respective of the
cyclic conditions in the market. But whatever I talk about there are certain products where
they are highly fluctuated by the seasonal factors.
Like a cold drinks company, you talk about a ice cream company then; what happens? Those
kind of companies’ sales increases in a particular period and then another period this sales
figure basically may get affected due to the seasonal changes. So, here what we are trying to
say? Different type of industries behave in the different fashion; in a different way whenever
there is a change or on the basis of the nature of the product of that particular industry.
So, therefore the process of the industry analysis basically what? The process of industry
analysis is trying to answer that how the various business cycle is related to the economic
fundamentals; you know business cycle can be measured by the real growth rate of the GDP.
Then it can also be measured by the term spread; term spread is the yield difference between
the short term government securities and long term bonds. You can have the default spread;
the default spread is the difference between the highest rated and lowest rated investment
grade bonds. So, these are the different measures which are used to say that or to predict that
whether the market is going to be in the boom. So, these are the different proxies which are
used to measure the business cycle.
But here what you are trying to see? What kind of industry it is? Whether the industry is
going with the business cycle, there is a boom the industries also will be increasing or the
prospect of the industry will be increasing, there is a recession then the industry will go
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down. So, all kinds there are some industry whatever way the business cycle will be, but my
industry is not going to be affected by that.
So, these are the different issues or different questions comes to the industrial part. So, those
things has to be considered; those things has to be analyzed before participating in that
particular industry or choosing that particular industry whenever you go for investment in
that particular sector. Therefore, we have to relate it with respect to the business cycle.
Then economic changes in alternative industries if there is any change in terms of other
economic fundamentals, there is a change in inflation, there is a change in interest rate then
how this industry is getting affected by that? Change in the interest rate may affect financial
industry largely, other industry also directly affected because increase in interest rate will
decline the investment. So, obvious with the production gets affected; if the production gets
affected then what will happen?
Then; obviously, this particular industries prospect or the industry will suffer from certain
kind of losses because the prospect of that industry will go down. So, anything basically any
economic parameters whenever we consider that we have to check that how that industry gets
affected due to the changes in any kind of macroeconomic fundamentals.
Then we come to another quite interesting factor that is evaluation of lifecycle of the
industry. You might have known that industry has a life cycle the industry life cycle is what?
In the beginning we are in infant stage; then it will grow like this, there is a growth stage.
Then once it will reach in the steady state; it remain certain time, then it will start declining.
So, there is certain kind of stages always we will observe in industries cycle. So, then we
have to see whenever we are choosing that particular industry that industries in which phase?
That industry is already in the matured states or industries in the steady state or industries in
the infant states. You see if the particular industries in the matured stage already then
probability of growth of that particular industry will be less because already industry is
grown.
The growth of the industry is already taken place; though expecting more return from that
particular stock in that particular industry is relatively less likely. But if the industries is in
the growing stage or the industry is growing; that means, the growth opportunity for that
particular industry may be possible more. There is a possibility that there is much more
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growth opportunity, there is investment alternatives available for that particular industry
because they can generate more project for their output generation or maximization of the
output.
So, in that context what will happen? Those industries can give better return in the future they
may not give now because the scope is high. So, depending upon the investor to invest or you
can choose that industry we want to take. Whether you want to invest in a matured or the
growth industry or you want to invest in industry which is in the growing stage or the
industry which is all started. So, these are the different kind of issues or different kind of
concepts we have to analyze whenever we talk about the industry analysis that when the
industry life cycle has to be discussed has to be analyzed; whenever we are going to choose a
particular stock or particular bond from that particular industry or from that particular
company which belongs to that particular industry.
Then you know how competitive the environment is or industry is highly competitive or
competition is over or it is perfectly competitive. Now more number of players are available,
there is no kind of monopolistic characteristics available in that particular industry. So, if it is
going to be highly competitive then the price what I get that is mostly very competitive price.
If the market is not competitive then the market is monopolistic or the market is in monopoly;
then the price what basically I am going to pay that may be relatively little bit higher. So, in
that context we have to see in what kind of competitiveness the industry has; whether that
particular industry is already in a perfectly competitive stage or there is a monopolistic stage
or there is a monopoly stage; depending upon that the investor can decide whether they
should go for that particular industry or not.
And whatever price they will give that price will be competitive price or equilibrium price or
not. So, therefore, the competitiveness of that particular industry is also quite important to
know whenever anybody wants to invest in that particular industry or particular sector. This
is what about the overview of the industry analysis; then we can move into the company
analysis which is the last step of the fundamental analysis.
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So, already I told you that company analysis is nothing but the comparison of an individual
companies performance relative to the entire industry; using various financial ratios which
are based on the company’s profitability, efficiency, liquidity and growth opportunity.
So, here what we are trying to say? We are trying to find out that what kind what is the
profitability of the company, how much is the growth opportunity the company has? Whether
the company is liquid or not, what kind of efficiency the company has? All kinds of things
will decide also will tell us whether we should go and invest in that particular company or
not.
So, whenever we talk about profitability you might have known what are those ratios we look
at from the profitability point of view? We look at Return on Asset (ROA);
net profit
ReturnOn Asset =
total assets
You can also look at the Return on Equity (ROE); equity your net profit/ total equity. So,
these are the different profitability measures; you can go for the liquidity like current assets to
current liabilities.
You can also have the quick ratio current assets minus the inventories divided by current
liabilities. Growth opportunity can be measured, market to book ratio of the company market
price of the asset divided by the book value of the asset. So, there are different ratios
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basically we analyze to decide that what kind of prospect the company has; whether the
company has better growth opportunity, what kind of profitability the company has and all
these things and accordingly we will decide that whether we should invest in that company or
not.
So, the company analysis basically helps the investor to answer the questions; what are those
questions? Which are the best companies within that particular industry depending upon this
ratio analysis; what is the intrinsic value of the stock, whether the intrinsic value is above the
market value or below the market value. You remember what is the intrinsic value?
That already I told you that
CF t
p0 = t
( 1+r )
This is basically called the intrinsic value. Then what we are trying to see? That whether we
check whether the intrinsic value is above the market. Market value means actual which is
happening due to the market forces. So, the market if the intrinsic value P 0 is greater than Pm;
that means, the P0 is greater than Pm; what does it mean?
It means that the intrinsic value is less than the market value; that means, still there is a
chance the intrinsic value is greater than the market value; that means, market has
undervalued this particular asset. There is a possibility that this particular asset will go up; the
value of that asset the price of the asset will go up; that means, it is undervalued company.
So, if the P0 is less than Pm what does it mean?
Market has already overvalued the intrinsic value that is P 0, but the market value is more than
that; that means, this company’s stock or company’s asset is overvalued. Possibility of
getting more return may be possible may not be possible. In that sense what basically we can
say? That from the investment point of view maybe this particular asset is better because here
there is just the stock is already or the particular asset is undervalued. There is a possibility
that stock price may go up, but here it may go up, but the possibility is relatively less in
comparison to the another company where this particular scenario arises; so therefore, the
company analysis itself to decide all kinds of things.
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Then another part of the company analysis is we also do these SWOT analysis. The SWOT
analysis already you are very much comfortable with that; here we calculate the strength,
weakness, opportunities and threat of the company. Strengths and weakness these are
basically the internal to the company what opportunities and threats are basically external to
the company.
So, what kind of strength the company has? What kind of opportunities the company has,
what are the weaknesses the company has? So, then those kind of things if you analyze then
you can have the better idea how the company is going to perform in the future. So, on the
basis of the different ratios or the companies are classified into different types. And
accordingly you decide that whether we should go for investment into that particular category
or not.
So, if you classify them the companies are like growth company, defensive companies,
cyclical companies etcetera etcetera or value companies from the investment perspective we
decide value companies. So, the growth company is a company which consistently able to
make investment that yield the rate of return greater than the companies the required rate of
return; just now we can calculate the required rate of return of the company which is using
the CAPM; Capital Asset Pricing Model.
And the growth companies that company, which is consistently giving more return than the
expected return what we are trying to get from that particular stock or from that particular
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company. Defensive companies are those whose future earnings are likely to sustain in the
recessionary period. I have I was giving you the example like pharmaceutical industry; the
pharmaceutical companies even if there is a recession or there is a boom this particular
industries sales or these particular industries performance never gets affected.
Because this particular industry is totally free from this kind of business cyclic fluctuations.
Then you have the cyclical companies; the cyclical companies are basically the sales and
earnings are heavily influenced by the business cycle conditions. Those are basically we have
to be very careful whenever we invest in that kind of companies before analyzing; we have to
analyze first that what kind of cycle is going to prevail in the or economic cycle is going to be
prevailed.
And once we know that whether there is a boom or a recession; accordingly you can decide
that whether we should invest in that particular company or not and another type of company
the value company I can give you a link into this. That you see that these companies price to
earnings ratio, price to book ratio; then you have price to sales ratio these are the three or
price to cash flow also are high these are called the growth companies.
And all these ratios which those companies which are low these are called the value
companies. The best thing is you take those companies arrange it in the ascending descending
order and take the median value or the mid value of that. Above the average value we
consider them as the growth company and below the value you consider them the value
company. Those things are helpful from investment point of view and always we can use it
from whenever we participate in the market to choose any kind of alternative assets into the
system. So, these are the overview of the fundamental analysis.
This is the way the fundamental analysis we do to choose the stocks; then we can have
another aspect for choosing the stock or choosing any kind of other alternatives that the
technical analysis. I will give you the theme of the fundamental idea behind the technical
analysts; all the technical analysis part is quite vast, but still I will give you some idea that
what the technical analysis is. And how basically we go and invest in that particular we use
that technical analysis for choosing the different financial alternatives for investment in the
financial.
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So, please go through these particular references for this particular session.
Thank you.
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Lecture – 10
Technical Analysis of Financial Assets
So, after discussion on the fundamental analysis of the financial assets and most
particularly about the stocks, today we can discuss about another very important concept
always investors and people are concerned about there is the technical analysis of the
financial assets. So, basic difference between the technical analysis and fundamental
analysis is for the fundamental analysis, we need all kinds of macroeconomic
fundamentals, industry factors and company specific variables to see that how that
particular financial asset issued by a particular company is going to perform or whether it
is advisable to invest in that particular kind of asset or not.
But, whenever we are talking about the technical analysis, the technical analysis
basically believes that the market is inefficient. And if you want to invest in a particular
stock or invested in particular financial asset, analysis of the past data about that
particular asset is sufficient enough to decide whether we should go for investing in that
particular asset or not.
So, that is the basic fundamental notion of the technical analysis.
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So, here if you see that, so, in true sense if you define the technical analysis, what the
technical analysis is all about? Technical analysis basically involves the examination of
past market data such as prices and the volume of trading which leads to an estimate of
future price trends and therefore an investment decision. What does exactly it means? It
means that whenever we are using technical analysis, we only take the data for that
individual asset data.
And basically, if we have the historical data with us and this historical data we analyze,
particularly this price data and volume data and by analyzing this, we are basically tried
to find out certain kind of trend or certain kind of features or certain kind of
characteristics about this data and using that characteristics, we can decide whether we
should buy that particular asset or we should sell that particular asset.
So, that is the basic objective or basic notion behind the concept of the technical analysis.
That is why technical analysis does not believe or does not consider any kind of
economic fundamentals. Any economic fundamentals are not considered whenever we
talk about the technical analysis and by using that, we are trying to estimate the future
price trend. We are not estimating the future price where you can note it down that you
see we are not trying to see that how much will be the price, but we are trying to find out
that how the trend will be; whether the price will be up or the price will be down for that
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particular asset. So, accordingly we take our decision whether we should invest in that
particular asset or not.
So, that is basically the basic or central theme of the technical analysis. So, the basic
philosophy of the technical analysis is market itself is a good idea because market is its
own predictor. When if you are analyzing the data of that particular asset or particular
stock whether it is price data or volume data, what we are trying to say that that itself is
captured all kind of information, all kind of issues, all kind of things which are related to
that particular asset. So, if you are analyzing that thing that particular asset that is
sufficient enough to give the idea that whether this particular investment is a good
investment or not in that particular point of time.
So, technical analysis is basically always believes in the concept of market inefficiency.
Then, second thing is basically what: there are different ways this technical analysis is
defined.
If you see that whenever we talk about the technical analysis, there are certain
advantages, because the fundamental analysis needs lot of exercise, we need lot of data
about the company, about the economy, about the industry and all kinds of things. But
whenever you talk about the technical analysis; the technical analysis first of all is not
heavily dependent on financial accounting statements. The first point if you see it does
not basically bother about that what kind of financial accounting statements data is not
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required, that particular return a particular stock price or particular bond price data is
enough for us.
Because, whenever we are analyzing the accounting data, there are certain problems
always we face. Sometimes whatever information we need that may not be available.
And accounting standards you see this Indian accounting standard, American accounting
standard allows the firm to select the reporting procedures resulting in difficulty
comparing statements from firm to firm. So, whenever the reporting process changes the
reporting procedure changes whatever information the analyst or the investor needs, they
may not get that particular information whenever they go and invest in that particular
stock or a particular kind of financial asset. So, therefore, there is no kind of hassles
always we face whenever we go for technical analysis.
And another biggest advantage of the technical analysis is non quantifiable factors do not
show up in the financial statements. You see financial statements basically deals with the
particular data point which are basically they related to quantifiable nature or all those
data can be shown in the figure term. But whenever we talk about a financial statement,
there the non quantifiable factors are not basically considered. So, the non quantifiable
factors whenever it is not considered, but non-quantifiable factors also play the role for
the investment decisions and we are here the technical analyst believes that the non
quantifiable factors impact is already captured in the stock prices or in any kind of asset
prices where we are interested to invest. So, because of that what is happening that these
are the major advantages what we get it whenever we are analyzing only the past data of
that particular financial asset.
And another thing is the fundamental analyst must process new information and quickly
determine a new intrinsic value, but technical analyst merely has to recognize a moment
of equilibrium. Technical analyst basically is not always interested to find out the
intrinsic value of that particular asset. Because according to technical analyst, there is no
use of the intrinsic value of that asset, because we are believing on the past trend. By
looking at the past trend, we are trying to say that whether this particular asset is going to
do well in the future or not and what kind of trend we can predict whether there is a
upward trend or there is a downward trend. So, those trends can be predicted by using
the technical analysis. So, therefore, other kind of fundamentals is not required whenever
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you go for this. So, therefore, the intrinsic value calculation is not that much important
from the technical analysis point of view.
So, therefore, that here we have certain advantages already we have realized that
technical analyst does not need any other information and as well as they do not have to
go for calculating the intrinsic values and all the subjective impact or subjective
information impact is already captured through. The prices and market is the best
predictor. And by using the technical analysis the investor always feels that the trend can
tell you that whether the price will be up or down or depending upon that they can
maximize their return or they can change their positions in the market.
So, this is what basically the major concern about the technical analysis.
And then, you see that there are so many indicators, there are so many kind of process,
so many kind of analysis is available for the technical analysis. Remember, here we are
not going to discuss all type of indicators all kind of rules which are always applied to
the technical analysis. I will just give you a brief idea and some of the major indicators
which are used, but you can get to know about the technical analysis much once we will
go through that or after this you can get the idea that what the technical analysis is, how
the basic how the investors go for technical analysis.
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And then further if anybody is interested they can go and read because the concept of
technical analysis is quite vast. And as well as there are more than hundred indicators
which are available to say that or to conclude that what kind of trend we are going to
observe in the future which are mostly used by the technical analysts in the market.
You see that technical analysis first of all believes that the asset prices typically go
through a peak and trough. You see that, whenever we are talking about; for example, if
you see if you remember there is a business cycle, let the price is basically going is in
this way and it is go on recess in the particular phase and start declining and again and
again, again, it will reach a place then again start increasing so like that. So, here what
we are trying to find out you see this is one lowest range and here also you can make
another lowest range.
So, these are basically the troughs. These are the trough and this is basically your
recovery period and once it is reaches in the peak, this is the flat trend what we have
observed this is the upward trend and then the downward trend starts then again this is
basically we call it the recession. And finally, it is recess again in the top and again start
picking up. So, any kind of asset prices also follows in the same kind of path.
So, whenever any investor goes to the market, he will always try to find out we are in
which particular range. If somewhere, basically this investor is here or here basically
they will buy and once they will reach here they try to sell. And again, they can hold on
in a particular point of time because that is a flat range they are getting and once they
will reach here then again it will start declining then obviously, they will sell here and in
this range basically again what they will show the price is going down. So, before that
they will sell it. And in the downing stage basically also they can go on buy it. And they
will wait once they reach in the trough and again it will go on increasing then they can
get some kind of return.
So, there is some kind of cycle always we can observe whenever we are analyzing this
stocks. So, here what we are trying to find out that like the business cycle also goes in
the same way, there is a trough, there is a peak, there is a recession, there is boom and
etcetera, etcetera. The same thing we can observe in those stock prices or any kind of
financial assets which always we deal with in the market. So, here the technical analyst
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always try to identify we are in which phase and accordingly they take the decision
whether they want to buy or they want to sell.
So, in this context, this gives a better idea that whether we should go for taking the
position in that particular asset or not.
So, there are different type of trading rules. Already I told you I will explain some of the
trading rules which are popularly used because it is not possible to discuss all type of
rules, because that technical analysis itself is quite very vast; if you talk about the all type
of technical indicators which are used by the technical analysts.
So, the first trading very popular rule is contrary opinion. If you see this, then you will
find that the contrary opinion is basically the first one. Then, what do mean why the
contrary opinion? The contrary opinion is that which is basically going against the
majority. What does it mean? Sometimes what happens many analysts rely on the rules
developed from the premise that majority of investors are wrong as the market
approaches peak and troughs.
So, when exactly the market reaches the peak, when exactly market reaches the trough;
sometimes, the prediction or calculation is relatively difficult. So, therefore, what
happens if the market everybody believes that the market is going to be bullish our
market is going to be up, but or everybody believes that the market is going to be down
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in that particular point of time, the technical analysts who are basically believes in the
concept of contrary opinion they basically go against this particular market or the
majority of the analyst. Or, investor what they feel, they feel that it is not exactly the
same thing it can be the reverse. So, in that context what they feel that whether investors
are strongly bullish or bearish and they take the opposite direction.
If investors feel that or most of the market participants believe that the market will be
bearish, they believe that the market will be bullish and everybody or most of them feels
that the market will be bearish, then this technical analyst believe that the market would
be bullish. That means, basically they take the opposite direction; that means, they go
against this mass. So, that is very popular and contrary opinion investing investment
strategy is quite popular and 70 percent of the times, they succeed in the market to
maximize their return.
Then another trading rule they always use that is the mutual fund cash positions; what do
you mean by this? You see whenever we invest in the mutual funds if you feel that in the
mutual funds, there is a high amount of or low amount of cash depending upon that they
predict that how the market is going to be. If there is a low liquidity or low amount of
cash available with that particular fund; that means, the funds are fully invested and
market is already bullish that is why the fund is invested and market is near or at the
peak. Because, in this the particular fund manager has not kept any money with that
particular fund or any liquid cash in that particular fund. They have invested all the funds
into different type of financial assets because, the market is already in the peak or it is in
the highly bullish situation and therefore, they want to invest all type of funds to
maximize their return.
But whenever the market is near the peak, further increase is not possible. So, in that
case we believe that in the future the market may go down or we believe that there may
be a bearish approach or bearish market we can realize in the future. Accordingly, the
investor takes the decision, but if it is a high liquid; that means, funds are highly
available with this fund manager we consider them the market is bearish and this is a
good time to buy, you invest in your stock in that particular point of time. If the market is
already bearish; that means there is expectation the market is going to be up because the
fund manager have not invested the fund and they have kept with them and they are
waiting for the opportunity in the market is going to be up.
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So, because of that if the market is going to down, so now, it is a good time to buy
because the price will be less and after that obviously, there is a chance the market will
be up in the near future. So, this is what basically we use another condition that is mutual
fund cash position is one of the indicators which technical analysts always use as another
indicator, they have they have the confidence index. What do you mean by the
confidence index? The confidence index is the ratio of average yield on top ten grade
corporate bonds divided by the yield on stock markets, stock markets average of forty
bonds.
If ratio is high, it shows the bullish sign. If it is low, it gives the bearish sign; that means,
what they are trying to find out what are the top grade bonds, they find out the ten top
grade bonds, they find out that yield and another forty bonds, the average yield they try
to find out and take the ratio between them. And whenever the ratio is quite high; that
means, we are talking about later this is a high grade bond yield and this other bond yield
for the grade bonds yield.
So, they are in this case if the ratio is high; that means, this yield is basically high and
this is low and when it happens whenever basically the market is up market is basically
up where basically that means, it gives that the market is bullish and if it is this ratio is
low, then market is bearish. So, that is another kind of trading rule basically also they
apply. Then there are other major rules also available.
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So, other majors are basically here, if you see one is credit balances and brokerage
account credit balances whenever you already know that whenever we invest in the
market, we basically trade through the broker. But credit balances result when the
investors sell the stocks and leave the process to their broker expecting to invest them
shortly. But whenever we sell the stocks at any point of time and instead of getting back
the money to us, what we do we keep that particular proceeds with our stock brokers,
because we are expecting that in the near future we are going to reinvest in that particular
market.
So, what the technical analysts believe? The technical analysts believed that if the credit
balances is less or credit balances is more accordingly they try to see that whether the
market is going to be bearish or bullish.
So, a decline in the credit balances, a decline in the credit balances is considered as
bearish because, we are saying that already the money is invested in the market and here
that is why there is a decline indicate that lower purchasing power as the market
approaches the peak and now, we do not have to market is cons. Now, the market is not
going to be up there is a chance that the market is going to be down.
But if more money is there; that means, they are expecting that the market is going to be
bullish. You remember, these are basically depends upon the expectations about the
market. If the money available to the broker is high; that means, the investor feels that in
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the near future they are going to invest because the market is basically going to be up
that is why they put the money immediately, and the market is now going to be bearish
and they will buy the stock and expecting that the market will go up in the future.
But if already credit balances is low, then they are expecting that they do not want to
invest as the investment is already done and in the near future maybe market is going to
be down. So, depending upon that, they consider that whether market is going to be
bullish or market is going to be bearish. Then, another one is the put call ratio; the put
call ratio is basically gives the holder the right to sell the stock at the specified price and
signal when anybody wants to sell the stock, then obviously, in the near future the
market is going to be down. So, price is going to be down, that is why they want to
upload that stock.
So, higher put call ratio indicates bearish attitude and lower put call ratio gives a bullish
attitude. So, this is what the call ratio is the reverse it gives the right to buy the stock and
the put option gives the right to sell the stock. So, more the selling; that means, the
market is going to be bearish in the near future and the more the call option means the
market is going to be bullish in the near future. So, there is a threshold limit for that what
the technical analysts basically fixes; that when the 70 percent of this speculators are
bullish the contrary opinion technicians say it is bearish market and it is bullish signal
when it declines to 30 percent.
So, this is the kind of role, but that may not prevail in the market every time, but if the
put call ratio if you see this is very high then we can say that basically the market is
bearish and whenever the higher put call ratio indicates there is bearish attitude and what
technicians believe that it is a bullish indicator because if they follow the contrarian
investment strategy.
Then the there are some other indicators.
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The other indicators are basically what, there are different kind of charts, different kind
of other numerical indicators also they use. Here, I have given some kind of figures,
some kind of idea which are popular, you might have heard about the bar charts,
Japanese candlesticks points and figure charts. That means, here there are four things
they put high close upon low and they try to fill it up then how the price is basically
moving in a particular day or a particular time gap. Accordingly, they predict that the
how the market is going to be in the future and here whenever this, we are talking about
this point and figures.
So, here basically what we talked about if the market in a particular time is down. We are
putting this circle and the market is going to be up, we are putting a cross and after that
we see that what is the trend about this and accordingly we can predict that whether the
market is going to up and down. So, mostly these are the different type of charts the
technical analysts believe to know that how the market is going to be in the future, and
accordingly they change their positions.
Another one in the trend line, trend line is quite important because they find out the
trading range in that, uptrend where prices are generally increasing and up trend line has
a positive slope and formed by connecting two or more low points.
For example, if I say like this, so this is basically upward trend line but whenever you are
talking like this is basically a downward trend line. So, the downward trend upward trend
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if you draw, then this is basically your trading zone, and you might have the idea that
using the trend line what this investors basically do; they basically always go for a
drawing the support and resistance line.
They support and resistance line basically used in the market. So, the support and
resistance; just now whatever basically I have drawn.
Basically if the market is fluctuating like this, then what happens that they basically draw
two lines, there is a trading zone this is your support line and this is your resistance line.
So, here the support line the price level at which the buyer tends to purchase the asset.
So, the resistance line is the price at which the selling is thought to be strong enough,
because basically the investor feels that once the price has reached in this range further
increase is not possible or where a rare chance it will increase. So, once they will reach
in that particular point, they will sell it.
But the resistance line also can be broken if again it is broken for majority of the times,
then maybe new resistance line can be created for that particular stock or for that
particular asset. So, that is why the trend line is quite important which is basically always
helping us to draw the support line and resistance line in the market.
Then we have another moving average already you know that moving average is
basically very important from the prediction point of view. So, we have a measure called
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moving average convergence on divergent (MACD) which is popularly known as. It is
nothing but the difference between a 12 day and 26 day moving average, and a 9 day
moving average of this difference is used to generate the signal. The 9 day moving
average basically always used to generate the signal when the signal line goes from
negative to positive, you minutely observe when the signal line goes from negative to
positive, a buy signal is generated and when the signal line goes from positive to
negative a sell signal is generated.
So, the MACD is quite popular among the technical analysts. Always they use it in the
market whenever they go and investing in that particular sense. So, that is another
indicator which is very popular among the technical analysts.
Then, we have another one of the most important indicator. There is relative strength
index you might have heard about this word the relative strength index is basically a
measure of the ratio of average price changes and up days to the average price changes
on the down days. The most important thing to understand about relative strength index
is that above 70 indicates a stock is overbought and a level below 30 indicates that it is
oversold. Overbought means the price is already quite high; that means further increases
not possible. If it is 30; that means, is oversold then there is a possibility the price will go
up.
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So, this is a very clear cut indicator what basically we can use. So therefore, 0 to 100
basically that always we measure that relative strength index and if 70; that means,
market is already quite up; that means, most of the people have bought that stock, but
that particular asset that is why the price has gone up and most of the time the price has
gone up. And again if you are expecting that more return from this in the near future may
not be possible, but if it is 30; that means, most of the people have sold it already the
price is down. So, there is a possibility that we may incur certain kind of extra return
from these, because the price is already undervalued in that particular market.
So, that is what the relative strength index is used. Then, we have another indicator that
is called the On balanced volume. It is basically what; it is calculated by adding volume
on up days because these are all the price indicators on this unbalanced volume is a
volume indicator. So, here we add the volume on up days.
And we basically adding volume on up days and subtracting volume on the down days
the running total is kept. And the On balanced volume (OBV) basically believed that
volume leads the price. On that particular philosophy, we generally look for OBV to
show a change in the trend; that means, a divergent from the price trend. If the stock is
on uptrend, but the On balanced volume turns down that is the signal that the price
strength may soon reverse.
It is very clear cut if the volume trend is up, but the stock trend is down or the stock trend
is up and volume trend is down on balance volume trend is down, then what we can say
that there is a reversal. Reversal in the sense, from upward movement the price can move
towards the downward movement or from downward movement, it can move towards
the upward movement. So, that basically gives a clear cut signal for how the market is
going to be in the near future.
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Then, we have another popular indicator that is the Bollinger band. Bollinger bands are
based on the moving averages of the closing price. You know the moving averages
basically make the data smoother. So here, how the band is created? See band is created
in this way there are two standard deviation above and below the moving average. So,
we draw two lines two standard deviation below, two standard deviation above and a buy
signal is given when the stock price closes below the lower band and sell signal is given
when the stock price closes the above’s of upper band.
So, the fluctuation is two standard deviation they have measured the fluctuation can go
up to two sigma. And if the price basically closes above the upper band; that means, the
further increase or further fluctuation is not possible, then we should go and sell the
stock because further increase is not available or is not expected and if it is basically
stock price closes below the lower band; that means, we should buy that stock because
there is a possibility that the stock price will go up. So, closer towards the lower band,
you buy it closer toward the upper band you sell. It just like we have the support and
resistance line we can use that particular Bollinger band in this concept in this particular
context.
When the bands contract that is a signal that big move is coming but it is impossible to
say if it will be up or down if there is kind of contract which happening between these
two band and then some bigger reversal is going to happen, but in which trend or which
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direction that is very difficult to say whenever we are using the Bollinger bands. But
whenever any technical analyst uses the Bollinger band, the buy signals are far more
reliable than the sell signal. So, anybody who wants to invest in this part using this
Bollinger band and if they are going for the buying the stocks then this particular band is
more reliable, then if somebody wants to invest in terms of the selling.
So, this is what basically this technical analysis I have just highlighted some points or
some major indicators which are used, because there are more than hundred indicators
which technical analysts use for the investment.
So, this is all about the technical analysis. And hopeful you can read more about the
technical analysis from any investment management books or any specific books on
technical analysis that already available.
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Lecture – 11
Theories of Interest Rate Determination – I
So, after discussion on the different major issues which are related to the financial
system as a whole or financial market in particular, today we can start our discussion that
how the price of that particular financial market is determined. Whenever I mean price,
price means this is the interest rate. Whenever you talk about bond market it is the
coupon or the yield whenever you talk about stock market it is stock return, whenever we
are going to the foreign exchange market it is exchange rate, and whenever we are going
to the call money market it is call money rate.
So, there are different ways the prices in the financial system is determined but whenever
we talk about this pricing in the aggregate sense the price is nothing but the interest rate
in the market. So, first of all today we can start the discuss on how exactly the interest
rate is determined in aggregate sense, then every pricing basically you can relate it to the
every market that how this particular notion or particular theory works in different
individual financial market context.
So, there are whenever you talk about the interest rate, there are two ways the interest
rate is determined, one is normal interest or level of the interest rate in the aggregate
market, another one is the structure of the interest rate. The structure of the interest rate
means, why there are different rates available for short term and long term, why even for
a same type of maturity the interest rates are different for the different type of assets. The
maturity period is same but the interest rate is different. Those kind of questions are
answered by the term structure theories that we will discuss later.
So, today we can discuss on how the interest rate in general sense determined, what are
the theoretical arguments behind that and what are those factors which determine this
particular variable.
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So, let us see that what exactly the interest rate is. In general sense the interest is
basically nothing but the price the borrowers must pay to lenders to obtain the use of
money for a period of time.
Basically, the loan rate, savings rate whenever you are keeping the money or money in
the deposits, saving deposits we are getting some interest out of this that is also reward
what you are getting. And whenever we are taking a loan from the bank for some
specific purpose we are also paying the interest to the bank and a bank is charging
interest on us. So, that is basically we call it the interest rate in the system or in the
aggregate system as a whole.
So, as all the other prices are determined in different markets the equilibrium rate of
interest is also determined by the forces of supply and demand in the financial markets.
So, we have to ensure that what are those supply forces, which are those demand forces
which determine the equilibrium interest rate in the market or different type of financial
markets. And the demand and supply forces vary on the basis of the market or on the
process of the specific market where we are operating. Whether it is money market,
whether it is stock market or foreign exchange market or derivatives market etcetera
etcetera.
So, here that means, first before we go into specific market that we will be discussing in
upcoming sessions, but today I am just going to explain that in aggregate sense how the
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level of interest rate is determined. So, the supply and demand there is a big debate over
this economic history or various economic theories about how this level of interest rate is
determined in the market system.
So, in this context if you see that there are broadly 3 theories which are very much
prominent, all of you might have aware about this. All kind of theories are answered by
the Classical Theorists, you have the Loanable Fund Theory, the new of the Keynesian
Theory. So, these are the bigger theories or the prominent theories which try to answer
that how the level of interest rate determined in the market or financial market in
particular.
So, if you see one by one every theory provides the different type of supply and demand
forces or the factors which are responsible to determine the equilibrium interest rate in
the market.
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So, if you see the classical theory according to classical theory interest rate is a real
phenomena in the sense that it is determined by the real factors.
So, already I have explained about the real and nominal interest rate though there are
certain factors which are real; that means, monetary factors does not play any role for the
determination of the interest rate in the market that is what basically the classical theory
assumes. So that means, interest rate itself is a real concept. It is determined by some of
the real macroeconomic variables which are available in the system. So, then how it is
determined? It is nothing but it is the interaction of the supply of the savings and demand
for the investment determine the equilibrium. If you see this is your supply, this is your
demand, and this is the equilibrium basically always we get it. So, this is your r and this
is your quantity supplied and quantity demanded.
So, here whatever basically I am trying to say what this classical theorists or classical
economists are trying to explain that what are those supply side? What are those demand
side? What are those factors which affect the supply of the savings? And what are those
factors which operate the demand for savings? Then only your equilibrium can be
determined in the market.
So, therefore, already we are clear the interaction between the supply of the savings and
demand for investment determines the equilibrium as per the classical theory, that is
basically we are sure.
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Then we are going to that how basically the supply of savings, where the same savings
come. The saving is nothing but it is the difference between the national income and total
consumption expenditure.
You see already you know that your total income is equal to total consumption plus
savings. Then your savings is equal to Y minus C, that means, total income minus total
consumption is equal to the savings that is a saving investment identity we make for the
equilibrium sometimes we call it is Y is equal to C plus I, then if Y is equal to C plus S
then; obviously, your I is equal to S. So, if saving investment equality happens, then
what basically we can say? That is equilibrium which can be established.
Then who saves? Who are those stakeholders, who are available in the market, who
saves the money? The savings may be basically always done by the individuals,
household savings, business and the government. So, these are the different sources from
where the savings come. Mostly the savings come from the household sector, because
they we are more the business sector is known for more investment and the household
sector is more known for the savings. The household sector saves the money and that
money goes to the business sector for the investment and whenever that is the investment
and in investment and saving equality happens that particular point the equilibrium
interest rate determined in the market.
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So, therefore, why the household sector save, somebody can ask you the question that
why the household sector save. You see whenever household sectors save they expect
that they should get some return out of this that is what they charge they always expect
some interest payment against their saving deposits because they are following their
consumption instead of saving they could have spent the money, they could have got
their utility from that by utilizing that particular resources what they could have bought.
But instead of consuming that what they are doing? They basically saving it, if they are
saving it why they are saving, because they are expecting that they will get some return
out of the savings which is nothing but the interest rate.
So, if the interest rate is increasing; obviously, the supply of savings will be more. So, in
that sense what basically we are trying to say that interest rate is also determined from
the savers point of view and the supply of savings increases once the interest rate
increases.
Then next one is basically the demand for investment. Who demands? Already I told you
that the business sector demands, firms demand, producer demand, producers basically
demand. Why they demands? Because they demand to invest that money to create some
profit and also increase the output, and here also why they are investing now? They are
investing, they also investing and also sacrifice their consumption, what are the reason.
The reason is they can create more profit in the future and that profit can be utilized
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again for the consumption whether from the household point of view or from the
business sector point of view.
So, in that case the opportunities to produce more effectively by using, the methods of
the production determine the investment demand. How much scope is there, how much
opportunity is there? If the opportunity is high then I can go and invest in the market,
more projects are available market is ready to capture the demand what basically we
have on that particular product. The demand for product should be there. The consumer’s
appetite for that particular product should be there. Test on preferences should be there.
So, all those considerations always we consider whenever anybody goes to invest in the
market or they want to produce certain product in the market.
So, once we get all those idea then what we do? You go and invest in the particular
system produce more and once you produce more their profit may increase and again the
profit come to the market for the more investment and there again the production will
increase then finally, the output can increase. In this process the producers or the
business sector basically demand the money or demand this particular fund which is
coming from the household sector savings.
So, finally, what is happening? We have equilibrium which can be established. So,
already I told you that the supply is upward sloping and demand is downward sloping,
more the interest rate, more the supply of savings, less the interest rate, less the supply of
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savings but if the interest rate is less the demand for funds will be more. So, therefore,
we can say that always we can have the equilibrium point here which is the market
equilibrium interest rate in that particular point of time.
So, therefore, the equilibrium rate of interest is determined by the interaction of the
savings and investments schedule in the economy. So, we have to know that according to
classical theory the interest rate is a function of the total savings and total investments.
Then wherever the savings is equal to investment they are basically we have the
equilibrium interest rate can be determined. So, this is what basically always we use it
from the classical theory point of view.
But that is not the only theory we have in the system. We have the Loanable fund theory
which is the extension of the classical theory because there are certain issues which was
discarded by the people who believes in the loan able fund theory.
According to this theory the rate of interest is determined by the demand for and supply
of the loan able funds. Not all funds are playing the role for determination of interest
rate, it is the funds which are lone able, actually we are saving but all the savings may
not be demanded by the business sector that may not be demanded by the producers. So,
if it is idle that does not play any role for the determination of interest rate in the market.
So, therefore, this theory is more realistic and it is much broader than the classical theory
of interest.
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So, therefore, the loan able fund theory discards the independence of the interest rate
from the behavior of the money and banks. They give the importance of the creation of
money by the banks, they give importance to the monetary factors because the classical
theory was believing the real factors determine the interest rate. For loan able fund
theory basically believes, the role of the money and bank for the determination of interest
rate in the market.
So, here according to this theory the real supply and demand curves determining interest
rates should have added to them, a component of the supply of savings which is
associated with the creation of new money on the credit. We will come to know more I
will discuss with you that bank is the organization who can create the money, how the
bank can create the money there is a process called money multiplier through which the
bank is able to create the money.
If the bank is able to create the money, then what is happening? That the loan able fund
theory gives the importance to money which is created by the bank and the role of the
banks in the determination of the interest rate, because you know bank is the most
important economic units, economic agent in the system because it is the payment
gateway all kind of transactions take place through that. It is the most important
intermediary, and all kinds of loans most of the loans and everything always carried out
by the commercial banks.
So, here the loan able fund theory gives the importance to the role of the banks on the
determination of interest rate. That means, the funds which are loan able those funds
only play the role for determination of the interest rate. That is why the creation of
money function of bank has given importance in the context of Loanable fund theory.
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Then here, so there are two things one is your demand for loan able funds and supply of
loan able funds. Then what are those factors that determine the demand for loan able
funds? The the factors which affect the demand for loan able funds are investments,
hoarding and dissaving. What exactly those are? How it is defined? Already I have again
and again explaining to you investment is the most motivating factor for determination of
interest rate or is the most important one of the important factors.
So, one is investment, investment is what? Investment is basically nothing but the
expenditure for the purchase of making of new capital goods including the short term
inventories. And here already I told you there is an inverse relationship between interest
rate and the investment. Lower the interest rate more the investment because as the cost
of fund will be cheaper more people will demand for money and money will come to the
market and they can invested in the market and by that the demand for funds will go up.
If your interest rate will be higher than the cost of the funds will be higher if the cost of
funds will be higher then demand for that particular fund will be low. Then the
investment will go down, this is what basically from the investment perspective.
Then another factor we have the hoarding. Why people hoard the money? The people
hoard the money because to satisfy the desire for the liquidity. You see, basically what
happens there is a relationship of hoarding with the interest rate. The demand for loan
able funds for hoarding purpose is a decreasing function of the rate of interest. What
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does it mean? At low interest rate the for loan able funds for hoarding will be more and
vice versa.
Why? You see why we call that as a decreasing function; the people basically what they
do if somebody is going for saving if interest rate is low. Then what they will do? They
will not go for saving that money in the bank they better to use it for their consumption.
But if the interest rate is high they will hoard the money in the bank or any other
financial institution because to increase their return from this. So, there is some kind of
inverse relationship exists between then your propensity towards the hoarding, or your
intention towards the hoarding of the money and the interest rate. So, that is why the
hoarding and interest rate basically inversely related.
Dissaving means, this particular concept comes from the people that at that time when
they want to spend beyond their current income. It is also a decreasing function of the
interest rate. What does it mean? You see, sometimes what happen I do not have much
money but still I want to invest or I want to spend. So, that is why already in the system
we have the possibility that your consumption may be more than your income, then how
it is possible? I can borrow, I will borrow from the market, I will borrow from the bank
and spend it and I can borrow from the market and invest it.
So, dissaving means I do not save and when I do not save whenever the interest rate is
quite low that is there is no motivation for the savings, so because of that I do not save it
in the market. So, in that sense what basically we are trying to say that interest rate and
dissaving are basically and mostly related.
So, these are the factors which basically decide that how much money will be given or
taken as a loan from the financial system, which is nothing but the demand for loan able
funds. Which are the funds that can be loan able, how much funds can be loan able, that
is decided by these 3 major factors one is investment, hoarding and dissaving.
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So, after this we have another point that is the supply of the loan able funds. Then how
the supply basically comes; what are those factors which motivate to supply because you
see producer or the business sector are demanding this that is fine. If the business sector
is demanding this and investment, hoarding, dissaving these are the some of the factors
which basically compel them or basically motivate them to demand for the money or to
get the loan from the financial system. That means, it is loan able that is why this is
called the loan able funds.
But whenever we are talking to the supplier side who supplies? From where the supply
of the funds come? The supply of the funds come from the reverse side that is basically
first point is savings. If you see who saves, the individuals basically save to some extent
there is a corporate savings corporate sector also saves some money. But if the interest
rate is higher then savings will be more people will save more but that money cannot be
demanded.
At that particular point of time what is happening? The producer may not demand that
money because the cost of capital or cost of raising that fund will be difficult or will be
costlier for them. But saving side it will increase, that means, supply of the funds will be
more but demand for funds will not be there supply is there but demand is not there. But
still saving is the most prominent factor who supply is this loan able funds which come
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to the bank or financial institutions, and it goes to the business units or the producers
who want to use that money for the production and as well as the maximizing the output.
Then another factor is bank money. Already I told the bank and create money that is a
credit creation process through which bank can create money we will explain that. We
will discuss more on this whenever we talk about the commercial banking.
So, what is the major job of the bank? Major job of the bank is to provide loan and take
your deposits, the loan is their assets and deposits is their liabilities they pay the interest
against the deposit and they get some interest against the loans. So, the banks basically
advance loans to the businessman through the process of credit creation and a bank will
create, bank will give more loans they will create the credit in the system then obviously
the supply of loan able funds will increase. Because if bank is able to create the money
and bank is inclined to provide more loan to the business units for their investment and
as well as their other productive purposes. Then what will happen? Obviously, the supply
of loan able funds will increase in the system.
So, that is why the bank money is quite important in that particular sense, the bank
money also is quite important whenever we consider about the supply of the loanable
funds because bank is a very important economic unit who is responsible for creation of
the credit and they are the only intermediary who can create money. No other financial
institution can create money there is a reason for that and bank is a special kind of
organization in comparison to other financial intermediaries which are existing in the
system.
Then another factor we have that is disinvestment. When the disinvestment occurs? The
disinvestment occurs when the existing stock of capital is allowed to wear out without
being replaced by new capital equipment. We do not want to invest. That means, we do
not want to replace the existing capital with the new capital. You see investment is
mostly related to the fixed assets, also the inventor is a part of this.
But why we invest in the fixed asset. We buy more fix assets we create the infrastructure,
why we create the infrastructure? With a notion that we want to create the infrastructure
to generate certain kind of extra return or extra output. So, obviously, if you generate
extra output then it will be more profitable or for example, for some reason I do not want
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to replace my existing capital whether it is machine or whether it is building whether it
anything which are basically the fixed capitals.
So, if the fixed capitals are not replaced then what is happening? That existing capital as
are only utilized. So, in that case the investment goes down change in capital is nothing
but the investment. The investment if in the real sense if you define it is basically if the K
is the existing capital minus Kt -1, it is basically change divided by Kt – 1 i.e. (K- Kt -1)/
(Kt – 1). This is the way basically the investment is defined change in capital. So, here
you can also some people write it (Kt + 1 - Kt )/ Kt the same thing.
So, either of these way it can be represented. So, either we can use this existing capital
for your investment or you can buy the more capital to increase your output that means,
you are investing. But if some cases if the producer is not interested to create more
capital or then do not want to invest more on that particular capital then what is
happening that basically will affect the supply of the loanable funds. The high rate of
interest leads to higher disinvestment that is what the same investment will be more then;
obviously, they will not be interested to spend more money or borrow more money from
the market. So, in that sense the disinvestment will go up or disinvestment will lead to
the increase in the interest rate.
And another factor we have that is called the dishoarding. The individuals may dishoard
the money from the past hoardings at a high rate of interest; if the rate of interest is low
dishoarding would be negligible. You see why people dishoard? Individuals may,
whatever money they have hoarded before, so they may dishoard the money from the
past hoarding at the higher rate of interest. They will not keep their money with them
what they will do? Instead of keeping the money with them what do they do; they
basically go and spend that particular money, keep that particular money in the banks or
the float or they supply that money to the financial system.
So, in that case what is going to happen? That if they will supply that money to the
system and when it happens and whenever the interest rate is high the dishoarding will
be basically discarded the dishoarding is basically always will be not there whenever the
interest rate is low.
So, the individuals might dishoard money from the past hoardings at a higher rate of
interest and if the rate of interest is low then dishoarding will be negligible. So, these are
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the major 4 factors which are responsible for supply of the loan able funds. So, we have
4 things. So, we have savings, we have bank money, or creation of money by the banks
we have the disinvestment, we have the dishoarding, these are the contributing factors
from the supplier side. Then we have the investment, hoarding and dissaving which are
coming from the demand side.
So, these are the factors which are responsible for the determination of the interest rate
through the loan able funds.
So, then if you see that finally the interest rate can be determined in the same way, but
only difference is you see here we are talking about if I will summarize in this way. You
see what was happening the classical theory basically we are talking about all savings is
equal to investments there the interest rate was determined according to the classical
theory.
But according to the loan able fund theory we are basically going to the equality between
the particular funds which are loanable, supply of funds is a loanable is equal to demand
for funds which are loanable. And another thing what we can say another thing is
basically another importance of bank credit which was discarded by the classical theory.
So, these are basically the two major things which basically we have observed which is
deviated from the classical theory. So, there is a, that is why this loan able fund theory is
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more practical people argue and this gives a better idea for determination of the interest
rate.
Then another most important theory we have that is the Keynesian theory which is quite
relevant from the practical perspective or current perspective or maybe actual operations
of the market perspective or the behavioral perspective. So, those particular concept will
be discussing in the next class which is popularly known as the Keynes liquidity
premium theory.
So, this is what basically we are talking about. Then, please go through this particular
references for this particular session. We can discuss that thing in the next class.
Thank you.
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Lecture – 12
Theories of Interest Rate Determination – II
So, in the previous class we have discussed about the; Theories of Interest Rate
Determination; we started the discussion. There we have seen there are three different
theories: one is classical theory, second one is neo classical theory and the third one is
the Keynesian theory which is popularly called as the liquidity preference theory.
So, today we will be discussing about that liquidity preference theory which is very
popular in that sense, because it has some kind of popularity in terms of phase uses and
the practical applications.
So, what exactly this Keynesian theory or liquidity preference theory is? So, if you
remember that whenever we are talking about the classical theory; we are discussing that
the interest rate is real phenomena or the interest rate is determined by the real factors in
the economy.
But here according to Keynes if you observe this is another extreme theory which tells
that interest rate is totally a purely a monetary phenomena. That means, the monetary
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factors which basically always responsible for determination of interest rate in the
system. This means that the rate of interest at least in the short run is determined by the
monetary factors; that means, it depends upon the actions of monetary authorities that is
Central Bank or the Government and the attitude of economic units towards holding
money as an alternative to holding the bonds.
If you go back if you remember the Keynesian theory believes in the concept of short
run; you might have heard about the famous line what Keynes used to say Keynes in the
long run we are all dead. So, in this context the theory of determination given by the
Keynes also in that particular line that which tells that that interest rate is determined by
all monetary factors.
And here the monetary factors means if you remember according to Keynes the interest
rate is determined by the demand for money and the supply of money, there is no role of
other external or the real sector variables for the determination of the interest rate. So, it
is very clear in that sense the particular factors which are responsible for demand for
money and the factors which are responsible for supply of money; those are responsible
to determine the interest rate in the aggregate sense. But here the question is that
whenever we talk about the demand for money; then what do you mean by that? That is
why Keynes said there are two agencies one is your Central Bank or the Government and
another one is economic units or the public which are basically existing in that particular
system.
So, here if you see one particular agency is responsible for the supply side and another
agency is responsible for the demand side. So, according to Keynes the supply basically
comes from the monetary authorities; that is the central bank or the government and the
demand is coming from the other economic units which are existing in the system. So, in
that particular period of time we have only two alternative assets; one is your money in
the liquid form or the cash and another one is the bond.
So, what Keynes was trying to say that, how much money people are trying to hold with
them that is basically defined as the demand for money. So, instead of the holding money
in terms of the bond; the people may be interested to hold the money in terms of the cash
or in terms of any kind of liquid form. So, therefore, this line the last line of the first
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paragraph if you see; it is to the attitude of economic units towards holding money as an
alternative to holding the bonds.
So, whether the economic units want to hold the money in terms of the bond or they
want to hold in terms of the cash. So, that is the basically the question which is always
raised in the mind of the people who are the participants in the financial system that how
the money is demanded, for what reason the money is demanded because the interest rate
is determined with the interaction of the supply of money and the demand for money.
And according to Keynes this particular interest rate concept is purely a monetary
phenomenon.
Let us see that why the money is demanded or what are the different motivations, why
people demand for money? You know that those kind of motivations or different kind of
factors which are responsible for demand for money was not discussed before
extensively before this particular theory came into the existence.
So, Keynes is the first person who was trying to explore that why the money is
demanded? Why it is called the liquidity preference theory according to Keynes?
Because the demand for money or demand to hold the money is nothing but the liquidity
preference; so, whether people are interested to hold the money with them or not or they
or interested to invest the money in the market.
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So, in this context what Keynes was trying to say there are different motives, there are
different reasons that always forces the; household and other business units to hold the
money with them. Then what are those motives or what are those kind of reasons for
which the demand for money? The reasons are basically three reasons or three motives
Keynes has identified; one is your transaction motive the first motive Keynes has
identified that is your transaction motive.
Then you have the precautionary motive, then you have the speculative motive because
speculative motive is there because of the investment in the market. So; that means, what
it tells that money is demanded for three reasons; people want to transact that is why
there is a transaction motive, people want to keep some money with them for some kind
of unforeseen situations as a contingency plan, people also demand for money for the
speculations or to take care of the speculative advantages which ever are there in the
market. So, therefore, money is demanded for three reasons one is transaction,
precaution and the speculation.
Let us see that how this transactions demand or precautionary demand or speculative
demand is basically playing the role for determination of the interest rate in the system.
Then if you see that here one thing one by one if you discuss that let we can start with
the transactions demand for money. The transactions demand for money which is
basically what? The amount of money that consumer need for transaction purpose mostly
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for buying and selling of goods and services. In the day to day life, we need money
because we want to buy something and also we want to sell something. So, the
transaction motive is the prime motive for the individuals or household sector because
they want money for their day to day life.
They try to buy the commodities, they try to sell the commodities and because of that
they have some kind of motives to demand for money or they try to hold the money with
them. So, here there are various factors which are responsible for the transactions
demand for money. One is obviously, the major factor is income; if you have more
income, you will spend more, your transactions will be more, you have always inclined
to buy certain products and; obviously, the higher income group people go to the market
more because they want to spend more money and that is why the transactions demand
increases.
And; obviously, spending habits, there are some people they love to spend the money
and there are some people they do not want to transact more money even if they earn
money. But still if the income level is higher; then obviously, the spending habit also
changes. So, income is the primary factor; which affect the transactions demand for
money and second one is the spending habits of the individuals a spending habit is there
then; obviously, people go to the market. And if they have more confidence on the
market they always participate in the market mechanism for buying and selling of the
commodities; so spending habit is another one. So, therefore, if you see that another one
is that time interval; what do you mean by this time interval? The time interval after
which each income is received you see that at what time basically this particular money
you want.
For example, you are paying some kind of service charges whether the services charges
is paid weekly or monthly or it can be yearly. So, if it is monthly then; obviously, you
need more cash with you or may need more money with you. If you are paying yearly
then; obviously, you need less money now because in the yearly basis your payment has
to be made. So, on at which interval your money is paid or your income basically is
going to be utilized.
So, therefore we have this is also another reason that more the interval, more the
frequency; obviously, the demand for money increases and lesser the frequency the
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demand for money declines. But in terms of the income if you are filling that need within
one month; every one month you are going to earn, then that is also affecting your
transactions demand for money.
If your earning is frequent or maybe then the frequent interval you are going to earn
more or your income is received, then also that is affecting your spending habit and as
well as also your transactions demand for money. Another reason for the transactions
demand for money is banking developments. You see in today’s context there are
various alternatives the bank has, but if you go back previously those kind of alternatives
were not available.
For example, now we have the credit card, now we have the cheques, we have the drafts,
we have different kind of alternatives through which the money can be paid or the
transactions can be made. That is for example, before for everything you want to use
cash then; obviously, your demand for money increases. But if you have different
alternatives then; obviously, what will happen? You do not bother about basically
holding the cash with you and you can carry any kind of alternative instrument which are
available or the different instrument which are available or given by the banks for your
transactions.
So, that is why people may not carry the cash with them; they may go with their credit
card, they may go with their debit card for their transactions whenever they want to
transact or they want to buy something they want to sell something. Then another point
we have that is called the industrial structure; what do we mean by this industrial
structure? There are some places there is a vertical development or vertical integration of
the industry.
So, for example, you are talking about the Tata Group, you talk about the Reliance
Group; so in that context what happens that the transactions if this industry is growing
vertically; then the transactions demand for money basically declines. Because they may
not need cash they made; they may only simply transact the money within themselves.
So, that is a reason basically some people highlight that the vertical or horizontal
development or integration of the particular system may also affect the transactions
demand for money in that particular economy.
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So, overall what basically we have seen? We have income, we have spending habits, we
have time intervals after which the income is received, development in the banking
sector; mostly the different alternative instrument which are available for the mode of
payments and all other things; then you have the industrial structure these are the major
reasons which are affecting the transactions demand for money. But according to
Keynes; the most significant factor which is basically affecting the transactions demand
for money that is basically income.
So, let if you see that we have denoted the transactions demand for money as MT and
this transaction demand for money is a function of Y; Y is basically the income. And if
you write that; that means, that if your M T is equal to your transaction demand for
money is directly proportional to Y. So, in this context we can write that MT is equal to
KY.
So, this K is basically a kind of a constant which is basically gives you the slope. So, the
slope of the transactions demand for money it can be basically nothing, but the dMT/dY
which is basically greater than 0. So, the transactions demand for money curve what here
I have shown that is basically, you are here that is basically always greater than 0; that
means, it is a positively sloped curve. So here if you see if your total income is 200; then
if you see this one, if you extend this particular line let this is 50, then your K will be
50/200; that is 1/4; if it is 400, then you can say that is 100; then the again also your K is
equal to 1/4.
So, here the slope basically is remaining constant. So, in this context what we are telling,
that slope is positive. So, what we are trying to conclude here that the transactions
demand for money is positively related to the income and the; the relationship between
the transaction demand for money and the total income of the individual is always
positive.
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Then the other thing basically what we are talking about; so, here already I told you that
all these factors the frequency of income received or the length of time period which
elapses between the receipt of money income and disbursement. Shorter the pay period;
smaller will be the amount of money required for the transaction purpose.
And already I have explained or I have discussed with you about the alternative modes of
payment which declines the; transactions demand for money. So, although income is
most important factors, these are also the responsible factor which can affect the demand
for money because more amount or availability of different modes of payment that can
decline the availability of the cash with the individuals and vertical integration declines
the transactions demand for money that already we have discussed.
Here then after discussing this; then we can move to the precautionary demand for
money.
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So, what exactly the precautionary demand for money is? The precautionary demand for
money is nothing, but the people wants to keep certain money with themselves to meet
the unforeseen contingencies; there must be any kind of problem, there must be any kind
of situation will arise which cannot be foresighted now; so, because of that also people
keep some money with them.
Then there are various factors basically responsible for this because whole business unit
and as well as the individuals both are always ready to keep certain money for the
precautionary motives or they have certain motives to keep the money from the
precautionary purpose. Then what are those? The first factor if you see the first factor is
what kind of business the company is doing? If the company is doing certain business
which is relatively risky; they want to keep certain money with them always or they want
to maintain some liquidity with them to overcome that kind of uncertainty which may
prevail in the market.
And another factor if you see that access to money market; what here we are trying to
say the money market is a market which provide all those liquid instruments or liquid
assets. So, the money market is highly liquid it provides all those liquid assets, but the
question here is whether already from the beginning I can give you this example in
Indian context; the money market is highly restricted it is interbank market all the market
participants are not eligible to access to the money market.
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So, if the access to the money market is restricted then the business units always try to
hold some liquidity, some cash with them to overcome certain kind of uncertainty or the
risk what they may face in the future in their business process. So, access to the money
market declines the precautionary demand for money, but if the access to the money
market is restricted; then it increases the precautionary demand for money by the
business units.
Degree of conservatism if for example, some kind of individual, some kind of investors,
some kind of market participants they are highly conservative because they do not want
to take much risk while putting their money in the market; more so conservatism they try
to maintain more liquidity with them or they try to maintain some kind of precaution
with them because at any point of time they can need that particular cash with them and
they do not have that much trust in the market that the market is always prone to failure.
If there is a failure in the market then how they can get rid of that or they can get out of
that particular problem.
So, to bail out that particular issues or particular problem which may prevail in the
market what they are going to do? They keep certain money for the precautionary
reasons with them. So, that is why that also affects the precautionary demand for money
in the system. Then whatever assets they have; what is the degree of liquidity they have.
The companies also hold some asset with them, but how you know what do you mean by
the liquidity?
Liquidity is basically nothing, but how fast the particular asset can be converted into
cash. So, whatever assets we have; if those assets is easily can be liquidated or the asset
can be easily converted into cash, then we can say that we have more liquid assets; then
whatever assets the particular company or particular individual are holding the what kind
of liquidity or degree of liquidity the particular asset has.
If the degree of liquidity is more, then what is going to happen? That; obviously, the
precautionary demand for money will decline, the degree of liquidity is basically less,
then the precautionary demand for money will increase because at any time of
requirement they can sell that particular asset easily which can be easily converted into
cash and they can repay their loans or fulfill their requirements whatever they want.
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But here in this context, if the assets are not that much liquid whatever assets they are
holding if it is not that liquid then they have to keep certain money with them; which is
for the precautionary reason. Then; obviously, another factor we have that is income.
The income is basically the sole factor because; obviously, if more the income they can
keep more money for the precautionary reasons; even if after fulfillment of all those
requirements whatever they have.
They may not take much risk, but even if they take risk if they have more income
available with them, then that also can be used or some amount of money, they can keep
it as precautionary motive. So, more the income the precautionary demand for money
also may increase. So, what Keynes has said? Keynes said this precautionary demand for
money is also a function of income.
So, this is the way the demand function by the Keynes is basically defined. So, then if
you see that after to these two motives there is another motive is the speculative demand
which is the greatest contribution of the Keynesian theory.
So, what do you mean by this? It is basically amount of money people hold for making
speculations in the financial market.
So, here you see that income is also a factor, but Keynes has given the importance that
the speculative demand for money is mostly driven by the interest rate. The speculative
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demand for money is mostly driven by the interest rate and therefore, if interest rate
declines, then the demand for money for speculation increases because the cost of the
fund will be cheaper people can borrow more money and they can put the money in the
financial market to maximize their return.
But if the interest rate is very high, then the cost of the fund will be very costlier then this
investor may not be inclined to borrow the money in that particular high cost; that is why
the demand for money declines for the speculative motives. So, therefore there is an
inverse relationship between the speculative demand for money and the interest rate.
Then coming back if you see that if you make a relationship between interest rate and the
speculative demand for money this is basically called the liquidity preference curve.
So, the relationship between interest rate and the speculative demand for money is
defined as the liquidity preference curve; that whether the people are interested to hold
the money with them or they want to put the money into the market for speculative
motives to get certain amount of return. So, that is why the relationship between them is
defined as the liquidity preference curve; the interest elasticity of speculative demand for
money increases as the interest rate declines.
The interest elasticity of speculative demand for money increases as the interest rate
declines. Why? Because already I told you; if the interest rate declines then people will
be more interested to go for investment in the bonds and other financial assets than
putting the money in terms of the cash with them. So, therefore, in general what we can
say? That the speculative demand for money which is basically here we have denoted as
MSP is a function of r. So, here your r is equal to your interest rate; so if your interest
rate and speculative demand for money is inversely related. So, this is what basically
what Keynes was trying to highlight.
So, here after knowing this what do you mean by this speculative demand for money; let
us see that how this speculative demand for money curve look like or the liquidity
preference curve basically look like.
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So, therefore, if you see this one here this graph basically shows that how these interest
rate and the demand for money for the speculative purpose is basically moving or what
kind of relationship can be established between them. The rate of interest at which the
speculative demand for money becomes perfectly elastic is called the liquidity trap. So,
this is basically your liquidity trap; then why would it is called the liquidity trap? This
region is liquidity trap; why we call it liquidity trap?
Because any further change in interest rate is basically happens in a very low interest
rate; after any further change in interest rate the withholders hold their entire wealth in
the form of money; instead of holding the interest bearing bonds. So, you see that the
wealth holders into the interest liquidity trap, wealth holder hold their entire wealth in the
form of money as the interest rate is quite low. So, instead of holding it in the bond
market what they will see that because the interest rate is quite low the coupon is quite
low.
So, instead of holding it and because the price of the bond is quite high; so they may not
be interested. So, here what is basically we are trying to see? The speculative means
because that time Keynes was everything explaining through bond market, if the interest
rate will be up then what is happening? The price of the bond may go down; so that is
why people will buy more bonds.
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So, the speculative demand in this the investment in the bond market increases, but
whenever this interest rate is very low, so people the price of the bond is very high. So,
in that context they will be more, there is no point of investing in the bond they may
prefer to hold their wealth in the form of money instead of holding the interest bearing
bonds.
So, at the liquidity trap rate of interest money becomes perfect substitute for the bonds.
Already I told you that if the interest rate is very low that the price of the bond goes up;
the price of the bond goes up. So, if the price of the bond is very high, people may not be
interested to invest in that. So, here in this case what is basically here we are talking
about? We said that the demand for money the speculative demand for money is a
function of interest rate.
So, here what we are trying? If interest rate declines, the speculative demand for money
goes up because people will not be interested to invest in the bond market; they try to
hold the money with them, but if the interest rate increases, then the speculative demand
for money goes down. Because people will not be holding the cash people will be
interested to invest in the bond market because the return from the bond market is
relatively higher and the price of the bond is low that is why people will be interested to
buy more bonds in that particular point of time.
But in the liquidity trap region money becomes a perfect substitute for the bonds that is
what the liquidity trap basically talks about. So, if you summarize that what this
speculative demand basically talks about. The speculative demand basically says that the
in the high interest rate scenario; the speculative demand for money goes down.
And in the low interest rate scenario, the speculative demand for money goes up. The
reason is basically the bond market is not lucrative and people prefer to hold the cash
instead of holding the bonds. So, that basically is also affecting the interest rate in that
particular point of time. So, here this is what basically the liquidity trap is all about; then
we can move into the concept which is basically we talk about.
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Now, the total demand we have three demand for money one is transaction demand, one
is precautionary demand, and one is speculative demand. So, here what Keynes was
trying to say because that MP is also a function of Y, if you want to use it in a functional
form what they said? They have added that both the total demand for money is a function
of Y and r the r is equal to your interest rate and Y is equal to your income.
And here, if you decompose into three we have the transactions demand we have the
precautionary demand, then we have the speculative demand. So, both transaction
demand and precautionary demand is a function of Y and the speculative demand is a
function of; transaction demand and precautionary demand is a function of Y and
speculative demand is a function of r.
Then the; finally the total demand for money is function of interest rate and the income.
So, this is what basically this total demand for money, but another question here.
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Then obviously, the equilibrium can be established when we say that. The we should
know the supply side and according to Keynes the supply is excess money supply is
exogenously determined; exogenously determine means the monetary authority can
decide how much the money supply should be.
So, it is very important point to remember the exogenously determined means it is totally
depends upon the central bank or the monetary authority that how much money supply
they can make and once you know the money supply is fixed. So, then you have the
liquidity curve here and this is your money supply which is fixed in a particular period of
time.
Then wherever, it is basically interacting with this demand curve because this is your
total demand curve. Then here your equilibrium is established and here this is basically
the interest rate. Then once they will increase the money supply then; obviously, the
interest rate will go down. And further if you observe in the liquidity trap region
wherever the money supply was; even if the money supply has increased, the interest rate
is not going to be changed.
So, if the economy is in the liquidity trap or already the interest rate is quite low; in that
particular point of time any change in the money supply does not have any impact on
changing the interest rate. So, here in over all what we see? This is your liquidity
preference curve and this is your money supply because money supply is fixed in a
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particular point of time because this is determined by the monetary authority and if any
point of time.
So, this is your interest rate which is decided and once the change in interest rate will be
there; that can happen whenever there is a change in money supply; what change in
money supply will decline the interest rate, if money supply will increase. If money
supply will decline, then interest rate will increase; if money supply will increase, the
interest rate will decline, money supply will decline; then the interest rate will go up.
So, this is the way the interest rate is determined according to Keynesian framework. So,
now we have discussed about the three theories; the classical theory, the loanable fund
theory and Keynesian theory and all those theories were trying to explain then how the
interest rate in the market is determined. And what are those factors which affect the
demand side and supply side variables which can finally, determine this interest rate.
Please go through these particular references for this particular session. In the next class,
we will be discussing about the term structure theories of interest rate.
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Lecture – 13
Term Structure Theories of Interest Rate – I
So, in the previous class we discussed about the different theories which try to determine
the aggregate level of interest rate or level of interest rate in the economy. Then the other
issue related to the interest rate is basically the Term Structure Theories of Interest Rate.
So, before we analyze that what exactly the term structure theory of interest rate; let me
explain you that why we want to study the concept of term structure theory.
That whenever you talk about the term structure interest rate theories or the concept of
term structure interest rate; the term structure is basically nothing, but why the interest
rate in the long term bond or long term securities are different from the short term
securities.
So, in general what kind of questions or what kind of issues the term structure theory is
trying to answer or there are two questions what basically it address: one is what
determines the difference between long term and short term interest rates, which means
that what is that determines the term structure interest rates. And what determines the
general structure of interest rates, to be precise if I give you this example that whenever
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we are issuing particular bond that one bonds maturity period is 10 years another bonds
maturity period is 5 years. You might have observed that the bond which maturity period
is 10 years they provide more return than the bond whose maturity period is 5 years; why
is it. So, why basically these yield or the returned from a long term bond is more than the
return from a short term bond that is the first question.
And what is the second question? The second question is that whenever even if with the
same term to maturity, you will observe that may be one bonds maturity period is 10
years and another bond which maturity period is also 10 years, but the issuers are
different, may one bond is issued by one agency another bond is issued by another
agency. So, you might have observe even if the same maturity, the interest rates or the
return from these two are different, these two different bonds are varying. Why it is
varying? Why basically even if the same maturity the interest rate or the return from
these two bonds differ? So, here basically there are lot of issues or lot of reasons behind
that and all those reasons and all those concepts are explained through the different
theories of term structure interest rate.
So, in a general sense if you in a layman perspective or in a very common perspective if

you want to define what do you mean by the term structure interest rate or what do you
mean by the term structure. The term structure basically examines the relationship
between the yield to maturity and the maturity period. Just now I said that one 10 years
bond, one 5 years bond. So, here your 10 years are 5 years are the maturity period and
the return or the yield what you are getting from this, if you are holding the bond up to
that maturity that is basically your YTM or the Yield To Maturity. So, the particular
curve which shows the relationship between yield to maturity and term to maturity that is
basically called the yield curve.
So, the yield curve determination or how to derive the yield curve that basically we get
through this term structure interest rate theories; that means, the term structure interest
rate theories try to, theories basically try to help us to derive the yield curve of a
particular bond. So, these are the major issues always we encounter whenever you talk
about the term structure theories of interest rate.
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So, let us see that how that particular theory works; you see already I have mentioned
you or I have discussed with you that the term structure theories try to explain or try to
measure the yield curve a particular of a particular bond. But then what is the shape, how
the particular yield curve looks like, what is the shape of that yield curve. If you say in
general sense always you might have known that the return from a long term bond is
always more than the return from the short run bond. If the return from a long term bond
is more than the return from the short term bond then always we can find there is a
positively sloped yield.
That means, the yield curve can be positively sloped with long term rates being greater
than the short term bonds that always we can find out and that kind of yield curve is
basically known as the normal yield curve or the upward yield curve. So, how it basically
exactly look like? If in one axis we have the term to maturity another axis we have the
yield to maturity mostly the yield curve looks like this; that means, if this is your yield to
maturity and this is your maturity period; if maturity is a increasing then the yield is also
increasing. So, this is basically an upward yield curve or positively sloped yield curve.
So, this is basically also the normal yield curve, but in general sense always we know
that the long term yield is always more than or the bonds are having longer maturity
gives more yield than the bonds having shorter maturity.
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And this is usually convex from below that particular diagram basically shows that and
with the YTM flattering out in the higher maturity. So, if you go for higher maturity
period you will find not much fluctuations in terms of the yield whenever you compare it
with the shorter term maturity bonds. So, the yield curve also can be negatively sloped
where the short term rates is greater than the long term rates. So, there is also possibility
that the short term rates can be lesser than the long term rates and when it is possible,
whenever the purchasing power of the consumer is very low or the inflation rate is quite
high in the economic system. In that time investing in the short term is relatively more
risky than investing in the long term. The reason is the inflation is already high there is
the high probability that in the near future this inflation rate may go down.
So, because of that what happens that; obviously, the return or the yield from the short
term bonds may be more than return or the yield from the long term bonds. So, this is
what basically the yield curve or an inverted yield curve we can observe. In some of the
countries whenever this kind of situation arises, you might have observed the shape of
the yield curve looks basically inverted.
So, this is what basically we are talking about the inverted yield curve. So, here like
normal yield curve these curves also tend to be convex with the yields flattening out at
the higher maturity, the yield curve also can be relatively flat if the short term rate and
long term rate both are different. So, that is basically another way of understanding or the
way of looking this yield curve; that if the long term yield and short yield both are same
then what you can say that the yield to maturity is invariant to the term to maturity. So,
with the change in the term to maturity the return or yield also is not going to be
changed.
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So, after this, if you see that just now I have told that and this is the way the shape of the
yield curve looks like this diagram I have shown you that is a normal yield curve and this
is the way basically the inverse yield curve looks like you see here YTM term to
maturity increases here YTM basically changes right. So, this is basically another type of
yield curve then this is basically your flat yield curve which is your yield to maturity is
not changing even if the period is changing.
So, whatever period you are talking about the yield is not going to be changed. So, that is
basically we call as the flat yield curve and the yield curve already I have mentioned you.
So, the relationship between your yield and term to maturity; so, this is what basically we
talked about the yield curve and this is convex from below that is already we have
explained in the previous slide. So, then we have after getting these idea that what these
yield curve look like and what are those different types of yield curve can be prevailed in
the market then we can move in to another argument on these that what are those factors
we decide the shape of the yield curve
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So; obviously, the shape of the yield curve depends upon the types of the bonds you
know there are different type of bonds available in the market, you have high rated bond
like AAA or B rated all kind of bonds. So; obviously, the long term bonds give low
return.
The yield from the long term bond is low and yield from the low rated bond is high it is
the high rated bond and it is the low rated bond. So, that is what because this is more
risky and that is why to compensate the risk the issuer can provide more yield for the low
rated bond to the investors and another one the economic conditions; obviously,
monetary conditions monetary policy if the policy rates are very low then; obviously, the
interest rate in the market also will be low. So, because of that we can expect that yield
also be low because that time the money supply in the economy will be very high.
Now the policy rate will be low, the interest rate will be low then that will have the
impact upon the yield in that particular point of time. So, in this context this yield may
increase because the price also gets affected by that. So, the tight monetary policy means
if the interest rate goes up, then the money supply basically goes down then it will have
the impact on the investment on the different financial securities then; obviously, your
yield also gets affected.
So, this is what basically this economic conditions including monetary policy also affect
the shape of the yield curve in the economic system. Then the maturity preferences of
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investors and borrowers that we will discuss through the different theories that for
example, some investors prefer only to invest in the long term bond on the basics of
requirements, because if somebody wants money after 10 years and he can hence
specific amount of money they want to get out of these or specific amount of return they
want to get out of these. Then what they do? They prefer to invest in the long term bond
instead of investing in the short term bond.
But there are certain investors or certain participants they always preferred to invest in
the short term, investment arising period is very short therefore, there is a preference. So,
always we will find that under these economic conditions the investor basically is in
interest rate for investing in the long term bond and short term bond that basically will
decide that how the shape of the yield curve will look like. And also the investors and
borrowers expectation about the future interest rate inflation and the state of the
economy. So, how this economy is going to behave in the future in terms of the different
macroeconomic fundamentals that also affect the yields of that from that particular bond
and accordingly the yield curve shape can be changed. So, this is what basically the
common factors which can decide the shape of the yield curve.
But we can explain all those arguments through different theories when the basic
question here is how the long term interest rates can be determined what is the logic,
what kind of different theoretical arguments through which we can say this is the way the
long term interest rate can be determined.
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So, we have four theories which explain basically the term structure interest rate theories
one is your pure expectations theory, you have the liquidity premium theory, you have
the preferred habitat theory, then you have the market segmentation theory. These are the
four different theories which explain the term structure interest rate theories in the
system. So, one by one we will see that how this interest rate theory is trying to explain
that how the long term interest rate is determined in the financial system.
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So, first of all if you see the pure expectations theory is based upon certain assumptions
and mostly the pure expectations theory is believing that there is a perfect competition in
the available market; that means, there are more number of buyers and sellers exist
investors are rational; that means, they want to maximize the yield in that holding period
everybody is thinking rationally. Investors have a perfect foresight and large enough
body of investors hold uniform expectations about the future changes in the different
interest rate like short term interest rates and the prices of that particular security.
There is no transaction cost and obviously, the risk is neutral here in this particular
context the risk is not available or risk is there everything can be predictable from the
beginning that is why there is no uncertainty which is existing in the market. And the
securities of the different maturities are perfect substitutes; that means what? If anybody
there is no difference in terms of the investment arising period, anybody can invest in
any type of bonds in terms of the maturity.
So, in the previous slide we are explaining that some people prefer to invest in the long
term bonds some people will be invested in the short term bond, but here whenever you
are explaining the pure expectations theory we believe that there is no such kind of
preferences or differences in terms of the short term and long term bonds. Everybody
wants to invest in there is some kind of perfect substitutability between the short term
and long term bonds which are available or existed in the financial system.
And holding period is the period of time for which the investor plans to hold or actually
hold the security, it may be same with the maturity or it may be differ from for maturity,
but if it is longer than maturity period the investor must reinvest in that particular bond
or if it is shorter he must sell the security before the maturity is over. So; that means,
hear what we are trying to explain, let there is a bond whose maturity period is 10 years
then the investor if go on up to 10 years the investor can sell the bond after 5 years. After
5 years they can sell the bond or they can hold up the bond up to the maturity or if they
are trying to hold that bond after this maturity then they have to again reinvest that bond
they can extend that maturity period because maturity period is fixed from the beginning.
So, therefore, these are the different assumptions what this pure expectation theory takes.
Then using these assumptions what this theory basically tries to explain?
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It explains that the today’s long term rate is the unbiased average, the average can be
arithmetic or geometric of the current short term rate and the successive forward rates or
we can call it expected one period short term rates during the period of long term loan.
So, for example, if you want to calculate the long term rate where here in this case your
Rn is equal to the long term rate, let n = 3. So, then what basically we trying to measure
this if you are using this that 1+Rt n is equal to nothing but 1+ R1.
Here the R1 is basically the current spot rate and we have the forward implied forward
rates that is (1+ Rt 1+ 1) * (1+ Rt 2 + 2). So, on and then you can take the geometric mean
of that to the power 1 by N that basically will give you what is the long term rate for that
particular 3 years or 4 years. And here the one thing is this r which is basically your
forward rate that we have to measure it and if you know this spot rate of today then
forward rate of the next year, then we can calculate the spot rate of two years bond or
three years bond from today. So, in this context it is nothing, but the long term rate is a
arithmetic or geometric mean of the current spot rate.
And the future or the forward rates in that but, for that particular bond in the financial
market in that particular point of time. So, then this is what basically we are talking
about the definition of the pure expectation theory then we can see that how this
particular theory works.
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So, if you are trying to find out this is your general formula for this pure expectations
theory then here if for example, 7 year spot rate is 15 percent and 6 years spot rate is 13
percent. If you want to calculate the forward rate or implied forward rate from this then it
is nothing, but {(1+ 0.15)7/ (1+1.3)6} -1= 0.277 or if the 27.7 % is available to you or
13% is available to you.
Then you can also calculate this 15 percent which is the spot rate for the 7 years maturity
bonds. So, this is what basically the pure expectations theory is trying to explain. So, in
overall what it tries to measure that if you have the current spot rate or one short term
spot rate and you have the forward rates then the long term rate can be calculated. And
this long term rate is nothing, but it is an arithmetic mean or the geometric mean of the
these two rates current spot rate and the implied forward rates which are available in this
particular system. So this is the way the long term rate can be calculated. So, this is what
the expectation theory is trying to explain.
So, another thing here that if you observe that the expectation theory tries to incorporate
trying to measure the expected spot rate from today, what is going to happen after 2
years, after 3 years, after 4 years and depending upon the implied forward rate and the
spot rate the long term interest rate of that particular bond can be calculated.
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So, here if you want to see that how basically this theory works and how basically this
kind of conclusion we can draw. So, the long term rate would be higher than the short
term rate if the yield curve will upward slopping if the investor expect future short terms
spot rate could be higher be than the current short term spot rate.
So, if you see just now what we are trying to say, we are trying to say that here the
question, this issue was your long term rate is the arithmetic mean or the geometric mean
of current spot rate and the forward rates. So, here what we are trying to say that if after
the measurement if the forward rates are basically more than the current spot rate then;
obviously, the long term rate the average of the these two rates will be more in the long
run. So, the long term rate; obviously, be more than the long term spot rate will be more
than current short term spot rate if your expected short term forward rates will be more
than or will be increasing or will be more than the current spot rates.
So, this is what basically we are talking about. So, in that particular point of time if your
yield curve basically looks like this, but if the long term rate will be lower than the short
term rate; that means, the yield curve will downward slopping.
That already we shown these, then what is happening? When it happens, when the
investors expect the future short terms spot rate could fall below the current short term
spot rate. That means, the future spot rates what we are expected spot rates, what we are
calculating expected spot rates and the forward rates, if this is basically which is
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calculated on the basis of the forward rates and the spot rate of today. If this one is
basically declining or will be lesser than the current spot rate then what is happening the
short term rate will be more than the long term rate. So, this is there then that particular
point of time what we can observe that the yield curve basically downward sloping and
in that point of time we call it an inverted yield curve.
So, if no changes in future short term spot rates are expected then, the long term and
short term rate be equal to each other and finally, the yield curve will be flat so this is
what basically we can say the yield curve will be flat. So, in overall if you see that the
pure expectations theory basically tries to explain about the future short term interest
rates are the only determinants of the term structure interest rates. And there is no other
factor we have to know only the current spot rate and the future short term interest rates
or the forward rates. Then we can calculate the long term rate of a particular bond by
using this two different variables is simply the geometric or arithmetic mean of those
rates which are available in the system.
Thank you.
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Lecture – 14
Term Structure Theories of Interest Rate - II
So, in the previous class we discussed about the pure expectations theory which tells that
the long-term yield or long-term interest rate is nothing, but arithmetic and geometric
mean of the current spot rate and the forward rates. And, after that already I have shown
you that we have other theories which also explain this concept of term structure interest
rate, and one of them the most prominent theory is also the liquidity preference theory.
And you can observe that the liquidity preference theory is or can be thought of an
extension of the pure expectations theory. Why you say that this is an extension of the
pure expectation theory? Because, whenever we are explaining the expectations theory
we are assuming that there is a risk neutral world, and people are not much concerned
about the uncertainty what they are going to prevail or going to avail in the particular
system. But, whenever we talk about the LPT or the Liquidity Preference Theory,
liquidity preference theory tries to include that what is the role of risk, whenever we are
investing in the different financial securities including bond.
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In that context because, in general the long-term bonds are more risky in comparison to
the short-term bonds. Then we should expect that the return from the long-term bond
should be higher or the yield from long-term bond should be higher because, we expect
premium out of this. Because, we are going to take more risk which may prevail in the
future and to compensate that risk some amount of return should be awarded. An extra
should be awarded in comparison to the short-term bonds which are available in the
financial system.
So therefore, the liquidity preference theory consider risk whenever they calculate the
long-term yield or long-term interest rate in the bond market. Then another thing you
might have observed that here if you see the long-term bonds are more price sensitive to
interest rate changes than the short-term bonds. That means, if I tell you that 1 bonds
maturity period is 5 years and another bonds maturity period is 12 years. Whenever,
there is a change in interest rate, you will find that the price change for the 5 year bond
and the price change from the 12 year bond; if you compare then the sensitivity of the 12
year bond will be more than the sensitivity of the 5 years bond. So, you know what is the
bond price already we known that, it is basically nothing, but this Cft/ (1 + r)t.
So, here if you discount it with respect to a discount rate you will find whenever this r
changes; if the maturity period is less than the sensitivity of the price with respect to the
original price is less for a shorter maturity bond than the longer maturity bond. So
therefore, we can say that the price sensitivity to interest rate changes is more for a long-
term bond than the short-term bond. As a result the prices of long-term securities tend to
be more volatile and therefore, more risky than this short-term securities. Because, the
interest rate sensitivity towards the long-term bond is more than the interest rate
sensitivity towards the short-term bond.
That is, if there is a change in interest rate whether it is in the upper side or in the lower
side, whatever price fluctuations we can get it from that particular bond; you will observe
that the price change for a long-term bond is more than the price change for short-term
bond. That is why the sensitivity is more and if the sensitivity is more than obviously we
can say that the volatile; this particular bond price is more volatile. And therefore, the
risk is more. And, to compensate that risk some kind of premium should be given or the
yield from that particular bond should be more than the short-term bonds that, is what the
basic physical argument behind the liquidity preference theory.
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So, that is why the other name of liquidity preference theory is the risk premium theory,
because we are providing certain premium or because the long-term bonds are more
risky than the short-term bond; we are giving certain premium against that because of the
risk aspect. So, that is also consider as the risk premium theory, which says that there is a
liquidity premium for long-term bonds over the short-term bonds whether you can call it
liquidity premium or the risk premium. But, the premium are given because the
particular bonds exposure towards the risk is more than the short-term bond. The risk
exposure for the long-term bonds is more than the short-term bonds, that is what
basically the basic theme of the liquidity preference theory.
Then how basically it works? Here, what we are trying to say, if you go back to our
previous calculations of the pure expectation theory; the premium is over and above the
average of the current and net expected short-term rates. Just now we are talking that
according to expectation theory, the long-term rate is nothing, but the average of the
current spot rate and forward rates.
But, here it is telling that according to liquidity preference theory we have to add some
premium into that. So therefore, whatever average we are calculating: the average plus
premium basically will give you the interest rate for the long term interest rate; that is
what basically the liquidity preference theory is trying to explain. Therefore, there is
always existence of the upward sloping yield curve than the others shape of the yield
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curve that always we see. So that means, once you are adding a premium into that what
we can guess from this. Because there is establishment of the premium and some risk
premiums are given to that, we can say that always the return or the yield from a long-
term bond is more than the short-term bond.
So, here if you observe this LN which is nothing but the liquidity premium. This is your
liquidity premium which has been added to whatever interest rates we have calculated by
using the expectation theory. So, here liquid you can assume that the liquidity premium
and it is expected to increase with maturity as the volatility increases with maturity. So,
more this term to maturity more will be the premium because, already we have argued
that the long-term bond price volatility is always more than price volatility of short-term
bonds. So, this is what the basic concept or basic notion of the liquidity reference theory.
Then we can move into this what basically the central theme of this. So, the liquidity
premium highlights the preference for liquidity and it highlights the preference for
liquidity and the desire to minimize the sum of income risk and capital risk as the
additional factors determining the term structure of interest rates.
Because, you see whenever we are talking about the bond, the bond can have some other
type of risk also because, the bond can give the coupon, but there must be sometimes
also the income may be generated, whether may be some kind of default. So, that risk is
involved in that. So, capital risk means in the end of the period whenever I or any
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investor wants to or bondholder wants to sell the bond, what kind of interest rate scenario
exist in the market; whether the price of the bond will be higher or the price of the bond
will be low.
So, all kind of risk is involved into that. So, because of that from the beginning what the
investor always expects that I should get more return, more yield from the long-term
bond which can be reinvested in the market at appropriate time to compensate my risk
what I am going to face in the future. So, because of that always the long-term bonds
gives more returns than the short-term bond as for the liquidity preference theory. So,
already we have explained this, given that the long-term bonds are more responsive to
interest rate changes. There is more risk holding a long-term bond for one period, with
the risk increasing greater the bonds maturity.
So, the risk premium always increases with the term to maturity that basically we have
seen, the risk premium increasing with the term to maturity. So, then how much and
what kind of return we can expect from this. So, this would suggest that the yield curve
is governed by the condition that expected spot rate is equal to the forward rate plus a
liquidity premium. So therefore, we are adding that it is the average of the current spot
rate and forward rate, but now you are saying that it is the average of current spot rate,
the forward rate and the liquidity premium. And, how this premium is calculated this is
basically calculated as the maturity spread. It is the return from the long-term bond
minus the return from the short-term bond which is called the maturity spread, with the
premium increasing with the maturity.
So, always we say that the premium is positive and the premium increases with the
maturity period or the maturity of the bonds which are existing in the market. So that
means, it is very clear the liquidity premium theory tells that whatever return or whatever
interest rate we can calculate from the expectation theory; we have to add the liquidity
premium into that. And, why we are giving that liquidity premium because, we are
taking more risk whenever we are investing in a long-term bond, because the long-term
bond is more risky. Why it is more risky? Because if there is a change in interest rate, the
price volatility of the long-term bond is always more than the price volatility of the short-
term bond.
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So, keeping that thing in the mind what we are trying to say that the interest rate from a
long-term bonds should be higher than the short-term bond. And obviously, therefore,
the yield curve should be upward sloping and also positive; that is what basically what
we can conclude through this liquidity preference theory which is as per the pure
expectation theory.
Then we have another theory which explain the term structure interest rate, which is
basically your market segmentation theory. It is a very interesting theory. What exactly
the market segmentation theory is, market segmentation theory is mostly driven by the
requirements or the psychological biases or psychological preferences of the investor
towards a particular segment of the particular market. What exactly it means? It means
that the markets are segmented on the basis of the maturity.
So, according to market segmentation theory the yield curve is determined by supply and
demand conditions which are unique to that particular maturity segment. How much
demand is there for that particular short-term bond and how much supply is there for that
short-term bond, that determines the interest rate of the return in the short-term bond
market. And, whatever demand and supply is there for the long-term bond that will
decide the interest rate in the long-term bond market.
So, in this context what we are trying to say the bond market is segmented and the
preference of the investor is always there or always fixed towards a particular segment.
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And, this preference arises on the basis of their requirement, on the basis of their
necessity. If anybody is interested to invest in the short-term bond they will stick to the
short-term bond, because they need money in the short-term period of time. And, if
anybody interested to invest in the long-term bond they will stick to the long-term bond
market segment, because the investment they want to make it because they need money
of the requirement is for the long period.
So, that is what basically the basic theme or basic logic of the market segmentation
theory. So, that is why the market segmentation theory recognizes the interdependence
within markets in different sectors. That means, it assumes that short-term investors will
substitute between short-term bonds; whatever short-term availability is the short-term
instruments are available in that particular segment. And, the long-term investors will
substitute between the long-term assets or long-term bonds which are available in that
segment; whether they will invest in the long-term treasury bills or long-term corporate
bonds wherever or, long-term government securities wherever means whatever bond
they want to prefer they want to prefer within that maturity segment.
The long-term bond investor will not move into the short-term segment and the short-
term investors will not come into the long-term segment. So, there is a pure demarcation,
there is some kind of segmentation already it is available. And, the interest rate of that
particular bond is decided by the demand and supply of that particular bond within that
particular segment; that means, the aggregate demand and supply of the bonds is not
considered for determination of the interest rate. So, because of that there is a change in
the interest rate between the short-term and long-term bonds.
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Then if you see that whenever you talk about the short-term market, the supply of the
short-term corporate bonds depends upon some of the factors like business demand for
short-term assets such as inventories, account receivables etcetera that already know.
Then why the demand for a short-term bond, because they want to basically fulfill the
short-term obligations; the short-term obligations includes accounts receivables,
inventories etcetera, etcetera.
So, to fulfill the requirement they can issue the short-term bond, when the demand for
short-term corporate bonds comes, investors looking into their investor excess cash for
the short period. Who invest in the short-term bond? This demand for short-term supply
is coming from the business side, who wants to issue certain bonds because they want to
fulfill their short-term obligations. Then who demands long-term bonds? The bondholder
who needs certain kind of return in the short period of time, they basically demanding
short-term bonds.
So, then the demand and supply basically works in this direction within that particular
segment and the demand for short-term bonds by investor and supply of the short-term
bonds by corporations or the companies ultimately determine the rate on the short-term
corporate bonds. So therefore, the demand and supply here we are not concerned about
that how many investors or how many issuers are issuing the long-term bond. We have
only confined ourselves the particular investors who are issuing the short-term bond.
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And, a particular issuer who are issuing the short-term bond and particular investor who
want to invest in the short-term bond. They invest from an investor point of view, this is
coming from the demand side and from the corporate or business point of view this is
coming from the supply side. So, that interaction will decide the interest rate of that
particular short-term bond in that particular segment.
Then whenever we talk about the long-term market why this, there is a supply of the
long-term bonds, because the company can need the issuance of the long-term bond.
Because of the plant expansion, equipment purchase, acquisitions etcetera, etcetera so,
which is basically longer term in nature; they need cash or they need money for this, that
is why the issue the long-term bonds in that particular point of time with that period
relatively more longer, more than 5 years, 10 years, 15 years like this. And, who
basically is in interested to invest in that type of bond? This is basically mostly the
financial institutions like pension funds, mutual funds, insurance companies they want to
invest in the long-term bonds.
Because, they have the long-term liabilities or longer term liabilities and the horizon
period is also long. They want to match between assets and liabilities in the long-term
and because of that the investments made by these kind of financial institutions or these
kind of investors is always there for the long-term bonds. So, if they prefer to invest in
the long-term bond and company wants to issue the long-term bonds because, they need
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finance, they need to finance their fixed assets or fixed project like plant expansion,
equipment, buying equipment, acquisitions etcetera.
So, then that demand and supply decides the long-term interest rate in that particular
segment, that mean the long-term investor does not come to the short-term segment; the
short-term investor also does not go to the long-term segment. So, the demands supply
forces comes from the requirements of the both demand from the business point of view
or from the investor point of view within that segment itself. Therefore, there is no such
kind of integration which takes place between these two. And they always try to maintain
their positions in that particular segment only. So, then we have if you see that how this
mechanism basically works.
This mechanism works in this case this is your short-term bond and this is your supply
side which is coming from the account receivables, inventories etcetera; corporate
financing of the short-term asset, and investor with short-term horizon who needs money
within a short span of time. So, this interaction supply and demand will decide the r B ST
means the short-term yield. This is your short-term yield. So, this is the way the market
works in the short-term market or the short-term bond market.
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So, like that if you summarize the long-term part, the long-term basically works in this
direction. Here the longer supply is coming for because, the company need money for
establishing new plants, buying major equipments, going for acquisitions, etcetera,
etcetera. And, the investor who needs money for the long-term period they want to invest
for a long time horizon.
So, the interaction between these two will decide this is what basically your long-term
yield. So finally, the yield of the long-term bond can be decided. So, the market
segmentation theory explains basically the interaction between the short-term and long-
term bond. So, in the context they are trying to say that there is no such kind of spilling
which takes place between the two different segments. So, the demand and supply forces
of one particular segment decides that what should be the interest rate in that particular
market.
So, if the supply and demand works in a particular segment then the interest rate can be
determined in that particular segment and the market is confined to that particular
segment in that particular point of time. So therefore, depending upon the demand and
supply; obviously, the interest rates in two segments basically vary. So therefore, here if
you see that what it is trying to say that there is no such kind of relationship between the
long-term and short-term because, the markets are highly segmented. But, the question
here is that; obviously, the investor who wants to invest for a long period of time, then
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demand and supply of that long-term bonds or long-term securities is always there for
that particular investor.
But, this is relatively risky investments. Why it is risky? Because, already we know that
the future is uncertain, the macroeconomic fundamentals may change. If the
macroeconomic fundamentals will change then automatically what will happen, it will
have the impact on the yield of the different type of bonds which are existing in the
system.
So, because of that what we can assume that; obviously, the return from the long-term
bonds market will be more than the returns from the short-term bond market. Even if the
market is segmented so, the interest rate can be more in the long-term segment than the
short-term segment. So, that is why just now I was telling you the short-term bond
market is unaffected by the rates determined in the intermediate or the long-term market.
So, here you see that this independence assumption is based on the premise, that
investors and borrowers have a strong need to match the maturities of their assets and
liabilities. You see whenever we are investing in a particular segment, what this investor
is trying to do? The investor is trying to match this assets and liabilities whatever they
have to minimize the risk. So for example, if somebody wants to invest in a short period
of time the reason is; they need money for their liability. And, they want to create the
asset within that short period of time to compensate that particular liability, then the asset
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and liabilities should be perfectly matched. So, it is always assumed that if anybody
believes in the market segmentation theory, that within that segment on the basis of the
requirements of the investors the assets and liabilities are perfectly matched. So, once it
is perfectly matched they can haze out the risk from their particular investment.
So, it is very important that whenever the investor invest in that particular segment for
whatever way or whatever objective they have to manage the risk; whether the asset and
liability management is properly taking place or not, whether the asset and liabilities are
matched within that particular segment or not. If it is matched and then there is the
requirement fulfilled by the investor and; obviously, the investment horizon period can
be confined into that segment. But for some example, if the asset and liabilities are not
matched then investor are exposed to more risk.
And, that segment may not be good enough to fulfill their requirements. So, because of
that again the problem can arise or the equilibrium may not establish in that particular
segment. And finally, what will happen that we can say that the yield or the return which
is determined in that segment may not be a actual price of that particular security. Or,
equilibrium price of that particular security on that particular point of time. So, total
disconnect between the long-term rate and short-term rate is a kind of extreme theoretical
justification which is given by the market segmentation theory, which basically relies
upon the assumptions that the short-term investor will not go to the long-term segment.
And, the long-term investors will not go to the short-term segment which may not be in
the practical sense is acceptable. The reason is basically what? Those kind of mismatch
of asset and liabilities always there in that particular segment and to overcome that some
kind of spilling over may possible. But, still this particular theory is trying to answer the,
or trying to analyze the supply and demand forces of the different segments differently.
And, try to determine the interest rate in such a way by that the equilibrium can be
established and the interest rate what is prevailed in that particular segment, it is also the
equilibrium rate.
And, there is a difference between the long-term rate and short-term rate because of the
investors preferences. And, according to the investors preferences on the basis for the
term to for the different term to maturity, then on the basis of the term to maturity the
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market is highly segmented. So, this is what basically the term structure interest rate
theory talks about.
Then this is the way basically the yield curve were initially sloped, then the economic,
financial rate changed. Then here if there are so many reasons for that shape of the yield
curve, determine the supply and demand, intermediate, long-term bonds, economic state,
expected inflation, credit risk and the sales purchase by the treasury and central bank
etcetera. So, changes in these factors will change the term structure of interest rate and
that will be reflected by the different shifts and twists of the yield curves.
So, this is what basically what you can say, example if the yield curve were initially
positively sloped, then the economic or financial change that increased the short-term
treasury rates would cause the yield curve to become flatter. If the yield curve were
initially negatively sloped, then the rate change would cause the curve to become more
negatively sloped. In general, we can describe that in such an impact having a ‘tendency’
to cause the yield curve to become negatively sloped. So, these are the different
examples you can go through. So, this is the way basically the market segmentation
theory can be explained.
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So, next class we will be talking about the other different theories which explain the term
structure theory.
Thank you.
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Lecture – 15
Term Structure Theories of Interest Rate –III
So, in the previous class, we discussed about the liquidity premium theory and the
market segmentation theory. What we have seen that in the market segmentation theory,
the market is highly segmented and the demand and supply forces of the market is
confined to that particular segment only. There is a different supply side supply sources
for the short term bonds and there are different kind of different type of investor who,
demand the short term bonds. The same thing also can be present in the long term bond
market. So, therefore, there is a difference between the long term bond and the short term
bond or the return, the return from the long term bond is different from the return from
the short term bond.
But, one thing you remember that the market segmentation theory tells that there is some
kind of independent relationship exists between the long term bond and the short term
bond rates. But in the practical sense, does it really happen or is there any possibility that
this long term investor can move into the short term bond market and the short term bond
investors can move into the long term bond market?
So, those kind of scenarios also can be established can be built up. So, assuming those
kind of arguments, those kind of justifications any another theory was established that is
called the preferred habitat theory.
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What this preferred habitat theory basically explains? The preferred habitat theory
basically assumes investors and borrowers are willing to give up their desired maturity
segment and assume the market risk, if the rates are attracted remember. If the rates are
attractive, what does it mean? They know that there is a risk involved by moving from
one segment to another segment.
Because, it does not fulfill their investment philosophy or investment horizon period
there requirement, but still there ready to move if the risk is fully compensated or
adequately compensated; that means, there is some kind of spillover can be possible.
And when it will be possible? Whenever one segment investors will be rightly or
adequately compensated by the different returns what they are expecting to get whenever
they are moving from one segment to another segment.
So, in that context what this theory basically assumes that investors and borrowers will
be induced to forgo their perfect hedges and shift out their preferred maturity segment
when supply and demand conditions in different maturity markets do not match. When it
is possible? It is possible whenever there is a demand supply disequilibrium in one
segment.
If there is a demand and supply disequilibrium, it will affect the yield so; obviously, if
the supply is more demand is not there then the yield will go down, you will see demand
is there, but supply is not there, then the yield will go up. So, in that context what will
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happen that they will find that whatever expectations they have whatever return they are
expecting that particular segment and that return is not being realized because of the
demand supply inequality, then what will happen? They will be ready to move if other
segment is doing well in that particular point of time.
Obviously, these investor can sacrifice their preferred segment in that particular point of
time. And the beginning we discussed about the segmentation part. But, even if there is a
segmentation still the investors will be ready to move from one segment to another
segment whenever they feel that there is some kind of disequilibrium exists in terms of
the demand and supply in that particular segment where they are operating.
So, because of that what basically they will do, they can move from one segment to
another segment. So, that is what; that means, that is not a perfect hedges which is
existing in their segment. So, therefore, they will be preferred to go to another segment
and that particular point of time.
So, that is why we can call it that the preferred habitat theory is a necessary extension of
the market segmentation theory. So, if an economy is poorly hedged; that means, more
investor want short term investments and more borrowers want to borrow the long term.
And obviously, it is not hedged perfectly, then the market will not being the equilibrium
that just now what I was explaining or I was discussing with you that if the economy is
poorly hedged, what does it mean? More investors want short term investments, but the
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supplier basically the borrower want to borrow the long term. So, in that case what is
happening? There is a disequilibrium which can exist between them. So, there is a
disequilibrium the interest rate which can be prevailed in that particular point of time this
is not an equilibrium interest rate which can be prevailed.
So, in such cases what generally happens the short term and long term rates will change
and the market can be clear as investors and borrowers give up their hedge. They are
basically will not be interested to stay in that particular segment and they will give up
their asset liability matching concept, matching principle and they can move from one
segment to another segment. This is what can be possible whenever this market is in the
disequilibrium that is what basically can be observed.
So, here if you see how basically it exactly happens. If you see this is the example in the
long term market, the excess supply would force the issuer to lower their bond prices
why? Because; obviously, what will happen that if there is an excess supply, but the
demand is not there, then what will happen? Then; obviously, then it will reduce the
bond prices that is why it is increasing the yield and the price goes down, the yield will
go up which induce some investors to change their short term investment demands. You
see if the yield is more in the long term bond market then; obviously, this short term
investors or the market.
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If we assume that the segmentation path, then who the investor, who are there in the
short term segment, they will be attracted by the return what the long term bond market
is giving. So, why they will stick to their short term bond market? They will be ready to
move from short term bond market to long term bond market. In otherwise another
condition if you see, in the short term market, the excess demand would cause bond
prices to increase and they yield to fall or rate to fall. Then what will happen? That kind
of scenario, it will induce some of the companies to finance their long term assets by
selling the short term bond claims short term securities whatever they have.
So, the reverse can be possible; that means, here in overall we are trying to say, if there is
some kind of disequilibrium which happens in one of the segments and another segment
is more attractive in that particular point of time both investors and suppliers will be
ready to move from one segment to another segment because, the yield is attractive in
that particular segment or it is profitable for them to take their positions in that segment
instead of sticking to the segment wherever they are already now. This is what basically
the preferred habitat theory is trying to say.
So, ultimately what will happen? The equilibriums in both market should be reached
with long term rates higher than the short term rates and a premium necessary to
compensate investors and borrower or issuers for the market risk, they have assumed or
they have taken. So, if there is a movement then what will happen? Obviously, there is a
disequilibrium makes the movement.
And once the movement takes place over a period of time, this equilibrium can be
established and market can take care of to come back to that equilibrium point because
there is a mismatch which was created before, this mismatch will be overcome and
obviously, the equilibrium can be established within that particular segment. Then how it
is basically explained? It can be explained in this way.
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If you see this is the explanation what basically we can give. This is a short term bond
market, this is a long term bond market and here this is your yield curve. What is
happening? This is your supply of the short term bond, this is your demand for the long
term bond, this is basically your original equilibrium all right. So, for example, now if
you see this, the supply is more in that, then what is happening? Demand is not there so,
in that particular point of time.
So, here if you go back whatever in the assumption we have taken that the interest rate
the supply is more, demand is not there then what is happening that the interest rate has
gone down. Here the price of the bond basically increases in that particular point of time
what basically happening the there is a movement to the long term bond. So, in this case
what basically we have seen? The interested which was there in this level, the interest
rate has gone up to that level. So, here the demand has increased supplies there so,
because of that the return will be higher. So now, the new interest rate or the yield will
be more. So, now, the yield will be more in this particular segment.
So, finally, if you bring this back, this is basically your yield curve which can be drawn.
So, what is the explanation we can give in this context that the bond demand in each
segment is assume to depend directly on it is own segments rate and the rate in the other
segment. Bond supply in segment is assumed to depend inversely on it is own rate and
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the rate and the other segment that is the general notion of the relationship between the
supply and demand with the yield.
Whenever, if you see that if you go back to our previous slide what basically we have
seen that whenever there is an excess supply. The excess supply would force the issuer to
lower their bond prices; thus increasing the bond yield. So, here what basically we are
trying to say? If you see in this diagram also what here we are trying to show, there is an
excess supply in the long term bond market, the excess supply in the long term bond
market has increased the rate.
So, in that particular point of time, what has happened in the short term bond market?
The short term bond market if you again if you see what assumption basically we have
taken, the in a short term excess demand the excess demand basically has reduced this
interest rate. Here there is an excess supply, here there is an excess demand. So, in this
part, we have excess supply, here we have in this excess demand.
So, therefore, the interest rate has gone up in this segment and here the interest rate has
gone down. So, then there is a movement from this to this because the yield is very
attractive in this segment. So, there then; obviously, what will happen that again this two
in the two different markets whenever this there is a moment, this demand will increase;
then once the demand will increase, then it will compensate with the supply. Then
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finally, what will happen a new equilibrium can be established in this segment. Here
whenever this supply is there the demand is basically more.
Now, supply is not there and more people move into that then; obviously, what will
happen that the demand supply equality also can be established and equilibrium can be
established in this segment. So, in this context both the market will be in equilibrium and
finally, what you can do that you can draw your yield curve. This is what basically we
try to explain and the preferred habitat theory is trying to show.
So, here if you can summarize in this way, the excess supply in the long term market
would force the issuer to lower their bond prices, increasing the long term bond yield and
excess demand in the short term market would cause the short term bond prices to
increase and the yields to fall. So, then how it is basically explained you see in this
context that is investor prefer the short term bond. So, that is why the excess demand in
the short term bond market which increases the price of the bond, then the yield will go
down and this particularly attracts the long term borrowers. Obviously, the rate of
interest is very low, this will attract the long term borrowers more people wants to
borrow the money from that particular market.
So, here the borrowers basically prefer the long term bond here the investor, here it is the
borrower and excess supply in the long term market then the price of the bond goes
down. When the price of the bond goes down, the yield will go up; the yield will go up,
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then this attracts more investors. So, here this market will attract more borrower because
the interest rate is very low and this market will attract more investors so; obviously,
here there was an excess demand. Now, the supplier will be there in that particular
segment investor on an average prefer the short term investments, then cooperate issuer
borrowers and average prefer to borrow the long term and sell this long term corporate
bonds into that particular segment.
So, therefore, the equilibrium can be established in two different segments and the
spilling over from one segment to another segment can take place. This is what basically
the overall theme of the preferred habitat theory where they can basically assume that
there is kind of disequilibrium in the different market segments which were basically
argued by the market segmentation theory can cause some kind of movement from one
segment to another segment because of disequilibrium or between the demand and
supply within that segment affects the field.
And once the yield is attractive in another segment, this movement can take place. So,
this is what the preferred habitat theory is trying to explain. So, this is what basically this
the basic notion of the different theories which are existing or which are arguing about
the determination of term structure interest rate in the markets.
Then if you see that other thing is if you summarize that a long term bond yields
increased and short term yield decreased and some investor would change their short
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term investment demands or preference increase their demand for higher yielding long
term bonds; that means, movement down the long term bond demand curve and
decreasing their demand for the lower yielding short term bonds. So, movement up to the
short term demand curve. The decrease in short term rates and increase in the long term
rates so, induce some corporation some companies to finance their long term assets by
selling the short term claims.
This will lead to a substitution in which the companies would increase their sale of the
lower yielding short term bonds and decrease their sell on the higher yielding long term
bonds. So, this is the conclusion what we can draw from the preferred habitat theory. So,
here what we are trying to see.
So, in this kind of scenario, the there is a shift or they shifting can take place from one
segment to another segment and as well as the interest rate may not be perfectly hedged
or their risk may not be perfectly hedged within that particular segment. Therefore, it
will have the impact of on the interest rate or the yield and finally, what will happen?
The movement can make the equilibrium in both the markets and finally, accordingly the
business units make their policy or strategies by that they can minimize the risk and as
well as the interest rate of that particular system can be determined.
Then if you see that effort from all these theories in general sense whenever you talk
about the term structure interest rate, why there is a differences? For example, the there
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are some of the factors which are very general factors common factors, if anybody wants
to specify econometric model that how the term structure interest rate is determined,
what are those factors which makes the differences between the long term and short term
bonds. Then in that context we have to specify a model and that model is basically
derived on the basis of certain common or general factors which are affect the interest
rate differential between these two types of bonds.
What are those? You know that whenever you talk about the models basically what we
see your econometric model is basically defined in this way normal regression model
your y = α + βx + u. So, here your y is equal to your dependent variable x is equal to
your independent variable, beta is the slope or the coefficient alpha is the intercept.
So, here it I have shown you that one single independent variable equation. What it can
be also the multiple variable equation that if you see that if you want to write that why
there is a difference between the long term and short term interest rate or we can say that
the long term interest rate is a function of certain variables. Let you can write in the
econometric way that long term rate = α+ β1 X1 + β2 X2 + β3 X3+….+βn Xn + u
u is the error term. So, here in this case what are those X 1 X2 X3 and Xn? So, we have to
determine theoretically, we have to assume what are those possible factors which can
determine the short term and long term interest rate differentials. So, this thing whenever
you talk about; obviously, there are many factors which affect this the first factor which
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comes to our mind that is the current and expected inflation. Current inflation already
current purchasing power determines that what kind of inflation risk exist in the market.
Accordingly this interest rates in the market also gets changed already you know that
your Fisher equation already we have explained that and this is nothing, but the nominal
rate nominal interest rate is equal to the real interest rate plus inflation right that already
we know or nominal interest rate minus inflation equal to real rate that is the equation
what we have seen.
And another one is the expected inflation and; obviously, if the inflation risk is going to
be more than the interest rate also is going to be more, then how it basically works? The
what do you mean by the expected inflation? I can give you idea that expected inflation
also can we measure. So, the practical measurement of expected inflation is you can
measure this 3 years moving average, 3 years moving average of actual inflation rate can
be proxy or expected inflation.
This is the popular measure unless you can measure also through this quantitative theory
of money equation M = PT; M is equal to you money supply V is equal to velocity. P is
equal to your inflation which is price level T is equal to transaction demand for money,
then P is equal to MV/T. You can have the money supplied at high of the velocity data; it
is more or less constant for a particular period. Here the transaction demand for money
through that also the expected interest on can be calculated.
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So, here what is the argument that if the expected inflation would be higher then the
interest rate also will be higher. Then you have the transaction cost then; obviously,
whenever you are using the transaction cost argument, there are two arguments always
works in this some people argue that because, the transaction cost is lower for the long
term maturity bond because once you have taken the position, you do not have to change
the position for a large period of time or the longer period of time.
Then because the number of transactions will be low because of that the rate should be
low, but other argument is that the transaction cost tends to increase with the length of
time maturity because greater risk of long term securities to dealers who make the
market. Because, whenever anybody invest in the market or the stock broke any kind of
broker or dealer who basically invest or invest on behalf of you, they take also more risk
whenever they invest in the long term bonds; then the short term bonds.
So, therefore, the transaction cost maybe more for the long term bonds than the short
term bonds. So, therefore there are different counter arguments in that. So, keeping those
everything in the mind expecting that the long term bonds more are riskier than the short
term bonds, we should expect that the return from the long term bond also should be
higher than the short term bonds.
So, then in that particular point of time if you read the yield curve, the yield curve can
give you the answer. If whether the yield curve is downward slopping or upward
slopping that will give you the answer whether which particular argument is more valid
in that particular context, whether the transaction cost argument is valid in for first
argument or the second argument. That means, the generation cost is low for investment
in the long term bond or the transaction cost is higher for the investment in the long term
bond that is basically another thing what we can observe.
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Then we have another factors, we have default risk. What do you mean by the default
risk? The default risk is basically the possibility of the failure to meet the terms of loan
arguments of delay in payment of total non payment or the partial nonpayment of interest
and the principle amount. What is the probability that the money which should be paid is
not paid at that particular point of time.
That means, for example if the bank has given the loan, what is the probability that the
borrower is not able to repay the loan. So, that is basically we called the default risk are
in our language also, we call it the credit risk. Then obviously, if somebody has invested
in the long term bond, then bond issuer should pay the periodical coupons to them. And
finally, the principle, but what is the probability that issuer will pay this particular
coupon and principle over the period of time regularly?
So obviously, for long term bond the probability of repayment is there probability of
nonpayment is there. So, because of that the credit risk is also will be high. So, if the
credit risk will be expecting that credit risk will be high, then the investor always
demands that more yield from that type of bond. So, therefore, the long term bond should
give more yield more return than the short term bond that is why default risk is one of
the major factor, then you have the call risk. What do you mean by the call risk? Some of
the bonds of the call feature.
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So, call feature means whenever the bond was issued at that particular point of time. It
was mentioned after certain period, the issuer can called the bond on at a particular price,
but the investor does not know when the bond will be called once the threshold limit is
over. So, because of that what is happening? They feel that at that particular point of
time if the interest rate is very low and if the bond will be basically called by them. Then
whatever thing basically they are going to get that may not from the bond issuer that may
not be sufficient enough to compensate the risk what they are going to face.
Because whatever proceedings they will find there if the value they will find at that
particular point of time, the reinvestment in the market will be costlier for them or they
may not get very high return in that particular point of time.
So, because of that they expect that the interest rate for the call bonds have been called it
should be higher. Then another the most important factor is marketability. So, the
security which is easily marketable can always earn lower return than the security which
is relatively less marketable. Marketable means that liquidity whether the bond is easily
treaded in the market or there is a demand for that particular bond in the market or not. If
the marketability is high, then the return will be high. If the marketability will be low,
then the return will be low.
So, these are the inflation, then you have the default risk, you have the call risk, you have
the liquidity risk, you have the transaction cost these are the major factors which
basically determine the term structure interested theory in the practical sense and the
which makes the differentiation between the interest rate what we expect from a long
term bond and a short term bond. This is all about the different arguments or different
concepts related to terms structure theories of interest rate.
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Lecture – 16
Financial Regulation in India
After the discussion on the preliminary issues related to Financial Institutions and
Markets, we can start about the different issues which are quite important in terms of the
particular financial system as a whole.
And one of the most important issues is the Financial Regulations. And there are
different regulatory bodies which exist in India and as well as in different other
countries. And we have to see that how this regulatory bodies function and what are
those, what is the basic objective of having those regulatory bodies in the financial
system as a whole.
So, before going to discuss about the functioning of the different regulatory bodies let us
first understand why we need regulations? Why the financial regulations are required and
what are the different types of regulations always we observe in the system? And is there
any merits and demerits always involved in that particular regulation aspects. So, let us
see that what do we mean by the regulation?
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In general sense if you see the regulation is nothing but it is basically specifying the
specific rules of the behaviour or monitoring or tracking the behaviour of the different
organization or supervising the functioning of the organization. And let us see that
whether the organizations are compliance with that specific rules whatever they already
it is defined and whether the particular organizations are functioning in terms of their
basic objectives or not.
So, overall regulation consists of three things; one is monitoring, then you have the
supervision, then you have basically to see overall whether the rules and regulations is
maintained by the particular bodies in the system or not. So, these are the major aspects
which is basically involved in terms of the regulations. The regulation basically another
objective of regulation is to ensure that the social and economic policy objectives are
fulfilled. If you take for example, the banks should be regulated.
And as all of us know that the Reserve Bank of India is the regulated body for the
commercial banks. So, what is the basic job of the regulatory body? The regulatory body
tries to see that whether the particular commercial banks are following the rules and
regulations what they supposed to follow number one. And whether what kind of
functioning or whatever way the particular organizations are functioning they are
basically comply with this guidelines which is given by the regulatory bodies or not;
whether this customer grievances are addressed by the organization or not and whether
the organization is working in terms of the benefit of the society as a whole or not.
So, these are the different issues or different things as a whole always we observe in
terms of the regulation. So, the regulatory bodies the basics job is to see whether the
rules and regulations are followed or not, number 1. Number 2, whether whatever
functioning the particular organization is doing or whatever job is the particular
organization is doing whether it is going towards the overall benefits of the social sector
or not. So, these are the different issues or different things always we ensure all should
be taken care of by the regulatory bodies.
And another basic job of the regulatory bodies is to avoid the monopoly power foster the
competition and protect the consumer’s interest. Just now already I told you that if there
is a single body or already you might have idea about the monopoly market and perfect
market. So, here what we are trying to see if one individual organization exists and the
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particular services are provided by that particular organization only; then what will
happen they will ensure always they will feel that they can use their monopoly power,
and by that they can increase their profit. But, even if they are increasing the profit it is
basically affecting adversely to the consumers.
So, what these regulatory bodies try to ensure that they should not utilize their monopoly
power and they should make certain guidelines certain policies by that the market can be
competitive and the consumer interest can be protected. So, these are another objective
of the regulation always we can observe or we can see in the financial system.
So, there are three things you keep in the mind reduction of the monopoly power,
fostering the competition in the system and also to protect the consumers interest. These
are the three things always we keep in the mind or the regulatory bodies always keep in
mind while regulating these financial institutions in the overall financial system in a
particular country.
So, then we will see that what are the different types of economic regulations? You see
the regulations are different ways defined this is what basically we just now discussed
that is basically the objective of the regulation. Why the regulation is required or why the
financial institutions or markets should be regulated? But, if you see the different type of
regulation, we can define it either it is a structural regulation or it can be a conduct
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regulations or it can be social regulation. So, what do you mean by the structural
regulation?
The structural regulation basically deals with the regulation of the market structure. What
does it mean? It means that it controls the entry and exit and rules the mandating firms
not to supply the professional services in the absence of recognized qualification. What
does it mean? It basically you know every market has a structure, how the market
basically functions they have a structure. The structure in the sense, who can enter into
the market and when this particular organization can exit the market. So, those things
basically if you any kind of regulatory norms we are preparing or we are trying to
regulate those things into the system then that comes under the structural regulation.
So, thats why the structural regulation deals with the market structure of that particular
system particular in terms of the entry and exit and whether the rules and regulations are
followed by that particular organization whenever they are operating in that particular
system. Whenever we are talking about the conduct of regulation this is basically is used
to regulate the behavior of the producers and the consumers in the market. For example,
it deals with the price control, it also deals with the requirement to provide or create the
demand in the system.
And they should ensure that what kind of advertisement and other kind of things which
are done by the firms they are following the actual ethical standards. And if the ethical
standards and practices are not followed by them then that basically we can that that
organization is not going for advertisement in the ethical way. So, if you bring the
financial market into the picture for example, if you go back the structural regulation
whenever you deal with the financial market.
For example, you take the stock market, there is a market structure how the trading takes
place? When this investor can take the positions? What are the different type of orders
exist in that particular system like limit order you have the or we can say that whether the
market is a quote driven market or the order driven market, when the settlements should
takes place and what are the settlement cycle all kinds of issues comes under the
structural part.
But whenever you talk about the conduct part what basically we are trying to see in the
conduct for example, you are talking about insider trading in the stock market. So, if the
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particular organization is going for insider trading then it will affect the price. And the
regulatory bodies always ensure that the insider trading should not takes place which
means which is unethical practice. And to stop the insider trading some of the regulatory
norms has been created the regulatory norms which have been created by the regulatory
bodies.
We have to ensure that those particular markets or the particular companies who are
going under this particular system they should always follow this norms which are made
by this regulatory body in that particular economy. So, that is basically a part of the
conduct regulations which deals with the pricing which deals with the approach or the
behavior of the producers and the consumers, and I have given the example of insider
trading whenever we talk about the financial market or particularly the stock market.
Then we have another type of regulation that is called the social regulation; so what
exactly the social regulation means? The social regulation means that whether the firm
which is operating or the company who is doing the business they are following this
environmental norms or occupational or health issues which may arise, because of the
operations or business of that particular firm where the laborers or consumers are
protected. So, all kind of real sector issues or the factor which are affecting environment
factor, affecting health factor, affecting safety all kind of issues should be basically
always addressed by the social revolution.
So, any company whenever they operates or any kind of financial organization or any
other organization when they operate in a system they have to ensure that they should
abide by the rules and regulations related to the environment protection. And any kind of
hazards or any kind of health issues which may arise, because of the operations of that
particular company and also they should ensure that the consumers are protected or
consumers are safe. So, in this context if you see broadly there are three types of
regulations always we observe.
One is structural second one is conduct and third one is the social. So, these three things
always the financial organization have to follow and always the regulatory bodies ensure
that this system always work in this direction.
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Then if you talk about the theories of regulation that already all of us know that every
kind of operational and practical aspects come from the theory there should be some
theoretical motivations. There should be some theoretical understanding always we
should have whenever you operate in a particular system. Like that in the regulatory
aspects also in the regulation also there should be some kind of theoretical understanding
what do you mean by this theoretical understanding?
If you see mostly there are two board theories which always work in this particular
direction; what are those two broad theories one is public interest theories of regulation
another one is the Chicago theory of regulation because, the Chicago school of thought
has given that particular theory. So, in name of that particular school this particular
theory’s name has been given that Chicago theory of regulation. So, what do you mean
by this public interest theory?
The public interest theory basically ensures or always deals with the regulation of firms
and other economic units or economic agents which contribute to the promotion of the
public interest. That means, in a layman perspective if you try to understand what it
exactly means, it means that the firms and other regulatory or the other economic agents
should be regulated in the interest of the public. That means, the regulatory norm should
be created in such a way that the social welfare can be maximized the social welfare can
be maximized or the public interest can be protected. So, any regulation what we are
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making that should not be in the benefit of the producer or not on the benefit of the firms
and whatever regulations we are making that should be for the benefit of the public or for
the maximization of the social welfare.
So, this is basically given by the, which is called as the public interest theory of
regulation. And another theory is basically called the Chicago theory which will
basically also says little bit different. So, according to this theory the regulation is
basically a rule which is acquired or which basically should be designed primarily for the
benefit of that particular economic agent.
Little bit biased theory what basically here we are trying to say the regulation also should
be made; that means, here if you combine both the theories basically both the theories
are relevant from the regulation point of view. The regulation should be made in such a
way that the public interest also should be taken care and as well as the firm or the
particular economic agent which is operating in that particular system their interest also
should be taken care.
So, here these regulatory norms should be designed in such a way that the interest of
both the stakeholder can be taken care. So, that is why one of the theory cannot be only
applicable whenever we talk about the practicality of that particular concept. So, we have
to ensure that the regulation can consist of or can be derived from the thought of both the
theories which takes care of the public interest and as well as the other interest on the
own acquired by the industry and design and operated primary for its benefits. So, this is
what basically we call it a Chicago theory of regulation.
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Then, there are let us come to the concept of the approaches to the regulation there are
various regulatory approaches, what are those regulatory approaches? There are different
approaches the regulatory body follows we will come to that the other aspect is also there
in the terms of the approach. But the first approach is basically in terms of you might
have heard this debate between whether this particular system should have a single
regulator or should have a multiple regulators.
So, keeping that thing in the mind there are different approaches have been established,
have been created. So, if you see that the first approach is called the integrated approach.
So, what do you mean by this integrated approach? The integrated approach tells that
there should be a single regulator who oversees all type of financial institutions. And
market and provides both prudential regulation as well as the conduct of business and
consumer protect regulation.
What does it mean? It means that there should be a single regulatory body, if you
observe that here; what we are trying to say that whenever we talk about this different
approaches if you observe that whenever we talk about the single regulatory bodies
should take care of both the prudential regulation and as well as the conduct of the
business or the consumer protection regulation. What does it mean? It means that the
regulatory bodies should create the norms should create the rules and regulations for the
conduct of that particular or functioning of that particular organization and as well as
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they should make those certain kind of rules and regulation which helps the consumer for
the benefit for participating in that particular process.
That means it takes care of both supervision and as well as the prudential regulation the
two things will be integrated and one regulatory body or single regulatory body is good
enough for operating in that particular system. And another type of approach is twin
peaks approach. What do you mean by this twin peaks approach? The twin peaks
approach basically relies on two types of regulator; one is a prudential regulator and
another one is a conduct of business regulator what does it mean?
That means, there are two types of regulatory bodies; one type of regulatory body will be
responsible for creating the prudential norms and another regulator should ensure that
whether the norms are followed or not and the different economic units are functioning
in the whatever way the regulatory bodies have guided that. So, the conduct and their
prudential norms which are created by them that should be basically overseen by the two
regulatory bodies and that should not be taken care of by single regulatory body.
One regulatory body will make the prudential norms and another regulatory body will
see whether the prudential norms are basically followed by these particular economic
agents or not. So, that is basically popularly known as twin peaks approach then we have
another approach called the functional approach. So, what this functional approach
means? The functional approach basically seeks to regulate the financial institutions
based on the type of business they undertake without considering how a given institution
is defined legally. What does it mean? The regulation should be made on the basis of the
functioning of that particular organization or what kind of business the organization is
doing.
This particular; that means, the functional part of the organization should be regulated
legally, what kind of business this particular company is doing that should not be
basically considered. So, the functions should be ethical or the operations procedure of
the particular company should be ethical and the public interest has been taken care. That
basically should be ensured by the regulatory bodies whenever we are or any regulatory
body is following the functional approach. That is what basically always we observe or
we can define in terms of the functional form.
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And another approach is called the institutional approach; that means, the legal status of
an institution determines its regulatory supervision. You see whenever any organization
is made that basically is made on the basis of certain acts or certain laws. So, we have to
ensure from the beginning whatever acts and laws has been used to establish that
organization with a certain objective, whether the organization is fulfilling that objective
or not whether this particular objective of that particular organization is followed by the
functional operation of that particular organization in the system. So, that is called the
institutional approach.
So, the regulatory supervision is basically determined on the basis of the legal status of
that particular company in the system, but if you combine these are very much
theoretical in nature. And theoretically those kind of approaches give you the idea what
kind of regulatory bodies we should have or what should be the focus of, the regulatory
bodies in the system, that is what the basic job of the regulatory approaches, but
whenever we come to the practical sense.
That is exactly how the regulatory bodies work in the system; we have a single
regulatory body. There is a debate in India also the debate is still going on whether we
should have a single regulatory body or we should have the multiple regulatory bodies.
So, if you consider all those approaches. And the theoretical motivation behind the
regulation they always deal with one thing that whether this particular regulation is made
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by a single regulatory body or we should have a multiple regulatory bodies who takes
care of the different functional parts of the regulation. Like somebody can create
prudential norms somebody can supervise somebody can see the functional form of
operations of that particular economic unit’s etcetera.
So, there are various arguments whether we should have a single regulatory body or we
should have a multiple regulatory bodies. Whenever we see that if we see the arguments
in favor of the single regulatory body, the people are the advocator of the single
regulatory body is always assumed that because of single regulatory body there are
economies of scale for the regulator.
Since unification may permit cost savings on the basis of shared infrastructure
administration and support system cost. Basically we can reduce the cost. The man
power will be less, more infrastructure is not required, administrative bodies people also
will be less, and human resource requirement is also less. And we can have the single
regulatory body who have the different branches and they can operate in efficient way,
because it works with under same administration or same operational process that is
basically number one advantage what basically they agreed.
Second argument what they gave the regulated units also benefits since unification
mitigate the cost with supervised firms with diverse activities bear for dealing with the
multiple regulators. Whenever we see the multiple regulators basically one regulator
regulate one kind of market another regulator regulates another type of market.
So, then what will happen that whenever there is a chance if the two different markets
are related, then there must be a conflict that whether it should be regulated by this
particular regulatory body or that regulatory body which has happened in the Indian
context, also whenever the banks basically provide this mutual fund services or insurance
services. So, that time whether it should be regulated by the SEBI or regulated by RBI
those kinds of confusion always arise. And another issue is accountability can be
enhanced because since complexity of the multiple supervisory system could lead to lack
of clarity of the roles and consequently lack of accountability.
Regulatory arbitrage can be avoided in case of single regulator. In a multiple regulatory

regime fragmentation of supervision could lead to competitive inequalities in different
units. It can also reduce the number of regulators which can allow this scarce supervisor
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resources especially in the specialist areas we may not need more regulatory persons
whenever we have a single regulator. A single regulator can correspond more effectively
to market innovation and development.
As there to be regulatory grey areas in the sense nobody can hide the information,
because I do not know about what the other bodies is doing or other organization is
doing, because every all the information is gathered through one unified body that is
basically the single regulator. It is also aids and International Corporation as there is a
single contact point for all regulatory issues in the globalised scenario whenever we are
dealing with the multiple countries. So, that time it will not have any issues because the
contact point of regulatory issues is basically one.
So, these are the different arguments in favor of the single regulator. But there are some
demerits also. What are those arguments against this single regulator unification or
would lead to the lack of clarity? In functioning of the multiple regulator tend to have a
different objectives; the objective may be depositors’ protection for banks versus
investors’ protection for capital markets versus consumers’ protection for other financial
firms. Which firm should be protected or which agent should be more protected which
agent should be less protected? So, those kinds of confusion may arise if one body will
regulate all kind of entities.
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Concentration of the power could basically is a threat to the democratic policies it can
also go against this policies whatever we have. There maybe actually the diseconomies
of scale since monopolistic organizations can be more rigid and bureaucratic than the
specialist agencies. Then, there may be a unintended consequences of public tending to
assume that all creditors of supervise institutions will receive the equal protection, if one
body is regulating or one body is making the rules for all kind of economic units or all
kind of economic agents which are existing in the system, then maybe there is a conflict
of interest arises that which particular agent or which particular unit is more protected
which unit is less protected. So, these are the different arguments which are against the
idea of single regulator.
Another concept which has started after 2004 2005 in India and as well as other countries
that is called the financial self regulation we have AMFI we have FIMMADA all kind of
organization which comes under the self regulatory bodies. The self regulatory bodies
basically feel that, our system is matured enough that we can regulate our self. As the
association of that particular units can regulate themselves and their basic responsibilities
are regulation of market transactions, regulation of market participants, dispute
resolution and enforcement actions and pre commitment of the resources.
Like association of mutual funds, they try to dissolve the different conflicts which arise
within that particular entity or within particular system and they always want that the
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burden of those particular regulatory bodies like SEBI can be controlled through or can
be reduced through that. So, that is way there is self policing arrangements also can be
made whenever the market become much matured and the system can work in that
direction.
But, there are certain regulations the self regulatory organizations might transform
themselves into the cartels which may hamper to the competition in the system; short
term tension between the managers and authorities responsible for the self regulatory
organizations either discourage participation or diminish the long term confidence in the
market. Scarcity of institutional and human resources, they may not have that much
expertise to regulate themselves, or there must be some kind of less accountability for the
functioning, or the operations of that particular system, lack of reasonably homogeneous
institutions for a balanced structure within that particular regulatory bodies.
With limited competition in securities market self regulation may not be enough to
ensure safe and efficient markets, whenever the market is inefficient then in that
particular time the self regulatory bodies may not control or may not regulate the market
efficiently.
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And here, there are some of the acts which are related to financial sector regulation in
India starting with banking regulation act 1949 to the Companies Act 2013 then you
have the IRD Act 1999 then you have the payment and settlement systems act 2007. So,
there are different acts on which the regulations are based on the Indian system.
And here on the basis of these acts different regulatory bodies have been established
mostly it is RBI SEBI PFRDA and we have another bodies called the IRDA Insurance
Regulatory Development Authority. In the upcoming sessions we will be discussing the
functioning and of these regulatory bodies and how they function and how they regulate
the market in India.
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Thank you.
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Lecture - 17
RBI – Structure and Functions
So, in the previous class we discussed about the theoretical foundations of the regulation.
And here we have seen that we have two regulatory systems one is multiple regulatory
system, then we have a single regulatory system then every regulatory system has his
own advantages and disadvantages. But in general sense if you observe in India we have
a multiple regulatory system and there are multiple regulatory bodies which exist to
regulate the different type of institutions and the markets. So, out of the all those
regulatory bodies the oldest regulatory body is the Reserve Bank of India, which
regulates the commercial banks.
And the commercial banks is the most important financial organization or financial
institutions in the Indian system as well as the other system. That is why let us start the
discussion on how the commercial banks are regulated and what exactly the reserve bank
of India does to regulate this commercial bank and what is the basic role of the reserve
Bank of India what is the structure of the Reserve Bank of India how it basically
functions.
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So, this is the basic objective of today’s discussion. So, let us start with that what do you
mean by or what is Reserve Bank of India and when it was established and what is the
structure of that organization then we can move into the functional part? You see that
whenever we talk about the Reserve Bank of India or the structure of the Reserve Bank
of India already I told you the Reserve Bank of India is central bank of this country or of
India.
And is the centre of the Indian financial and monetary system all kind of financial and
monetary mechanism basically works with this Reserve Bank of India or starts with this
is the apex body who takes care of all monetary and financial aspects of that of this
particular country. This functioning of the Reserve Bank of India started from April 1st
in 1935 on the terms of the Reserve Bank of India Act 1934. That is why it is one of the
oldest regulatory bodies which is working in the Indian financial system.
And whenever you talk about this structure all of you very much aware about this that
the head of the organization is the governor and the governor and there are 4 deputy
governors, who always work on behalf of the Reserve Bank, they are appointed by the
central government. How the bank is managed? The banks structure is like this, the bank
is managed by central board of directors and 4 local boards of directors and a committee
of the central board of directors.
So, this is the way there is a central board of directors who basically looks after the
different policy issues and what inside whenever we go to this system what we have seen
that this hierarchy is like this. So, we have a governor we have 4 deputy governors and
each department is basically aided by executive directors then the other bodies work in
that particular system. But, if you see the Reserve Bank of India the final control of the
bank basically always rest upon the central board which comprises the governor 4 deputy
governors and 15 directors nominated by the central government.
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So, there are 15 directors who are not a part of this particular bank they are the
specialized people or the expert people from the different areas. And the deputy governor
and governor; obviously, a part of the central board and that is the way this Reserve
Bank of India basically functions and inside hierarchy. If you go that after governor
deputy governor we have the executive directors and directors and other people and they
always work for the functioning of the Reserve Bank of India at present it is always
subject to change.
But presently Reserve Bank of India has 26 departments and 28 regional offices which
work to regulate the financial system or monetary system. As a whole we can say
because the bank is the most important organization which always we observe in the
financial system. So, this is the way the structure of the Reserve Bank of India basically
looks like. So, if you see that what is objective of RBI?
RBI is established long back in 1935 so, what was the basic objective and now what is
the objective, whether there is a change? And if you see overall here what really I have
summarize that over the period of time what are the broad objective the Reserve Bank of
India has. And how the Reserve Bank of India is working in this particular system and
what is basically they are trying to do. The first and foremost thing is basically what the
Reserve Bank of India does that is basically to maintain the monetary stability. So,
whenever you talk about monetary stability you see that whenever you talk about
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monetary stability, how it comes? If you remember in economics we have the monetary
policy and we have the fiscal policy.
And whenever we talk about the Reserve Bank of India, Reserve Bank of India takes
care of the monetary policy and the government basically takes care of the fiscal policy
the finance ministry mostly is responsible for the conduct of the fiscal policy. So, as the
responsible authority for the smooth conduct of the monetary policy the Reserve Bank of
India always ensures that the monetary stability of the economy can be maintained.
Whenever you talk about the monetary stability; the monetary stability means we are
talking about the price stability.
So, the basic objective of Reserve Bank of India is to make this price level stable in that
particular country in a particular period of time. So, this is the first objective on the basis
of that Reserve Bank of India was established. Second one; to maintain the financial
stability and ensures sound financial institutions. So, that monetary stability can be safely
persuaded and economic unit can conducts their business with confidence. It is a very
broad objective you see what do you mean by financial stability? Financial stability is a
buzz word particularly after the crisis people are much more concerned about the
financial stability, but already what again and again I am telling you that whenever you
talk about the financial stability.
Financial stability means in Indian context that is basically stability of the banks mostly.
If the banks are stable, capital base of the bank is basically adequate and enough to
observe all types of risk what we are facing in the bank then automatically what we can
conclude that the financial sector in Indian context is stable. So, what RBI basically is
tries to ensure, the RBI try to ensure the financial sector in India should be stable, at least
the banking sectors should be stable the credit risk.
The instability of the banks and failure of the banks should be minimized as bank is the
payment gateway of this particular system. So, here what is happening the banker stable
automatic, what will happen that the monetary stability can be maintained and people
have the confidence on the market. And all of you know that the behavioral aspect is
quite important for the function of the market if the consumer confidence or the people
confidence on the market will be more then automatically what will happen that the
functioning of the marketing will be smoother.
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And, the operations and all those activities which is happening in the system that will
basically work in a better way so, therefore, we have to ensure that the financial stability
should be there. Financial stability mean the stability of the banks particularly the most
important organization.
In the economic system then once this is stable then the monetary stability can be
maintained, consumer confidence and people confidence will be higher than the market
will be working in a better way. To ensure or to maintain the stable payment. So, that the
financial transactions can be safely and efficiently executed, because already know that
the commercial bank has the only payment gateway or the most important payment
gateway in this particular system.
Then RBI ensures that the payment system should be stable; there should not be any kind
of hassles in terms of the transactions. If the transactions are hassle free the people
confidence on the market will be more. If the people confidence on the market will be
more automatically what will happen that the safely and efficiently all kind of transaction
can be executed and participation in the market also will increase.
And more the participation; obviously, will tend to the efficiency in the market because
market will be more competitive and if the market will be more competitive in that sense
whatever price and whatever economic output what we are determining that will be
actual equilibrium output what we can get. So, therefore, the stability of the payment
system is one of the major objectives of the Reserve Bank of India.
And another most important thing to promote the development of the financial
infrastructure and to ensure or to enable them to operate efficiently. So, here what we can
say that what do you mean by the financial infrastructure? Financial infrastructure means
establishment of new banks establishment of the new branches of the commercial bank
establishment of the different organizations which can help the trading. And as well as
help in increasing the efficiency of the market like the example of CCIL clearing
corporation of India limited which was established by RBI for the trading for the
government debts.
And as well as to some extent for the foreign exchange and the derivatives instrument to
some extent not derivatives mostly it is related to the government debt there are. So, that
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is why the RBI’s basic job is mostly deal with establishment of the new infrastructure
which can help for the functioning of the market in a better way also.
Another one is to ensure that credit allocation by the financial system broadly reflects the
national economic priorities and the social consensus. You see whenever the commercial
banks give loan to whom they are giving loans they are giving loans from where they can
maximize their benefits, they give the loans they try to find out the customers to whom
they can get more returns, but that may not also fulfill the social objectives there are
some small units like small farmers small business units.
So, they may not be able to pay that much kind of money or that much kind of interest
rate what the bigger commercial units are able to pay. So, then if there is no regulation
there is no such kind of a norms which are there where this lending also, the credits also
should be given to these kind of entities than those entities can be marginalized and those
entities cannot grow in this particular system .
Because, the Indian economy is mostly based up on the rural economy and most of the
people live in the rural areas hence also long before our maximum percentage of the
share of GDP is coming from the agricultural sector. So, keeping that thing in the mind
the commercial banks should provide the loans to these kind of sectors the Reserve Bank
of India also make the policies which is basically related to the societal concerns.
So, at a time all kind of sector should grow simultaneously, we can say that is the basic
objective, the basic notion, our motto of this Reserve Bank of India and to regulate the
overall volume of money. And credit in the economy with a view to ensure reasonable
degree of price stability that already I have explained you because monetary stability
leads to price stability. So, that is what basically the major broad objectives on which
basis the Reserve Bank of India was established. So, now, we will see that how this
Reserve Bank of India basically functions.
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What are those basic functions of RBI? There are many functions RBI does so, I will
highlight some of the major functions what RBI basically follows all of you know that;
obviously, RBI is the note issuing authority. Whether RBI issues the note or not every
common man and everybody able to know that after this the demonetization and all these
things because everybody was watching and reading in the newspaper that RBI is trying
to change this note they are going for the new 500 notes and all these things or hundred
rupees notes.
So, if you see that; obviously, the basic function of RBI the first and foremost important
function of RBI is note issuing authority except the 1 rupee coin. The 1 rupee note of the
coin is not basically made by RBI; this is issued by this finance ministry apart from this 1
rupee note the other type of notes like 10 rupees, 5 rupees, 20 rupees to 2000 rupees,
these are the denominations which are existing in the system.
Now, 50 10 20 50 100 500 and 2000 so, only RBI has the authority to issue the notes
other than 1 rupees notes and the coins that is what already I have been mentioned you.
So, the prime function of the RBI is to issue notes it is the note issuing authority number
1. Number 2 it is also called as the government banker because, RBI is the banker to the
central and state governments.
It provides all kind of banking services to the government such as acceptance of deposits
withdrawal of funds by cheques making payments as well as receipts and collection of
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payments on behalf of the government transfer, transfer of the funds and management of
the public debt. So, all kind of banking operations what always we do with the
commercial banks the same kind of banking operations the Reserve Bank of India does
with the central government and as well as the state governments.
So, anytime the central government needs money they can borrow from RBI, anytime
central government has some reserve money, they can keep it with the RBI any kind of
foreign exchange transactions and everything anything what the central government tries
to do or any state government tries to do. So, every kind of banking operations is done by
the Reserve Bank of India only.
So, the Reserve Bank of India that is why popularly called as the government’s banks or
it is the government’s banker. So, in that constant what we say that without the reserve
bank the financial transactions of the central government may not be possible because, in
a holistic way the countries bank is or the central governments bank is basically the
Reserve Bank of India at the time of requirement. They provide the money and at the
time of surplus they deposit the money and they also act as the agents on behalf of the
central government whenever the foreign transactions are basically made. So, this is the
way that is why they are called as the government banker.
Then, another function of RBI already I told you they manage the public debt they play a
very active role for management of the public debt.
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How they manage? The Reserve Bank of India basically manages the public debt and
issues the new loans on behalf of the central and state governments. It involves issue and
retirement of rupee loans, interest payment on loans and operational matters about debt
certificates and their registration what does it mean? It means that whenever any kind of
loans are taken by the central government or the state government mostly it is central
government.
All the loans are basically taken through the Reserve Bank of India. Number 1 and
whenever they want to raise money from the public, they sell the securities through
Reserve Bank of India on behalf of the government. The government securities are sold
by Reserve Bank of India, whenever they try to extract or try to absorb the money from
the market what they do they sell the bonds and get back the money. And whenever they
try to inject the money into the system what they do they basically buy the bonds from
the public and give them the money.
So, either buying and selling of the bonds either increase the money supply, decrease the
money supply, management of the debt from the different agencies all these things of the
government are done through the Reserve Bank of India. So, they play very active role
for management of the public debt which is done by or basic job is done by the RBI. The
RBI plays a vital role for the smooth functioning of the public debt management system
in the country.
Then; obviously, this is also called as the banker’s bank like; RBI. Whenever any
commercial bank need money, from where they get the money? They get it from RBI
only. So, if you see the bank basically controls the volume of reserves of commercial
banks and there by determines the deposit and credit creating ability of the banks. You
might have heard whenever there is a change in the policy by the Reserve Bank of India
it affects the functioning of the commercial bank, why?
Because, through that commercial bank tries to cover, we will discuss more about this
whenever we talk about the instruments or the policy instrument where RBI uses to
control the money supply to make the price stable. So, that will come later, but here what
we are trying to say RBI controls other commercial bank like State Bank of India your
Punjab national bank, Syndicate bank all kind of banks which are there through different
ways two different mechanism to different instruments.
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Therefore, what RBI basically allowed; the Reserve Bank of India opens the current
account in banks with itself and enabling the banks to maintain cash reserves as well as
to carry out interbank transactions through these accounts.
Every commercial bank can transact with another banks they should maintain a certain
kind of cash reserves with Reserve Bank of India that is why in our term called CRR.
The basic objective of CRR is to decrease the probability of default of the liquidation of
the banks in the future although that does not carry an interest, that we will discuss more
afterwards. Here if you see basically every commercial bank has an account with the
Reserve Bank of India.
So, whenever they need money they can borrow also from Reserve Bank of India
through different ways such as through liquidity adjustment facility, through repo
operation etcetera. And whenever they have any surplus money they can also park their
money with the RBI and the inter bank transactions can be settled by the transfer of
money through electronic fund transfer system which is basically real time gross
settlement system which is operated through RBI .
So, every commercial bank has an account with the RBI and all the transactions which
they make either through inter banking system or this access reserve whatever they have
or any kind of excess money what they want to borrow from RBI everything is done
basically from the RBI itself. So, therefore, whenever the commercial banks are in
security of the money or whenever they have the surplus of the money they depend upon
the RBI and because of that they are called the bankers bank.
So, RBI is the bank of the all those bankers that is basically another function of Reserve
Bank of India. So, that is why they are the most important organization in the financial
system particularly in Indian context.
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Already I told you as a regulator, they are the supervising authority. So, what kind of
supervisor the whole Reserve Bank of India plays? What kind of functions they do?
What kind of jobs they do to supervise this banking system first of all. It issues the
license for these establishments of new banks, you might have known those 2-3 years
back we have. So, many private banks got the license. So, only Reserve Bank of India
has the authority to issue the licenses by going thorough process they have to see
whether this particular entities are able to do the banking operations or banking business
or not.
So, keeping those things in the mind what they do they can issue the licenses for the
establishment of the new banks. Even any bank whenever they want to set up a new
branch for that also Reserve Bank of India provide the licenses and the licenses have
been given after this thorough mechanism or they are going through the actual process
whether the banks are fulfilling those criteria or not.
And this RBI ensure that this particular bank is able to fulfill those requirements then
only the license can be issued to them. It prescribes the minimum requirement regarding
the paid up capital and reserves transferred to the fund maintenance of cash reserves and
other liquid assets. You see how much loan one individual can take that regulation RBI
makes, how much industrial loan can be directly given by commercial bank and if more
than that then how much money should be above the limit and above which monetary
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limit the RBI should interfere or the commercial banks should take the permission from
RBI?
This is basically done to smooth control of the operation or to make this financial system
more stable. It also inspects the working of banks in India as well as Abroad in respect of
their organization set up branch expansion, mobilization of deposits where the money is
invested.
What is the credit portfolio management they are doing? How much loan they are
giving? How much is the NPO? How much money can be recovered? What kind of
credit appraisal policy the banks are following? What is the performance of the banks?
What kind of credit planning, the banks are doing? What kind of manpower planning or
training the banks are doing all kind of integrity issues which is responsible or which is
important for the commercial banks those are all basically supervised by the RBI.
It conducts the investigation from time to time into complaints, irregularities and frauds
in respect of the banks, all kind of frauds basically if any kind of irregularities which can
happen. So, for all these things basically investigation is done by RBI first. So, it also
controls the appointment, reappointment, termination of the chairman and chief
executive officers of the private sector banks because the public sector banks CEO’s and
chairman are appointed by government.
The RBI is responsible for the private sector banks and RBI’s approval is very much
required. It is also approves and force the amalgamations means actually if some of the
banks are not functioning well their performance is not basically good the RBI can tell
them to merge or RBI can tell this from particular banks to merge together to get rid of
this kind of problems and to improve their performance in the future. So, this is what
basically what we are talking about the supervising roles.
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And another major function is exchange control. RBI is the exchange control authority
because all foreign exchange transactions in India are done through Reserve Bank of
India, only it administers the foreign exchange control. In today’s exchange rate system
mostly India follows a managed exchange rate system.
If there is any kind of instability in the exchange rate fluctuations then RBI can intervene
into that to control that. It also manages the foreign exchange reserves, whatever we
have. It has also the responsibility to interact with all those foreign bodies like a IMF,
World Bank and Asian development bank etcetera for any kind of suggestion or any kind
of functional relationship in time at the time of requirement.
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So, RBI has authority to do that; it is also responsible for formulating the prudential
norms. RBI formulates various norms to create and maintain an efficient well-
functioning financial system in India. So, all those kind of market disciplines all kind of
regulations with respect to commercial banks are created by RBI. I can give an example
for example, in terms of the market discipline the commercial banks are always directed
by RBI to disclose their balance sheet in a periodical basis if they do not disclose that
balance sheet then the adequate amount of fine or penalty can be imposed upon them.
So, like that what are those disclosure, what are the thing they should disclose and which
are the things is beneficial for shareholders and all kinds of others stakeholders of that
particular bank. For everything the rules and regulations or norms are basically
maintained by RBI and RBI also ensures that they should follow this; the CRR should be
maintained. And as well as they should maintain this capital adequacy ratio norms which
is given by the Basel. So, all kind of things norms basically always monitored and
regulated by RBI. And already I told you these are the promoter of the financial system,
they help in mobilizing the savings, they also render the developmental in promotional
services.
And establishes also already I told you they gives this guidelines to provide these loans
to the different priority sectors and also RBI can establish the different specific
organizations to develop the particular sector like NABARD. NABARD was established
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in 1964 by the Reserve Bank of India to promote the agricultural sector because, the
agricultural sector was not that developed. So, specific organization has been established
to develop that particular sector. So, like that there are different kind of organization can
be all set up by RBI to promote this particular entities which are not developed in that
particular system .
Already I told you it regulates the supervision by the payment system; it created a board
of regulation and supervision of payment in settlement system as a committee of the
central board, your new department called department of payment in settlement system
was constituted to assist this particular committee in performing. These functions and;
obviously, it conducts the monetary policy which is the most important or vital thing
what the central bank does because from the beginning we said that the monetary
stability is the prime objective of the financial stability of the Reserve Bank of India.
So, that is how the Reserve Bank of India conducts the monetary policy. How they will
ensure that price can be stable? How they can ensure that the bank should run in an
efficient manner? So, this is the way basically that is why the RBI basically is the
regulator of both money and credit.
So, the most important job RBI if you see overall three things they do they create the
rules for the banks, they monitor the exchange rate and control that and control, they are
the exchange rate controlling authority. And as well as the all kind of transaction foreign
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exchange transactions basically drawn through them and the most vital thing is they are
the government bank and also banker’s bank.
And the most important thing is they are the implementer of the monetary policy in the
system and they conduct the monetary policy in such a way by that monetary stability
and financial stability can be enforced. So, in the fourth coming classes we will be
discussing about the instrument of monetary policy and how the RBI basically conducts
the monetary policy to make this price level stable and to increase the output of the
economy.
Thank you.
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Lecture - 18
Monetary Policy Instruments
Good morning. So, in the previous class we started the discussion on the Reserve Bank
of India, its about the basic functions of Reserve Bank and as well as the major
objectives of the Reserve Bank. And, one of the major objectives of the Reserve bank is
the conduct of the monetary policy. Because, as you know that there are three different
measure policies always we observe for functioning of the economic system: one is
monetary policy, second one is fiscal policy third one is the foreign exchange policy.
So, this monetary policy is totally regulated and controlled by the central bank and
Indian context this is the Reserve Bank of India. And, the fiscal policy is controlled by
the government itself and the foreign exchange policy also is governed by the Reserve
Bank of India. So, there are the three major policies always we see. So, today we will be
discussing about different type of instruments what the central bank always uses for the
conduct of the monetary policy.
So, let us see that what are the basic objectives of the monetary policy in the actual
sense. So, as you know the basic objective of monetary policy is to increase or accelerate
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the economic development in an environment of reasonable price stability. Because, if
you see that always we have major two objectives: one is your price stability and another
one is increase in the growth rate.
But particularly in the country context we call it the GDP growth rate, but the price
stability and GDP growth rate basically does not go together. Why? Because, you see if
for example, we are changing the interest rate. So, if we are declaring the interest rate
then what will happen the money supply will increase because, more banks can provide
the loan or more demand for the loans will be there.
The money supply will increase, then investment will increase; if investment will
increase, then the output will increase. Then if output will increase then obviously, the
growth rate of the GDP will increase. But at the same point of time, if your money
supply is increasing it will also increase the price level, so that means, there will be
inflation. So, this is a very tricky task for the Reserve Bank or the central bank that
whatever way the monetary policy can be implemented; by that both price can be stable
or the price stability can be maintained and as well as the economic growth also should
not be hamper.
So, this is the major objective whatever we have in terms of the monetary policy. And,
second one is to develop the appropriate institutional set up to aid this process and how
this particular process will work because, there is a channel which works in this
particular context. And, for the smooth operation of this particular channel we need one
appropriate institutional set up and the Reserve Bank of India is a responsible to see that
in this context how the commercial banks are working.
What are the effectiveness of this bank credit channel in this particular system? And all
kinds of instructional set of always looked upon by the central bank for this smooth
conduct of the monetary policy of that particular country; that is also another thing we
have to keep in the mind.
Then, another objective of the monetary policy is to achieve the financial market
stability, and again and again we are telling that the market should be stable; that means,
you see in a general sense stability means basically what. Always we ensure that the
market should be fluctuating, the market should be volatile. Why volatile? Because, this
is a desired concept unless the market is not volatile may be people will not be interested
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to invest in that particular system. But, the volatility is required up to a particular level or
a particular range.
Let the volatility can be accepted to a particular range. But, beyond that limit if the price
is fluctuating then we can say the market is unstable; that means, too much volatility
leads to instability. So, volatility is a desired concept desired phenomena, but whenever
we are talking about too much volatility then it is basically an undesired concept or
undesired phenomena.
So, basically in a true sense volatility is required, but whenever we talk about the
instability, it is basically undesired. So, one of the basic objective of the monetary policy
is that they can control that particular volatility by that the market can be stable. So,
these are the three major objectives of the monetary policy in India.
Then, if you see the next is how the framework for the monetary policy in India basically
works. Already I told you that the monetary policy is basically works in a particular
system, there is a proper framework is existing for the conduct of the monetary policy.
So, again we can go back to our discussion; that whenever you talk about the policy there
are two debates. The basic instrument is we have to change the money supply. If the
money supply can increase or decrease depending upon the investment, output, and price
stability all these things basically get affected. So, the question here is whether the
money supply is an endogenous or it is exogenous.
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What do mean by endogeneity and exogeneity? The endogeneity means basically that
depends upon some other variables. If you want to change then how this particular
endogenous variable determined, then that is Y, then Y should be a function of x. And,
here the x is basically what the exogenous variable which can be controlled by the
regulator, if you want to change Y then you have to change the x.
So therefore, the question here is whether the money supply is endogenous or it is

exogenous. If you go by the economic theories there is a debate that whether the money
supply is endogenous or money supply is exogenous. So, according to Keynesian
framework money supply is exogenous. Whenever the regulator or the central bank
wants they can change that money supply on the basis of the requirement to control the
price or to increase the growth rate. But, the question here is in a true sense if you see the
money supply is not exactly exogenous or money supply cannot be exogenous.
Then why this money supply cannot be exogenous? If you talk about in our countries
context that there are two factors which affect the money supply, but this is not in the
control of the regulatory bodies like Reserve Bank of India. What are those factors? One
is the inward remittances of the foreign exchange. How much foreign exchange is
coming to India, they enclose and the requirement of credit for financing the purchase of
the food grains.
But the requirement of the credit for financing the purchase of the food grains that
depends upon the various other external factors like monsoon, then the demand for that
particular food grain all these things. So, how much production will be there in that
particular point of time whether the particular country has to buy the extra product or the
particular is an excess amount of the product which has been produced. So, there are
different factors which are responsible for this.
So, the RBI or the any central bank cannot decide that how much money is required to
buy the product at that particular point of time or how much loan can be given or should
be given to procure that amount of the product particularly food grains. So, this is not in
the control of the central bank or the RBI and another one is how much foreign exchange
is coming to India in that particular period; and what those two variables, how that
impacted the money supply.
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So, in a practical sense the money supply cannot be exogenous at least for the Indian
context because, the total money supply cannot be controlled by the regulator. So, if the
money supply cannot be directly controlled by the regulator or cannot be changed by the
regulator, then what basically we are thinking of? We are thinking of a framework and
how that particular framework looks like; if you see this framework we have a
framework like this. We have to change certain instruments, there are certain instruments
has to be used to change the money supply.
So, these instruments will have the impact on the money supply, on here the money
supply and bank credit are the intermediary targets or intermediate targets. These are the
two variables which are the intermediate variables in our context. Then finally, if the
money supply gets changed and the bank credit gets changed or the bank credit mean the
amount of loans where the banks are giving; if those things will change this will have the
impact upon the investment and finally the output. So, this is the way the channel works.
So, that is basically you call the monetary policy framework.
So, then the question is that intermediate target is money supply and the bank credit and
final outcome variable is the either price stability or the output. And, the question here is,
what is the instruments through which monetary policy can affect the money supply and
as well as the bank credit? So, these are basically we call it the monetary policy
instruments. So, our basic discussion is basically to try to identify which are those
instruments the commercial banks or the reserve bank always uses to change the money
supply or the bank credit. And finally, the output variables like your price stability or
inflation and the GDP growth rate get affected.
So, let us see that what are those instruments basically we used as the monetary policy
instruments for India?
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So, there are many instruments we have over the years the Reserve Bank of India is
using as the instruments for the monetary policy; the first instrument which is very
popular in the market that is called the open market operations. What basically the open
market operation means, the open market operation in an actual sense is nothing, but it is
the buying or selling of the government securities to adjust the liquidity conditions in the
market. What does it mean?
If for example, the money supply or liquidity is very high in the market. If the liquidity is
very high in the market, then what this Reserve Bank of India can do. The Reserve Bank
of India can sell the government dated securities. So, if they sell the government security
then what they can do, they will suck out the money which is available to the public to
them.
Against that they will provide these bonds or government securities and money will be
basically going to the Reserve Bank of India. So, the total circulation or total availability
of the money in the economy or with the public will go down. Then obviously, what will
happen it will basically reduce the money supply and the other channel will work
accordingly. The reverse can work whenever there is an illiquidity or the money supply
or the liquidity condition in the market is very low or there is illiquidity in the market
then what Reserve Bank of India can do.
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Reserve Bank of India will buy the securities from the public or from the market. So, if
they will buy the securities from the market then what will happen; they will pay them
and against the bond whatever these banks and other market participants are holding,
they will take that bond with them. Then more money will be coming into the market and
therefore, the money supply or the liquidity of the market can go up.
So, the open market operation is nothing, but buying and selling of the government
securities to create the liquidity or to inject the liquidity or to observe the liquidity from
the market. This is one of the instruments which is used by RBI to change the money
supply in the economy. Then another one is bank rate, by changing the bank rate also
which was popularly used before. Nowadays it is not a very popular instrument which is
used to control the money supply, but in 90s it was used as a popular instrument, as the
popular monetary policy instrument to control the money supply.
What is the bank rate? The bank rate is basically a rate at which the commercial banks
can borrow from the Reserve Bank of India. But the bank rate is relatively a long term
rate; the bank rate does not change frequently. The bank rate is the rate at which the
central bank allows finance to the commercial banks or in otherwise the commercial
banks can borrow from the central bank. So, if the bank rate will increase then the
availability of the money supply will go down.
Because, the bank rate will increase, then the market lending rate will increase. The
market lending rate will increase then the demand for money will go down, then
available of money to the public or to the market also will go down then the money
supply will go down. And, this reverse thing can happen whenever the bank rate will be
less or bank rate will be low. So, there are two instruments.
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Then, the other instruments are if you see that another one instrument is the cash reserve
ratio, which is again and again used by the Reserve Bank of India to control the money
supply. What is the cash reserve ratio? Cash reserve ratio is nothing, but it is the cash
which the banks have to maintain with RBI as a certain percentage of their demand and
time liabilities. Here if you remember, what do mean by this demand and time liabilities?
It is nothing, but the deposits your saving deposits or the time deposits or the fixed
deposit.
So, certain percentage of the total deposit has to be kept with the RBI as the reserve. It is
6 percent or 7 percent; it varies on the basis of the liquidity condition in the market. And,
here if your CRR is increasing then availability of the money to the bank will go down
then; obviously, your money supply will go down. If CRR will be less or will decline
then money available to the bank will go up then money supply will go up. So, this is
also the way the Reserve Bank of India by changing the cash reserve ratio can control the
money supply.
Then, another one is your statutory liquidity ratio, which is popularly known as the SLR.
What does it mean? According to the RBI regulations there is a mandatory percentage of
the total deposits, what the commercial banks have to invest in the government bonds
and other approved securities; mostly the securities which are highly liquid. Certain
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percentage of the money should be invested in the government securities or highly liquid
bonds.
But the question here is, why it is so? It is so basically to restrict the expansion of the
bank credit because, the commercial banks may not be free to use their funds in whatever
sector they want to use it. To increase the banks or to augment the banks investment in
the government securities and to ensure the solvency of the banks which are very
important. What does it mean? The solvency of the banks means, once stipulated amount
of the money is invested in the government securities, then if there is any kind of crisis
or any kind of instability probability is there, then, what will happen.
Those kinds of instruments are risk free more or less there is a perfect kind of guarantor
for that because this is guaranteed by the government. So, in that context what will
happen the bank can basically get out of that any kind of liquidation or the insolvency?
So, that is one kind of security what the bank always should have, if they have invested
some funds in the government securities and as well as also controls the money supply.
So, this is the basic objective of having the SLR instruments or SLR kind of instrument
for conduct of the monetary policy.
Then which are those other instruments? These other instruments are the direct credit
allocation and the credit. You see the Reserve Bank of India also control the distribution
of allocation of the credit among different sectors. There are some priority sector, some
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amount of loans should be given to the priority sector and there are some sectors which
are highly risky sectors. The loans given to those sectors also should be controlled, that is
basically this guidelines what the Reserve Bank of India has given. So, by controlling
this what they can do, they basically go for a fixation of specific and direct quantitative
credit ceiling and credit targets.
Then given the limit that how much loans can be given to that particular sector or
particular company or particular individual and as well as which are the sectors also
should get some loan. Like the priority sector, like the agricultural sector, and small scale
industries and etcetera which restrict the drawing power of the borrowers under the cash
credit limits. Certain prescribe credit deposit ratio also already given in respect of their
rural and semi urban branches separately, that mean the 60 percent credit deposit ratio
should be there. Credit to deposit ratio should be at least 60 percent and that credit
deposit ratio can vary across the regions.
Some of the banks may be in the rural areas some of the banks in the urban areas. So,
depending upon the credit worthiness of the customers or the individuals or the different
kind of borrowers the Reserve Bank of India has fixed this credit deposit ratio for the
different type of customers. So, this is what basically the one of the instrument through
which they can control the money supply in the system. Then we have another
instrument we have selective credit control. Why basically the selective credit control is
there; because, they are use to reduce supply credit in certain directions and to encourage
it in desired directions. Why? Basic objective of selective credit control is to stop the
hoarding.
What is basically happening at the time of low price sometimes what has been observed,
some of the producers can hoard that particular product by taking more loans from the
banks and in the future period they can sell it under the higher price. So, RBI basically is
ensuring to maintain the price stability. What basically RBI does? What is the central
bank does? They can regulate, they can control that particular entity or particular sector
in terms of providing the loans.
So, if the loans can be restricted automatically it can discourage the hoardings and as
well as the price fluctuations also can be controlled through that. So, the selective credit
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control is also a very quiet old measure and RBI also use it as one of the monetary policy
instruments whenever it is required. Then what are those other instruments?
The other instruments are like we have the credit authorization scheme. Here under this
scheme what basically happened, the credit proposals for rupees five crore and above in
the case of working capital and two crore and above in the case of term loans has to be
submitted to the RBI for the post sanction scrutiny; because, every companies need the
working capital finance. If the working capital finance and the day to day finance, if they
want from the commercial bank and with the amount of money is going below the five
crore they need the prior approval from RBI; the bank should take approval from RBI
this is the number 1.
And number 2, if it is an individual entity who taking the loan more than two crore then
what is happening for that also the prior approval is second from RBI. And, through that
process RBI tries to control that what kind of customer is taking the loan and for what
purpose the loan is given. It has two objectives: one is to control the non-performing
asset in the system and as well as to control the amount of money supply to the system at
a particular point of time. So, this is basically defined as the credit authorization scheme
under that we have credit monetary arrangements through which this particular
mechanism works. Then we have a process of credit planning. What do we mean by the
process of credit planning?
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You see each bank is required to prepare a realistic annual credit budget, incorporating
estimates of the volume and growth of deposits and other resources and the demand for
credit. That means, RBI has given the kind of information or given certain kind of
notification to all the commercial banks to prepare the budget for their credit allocation,
and as well as that what kind of deposits they are expecting in that particular year.
Forecasted figure of the real increase of the deposits or the expected demand for the
credit that thing and all those details has to be prepared from the beginning.
And once the proposal is ready it is subject to change, but at least the proposal from the
beginning should be ready. And proper planning has to be done to ensure that the money
supply in the system and a particular point of time can be controlled. So, in this context if
there is a proper planning which exist then that can go to RBI and RBI is ensuring that
this is the way the money supply is going to be there in the next period. Then moral
suasion means what, it is basically writing letters holding discussions between RBI and
the banks about the trend in the economy in general. And money credit and finance in
particular about the measures which ought to be taken from time to time in light of the
different objectives.
And, the objectives are basically nothing what the price stability and the increase in the
growth rate. So, this is basically informal kind of way of controlling the money supply.
Because, if RBI feels that the bank needs advise or they should understand or what is the
economic scenario. And, what kind of demand should be there for the credit and as well
as whatever amount of deposits should be there in that particular system or that particular
point of time. So, depending upon the economic conditions what basically the RBI and
banks decide that how much loan can be given in that particular point of time. So,
because of that the moral suasion is one of the instrument which also can be used.
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Then the most important instrument which is basically done by RBI in today’s context
that is called the LAF: Liquidity Adjustment Facility. You are already aware about the
reverse repo rate, repo rate. So, these are the different rates which are used under this
LAF or the liquid adjustment facility and it is basically manages the liquidity on a day to
day basis. So, the operations of LAF is conducted by way of repurchase agreements, repo
and reverse repo with the RBI being the counterparty for all the transactions.
What basically happens repo contract is basically an instrument for borrowing funds by
selling securities with an agreement to repurchase the said securities and mutually agreed
future date at an agreed price which includes interested for the funds borrowed. That
means the commercial bank will borrow from RBI. Here the commercial bank will
borrow from RBI with an agreement that the security can be repurchased further with the
interest rate. And, the reverse repo rate is, which is the lending of funds against buying of
securities with an agreement to resell the said securities on a mutually agreed future date
at an agreed price which includes the interest rate at the funds lent, it is reverse.
This repo rate is charged by RBI and the reverse repo rate is basically charged by the
commercial bank. So, if the commercial bank wants to borrow the money for overnight
basis from RBI they wants to borrow at a repo rate with the agreement that the money
can be again given back to the RBI. And, again if there is any express kind of money
which is available with the commercial banks then RBI can take out that money from
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commercial bank, it can be parked in RBI. And, that is basically rate for that RBI with
paid from interest to the commercial bank that is basically the reverse repo rate. And, the
reverse repo rate and repo rate both are basically always change from time to time by the
Reserve Bank of India.
So, using this repo rate and reverse repo rate, a monetary policy operating procedure has
been established. In the current context if you see the RBI wants there should be
corridor. So, this total one is basically your corridor. So, here in the corridor they have a
single policy rate that is the repo rate and in the below which is the floor that is the
reverse repo rate and the above they have a marginal standing facility rate. What
basically happens and here if the repo rate is X your marginal standing facility rate is X
plus two point 0.25 percent and a reverse repo rate is X minus 0.25 percent.
That means the total corridor is 0.5 percent or the 50 basis point. So, what is the
objective and the target rate is the call money rate. The mechanism works like this, if
repo changes repo increases. So, it will change basically the call money rate call money
rate means the interbank lending rate. It will have the impact upon the call money rate.
So, if the call money rate changes we can define it in this way; if repo will have the
impact upon call money rate, the call money rate changes then the market interest rate or
the lending rate changes then; obviously, your investment and output also gets changed.
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So that means, the RBI always ensures that the call money rate should be below the
marginal standing facility rate. What is the marginal standing facility rate? The marginal
standing facility rate is little bit more than the repo rate. So, if RBI wants to borrow
wants to lend more money to the commercial bank or commercial bank wants to borrow
more money from RBI. So, they can borrow at a MSF rate after their limit is over in
terms of a repo rate. So, then at that particular point of time RBI ensure that instead of
going to RBI they should go to the call money market. Call money market means one
bank and borrow from another market another bank.
So, that can what is happen the total amount of the money supply will not get changed.
So, the RBIs target is maintained if the overnight call rate or the call money rate is below
the marginal standing facility rate. The only whatever target RBI has made that particular
target can be maintained over the period of time. So, if at any point of time the marginal
standing facility rate will be cheaper than the call money rate, then the commercial banks
will prefer to borrow from RBI. Once the money is coming from RBI, it will affect the
total money supply then automatically it will affect the price stability and other issues.
So, that is why RBI will have ensures that this corridor should be maintained and once
the corridor is maintained then, the whatever forecasting and the planning has been made
in terms of the price stability and growth rate that will not going to be affected in that
particular period of time. So, this is called the operating procedure of the monetary
policy. But there are certain challenges; there are certain revisions which have been
made in terms of the monetary policy that will be discussing in the next class. This is
what basically we are discussing today. Next class will be talking about the challenges
and as well as the autonomy of the reserve bank.
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Thank you.
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Lecture –19
Challenges and Reforms in Monetary Policy & Central Bank Autonomy
So, after discussing about the different instruments of monetary policy and as well as the
operating procedure of the monetary policy of the Reserve Bank of India. So, today we
will be discussing about what are those challenges and the reforms which have taken
place in monetary policy framework in the Indian context. And as well as another
concept will be discussing which is called the Central Bank Autonomy, which is a very
debatable issue nowadays which is the people are very much concerned about.
So, let us see what are those challenges we always face or Reserve Bank of India always
faces whenever they are implementing the monetary policy. The first challenge basically
they face because there is integration in the global economic system every markets are
highly integrated both domestically and as well as internationally.
In that particular context the price is basically highly fluctuating, asset pieces, stock
price, the instrument which are available in other markets which are very much highly
fluctuating. If they are highly fluctuating in that particular contest what is happening it is
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very difficult to forecast the price in such a way; by that the policy implementation
should be done to control the price level.
So, in this context the managing liquidity in greater liquidity management with special
focus on short end of the market spectrum is basically very important. But that may not
be possible at any point of time because of the volatility of the asset prices. There is also
considerably difficulties faced by the monetary authorities in detecting.
And measuring the inflation, how the inflation can be measured particularly this inflation
expectations. Why basically it happens because we have the different measure, we have
WPI and CPI, there are different components of CPI which should be actual reflection of
the pricing which particular index should be considered for measuring the inflation; that
is basically the another issue always Reserve Bank of India thinks.
And they cannot also predict the money supply because there is a volatile increasing
capital flows relative to domestic absorptive capacity. The absorption capacity of the
domestic market whatever we have that sometimes is also in comparison to the
increasing capital flows to the system in terms of a FII or FDI. Sometime it is very
difficult to predict or to expect that how the price is going to be or how the money supply
is going to be in the next period. So, the actual corridor or actual money supply whatever
is the intermediate target the RBI may not be followed.
So, that is basically another question. In the emerging scenario there is a large and
uncertain capital flows, the choice of the instrument of the sterilization and other policy
responses have been constant. You know whenever we will discuss more about the
sterilized policy and non sterilized policy. We talk about the Reserve Bank’s intervention
in terms of the exchange rate and as well as the money supply.
But here whatever the way basically the foreign capital flows are coming to India or
whatever fluctuations they have realized in terms of that capital flows that basically is
creating difficulty for the Reserve Bank of India to device certain domestic policy which
can control the money supply in such a way by that the price can be stable as well as the
growth can also be increasing on that particular point of time. And another point is in the
liberalization process aligning the operations of the large financial conglomerates and
foreign institutions with the local public policy priorities remains challenge for the
domestic financial regulators.
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There is increasing in the number of MNC’s, the parent company is somewhere in U.S.
or some other countries and their operations are in India and their operations and the
objective of those companies and the objective of the public policy priorities within that
hosting country sometimes differ. So, the money which is circulated through that kind of
transactions that also sometime may create the problem for the public policies in that
particular hosting country.
So, whatever actual process of for the monetary policy should be adopted by RBI or by
the reserve bank of by the central bank that also create sometimes the challenges for
them. The dominance of all being financial intermediaries increases the concentration
risk because, you see if there is a dominance of big financial intermediaries they can also
regulate the price.
If the price is not very competitive in that sense what is happening the concentration risk
in the market may also increase; which also creates the problem to devise a proper
monetary policy for them. So, these are more or less the different challenges for this
Reserve Bank of India face whenever they devise this monetary policy or implement this
monetary policy in this particular country.
So, keeping those things in the mind way back in 2014 India not 19 it is 2014 there was a
committee which was established and this committee was headed by the current
governor Urjith Patel. Mr Urjith Patel was the governor of that was the chairman of that
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particular committee that time he was the deputy governor and that committee has
recommended certain things to revise the monetary policy framework for the Indian
context.
Then how this revised framework basically looks like we have summarized that
particular report in this case we just discussed certain major issues or major points which
has been highlighted in that report. So, the first of all the first thing what this particular
policy or policy revised document has said or the recommendations have said; the
inflation should be nominal anchor for the monetary policy framework. More or less
instead of a multiple objective they are going towards a single objective.
Previously we have what is happening we have to control the price the price stability
should be controlled or price should be stable, or the in volatility of the price should be
controlled, or the inflation should be controlled, in the general sense and as well as the
growth rate of GDP also should increase. So, that a multiple indicator approach the
central bank was following, but now what is happening this objective of the monetary
policy is going towards a single objective function mostly they are concentrating on
controlling the inflation. Because the argument is if the price becomes stable than growth
can take place; so, that is the basic notion or basic intuition of the revising the monetary
policy framework in the Indian context.
So, therefore, what they said the inflation should be nominal anchor for the monetary
policy framework. And they have taken CPI or consumer price index as the measure of
the nominal anchor for the policy communication. Previously there was a debate
confusion was whether they should go for WPF wholesale price index or CPI. But they
have said that CPI should be used and here they have constructed a new CPI index which
basically covers of more commodities which are really in the true sense it is used as a
necessity commodity there are necessary products in the day to day life.
So, CPI has been used as the indicator for measuring the price in the Indian market. This
is the first kind of recommendation whatever they have given. And already I told you
that they are going towards the inflation targeting; so, because of that the targeting
inflation of 4 percent with a band of 2 percent plus or minus around it.
So, there is a model whatever they have formulated and using that model what they
trying to say if the inflation is 4 percent, then the growth rate can be achieved this is a
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particular amount of growth rate can be achieved or if the inflation will deviate by 2
percent either it can become 2 percent or it can become 6 percent that also should not
hamper the expected growth rate what the economy is trying to achieve.
So, the inflation target means that should be this 4 percent in the Indian context plus or
minus 2 percent and for that we have the contingency plan or the monetary policy has
made the contingency plans, this is the way these particular things will work out. Then
monetary policy decision making should be vested in a monetary policy committee that
we separate a monetary policy committee should be established and the monetary policy
committee is basically governed by certain bodies.
And here governor of RBI will be the chairman, deputy governor in charge of monetary
policy will be the vice chairman and the executive director in charge of monetary policy
will be a member. And two other members will be the external basically who are the
experts in the monetary policy in the macroeconomics monetary policy experts who are
the external they are not a part of RBI, but they are the members and from their time to
time they will device that how the monetary policy should look like and what are those
way basically the system should work. Then we have if you see, what are the other
recommendations they have given.
The other recommendation they have given that the weighted average call money rate
should be remain the operating target. And the overnight repo rate liquid adjustment
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facility repo rate will continue as the single policy rate. Previously if you have
remembered.
The either repo rate and reverse repo rate was changing by RBI, but nowadays you might
have observed RBI is only changing the repo rate because reverse repo rate marginal
standing facility rate and everything are basically linked to repo rate. If repo rate will
change automatically reverse repo rate will be 0.25 percent less than repo rate and MSF
rate will be 0.25 percent above the repo rate. So, repo rate is used as a single policy rate.
The target rate is the call money rate, if the repo rate will change then it will have the
impact upon the call money rate or the weighted average of the call money rate. If the
call money rate will change then it will have the impact upon the market rate. So, already
I told you in the previous class that the intermediate target is the call money rate; that
means, the target is the call money rate if the call money rate is below the standing
facility rate then the amount of money supply whatever the RBI has predicted.
That can be maintained in the system at that particular point of time. So, that is why this
is called the operating target. Then provision of liquidity by RBI at the overnight repo
rate will have however, be restricted to specified ratio bank wise net demand and time
limit. How much money the commercial banks can borrow from RBI through repo
operation; that also will be a certain percentage of the total deposit base whatever they
have that has been fixed by Reserve Bank of India.
That means, the unlimited amount of money cannot be borrowed by commercial bank
from RBI whenever they required. Then this support this operating frame work. The
committee recommends that some new instruments can be added that is basically call the
term repo rate. Because this repo rate which was working now which is basically the
overnight rate they have also recommended we should have a term repo rate if any bank
wants to borrow money little bit for longer period of time.
Then for that also this different interest rate should be determined or different kind of a
policy they should be determined. And by that maybe sometime can be given to that
particular bank to repay that particular money to the central bank or the reserve bank. So,
that is another recommendation, but this recommendation also is considered to device the
new policy framework for the monetary policy.
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Then we have another recommendation they have consistent with the time path of fiscal
consolidation mentioned SRL should be reduced to a level in consonance with the
requirement of the liquidity coverage ratio. That means, they said this statutory liquidity
ratio whatever we have that basically should be reduced to a level in accordance with the
liquidity coverage ratio of the Basel III norms.
The liquidity coverage ratio is a ratio which is basically measured are used to measure
the liquidity of the commercial bank. So, the liquidity coverage ratio and SRL should go
together by that if the liquidity ratio is maintained or the liquidity coverage ratio is
maintained then what is happening that automatically takes care of the investment in the
government securities and different kind of liquid instruments whatever we have.
Then another revision they basically recommended that open market operations have to
be detached from fiscal operations; instead links only to the liquidity management. To
control or to fulfill the gap of the government financing the open market operations were
using to finance this kind of deficits by the government sometimes open market
operations were used as an instrument. But what RBI has recommended let us detach that
open market operation from the fiscal operations part open market operations should be
totally related to the control the liquidity in the market.
That should not be any kind of link between the open market operations and the fiscal
policy or fiscal operation of the government. It should be directly linked to the liquidity
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management or the change control of the money supply in the system. That is why the
open market operations should be totally monetary policy instrument not are the
instrument to also take care of the fiscal consolidation of the government.
And a proper sterilized policy for foreign exchange reserves the foreign exchange
already I have told you sterilized policy means whenever there is a change in money
supply for the buying and selling of the foreign securities or foreign currencies so in that
particular point of time this may affect the total money supply in the system. So, in that
particular context what RBI does they take the reverse position in the domestic economy.
For example, if they are buying more dollars in the domestic economy this particular
domestic economy the demand for foreign assets should be there. So, because of that the
total money supply may get changed and that particular point of time they make certain
kind of policies, they take certain kind of steps by which the domestic money supply will
go down.
If the domestic money supply will go down and the foreign money has been injected in
the system the net effect on the money supply will be 0. Any way that is called the
sterilized intervention that we will discuss more, but this is the way this sterilized policy
for foreign exchange reserve should be properly utilized. By that it will not basically
affect adversely the price stability in the economic system. So, these are the different
recommendations whatever they have given and over the period of time this
recommendations have been incorporated in the monetary policy framework of the RBI.
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If you see this one I have just giving the glimpse of what we mean by the inflation
targeting. Here the inflation targeting means that this monetary policy committees
empowered and responsible to set up the benchmark policy rate that is repo rate, in such
a way that the inflation can be kept within a certain limit. Then here the inflation target
always can be maintained and it can be changed in every 5 years so that is basically
depends upon the consumer price index.
And here what basically here the central government of India has fixed the inflation
target for the period beginning from august 2016 ending on the March 31st 2021. So, this
is the target now whatever is working now that is an inflation target is 4 percent, upper
tolerance limit is 6 percent lower tolerance limit is 2 percent that already I told you. The
key advantage of a range around the target is that it allows the monetary policy
committee to recognize the short run tradeoff between inflation and growth what enables
into to pursue the inflation target in the long run over the course of the business cycle.
So, what is the condition for a failed monetary policy with respect to the set target as per
the policy if inflation goes above 6 percent or goes below 2 percent for three consecutive
quarters then it will be treated as the failure of the RBI monetary policy in such scenario
the RBI will initiate counter active measure to meet the required target. If it is fluctuated
within the 2 percent then no action will be taken for that. If what the RBI should do if
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inflation target is not met, then the new notification also prescribe the procedure to be
followed by RBI if the target is missed.
Where RBI fails to meet the inflation target, it is all sell out, it will set out a report to the
central government stating the reason for failure to achieve the inflation target. Remedial
actions proposed to be taken by RBI and an estimate of the time period within which the
inflation targets are achieved pursuant to the timely implementation of the proposed
remedial actions. So, those kind of actions will be taken if the inflation target is not met.
If it is met it is fine if it does not met then those kind of things or those kind of action
should be taken by the Reserve Bank of India with respect to the Government of India.
So, this is called basically or features of the inflation targeting what we can say and up to
2021 this particular target will work. And after 2021 one revised target can be created.
And accordingly one range also can be created like upper tolerance can met and lower
tolerance can met. So, this is about the different kind of instrument challenges and
revisions of the monetary policy.
Then we can move to another important issue which is called the central bank autonomy.
Some days back you might have read in the newspaper that one of the central bank
deputy governors Viral Acharya had said that more autonomy should be given. Before
that also the other governors deputy governors upgraded for the autonomy. And in that
context; obviously, the question can arise what do you mean by the autonomy?
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How the autonomy is define and whether the autonomy is good or bad from the central
bank perspective and from the public perspective. So, in this contest if you see in general
sense the autonomy is or the independence is related to three areas; one is personal
matters, financial aspects, and conduct of the policy. These are the three things always
comes whenever it can related to personal issues, financial issues, and policy issues.
These are the three issues through which the autonomy can be defined autonomy can be
examined. What do you mean by the personal independence?
The personal independence means to what extent the government distances itself from
the appointment term of office dismissal procedures from top central bank officials and
the governing board. It also includes the extent or and nature of representation of the
government in the governing body of the central bank. Who appoints the governor?
Central bank. Who appoints deputy governor? Central bank. So, all those top bodies are
basically appointed by the government and again in the central board of directors.
There are many government bodies or government representatives who basically work
on behalf of the government. So, in that context up to what level the policy decisions or
particular appointments which are taken for the Reserve Bank of India are free from any
kind of government interventions. So, one is your personal matter; in the personal point
of view that how far the particular reserve bank or particular central bank is autonomous
that is first point.
Whenever you talk about the financial independence; the financial independence
basically relates to the freedom of the central bank to decide the extent to which
government expenditure is directly or indirectly financed by the central bank. Previously
what was happen if there is kind of deficit by the financing deficit by the government
then it has to be financed by the issuance of the treasury bills. The Reserve Bank of India
will automatically issue the treasury bills to overcome or to fulfill the deficit what the
government has; that is called the automatic monetization of the financing the deficits.
There is no need to do anything there is no such kind of it is mandatory by the RBI to do

that, but this has been discontinued since 1997 to some extent this Reserve Bank of India
has got the financial autonomy. That means, to fulfill the financing deficit Reserve Bank
of India it is not mandatory for the Reserve Bank of India or the Reserve Bank of India is
not bound to do that whenever there is a deficit in the system.
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So, financial autonomy to some extent we have. So, direct or automatic access of
government to central bank credit to natural imply that monetary policy subordinate to
the fiscal policy. So, this is what basically what we can see, that whenever there is some
automatically financing deficit is taken place then we can say that fiscal policy
dominating over the monetary policy and to fulfill that financing deficits RBI has to do
some kind of decisions or there has to take certain kind of decision by that the deficit can
be covered up. Finally, the policy independence is related to the flexibility given to the
central bank in the formulation and execution of the monetary policy.
Government or finance ministry should not interfere for the formulation or are the use of
instruments for the monetary policy by the reserve bank. What instrument is Reserve
Bank of India is interested to use; whether they want to increase the interest rate or they
want to decrease the interest rate, those kind of an interference from the government side
should not be there. If from the government side the interference will be there then we
can say the autonomy is less if the interference is less, then we can say that autonomy is
more. So, in that context the three types of autonomy is defined.
Then we can see that why basically we are in support of autonomy what are those
advantages of the autonomy. If autonomy will be given then what is the merits. There are
three things we discuss in this context one is time inconsistency theory, theory of
political business cycle and theory of public choice. You see if a conservative central
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banker is there then they will always look for something by that the price can be stable
and inflation can be controlled.
But some times what has happened there is a contract that there is no such kind of
autonomy when sometimes the Reserve Bank of India governor will be appointed or any
central bank governor will be appointed. And, there is an optimal contract between this
government and this governor and they will act on their own benefits or the particular
political system or political parties can work or the government can work in such a way
that it to some extent maximize the social welfare.
But it also help this government and as well as the public in such a way that maybe this
total control will not be there in terms of the price stability or the output increase. So that
means there is a tradeoff between or there is some kind of contract between the governor
and the government by that any decisions which are taken that may not be in the public
interest. But if this there is an autonomy then the governor can take their own decisions
by that it may be with the special interest which is driven by the economic factors.
And another one is there is a theory of political business cycle which tells that; whenever
any new election takes place, this incumbent policymakers who basically they do or the
incumbent party which comes to the power they take certain decisions which are very
much relax decisions which may; deviate from the actual kind of target whatever the
central bank has.
So, that may destabilize the price and all these things and whenever they were going
towards the end of this period or their term is going to be over. Maybe some decisions
will be taken which may be friendly towards the public and it may be a populist policy
which can create some kind of economic disturbances. So, in that particular point of time
what happened in the beginning maybe policies are good, but after the period or over the
periods whenever this term is going to over they take certain policies which is beneficial
for them, but may not be beneficial for the public.
So, in that particular point of time what happens in the long run that may affect the
economic system adversely. So, if the governor is independent or the autonomy is given
more then maybe the monetary policy part will be taken in such a way that those kind of
problem may not arise. Basically the theory of public choice says that central banks has
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an effective institutional constant to control the inflation and increase output because
they have expertise.
Where there are some limitations of the autonomy because it lacks the democratic
legitimacy because government is chosen by the public. So, any decision which is taken
by the government we should ensure that it is in for the interest of the public. But here if
everything is totally driven by only the economic factors or by theoretical factors may be
that lacks the democratic legitimacy. It may also lead to fictions between fiscal and the
monetary authorities and that will basically will be costly for the participants in the
market and as well as for the society.
Because the government and the reserve bank or the central bank if they do not go
together that will also create the problem for the society at a large. So, there may be
significant divergence in the preference pattern of the independent central banks in
society at a large. Because society need something else, but in terms of functioning point
of view Reserve Bank of India or the any central bank wants something else that creates
the divergence in terms of their choices in that may create the problem in the economic
system. So, these are the different limitations of the autonomy that also always we see.
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So, this there are indexes which are available to measure the autonomy for the central
banks. So, autonomy is measured from two angles; one is political autonomy and the
economic autonomy or political independence and economic independence. So, if you
see ranks have been given and this is an index which is created for all over the world to
the different central banks. And India have scored 0.8. Basically it is in the percentage
basis it can maximum go to 1, 0 to 1. So, India has scored 0.25 for political autonomy of
the central bank, as against the average score of 0.56 for the group of emerging markets.
That means we do not have any political autonomy or our political autonomy is very less
in comparison to the other emerging economies which are existing in India. But they
have scored 0.75 for the economic autonomy of the central bank which is the same with
the average score of that group. That means, in terms of economic autonomy like
financial autonomy because there is a removal of automatic monetization of the
financing deficit etcetera etcetera. We have some economic autonomy or the financial
autonomy, but political autonomy in terms of appointment in terms of the
implementation of the policy and all these things are relatively less.
Less autonomous in terms of the personal matter but some degree of the financial
autonomy that already I told you. So, in terms of the measures we are basically to some
extent we better off in terms of the financial autonomy. But whenever it is political
autonomy we are basically lagging behind.
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Please go through these particular references for this particular session. So, this is about
the autonomy of the Reserve Bank of India and as well as the central bank as a whole. It
has both merits and demerits. But still it is a debatable issue and this is basically the brief
idea about that. And we can explore more that whether the autonomy is good or bad for
the central bank or for society at a large.
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Lecture – 20
SEBI, IRDA and PFRDA: Structure and Function
So, in the previous class we discussed about the functions and the operations of Reserve
Bank of India, who is the one of the most important regulators operating in the Indian
market or Indian economy. And, the basic job of the RBI is to conduct the monetary
policy and to ensure that the price stability can be maintained. And, as well as the growth
rate of the total output or the GDP also can be enhanced. So, then we have another major
three regulators which work in this particular economy.
These are Securities and Exchange Board of India: SEBI, Insurance Regulatory
Development Authority: IRDA and the Pension Fund Regulatory Development
Authority that is the PFRDA. These are relatively new regulators which operate or which
work in the Indian context. But, today we will be discussing that what are the structure of
that particular regulatory bodies and what are the major functions and how they basically
work in the Indian context.
So, if you see first of all the SEBI already what I told you that this is relatively a new
regulatory body which is working in the Indian market which was started after the
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liberalization. When the stock market was developed or there was an urge to make this
capital market more developed in comparison to other emerging economies. So, in that
context the government has established the SEBI under the SEBI Act, 1992. So, here
there are certain things if you talk about the structure.
The SEBI is a body of eight members comprising the chairman, three full time members,
one part time member and two officials of the ministries of the central government. And,
they all deal with the finance and law, who are basically the members from the ministry
and one member from the RBI. One nominated member from the Reserve Bank of India
because, as you know there is a link between the capital market and the money market.
And, the money markets are mostly controlled by the RBI and the capital market, the
stock market which is mainly controlled by the securities and exchange board of India.
So, because of that to make this kind of arrangement there is a plan that or there is some
kind of necessity that one member from RBI also should be there in the SEBIs bodies.
So, this is what basically this governing body of SEBI is comprised or formed. And all
those members who are basically this part of the SEBI, they are basically selected or
nominated by the government except the member which is coming from RBI. Because,
RBI nominates that person and the other persons who are the members of the SEBIs
governing body they are basically appointed by the Government of India. So, this is the
way the structure of SEBI is designed in the Indian context.
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So, what is the major functions what basically SEBI does, but what is the necessity that
the one regulatory body was formed to control the capital market in Indian economy. So,
the first job of SEBI is basically or the foremost important job of the SEBI is to protect
the interest of the investors and to promote the development and to regulate the securities
market. Basically, the participants whether they are the institutional investors or the retail
investors, they basically work or they take the positions in the equity market for their
maximization of the return.
So, SEBI ensures that their interest should be protected or whatever positions they are
taking whatever monetary transactions are happening; so, all those transactions are well
protected. And, the all kind of transactions which they supposed to make those are made
through proper rules and regulations. Those kinds of things were over basically totally
governed by or may be regulated by the securities and exchange board of India. And,
next thing is to promote the development the infrastructural development.
And as well as other development activities which should happen both administrative
and as well as infrastructural which should take place in the Indian equity market that is
totally looked by the SEBI in the Indian context. And, they regulate the securities market
in the sense they basically make the rules and regulations norms and period to period
they see that whether the market is functioning in the better way. So, these are the major
functions of SEBI in the Indian equity market.
And, another function of SEBI is to regulate the business in the stock exchanges. So, this
would ensure that whatever business the stock exchanges are doing or whatever
transactions in the stock exchanges are made they are fair. So, all kind of transactions are
basically is in the interest of the shareholders or the equity holders who are investing in
this. And, stock exchange is transparent providing all kind of information or stock
exchange is really working in a clean manner for the investors, where the investors take
their positions to maximize the return.
Then, the third thing and another function is to register and regulate the working of the
stock brokers, sub-brokers, share transfer agents, bankers to an issue, trustees, registrars
to an issue, merchant bankers, underwriters, portfolio managers, investment advisors
etcetera. Because, you see all these agents participate in the pricing of the equity
particularly in the IPO process and as well as also they participate whenever the
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transactions of a particular positions are taken place. When the settlement of any
positions basically take place all the settlements are taken care of by some of the
economic agents.
So, SEBI ensures that all these economic agents who are the major participants in the
equity market they should register themselves. They should be authorized by the SEBI
that they are allowed to participate in the equity market. They should act as an economic
agents in the equity market and also the rules and regulations related to those kind of
economic agents also should be time to time can be revised for the interest of the equity
holders or for the interest of the share holders.
And, also another things SEBI basically regulate the foreign institutional investors and
credit rating agencies. Because, you see where credit rating agencies is also working as a
company in the Indian equity market or Indian capital market what we can say. And,
because the Indian market is highly dominated by the FIIs or the Foreign Institutional
Investors, SEBI ensures that all these FIIs which are coming to India they have registered
themselves with the SEBI and as well as they are functioning.
And their operations and their positions they are all basically can be regulated by the
security the exchange board of India. They also regulate the venture capital funds,
mutual funds, collective investment schemes. These are all regulated by the SEBI and
also they make the arrangements to promote and regulate the self regulatory
organizations. If you remember I was discussing about the self regulatory bodies like
AMFI: Association of the Mutual Funds.
So, those are basically promoted by the SEBI to ensure that the market is working in a
right direction or all kind of or any kind of unethical practices are not happening. And,
whatever disclosure norms and everything should be reported to the market everything is
done by the companies. And, because of that what is happening SEBI also ensures that
those kinds of self regulatory bodies can be developed or should come to the market.
Because, once the market is matured maybe they are able to control the market in that
way.
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So, these are the major functions and some other functions are already I told you it is a
part of that to prohibit the frauds and unfair trade practices relating to the securities
market. Any kind of trade practices which are happening; any kind of frauds which are
happening in the equity market that should be always controlled by the SEBI. SEBIs
major job is to control that and to ensure that those kind of unfair practices are not
happening in the market. And today’s time because the equity holder’s participation is
very less in terms of the retail investment point of view SEBI also started this investors
education schemes.
So, the basic job of SEBI is to promote this investors education and training that how
they can participate in the equity market or they can take their positions in the equity
market. Because equity market is also one of the most important markets to maximize
the return or to make their portfolio in such a way; it can be considered as one of the
assets in their total portfolio. To prohibit the insider trading because, the insider trading
is unethical practice which may happen inside the companies. So, the SEBI basically
makes the rules and regulations in such a way that also the stringent rule, policies, norms
basically always try to prohibit the possibility of an insider trading within the companies.
And, SEBI is much more vigilant for this kind of thing. To regulate the substantial
acquisitions of shares and takeover of the companies, the SEBI should always ensure that
whatever acquisitions and takeovers are happening in the market; they are basically
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following the rules and regulations which is already drafted by SEBI or all the guide
lines which are basically made by the SEBI. So, those things basically are very important
because that has lot of implication on other investors which are investing in that stocks
which are taken over or with the company which is taking over.
To call for information, conducting enquiries, audits of the stock exchange and mutual
funds all are basically the major responsibility of the SEBI. Because, SEBI ensures that
all the firms which are operating they are doing their business ethically. And, all kind of
financial frauds and all these things are not happening in the market. And, as well as
those kind of bodies are basically working in the interest of the share holders. The SEBI
also can issue the guidelines in respect of information disclosure, what kind of
information the companies should reveal. Those kind of guidelines SEBI can give:
operational transparency and investor protection.
So, all those guidelines are always coming from the SEBI that what are those things the
companies should follow by that all this information can come to the investor, whenever
they take their position in the company, in the equity market. And as well as all those
guidelines also they provide to protect the investors whenever they participate in the
equity market. They are also provided the guidelines for the development of the financial
institutions, pricing of issues. Pricing of issues in the sense of we are talking about the
initial public offerings and all, because all those guidelines rules and regulations of IPO
pricing are basically done by the SEBI.
So, in this particular subject we will be discuss more on this pricing part, but the pricing
part is very important. Because, whenever any company comes to the market for the first
time they should ensure that the pricing of that security is fair. And, whatever price they
are paying for to invest in that particular security that also should be the equilibrium
price in the market. So, because of that all those book building process and all those
things which are already in its guidelines and all these things are drafted by the SEBI and
every company has to follow that.
What are those? All those guideline related to the bonus issue, the preferential issues.
Preference shares basically whenever any company gives then what are the policies or
what are those steps the company should follow. So, all these things are should be given
by the SEBI or SEBI provides all those kind of guidelines by that any kind of unethical
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practices will not happen. Firm allotment and transfer of shares among promoters, then
how the shares can transfer from one promoter to another promoter.
Then, when these particular shares should be transferred and what are the particular
guidelines should be followed. All kinds of regulations and guidelines are basically
formulated by the SEBI for the better functioning of the equity market and as well as
they would ensure that the market is working smoothly. So, these are the major things or
major functions of SEBI always what we see.
And, another major function what SEBI does, that is basically this would ensure that the
governance system in the company is adequate enough to attract the investor to invest in
that particular market. So, whenever we talk about corporate governance, through
corporate governance basically what we are trying to make. We are trying to make the
particular company more discipline, whether the company is basically working in a
disciplined manner or not, whether the transparency about the company is existing or
not. Those things are basically drawn by the different type of discipline: one is self
discipline, market discipline, and regulatory discipline.
So, all kind of discipline whatever is imposed by the regulatory bodies all those things
are basically followed by the companies or not, that basically we have to ensure. So, that
is basically overall corporate governance means what; the corporate governance means
that whenever the company works in a particular system, the governance system of the
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company should be in such a way that it can take care of the interest of all the
stakeholders of the company. So, it can be equity holder, it can be debt holder, it can be
suppliers, it can be government, it can be customers, it can be employees. So,
everybody’s interest or it can be investors so, whoever it may be all those interest should
be taken care.
So, to take care of the interest of all kind of stake holder who are the parts, who are
basically the major participant with respect to or major stake holders with respect to the
company; the corporate governance system should be strong. Because, corporate
governance system should ensure that the company is a good company for investment.
And, SEBI is ensuring that the governance system of that particular company is good.
So, that is why the governance has a lot of role in terms of the value creations, the
strength of the stake holder relationship, it has the relationship. Wealth created is evenly
distributed across all classes of stake holders that can be ensured by the governance
system.
What kind of management quality we have, management quality in the sense who should
be the CEO and whether the CEO follows this criteria whatever we should have, what is
the board structure of the company. And, whatever rules and regulations the companies
act is making and whether the company is following those rules and regulations or not.
What kind of audit practices they have, what kind of remuneration policies they have.
So, all those are the components of the corporate governance. So, SEBI ensures that all
kind of issues are taken care of by the company and then only we can say that the
company is transparent.
So, mostly if we are talking about the governance system already I told you this is related
to your board structure. Then we have the audit, then we have the compensation policy.
These are the major issues which comes under the corporate governance part and the
CEO or the managing directors. What should be the composition of the board and
whether the company is following the audit practices properly or not? What kind of
compensation policy they have, everything should be transparent and should be
according to the guidelines of the securities exchange board of India and as well as the
Companies Act.
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So, this is responsibility of SEBI to ensure that the governance practices of that
particular company is fair enough. And, whatever information they are providing to the
different stake holder, there they have the authenticity and they have the right
information. Because, of that the investors can take the right position whenever they go
to the market for investing in that particular share, that also ensures that the stability of
the future wealth creation. Because, once people will be looking at that kind of
governance practices and come to the market for the investment, that can help that
whether the future wealth creation can be made by the company or the cash flow of that
particular company can be positive or not.
So, these are the different ways the governance system helps for the betterment of the
company. And, SEBI ensures that all those governance characteristics are made by the
company in such a way that it can give a better idea about the company itself and the
management quality also and as well as the stability of the future wealth creation. So,
these are the different issues related to the corporate governance where the SEBI has a
strong role to decide that whether the particular thing are happening with that particular
company or not.
Then, here whenever the SEBI ensures that whether the governance practices are
happening in the company or not; this should ensure the timely disclosure of the relevant
information, providing an efficient and effective market system, demonstrating a reliable
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and effective enforcement and enabling the highest standard of the governance. So,
SEBIs major policy aim is that whether the companies should have a better standard or
high standard governor system.
By that the information which is coming from that particular company, it has some kind
of authenticity and the information are relevant for the investors whenever they go to the
market for investing in that particular shares. So, these are the different issues what
basically related the corporate governance in the context of India and as well also other
countries. What SEBI is ensuring that governance practices is really followed in the
Indian market.
In this context different communities were established, there are many committees, but
here we are highlighting the committees which are set up by SEBI. But, there are other
committees also government has established there is a J. J. Irani committee in 2005.
There are other communities, but there are major three committees what SEBI has
established to increase the corporate governance system in the companies in India. The
first committee was established under the chairmanship of Kumar Mangalam Birla in
2000.
So, on the recommendations of that particular community that is introduction of clause

49 of the listing agreement was to be complied by all the listed companies that was
started in 2000. And, another major recommendation is that although the committee has
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given a long recommendations as summarized here some of the major issues what the
committee has recommended. And, another recommendation the committee has given
that the board of a company should have an optimum combination of executive and non-
executive directors with not less than 50 percent of the board comprising the non-
executive directors.
And, the disclosure should be made in the section on the corporate governance of the
annual report. The annual report should have a corporate governance section then all
those board structure, audit issues, remuneration issues all kind of things, we just
discussed now. So, all these things will be reported in annual report, all the information
should come through the annual report. And, shareholder and other investors or the
market participants should have the fair idea that what kind of governance practices the
company has. And, what kind of governance structure the company has. Then after that
in 2003 another committee was set up under the chairmanship of Narayana Murthy, the
then chairman of Infosys.
So, here what basically here we are talking about according to that recommendation
there are certain issues were installed or may be included in that. The person should be
eligible for the office of the non-executive director so, long as the term of office did not
exceed nine years. It is basically we are talking about to make that particular policy in
such a way that some kind of relevancy or the authenticity. Or, maybe we can say that
the executive directors should not be there for a long period of time. Some kind of time
limit should be there by that we can say that the maximum efficiency of that particular
person can be used for that particular company.
Or can devote to the company to make the company more efficient and more profitable.
Then the age limit of therefore, the directors to retired should be decided by the company
themselves. It should not be decided by the government or any other body or by the
regulator; it should be decided by the companies itself. The audit committee members
shall be non-executive director because if your own employee will be in the audit
committee may be there is the possibility of fraud.
Or, there is some kind of unethical practices may happen because if all the audit
committee members will be the non-executive directors then, the probability of fraud and
probability of unethical practices will be less. They should be financially literate and at
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least one member should have accounting and related financial management expertise.
So, you should have those members who have the expertise in that particular area and
there should be the outsiders or the non-executive directors.
They should not be the employee’s regular employees of that particular company. Audit
committee of listed companies shall review mandatorily the information on financial
statements, risk management practices. The IPO issues or the process followed for the
IPOs etcetera or the party transfers or stocks transfers and everything.
All kinds of things are basically taken care of by the audit committee and audit
committee then power to see all kind of transactions financial transaction whatever the
company has made in that particular financial year. So, these are the major
recommendation what the Narayana Murthy committee has given.
Then recently in 2017 they have established another committee under the chairmanship
of Uday Kotak. Here there are different issues the committee has addressed. The issues
are like ensuring the independence in spirit of independent directors and their active
participation in functioning of the company, improving the safe guards and discloser
pertaining to the related party transaction.
Issues in accounting and auditing practices followed by the listed companies; improving
the effectiveness of the board evaluation practices, addressing the issues faced by the
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investor on voting rights or the participation in the general meetings. Disclosure and
transparency related issues and any other matter as the committee deems fit pertaining to
the corporate governance in India.
Almost all those and the committee has to submit the report, but the final
recommendation has to be given. But, almost all those issues which are addressed under
this corporate governance norms; this should be addressed by this committee in a
comprehensive manner. And, by that if it is required then some of the changes can be
carried out with the regulatory or existing norms whatever the SEBI has in terms of the
corporate governance.
So, then we have another regulatory bodies. We have IRDA, IRDA was set of little bit
late once to make this insurance sector more developed. So, this basic objective of IRDA
was to protect the interest of the policyholders and to promote and regulate this insurance
industry in India. Here if you see as on 31st March there are 24 life insurance companies
out of them 1 is public sector like LIC and 23 private sector companies.
And 29 non-life insurance like 4 public insures and 2 specialized insures and 1 reinsure
and, 22 private insures including 5 standalone health insurance companies which are
operating in India. And, the major job of IRDA is to regulate them and to see that these
policy holders interest is taken care of by this particular companies.
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Then, whenever we talk about the structure of IRDA, the IRDA has a ten member body
appointed by Government of India consisting of the chairman, five whole time members
and four part time members. There is the insurance advisory committee, they advice
IRDA in framing the regulations of the insurance companies. And, the IAC that
Insurance Advisory Committee consists of not more than 25 members excluding the ex-
officio members who are the part of the IRDA. So, their basic job is to provide this
advice for the regulation and functioning of the insurance companies in India time to
time.
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Then, if you see the functions of IRDA, already I told you this basic job of the IRDA is
to regulate and to protect the interest of the insurance policy holders. But to the issue the
applicant a certificate of registration, renew, modify, withdrawal, suspend, cancel such
registration if they want. Protection of the interest of the policyholders in the concerning
matter are the issues related to policy, nomination of the policyholders, insurable interest,
settlement, surrender value of the policy or any kind of conditions which are there in the
contract of the insurance. All these things will be taken care of by IRDA.
Specifying the code of conduct for the surveyors and the loss assessor, the people who
are coming to assess the loss they make of code of conduct for them. Promoting
efficiency in the conduct of insurance business, regulating the professional organization
connected to the insurance and reinsurance business. Generally, levying the fees and
other charges for carrying out a particular business in the market. Regulating the
investment of the funds by the insurance companies, whenever the insurance companies
invests the money on whatever they take as the premium. They should ensure that
whether the money is properly invested and what are the different instruments they are
using for the investment.
Maintenance of the margin of solvency, whether the insurance companies are solvent or
not? Or, they are going towards any kind of insolvency that is the job of the IRDA to
check whether the insurance companies are solvent or not. And, also they tried to go for
making any kind of policies related to or any kind of interventions they always make for
the dispute between the insurers and intermediaries at the time of requirements. So, these
are the major functions of IRDA.
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But, then we have another regulatory body we have that is PFRDA which was
established in the year 2003. The basic job of PFRDA was to promote, to regulate the
develop the pension sector in India after the establishment or emergence of non NPS that
New Pension Scheme and the major job of PFRDA is to regulate that. The PFRDA board
consists of seven members including chairman, three whole time members and three part
time members.
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And, if you see the functions it is basically the regulation of intermediaries and national
pension system; just now I was talking about that is the NPS. Registration and regulation
of pension schemes, approval of the pension schemes and reporting the exit of the
subscription form of the NPS. Formulate the regulations in respect of pension funds,
national pension trust, trustee bank, recordkeeping agency, point of presence. All those
parties which are part of the pension scheme or pension fund they are all regulated by the
PFRDA.
So, these are all the point of presence, then you have central record keeping agency,
custodian of securities. So, these are basically all regulations related to insurance made
by them. All the grievances of subscribers should be addressed by the pension funds and
all for those the mechanism is created by PFRDA. And, educating the subscribers and
the general public on the issues related to pension, retirement and related issues; and they
also provide the information about the performance of the pension funds.
And performance benchmarks from time to time which attracts the investors or the
people to go for the pension schemes and to invest their fund in the pension sector.
Because, the amount of only 23 percent of the people who are participating in the
pension sector in India or they have this pension policies. So, to ensure that more people
can come to participate in this process, the basic job of the PFRDA is basically to aware
them, to provide them certain information by that this particular sector can be developed
over the period.
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Thank you.
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Lecture - 21
Commercial Bank : Structure and Services
So, after discussing about the different regulatory bodies which are functioning in the
Indian market or Indian economy, we can start the discussion on the commercial bank
today which is the most important financial organization in any economy, any system in
the world. Because, banking sector has its own relevance, it has its own significant for
the financial sector as a whole which provides all kind of amenities either from the
transaction prospective or from the investment prospective.
So, keeping those things in the mind it is very important to understand how the
commercial banks basically work in a system, what are the major kind of services they
provide. And why the commercial banks are so special among the different financial
intermediaries which work in any financial system in the country or all over the world.
Today we will be discussing about the structure of the commercial bank in India and
what kind of services they provide.
If you see that in Indian context the banks are regulated by RBI. So, RBI is the apex
body which is the central bank and we have two types of banks which is scheduled banks
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and non-scheduled banks. The scheduled banks means the scheduled banks are basically
established under the act of the Reserve Bank of India act. There are certain rules and
regulations they have to follow to become that particular bank scheduled and there are
some non-scheduled banks mostly the cooperative banks are the non-scheduled banks.
And within this scheduled banks we have the state co-operative banks, we have the
commercial banks, but the basic importance of the Indian banking sector is always
concentrated on the commercial banks because, they actively participate in all kind of
payment mechanism which is happening in the Indian context.
So, again Indian commercial banks are divided into two parts; one is Indian banks and
the foreign banks. There are some foreign banks which are also operating in the Indian
market. So, we call them the foreign banks. Then, within the Indian banks we have
public sector banks and the private sector banks. you will little bit go into the deeper for
the classification. There are some old private sector banks and there are some new
private sector banks over the years like RBI is giving license to many private sector
banks to start their banking operation or banking business in Indian financial system.
So, we have public sector banks, you have old private sector banks, you have new
private sector banks and if you again go by public sector banks and we classified as State
Bank of India. Now, this State Bank of India has been merged that one State Bank of
India is existing, other nationalized banks like your Syndicate Bank, Punjab National
Bank, then Canara Bank, these are all the public sector banks which are nationalized
banks and we have the other some regional rural banks or the RRBs. So, this is the way
overall the banking structure of the Indian context or Indian market looks like.
So, this is the overall structure of the Indian banks, but after looking this is basically for
the understanding we have to know that, what are the different types of the banks which
are existing in the Indian market.
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Then, if you see that the banks are little bit different bank also. People call it bank is also
the finance company because like other products or other companies sell their products,
bank also sell the financial products. So, that is why there is some kind of similarity or
always we can consider that bank is a finance company who also works for the
profitability. They also have some products and they provide the services and against
that these create certain money or they basically charge some service charge from the
customers and as well as also they provide certain kind of services to maximize the
profitability of the other customers.
So, this is the way the bank can work like a company or bank can be considered as a
finance company, but what is the basic difference between banks. Let’s assume that
another manufacturing company which is operating in India or any other country. So, if
you see the basic difference between these two are that the other companies, the major
objective is to maximize the profitability and their basic aim is how they can enhance
their profitability by that. They can satisfy their shareholders and they can maximize the
value of the shareholders, but whenever we talk about the bank, bank works in a different
direction.
Bank cannot work only on the basis of the profitability. The basic philosophy of the
banking sector is not based upon the maximization of the profitability. Bank also ensures
that adequate amount of liquidity is maintained. Why the liquidity is maintained?
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Because they have to fulfill the customers requirement and at a short notice and as well
as at the time of requirement they should provide enough working capital finance to the
companies if the company needs. So, liquidity is another aspect which is very important
for the banking point of view.
The liquid is also important from the other company’s point of view, but that is not that
much important and their most important factor is maximization of the profitability, but
whenever you talk about the banks, the banks major job is to maintain both. But, the
question here is if you want to maintain more liquidity, your profitability gets hampered
because the relationship between profitability and liquidity is basically inverse. If you
want to use more money in the market and try to invest the money in the market, then
obviously you can enhance your profitability, but liquidity, if you want to keep enough
cash in your hand to fulfill the requirement of the customers demand, then what is
happening money cannot go to the market. That is why the profitability gets hampered.
So, that is why balancing between profitability liquidity is very tedious job what the bank
has to do. That is why this is basically the first important thing what we have to always
understand that bank is different from the companies in terms of their objectives. The
objective of the company is only to maximize the profit, but if you talk about the banking
prospective the basic objective of the bank is not only to maximize the profit, but also to
maximize the liquidity. Another thing is also management of the reserves, you see what
do you mean by the reserves.
Because our banking system is a fractional reserve system out of the total deposit what
are the customers keep in the bank, some of them has always go to RBI as a cash reserve
requirements. Some of the money has to be kept with the banks to fulfill the customer
requirements in the short run and some amount of the money has to be used as
investment and some amount of the money has to be given as loan. So, we have a
fractional reserve system. So, the bank is always ensuring that all type of things has been
taken care of by the banks in a proper way by that at any point of time, any kind of
disturbances, any kind of asset liability problem should not take place.
So, the management of reserves is quite important from the banking perspective because
the requirement or the business of the banks is totally different than the normal
companies which operate in the market for the maximization of the profit. Bank also can
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create the credit. It is not necessary that whatever deposit base we have your credit can
be given from that. There is some kind of scenarios where bank can also give more loans
than the whatever deposit base they have or the required amount of loan they should give
it can be more than their stipulated limit because bank can create the credit. That is only
possible by the banks and how they can create this, and we always consider the bank can
create money.
Why the bank can create money? If you see the money multiplier process, if you are you
might have read it in macroeconomics and other subject the money multiplier process
basically works in this way that whenever anybody wants to have a loan account, they
should have a deposit account for somebody has deposited 1000 rupees and if you are
deposited 1000 rupees in bank, a 10 percent has gone to let CRR, then 900 net 900
rupees will be kept as the within the bank that this 900 rupees has been given as a loan to
bank B.
Somebody has account in bank B, the loan has been given there; the 900 rupees are
deposited there and out of them 10 percent has gone to CRR. Then another 990 has been
deducted, then 810 rupees has been deposited in that process and there are n number of
banks which are existing in the system. In that process if you add on 1000 plus 900 plus
810 plus and again so on the 10 less than 10 percent of that if you go on, then if you will
find that the end of the day to total circulation of the money has been gone off up to how
much whenever the particular money the amount of money will be starts with the 100
rupees, then the multiplier will be basically 1 by your CRR. That means, 1000 divided by
the 0.1. That means, it is going up to 10, 000.
So, this is the way the money can be created, the money multiplier process which works
by the commercial bank. So, that is why the money multiplier is defined as the ratio of
new deposits to the original increase in the reserves that is basically called the Money
Multiplier or it can be called Credit Multiplier or it can be also called the Deposit
Multiplier. So, this multiplier will be equal to the reciprocal of the required cash reserve
ratio that is one by CRR.
Just now what basically I was trying to say if your CRR is 10 percent that means 0.1,
then if you start your transaction of rupees 1000, then your total amount of the money
will be created in the system through this process will be 1000 divided by your multiplier
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will be how much? 0.1. So, then if you say this thing, then it will be how much? 10000.
So, 10000 rupees can be created in the system through this way.
So, this is called the Money Multiplier Process. 1 by 10 means this is 0.1. So, in this
process the 10000 rupees can be created and this is only can be possible by the
commercial banks. So, that is why we argue that always commercial banks can create
money, then these are the different bases theoretical basis on which the banks operate in
a particular system or the commercial banks can operate in a system.
Then another question is the banks are special among all the intermediaries which work
in the system. Why? They are special. There are certain characteristics were the banks
have the same characteristics. Other kind of financial organizations may not have even if
they are operating in the same system. Then, what are those? The banks are basically
specialized or banks are special to create and channelize the credit for the productive
investments because bank is the payment gateway or bank has the direct connection with
the Reserve Bank of India.
So, whatever credit basically they provide, they can create the credit and they provide
only for the productive investment. The reason is the monitoring system of the banks is
quite robust. The reason is if somebody wants to take a loan in Mumbai, but he is based
in Kolkata, but the bank can be bought the property in Mumbai, the loan is taken in
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Kolkata. This is possible because the monitoring system of the particular bank is quite
robust because they have branch in Mumbai, they have a branch in Kolkata.
So, the reason is that from the logistic point of view and as well as from the expertise
point of view, in those particular cases the transaction cost of the commercial banks will
be less. If the transaction cost will be less, obviously the operations will be better and
because of that they can channelize the credit in a better way for the productive
investments.
That may not be possible by the other financial entities which are existing in the financial
system and this is also act of the economic support system because for any kind of thing
we always required the bank. If you are investing in stock market the role of bank is
there, if you are investing in foreign exchange market the role of the bank is there, and
even if you have insurance policy the role of the bank is there. For everything the bank is
linked. So, that is basically a support system for the economy.
So, in that context we can call it the Indian banking sector is a bank based economy.
There are two types of economy always you might have known. One is your market
based economy and another one is the bank based economy. So, the Indian economy is a
bank based economy and another thing is the market based economy. US is the market
based economy. So, there are many agents who was specialized agents who participated
in the different system, but in Indian context mostly we are concentrating on the banks
for all type of financial transactions which are taking place in Indian Financial System.
And if you have read from the economics point of view, if you see there is economies of
scale which can be possible by the commercial banks because the availability of the
banks are more than the other financial entities. The banks operate in very remote rural
areas; banks also operate in the metropolitan cities. Because of the economies of scale
already I told you they can reduce their cost and their monitoring system will be quite
robust. So, because of that whatever transaction cost we can incur if you go for dealing
with other financial entities that will always be more than the transaction cost what we
incur whenever we deal with the commercial banks.
So, because of that the services will be better and as well as the cost from the customer
side or from the investor side also will be less. So, economies of scale which can be
possible with respect to the commercial banks, the same economies of scale it may not
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be available with the other financial entities or other financial organizations which exist
in the financial system. So, that is also another special kind of characteristics what the
commercial banks have. Then we have economies of scope. Already you know that what
do you mean by economies of scope.
Economies of scope in the sense we have varieties of the products in the same line which
are basically provided by the companies. You can take example from the company
perspective you can take the example of Hindustan Unilever who has n number of
products basically come to the market and they provide, but all the products are produced
in the same line. They can produce oil, they can produce soap, they can produce
shampoo, and they can produce any kind of thing which are in FMCG sector.
But all the productions are made in the same line, so whenever the productions are in the
same line what happens the fixed cost is always more or less same for all types of
production, only change in the variable cost. So, that is why the average total cost of the
company will be less. Obviously, that will have the impact on the price of the product.
So, like that at a time the bank can provide different kind of financial services. It takes
the deposits, it provides loans, it also give other kind of investment opportunities within
the deposit, the varieties of the deposits within the loans. They have got varieties of the
loans. So, that makes that particular scope product. So, the economies of scope or the
commercial bank is very high, very large. So, in that context what happened what
happens then bank is able to reduce their cost and as well as they provide the better
services to the customer on the basis of their requirements.
So, this is what basically the economies of scope concept which better works with the
commercial banks. Obviously, they are the major participants for the transmission
monetary policy transmission mechanism because, already we have discussed that the
intermediate channel for the bank is basically whenever we talk about the monetary
policy, we have already explained there is instrument, there is intermediate target and
that is basically your final output or final objective or final goal. So, your intermediate
target is the money supply and the bank credit.
So, because the bank credit is one of the intermediate target though they have an active
role they play or very important role they play in the monetary policy transmission
mechanism of the particular country. They are also able to maximize the social welfare
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because they participate in all kind of public welfare schemes whether it is microcredit or
it may be providing part of the financial inclusion, it can be a part of any kind of Jan
Dhan Yojana and other things which are happening in the Indian market.
So, all kind of social welfare schemes which are always linked to the commercial banks
and as well as they provide the social justice because, of those though that provide equal
services to all type of customers which are existing in the financial system and as well as
economic system as a whole and that also carries more trust from the public. And,
because of that then people are more concerned about the commercial banks or there is
more faith on the commercial banks whenever they do the financial transactions instead
of have the faith on other kind of financial entities who provide any kind of financial
services in the economy. So, this is why we say that the banks are so special among all
kinds of financial intermediaries which are working in this particular system.
Then, we can see that what kind of services which are given by the commercial banks.
Commercial bank provide many services very difficult to identify all type of services,
but there are some major services. What we can highlight here then we can add also if
there is not any other services left out in this particular list, but if you see that what are
those services which are provided by the commercial banks. First of all commercial
banks always take the deposits from the customers.
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Because you see if any customer is not interested to the stock market still if they have
some surplus they want to deposit the money in the bank. Why? Because that is the
easiest and safest way of investing the money; so, at least some return can be realized
and your bank will be safe, your money will be safe because they feel that bank is the
safest place where the money can be kept. So, because of that they provide a very good
services in terms of accepting the deposits and the deposits also can be very small
deposits, it can be big deposits and because the bank plays a very major role in the
economic system for providing the money and as well as it is the only payment gateway
to a system which exists.
The money can be utilized in the system in a better way. By that it also affect the total
investment in the economy and finally, the output also gets affected by that. So, the
acceptance of deposit is the major service which is given by the commercial bank. There
are many type of deposits, savings deposit, fixed deposits within, recurring deposits,
different type of deposits which are available and depending upon the customer’s
requirement. The customer can go for any kind of deposits whatever they need lending
money or advancing of the loans.
This is the major thing where the bank also generate profit or income from this, but this
is one of the most important services what the bank gives because already I told you
bank create the credit for any kind of loan whether it is a commercial loan, whether it is a
housing loan, whether it is a kind of vehicle loan or personal loan or education loan
different any kind of loans. All kind of loans can be given by the banks. The portfolio of
loans, the lending activities of the commercial bank is quite big quite large.
So, in that context they also cater the services in a very bigger way, very larger way
because depending upon any customer’s requirement they provide the loan. Some
customers take short term loans, some customers takes long term loans and all kind of
demands are catered by the commercial banks. So, that is one of the most important
services what they provide which also provided by some other entities, but the
commercial banks basically is pioneering in that because the varieties of the services in
terms of the lending activities what they give that may not be available with other
financial entities which are operating in the financial system.
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Investment of funds whatever remaining funds are there, banks basically invest that
funds in the different instruments and one thing is the banks are bound to invest certain
money in the SLR instruments like government securities and the rest of the money they
can invest basically in the capital market or any other instruments wherever they want.
So, banks also provide this investment services and any kind of other services what the
customer need, they basically can invest in that particular fund which are provided by the
bank’s will. We will discuss more on all the kind of things or all kind of instrument
which are issued by the banks in the future sessions, but banks also provide the
investment services to the customers.
Remittance of the funds basically it is, it deals with the foreign exchange business on
kind of one remittances that basically comes to the banks. So, Foreign Exchange
Services that also given by the banks although RBI is the sole responsible authority for
this, but with the knowledge of the banks, some of the commercial banks are authorized
to do the foreign exchange business and those kind of business basically are done by the
commercial banks at the time of requirements. That is what they deal with the foreign
exchange business.
They can provide the overdraft facility. Commercial banks provide over overdraft
facility in the sense whatever money you have as a deposit on the basis of your profile on
the basis of your future cash flow generation capacity. The overdraft facility also can be
given or overdraft can be issued to the customer if they need it may not be applicable for
all, but within certain conditions the overdraft facility can provide it to the customer if
they need even if they do not have that much money as a deposit base in that particular
account.
The discount, this bills of exchanges, bills market basically any kind of bills which are
issued for any kind of purpose, those kind of discounting facilities are only available
with the commercial banks as the bill can be shown to the commercial banks to get back
that particular money whenever the bill was issued and today's world the one of the most
important service what are the commercial banks are giving that is credit card. You do
not have to hold the money with you, no cash transactions. All kind of transactions can
be done by the credit card and credit card basically makes your consumption pattern
smoother and your consumption also can increase because of that. Indirectly or directly it
is affecting the total GDP or the output of the economy.
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So, these are basically, this credit card is one of the major services. What they provide
you do not have to go to the bank because they provide the ATM service. 2 o'clock in the
night you can encash the money. You do not have to go to the bank whatever money you
have kept and against your account you have the debit card which can be used also like
the credit card they have provide. Today’s scenario we are all doing the online banking.
Those banking services are given by the commercial banks, now private banking. Some
specific kinds of services are also given to some high net worth individuals and as well
as the people who are the active participants in the commercial bank or the major
customers of the commercial bank.
They also provide the mobile banking; technologically the banks now very strong
enough. Now, the mobiles are also good enough for doing the banking transactions. And
another for the small savings point of view, the banks also provide the Public Provident
Fund account. You can open the Public Provident Fund account in the banks. The
maximum amount in a year you can deposit 1,50,000, but that services or that accounts
only can be always opened with the commercial bank.
So, instead of going to any other specialized agency those kind of services you can get it
from the commercial banks and that is one of the small savings which can help you for
your future for any kind of purpose, any kind of requirements. So, all these things are
very clear, but let us understand how the credit card and the online banking things work.
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If you see whenever you have a credit card, how does the credit card cycle work. If you
see the steps first we have purchased the credit card. Whenever the credit card basically
used you have purchased something from a shop or anywhere else, you have used the
credit card, then after that what has happened the particular processing of the credit card
is done, the merchant establishment delivers the good after taking an authenticated credit
card and noting the number and taking the signatures. And, nowadays also the signature
is not required because you have the SIM based credit card or the chip based credit card
which is available with you.
Then, the bill is raised, the merchant establishment raises the bill for the purchase and
sends it to the credit card issuing bank for the payment. They keep this particular bill
with them and send this particular bank to make the payments to their bank, then the
issuing bank pays the amount to the merchant establishment and the issuing bank raises
the bill on the credit card holder and send it for the payment and the cycle will be
completed whenever the credit card holder makes the payment to the bank.
You see you have made the purchase in so and so date and there is a 50 date cycle. If you
are making your payment after 50 days without any interest, so that cycle will be
complete only after 50 days. So, the transaction will be completed only after 50 days
whenever the credit card holder pays the money to the bank from which they receive the
credit card.
So, that is why the credit card is basically facilitated the people even if they do not have
money with them. Immediately it can help them for the consumption in that particular
point of time whenever they need. So, this is the way the credit card cycle works. So,
generally the period is they kept it around for 50 days period. You get this particular
period. Within that period you have to make your payments. If you do not make the
payment, then maybe you can pay some penalty and all other kind of cost is involved
into that, but at least the 50 days time has been given to the customer to make the
payments.
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Whenever you go for online banking all of you is very much aware about this, but still if
you see that we can create your login, then perform the banking operations, then in that
case you can make any kind of transactions through that, you can send the money to
somebody else, you can pay the bills, you can order the foreign currency, you can
transfer the fund, you can also make the provisions for the automatic fund transfer or
other services also online banking can give. If there is any requirement you can stop your
payment or you have issued the cheque.
What do you find that is something wrong with that particular transaction, you can stop
it, order the copy of the cheque, you can also order the copy of the account statement.
There is no need to go to the bank and give them this request that I want the account
statement because the account statement directly you can download from the banking
website, all kind of information, address changes, user information everything can be
done through that and once there is a verification system by the bank if all these things
are updated by the verification system, then the confirmation of that particular services
can be made.
So, online transactions basically online banking processes provides all kinds of services
whatever we need in terms of the banking perspective which makes our life more simpler
and as well as also easygoing. So, in this context if you see there is a great revolution
which has taken place from the commercial banking perspective, once the technology
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and all kind of credit card and online transactions are happening in the particular system.
So, this is basically about to the basic services of the banks and why the banks are so
special among the different intermediaries.
But there are many issues which are related to the commercial banks like how we can
assess the performance of the banks, what kind of financial statements the commercial
banks should have and how the commercial banks manage the risk and all these issues
and how these commercial banks are basically related to the special norms. So, those
issues we will be discussing in the future sessions.
Thank you.
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Lecture – 22
Commercial Bank: Financial Statements
So, in the previous class we discussed about the basic functions of the Commercial Bank
and what are the services the commercial bank give or provide. Here what we have seen
that the commercial banks are so special and they provide different kind of services
which are technology based. Mostly the importance was given to the online banking and
the credit card operations and all this things.
So, today we can discuss or we will discuss certain issues related to the financial
statements of the commercial bank and further we will see how the performance of the
commercial banks are measured.
If you see in general accounting term whenever you talk about the financial statements
there are three types of financial statements always we come across. The financial
statements are mostly the balance sheet, then we have the second statement is basically
your profit loss account or the income statement and another is basically the cash flow.
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But, from the banking prospective the cash flow has some different meanings. So, mostly
the performance is always consider, always observed, always analyzed from the two
financial statements that is the balance sheet and the income statement. If you know that
what do you mean by the exact balance sheet is, how the balance it can be defined? The
balance sheet is basically what? It provides the organizations financial condition at a
single point of time.
So, they if you see that any company’s balance sheet including the bank’s balance sheet
it is always prepared on a particular date, usually the last day of quarter or the year. So,
you might have seen that whenever we are talking about a balance sheet we are talking
about like as on 31 March 2018. That means, as on 31 first March 2018 what is the
financial condition or financial position of that particular company including the bank,
that is basically reflected through the balance sheet.
Whether it is a bank or any other company that has no difference and only we have to see
that the condition of that particular organization, particularly the financial condition of
that organization is observed through the different parameters, there are different items
and that is basically shows; that basically shows that the financial position of that
company on that particular date.
But whenever we talk about the income statement, the income statement basically shows
the all major revenues and expenditure, net profit loss dividends if at all the company
paid and it also the measures the banks financial performance over a period. It does not
show the performance at a particular point of time or at a particular date, but it shows the
performance over a period of time, mostly the period of time is either quarterly or the
period of time can be yearly.
So, the income statement is a flow concept or over the period of time what is the
condition of financial condition of the organization that is reflected through the income
statement. And whenever you talk about the balance sheet, the balance sheet shows the
financial position of the company or a position of the bank at a particular date or a
particular point of time; here the point of time is we are talking about a particular date.
So, that is the basic differences between these two types of financial statements.
Although the cash flow has a different meaning for the banks, but if you talk about the
cash flows, the cash flow is basically is always from the three activities; 1 is your
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financing activities. Whenever, we measure the cash flow it is basically measured
through the cash flow can be prepared from the financing activities of the company, 2nd
one is your investment activities how that money is utilized, investment cash flow and
3rd one is basically your operating cash flow.
So, these are the different activities which always we try to observe whenever we are
defining the cash flow statement of a particular company. But form a banking
prospective we always measure the performance in terms of the balance sheet items and
the items which are reflected in the income statements. So, this is the basically what the
financial statement of the banks are.
And here first of all we can discuss about the balance sheet. So, whenever we talk about
the balance sheet; the balance sheet of a particular bank is defined, is divided all those
items is basically in two side; one is your liabilities and another side is assets. There are
certain assets and liabilities which are always considered in terms of the balance sheet of
a particular organization including the bank.
So, when we are talking about the liabilities and the assets what are those differences, let
us first discuss about the liabilities then we can come to the assets. Then what are those
liabilities? The liabilities is what, first liability is always for any kind of organization is
the share capital. Share capital means we are referring to the equity capital.
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Why equity capital is a liability? The equity capital is a liability because the money
which is invested by the different equity holders within an organization then they are the
owner of the company and the company of the bank has to pay the dividend and also the
particular amount of the profit which is raised from that particular investment that is
basically should be shared among the individual shareholders or the other type of
shareholders, who are participating in that particular of operations. That is why equity
capital is considered as a liability for the organization.
Then we have the reserves and surplus; why we say that reserves and surplus basically is
a liability? Because, reserves and surplus does not provide any kind of return which is
always there within the organization for some kind of contingency reasons. So, that is
why this is also considered as a liability for the bank.
Then we have another liabilities the deposits. So, the deposits are basically the major
component one of the most important components in terms of the liabilities whenever we
are discussing about the banks. And the deposits for the people or the household sector
or the business sector who makes the deposits; deposits are the assets for them for
deposits of the liability for the banks.
Why the deposit is a liability? Because the bank has to pay the interest against the
deposits; so, any type of deposit what we are making, all though this is the major
instrument or major resources for the bank for the operation, but still it is considered as a
liability for the banks because we pay the interest against this deposits. So, the interest
basically, interest payments are made against the deposit or the bank has to pay the
interest rate against the deposit, that is why deposit is considered as a liability for the
banks.
As usual you have the borrowings, any type of long term and short term borrowings
whatever the bank take either the borrowings can come from RBI or the borrowings can
come from other type of; other type of banks which are existing in the financial system.
So, any type of borrowings what the banks take against that borrowings they have to
make the interest, they have to pay the interest against that. So, there is the fixed
obligations they have because they have to pay the interest and as well as in the end they
have to pay also the principal amount. So, because of that the borrowings are basically
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considered as one of the major liabilities for the banks and as well as the other
organization.
Then there some other liabilities, short term and long term liabilities then the provision
over the bank keep against any kind of loss; the provisions against any kind of loss
depending upon the credit risk. Whenever the bank provides the loans there is some kind
of risk involved in that, there are different type of risk involved in that and the major risk
what the bank can face that is basically the credit risk.
So, to overcome that kind of risk what are the banks do? The banks basically keep
certain kind of provisions, loan loss provisions what they keep and the loan loss
provisions are basically also considered as the liability because it does not provide any
kind of return over the period of time.
So, this is also another type of liability always we observe or always you see. So, these
are the major liability components of the commercial banks. So, here what we have seen
that mostly the major type of liability what the commercial bank has that is basically
your deposit. So, we have to understand more about the deposits what are the different
type of deposits and what are the factors which basically determine the deposit base of
the commercial banks?
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If you see this one then whenever you talk about the bank deposits because the maximum
component of the total liabilities comes from the deposit base. So, there are two types of
deposits broadly; one is demand deposits another one is the term deposits or the time
deposits. So, whenever talk about the demand deposits; the demand deposits again has
been divided into two parts, other two types of demand deposits; one is current deposit
second one is the savings deposit. That means, you might have already the idea that the
people either have a current account in the bank or they can have a savings account in the
bank.
So, whenever you talk about the current deposits or current account these are also the
chequable accounts, the cheque can be issued against the current account, but there are
no restrictions on amount or the number of withdrawals from these accounts and it does
not carry any kind of interest. So, if you are going to open the current account in the
bank then that account we will not face any kind of interest. So, will not be paid and
interest against the current accounts, but there are no restrictions for withdrawal of the
money in terms of amount and as well as the number of times.
So, n number of times, any number of times you can withdraw the money and also if it is
required you can also withdraw any amount of the money whenever you need. So, that is
basically a part of the current deposits and against that the banks basically open the
current account.
Then we have this savings deposits; the savings deposits is cheque can be withdrawn;
cheque can be drawn against that deposits and that carry generally the interest already
3.5 percent to 4 percent interest it carries and as well as also there are certain restrictions
in terms of the amount of money withdrawn and as well as the number of times the
money can be withdrawn in a particular period of time.
So, that is basically you called the saving deposits or the savings account what is the
customer can open with the commercial bank. Then we have the call deposits they are
accepted from the fellow bankers and are repayable on demand, this deposits also carry
the interest, the call deposits are not available to the regular retail customers. They are
basically available for the other banks which can have the account with that particular
bank and they can also repayable on whenever they need on or whenever they demand
that amount and this deposits also carry certain amount of interest rate.
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So, these are the part of the demand deposits whatever we have, then we have the term
deposits on more popular popularly it is known as the fixed deposit or we are more
accounted with the term fixed deposits. So, there are different type of maturity period the
term deposits of the fixed deposits can be made for 2 months, it can be made for 6
months it can be made for 2 years 3 years or one year like that. So, depending upon the
term to maturity the rate of interest varies.
So, the longer the term to maturity the rate of interest also will be more against that, but
it has a certain limit after that the interest rate does not vary. So, these are the part of the
term deposits or the fixed deposits and these are the two ways the deposits are basically
defined in terms of the commercial banks.
So, then we will see that what are those factors which basically affecting the composition
of the bank deposits particularly in India and as well as the other countries. If one first
and foremost factories and national income, if national income will increase then there is
a possibility that the deposit base of the bank will increase. Because the level of income
within the household and as well as the other kind of customers who are available in the
particular market at that particular point of time that may increase.
Expansion of banking facilities in the new areas and new classes of the people because,
you see if there are more number of banks and there is expansion of the banks and that
creates the avenue for the people to make their savings or to create their savings account.
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There is a possibility that your deposit base may increase, increase in banking habit
because every day we all try to make the transactions through online and all kind of
digital payments are in demand, for digital payments are increasing. So, that also make
the people increasing their banking habit.
So, the banking habit is more or people are more interested to do the transactions through
the banks because of kind of authentic record and as well as it has also has an free kind
of spending or the transactions, then that also will increase the demand for the bank
deposits in the system. And increase in the relative rates of return on the deposits, then
you see that whenever the deposit rate is higher than the other type of investments or
other type of instrument, financial instrument which are available in the financial system
then also people demand for the bank deposits may increase.
Increase in deficit financing this is another reason through which also we always need
more deposits should be there in the bank to cover off that financing whatever we have.
And increase in bank credit; if you see that increase in bank credit is another reason that
whenever you talk about the bank credit, the bank credit basically what? The loans.
If the loans will increase then it will increase the money supply already we have explain
that, a money supply will increase then the investment will increase, when investment
will increase then output will increase, then if the output will increase, then the profit of
the producer may increase. And if the profit will increase automatically that money will
again come to the bank as a deposit.
So, that is also another channel through which the deposit base can be increased. So,
there is a relationship between the bank credit or the bank loan against deposit base and
inflows of deposit from NRIs. Already you know that NRIs is also one of the major
sources of the money supply in the financial system, if the inflows are more from the
NRIs i.e. the Non Resident Indians then the total deposit base of the commercial banks
also increase.
Then the growth substitutes, the other kind of alternatives which are available in this
market and as well as other type of investment alternatives which are available in the
market that also decides that how much bank deposits we should have. If more
alternatives are available and that are lucrative industry, people may be interested to
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invest their money in terms of those investments or those kind of assets. So, then
automatically the deposit base will go down.
But if the alternative assets availability is relatively less, then what will happen? The
demand for bank deposits also may increase because people will consider that this is the
safest invest what they can make and the amount of return what they get out of this
although this is very minimal or it is very less, but still it gives kind of safe return and
also increases the saving habits of the people.
So, that is why growth of substitutes is very important factor whenever you talk about
the composition of the bank deposits or demand and supply of the bank deposits in the
particular system. So, these are the different factors which affect the composition of the
bank deposits for the commercial bank.
So, these are the items which are basically the assets. So, these are basically the items or
assets with the commercial bank; these are the different assets. So, these assets are
basically what? These are cash in hand, balances with the central bank, balances with
other banks money at call and short notice, balances with the banks which are outside in
India, investment in government and other approved securities, bank credit, fixed assets
and the other assets.
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So, whenever you talk about this we are basically what we are talking about there are
different type of assets because just now we are talking about the liabilities and assets
and out of them the major liability of the commercial bank is the deposits. So, there are
different type of assets whatever cash the banks have to fulfill their liquidity
requirements that is also asset for them.
Whatever balance they will keep with the RBI they get interest against that, because of
that is also one of the assets. Balances with other banks they get the interest out of this
because of that this is considered as an asset, money at call and short notice whatever
liquid instruments they have, they considered them as an asset. Balances with the banks
if they have anything outside India there are fixed assets like land buildings machinery
all this things whatever they have their considered the fixed assets.
But the major assets of the commercial banking system is investment in government and
other approved securities and the bank credit. So, these are the basically major assets one
is your investments and another one is the bank credit because the loan is one of the
major components of the assets and investment is another component of the assets. So,
these are the two things what basically we will discuss more, that what kind of policies
the bank adopt whenever they discuss about investments or the deal with the investments
and the bank credit.
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If you see that whenever you talk about the investments the investments can be three
type what the banks do; one is your government of India securities, government
securities which are SLR investments or SLR securities.
So, minimum amount of investment that is a certain percentage of the total deposit has to
be invested in that kind of securities and other thing is other approved securities. Other
approved securities been there are some certificate of deposit or commercial papers
whatever they have, they can be also part of the SLR investments, they can invest in
those kind of securities is a relatively very liquid and softer. And another is non
approved securities, they can invest in any kind of risky bonds either it is a corporate
bond or any other bond.
So, those kind of bonds are basically called non SLR securities, they cannot be
considered as part of statutory liquidity ratio requirements, but they are considered as the
investments and also they can also invest in the equity market or the stock market. So,
these are basically the non approved securities which are basically non SLR securities,
but bank always invest in that because return from those kind of assets are relatively
higher and they can maximize the return out of this.
And whenever we are talking about loans and advances there are different kind of loans
the commercial bank give, one is your overdrafts or cash credits. They can go for
discounting or purchasing the commercial bills and demand and term loans.
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So, if you see this demand and term loans these are the two most important type of loan,
what always we deal with. Whenever we talk about the loan, the loan can be anything
already we know that the loan can be industrial loan; Why we talk about demand and
term loan? Because the demand loans are relatively short term in nature and term loans
are relatively long term in nature.
So, industrial loan, you have a housing loan, you have the personal loan, you have also
the loans related to other objective like education loan so like that. For different purposes
the loans can be given and some of the loans are very short term in nature that is why
they called the demand loans. And there are some loans which are very long term for
example, the housing loan that can go up to lets 20 years, industrial loan also can be
given after 15-20 years. So, like that you have the vehicle loan also.
So, different kind of loans are available and depending upon the term to maturity of that
particular loan we define them whether they are the demand loans or that term loans.
And that is the major sources of revenue what the commercial banks can generate and
the major source of the profit or income what the commercial bank can generate. So,
these are the major loans and advances what the commercial banks always use, but
whenever you talk what the loans and advances what the commercial bank give there is
certain policy they adopt, then how basically they provide this loans and what kind of
theoretical basis against that.
If you see there are different approaches for the bank lending because this lending
activities based on the different approaches; the one approach call the liquidation
approach another approach is called the going concern approach. What do you mean by
the liquidation approach and going concern approach? The liquidation approach is
basically what? Whenever the bank provides the loan they basically look the value of the
assets of the borrower as a security for the loan; that means, whenever we take the loan
they see that whenever we are taking the loan they take certain kind of mortgage or
collateral against that particular loan.
So, if there is a default then the bank and liquidity of the assets and can recover money.
So, this particular approach is defined as the liquidation approach. So, it implies a short
term rather than long term view of the borrower’s prospects and usually involves taking
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charge of these assets. So, any point of time if you are asset value is not compatible with
the loan what you are taking then maybe loan may not be granted for that.
So, that approach is called the liquidation approach, but whenever we go for the going
concern approach, in the going concern approach the bank basically sees the borrower’s
ability to repay the loan out of the future cash flows rather than this ability to offer some
tangible assets as security for the loan.
They see that in the future how much revenue or how much cash flow this particular
customer can generate. So, whether is it possible to recover that loan in terms of the cash
flow what that particular customer is able to generate in the future. So, in that particular
context we see what is the prospect of the outflow or the future cash flow of that
particular customer. So, here the banks basically analyze your ability to pay banks does
not analyze whatever assets you have and whether the assets value is compatible with
your loan amount what you are demanding.
So, this is what the going concern approach, for your information the India follows the
liquidation approach mostly and US and other countries follows the going concern
approach. Some people argue that liquidation approach is a backward looking approach
and going concern approach is basically forward looking approach for the commercial
banks. So, these are the different approaches for the bank lending and either of these
approaches can be followed by the commercial bank.
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Then whenever they provide the loan they basically take certain kind of margin in the
liquidation approach. So, whenever the loan made by the bank against any kind of
security is always less than the value of that security so this difference is called the
margin. Just now we said in the liquidation approach whenever you provide the loan
always we consider certain assets as the security or as the collateral. So, whenever we
give the collateral, the collaterals value and your loan value there is a difference and
always the value of the collateral should be more than the loan value. So, that amount is
called the margin.
So, the margin basically differs from security to security and the major principles which
determine its marketability, there accertainability of the value, stability of the value and
transferability of the title of that particular security. For example, if you see if you are
using gold as instrument than 10 percent is the margin, if you are using gold ornaments
then it is 20 to 30 percent of the margin.
If you are using government and other securities then it is 10 percent, if you are using
your equity ordinary shares it is 40 to 50 percent, if you are using preference share is 25
percent, if it is debenture it is 15 to 20 percent. Life insurance policies 90 percent of the
surrender value, commodities 25 to 50 percent and any kind of immovable property that
is 50 percent, land and all this things if you are using that mortgage.
Than the value of the total land always should be 50 percent always we considered the
50 percent of total that will be sanctioned amount for your loan. So, these are the
margins which has been used and why this kind of margin concept is used because to
avoid any kind of loss valuation of that particular asset. So, if there is a possibility that
valuation of that particular asset may go down.
So, depending upon that from the beginning bank take the precautionary approach to
keep that particular margin by that any point of time if loss any if you are the defaulter
and the particular asset can be sold in the market then that should not affect the total
amount recovered from that particular loan. So, this is what basically the margin and
further will be discussing about the performance of the commercial bank and how it is
measured. Please go through this particular references for this particular session.
Thank you.
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Lecture – 23
Commercial Bank Performance
In the previous class we discussed about the different financial statements. And what we have
seen the measure whenever you discuss about the financial statements what we have seen;
that the deposit is the major liability, and the investment, and the bank credit, or bank loans
are the major assets for the commercial bank.
And we discussed certain issues related to the approaches to the bank lending and as well as
the factors which are affecting the deposit base. So, in this particular session will be
discussing about how the commercial bank performance is measured. And what are those
indicators we use to measure the performance.
So, the performance measures are mostly based upon the income statement. So, if you
minutely observe this particular table. So, there are a different major items which has been
highlighted here. You have the interest income from the loan, then interest expenses, because
the bank also borrow from another bank or from RBI they pay the interest.
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So, your net interest income is nothing, but your from interest income minus interest
expenses. Then you have some non interest income you are also providing certain services,
you are also investing in the market. You have certain noninterest income you can generate
out of this. Then your total operating income is equal to your net interest income and then
noninterest income; that will give you the operating income.
There are some expenses overhead expenses day to day expenses the commercial banks do.
They you also give some provisions for loans and leases that already we discussed in the
previous class. And you can also gain or loss in the securities whatever money or whatever
stocks and all this things you have invested.
Another a pretax operating income if you want to calculate; that is the total operating income
minus your overhead expenses minus the provisions for the loss and losses. And if there is a
gain in terms of the securities whatever you have invested that can be added here. So, that is
basically of pretax operating income then finally, you can pay the tax.
Then the net operating income is nothing, but the pretax operating income minus tax. Then
finally, your net income if you are any kind of extraordinary expenses and all these things if
you have then you can deduct that one. And finally, your net income of the commercial bank
can be measured. So, this particular table is trying to show that how the net income of the
commercial bank is measured.
Because net income is a measure which is mostly used to measure; any kind of ratios of, or
any kind of performance measure, of any kind of financial organization, or any other
organization. So, including bank you are much more concerned about how much net income
the commercial bank can generate.
And what are the different sources the income is coming and what are the different avenues
through which the expenditures are made. So, after this we can move into that different
ratios; what the commercial banks use to measure their performance.
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Like any other companies the first and foremost measure is the return on assets. The return on
asset means how much, how the particular company is able to generate the income out of the
assets whatever they have. So, that is why it is nothing, but the
Net Income
×100. And if you want to convert in terms of percentage then it is basically
Total Assets
multiplied by the 100.
So, one of the most popular used measure for profitability that is your ROE so this is a
profitability measure, this is a profitability of measure. So, anytime whenever we use any
kind of proxy for the profitability always we try to measure it through the ROA the first
foremost important measure or the popular measure for profitability that is the return on
assets.
Then you have the ROE which is return on equity. Equity holders the particular people who
invest in that particular bank stocks they are much more concerned about the return on equity.
Now, what is return on equity? So, the same thing this is your net income upon the total
equity capital whatever the company has. So, in the monetary term whatever equity value the
company has total amount of equity net income upon the total.
How that means, how this particular net income is distributed among the equity holder that
basically is measured through the return on equity. So, net income upon the total equity
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capital that will give you the return on equity and multiplied by 100 that will give you the
percentage. So, that is also one of the most important performance measure of the bank.
So here what I am trying to say that ROA and ROE: Return on Asset and Return on Equity.
These are quite used measure whenever you talk about the performance of the bank or any
kind of organization. When there is a relationship between ROA and ROE also in our term
we call it basically the due point analysis.
So, here what basically we were talking about this relationship between ROA and ROE how
it can be measured. If you see here the net income upon the total equity capital it can be
further also expanded. But here I just wanted to show you that how this two ratios are related.
If you see that net income upon total equity capital which is your ROE is nothing, but net
income by total assets multiplied by total assets by total equity.
So, total asset by total equity is nothing, but the financial leverage. So, if you have the ROA
which is available to you and you have ROE to you then you can find out your leverage or
the financial leverage of the organization or particular bank. So, if you have the financial
leverage and ROE you can find out ROA. So, there is some kind of inter linkage which exist
between the different two ratios like ROE and ROA.
Who are the most popular measures for the performance for any kind of organization. Then
what is the leverages? Leverage basically shows the finance risk, we discussed about the
financial risk already in the beginning of the sessions, the leverage is basically measures the
financial risk of the particular organization. So, the multiplier or the leverage equity
multiplier, the leverage multiplied by ROE that can give you the ROA. So, that is the
relationship between ROA and ROE in the particular system.
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Then we can move into another measures for the banking prospective the one of the most
important measure of performance is the net interest margin. Now, what is this net interest
margin? It is the already we know that what do you mean by the
that can give you the net interest margin.
Or net interest income is nothing but total interest income minus total interest expenses that
we have seen in the beginning of the discussion. So, net interest margin is the measure for the
banking prospective it may not be applicable for other kind of companies like manufacturing
companies and other things. But whenever we analyze the performance of the commercial
bank we are much more concerned about the net interest margin percentage.
Because that gives a clear picture that how the commercial bank is able to generate the
income and how much expenditure their making. And finally, what is the margin there
maintaining in terms of the net income what is the generating in terms of the interest
payments. Then we have the another one the provisions for loan loss ratio. That is the
provisions for loan losses divide by the total loans.
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This particular ratio basically shows how the bank is exposed to the different kind of risk,
mostly the credit risk. The more the credit risk involved of a particular loan the bank provides
more provisions against that particular loan. So, if the provisions are more this is not a very
good sign for the bank the reason is the provisions are given to avoid any kind of loan losses.
So, if the probability of loss is more than the amount of provisions allotted against that loan
will be more. So, in that context we should see that what kind of loan the banks are giving the
particular loan should be properly assessed and the probability of loss, probability of default
for that particular loan should be very less in that context. If the probability of loss will be
less than the provisions amount will be also less because, the provisions is basically the
liability for the commercial banks.
So, you should expect that amount of money should be less for the system or the bank. So,
that is why this is another measure which measures that how far the commercial bank is
exposed to the risk. So, that is why provisions for loan loss ratio is also considered as a risk
measure for the commercial bank. Then we have a temporary investment ratio; what do you
mean by the temporary investment ratio. This is a government securities sold plus the
investment securities with maturity of 1 year or less and the due from the other banks divided
by the total loans.
So, that basically temporary investment ratio in the sense how much short term securities are
very liquid securities we have sold in terms of government securities and as well as the
securities which maturity period is less than 1 year or at least or maximum 1 year. And what
are the dues we have from the other banks and how much loans we have given that basically
a short term view that how far this particular bank is able to liquidate their assets whenever
they need against that particular loan whatever they have given.
So, that basically says you that whether the banks in equality is better or not or at the time of
requirement whether the bank is able to generate certain kind of revenue to fulfill the
requirements of the customer or not. So, that is what basically we call it the total temporary
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investment ratio of the commercial bank. So, that is another measure always you used as a
performance measure for the commercial banks.
Then we can move into some other measures. The other measures are the volatility liability
dependency ratio this is one of the new measure for the banks use.
That means it is shows that how far the liability dependency ratio is volatile.
So, here you have the total volatile liabilities. Volatile liabilities in the sense possible
particular asset whose asset value or liability value is highly volatile and how much liquidity
we have that basically measures to the temporary investments. And how much loans and
leases we have made in that particular time period.
So, we have to see if these particular liabilities are highly volatile. The value is frequently
changing and to fulfill that particular gap how much investments we have made in terms of
the liquid assets. So, that basically provide how far the bank is prone to the liquidity risk. The
volatility liability dependency ratio is again related to liquidity risk of the particular bank.
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Whether the bank is liquid enough to fulfill any kind of requirements if; the particular
liabilities whatever they have they are basically highly volatile. So, for example, the current
liabilities are highly volatile we have no idea that when the particular current account will be
withdrawn. Like that you can identify some of the liabilities what the banks have; they may
change frequently.
Or there are certain kind of certain jumps at the time of or any very specific time period. So,
to avoid this kind of problem or any kind of situation which can be adversely affect the banks
reputation and other things. The banks should have enough liquid assets with them which
basically measured through the temporary investments. So, that investment is good enough to
fulfill that, particular fluctuations which is happening in terms of those liabilities or not that is
basically measured through the volatility liability dependency ratio.
Then we have the rupee gap ratio; this is basically this interested sensitive assets minus the
interested sensitive liabilities divided by the total assets. You see whatever assets the banks
have all the assets are not interest sensitive and all liabilities also are not interest sensitive.
So, if you can divide those assets the assets which are interested sensitive. For example, the
fix assets they are not interest sensitive, the equities are not interest sensitive.
To extend the sensitive because their fluctuations are there because the loans and as well as
the deposits they are the most interest sensitive assets and liabilities. Then we have to see
that: what is the gap between the interest sensitive assets and interest sensitive liabilities
against the total assets whatever we have.
So, if it is the interest rate sensitive assets are more against this interest rate sensitive
liabilities accordingly the bank has to adopt different kind of strategy to minimize the risk.
So, that is basically the measures concept of asset liability management of the commercial
bank.
But here we have to see that what is the difference between these two accordingly we have to
define that what kind of investment or what kind of portfolio the banks should make by that
this can be managed. So, that is considered as a performance measure for the commercial
bank. Then another very straightforward or linear measure always or the simple measure also
bank can use that is that net loans to total loans.
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How much loans they have given against the net loans in the sense what is the probability
that the loan can be recovered and how much total loan they have given. So, in that context
they have to see that whether the loans which are basically given the bank is able to recover
this loans at a particular point of time.
Or what is the probability that the default will be relatively less. So, these are the different
measures which are used for the or we can say that popular measures which are used to
measure the performance of the commercial bank. Then we can move to other measures other
kind of issues related to this performance.
That is your non performing asset, which is quite popular in today’s context because there are
huge debate. The non performing assets are increasing in a very rapid manner. The growth
rate of the NPA’s for the public sector banks are increasing. And particularly that is a worry
some matter for the whole banking system and as well as financial system.
Because those kind of problem in the instability in the banking or high risk in the banking
because the NPA’s are increasing that can spill over to the functioning of the other markets
because the markets are highly integrated. So, in this point of time we have to always ensure
we have to see that what is the probability or what is the causes of NPA’s.
And sometimes we see that the definition of NPA’s is also affecting that whether the NPA’s
should be more or less because since 2014 this concept of definition or the definition of
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NPA’s have changed and as well as we have seen that there are some other factors also
responsible for the NPA’s. So, here what we are trying to see first of all let us check what do
mean by the NPA.
What is the meaning of the non performing asset? And then we can move into the probable
factors which is responsible for the NPA’s in the system. If we talk about NPA, the NPA is
basically when the asset can be converted into NPA; when the interest or the installment of
principal remain overdue for a period, period of more than 90 days in respect of the loan.
So, whenever either the interest is not paid for 3 months or if at all the principal amount also
should be repaid. The principal amount is not repaid for 3 months then that particular loan of
the commercial bank will be considered as the non performing asset either interest or the part
of the principal which are supposed to be paid within 3 months or which supposed to be paid
periodically for every month basis.
But continuously for 3 months if it is not paid then we can call that particular asset is a non
performing asset, according to the reserve bank of India guidelines. What is there is an
agricultural loan and the loan is granted for short duration crops then the particular definition
is little bit different then here if it is short duration crop. Then if the installment of the
principal or interest there on remains overdue for two crop seasons.
And a loan guaranteed for the long duration crops will be treated as NPA. Overdue for the
two crop seasons and loan guaranteed for a long overdue as NPA if the installment of the
principal or interest remains overdue for the one crop seasons. If it is short term duration crop
then it will be considered as an NPA if the interest or the principal is not repaid for the two
crop seasons. But if it is a long duration crop loan then the particular amount will be
considered as an NPA if the particular amount is not paid for the one crop season.
Then more or less the crop season is more or less same 3 months to 4 months. So, in that
contest they consider the crop season is the parameter to define the NPA whenever they can
analyze about the agricultural loan. But whenever other of the type of loans we consider
either it is housing loan, or it is a vehicle loan, or it is a personal loan, on any other loan.
There the NPA’s are basically defined on the basis of the days of non repayment of the
interest or the principal so that is basically 90 days. So, this is the way the NPA in the Indian
context is defined according to RBI guidelines. So, then let us see that whenever we are
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talking about NPA then obviously, there are classification of the assets the assets are
classified into different ways whenever we considered the NPA or we define the NPA for a
particular commercial bank.
Then how the assets are classified if you see the commercial banks. The commercial banks
assets are basically classified into four types. And these are standard asset, substandard asset,
doubtful asset and the loss asset. What do you mean by the standard asset? The standard asset
is basically one which does not disclose any problem and which does not carry more than
normal risk attached to the business.
That means, they are not the NPA. So, any loan which has been taken and the loan is repaid
periodically, the interest is paid periodically, the principals are paid periodically. Then
obviously, that kind of asset is basically considered standard asset. Apart from the normal
credit risk and other risk which are already measured by the commercial bank. The other type
of problems does not arise which respect to that kind of asset or that kind of loans there
basically considered as the standard asset.
But whenever we talk about the sub standard asset; then sub standard asset is basically those
assets if it remained as NPA for a period less than or equal to 12 months. It will be converted
in the NPA if that is not paid for 3 months. But if it remained that in that category for
conjugative 12 months then we can call it is a substandard asset. So, that means, the
particular value or particular asset what the commercial bank has it has become an NPA.
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Once it has become an NPA then in that category it remains for one year then you consider
that particular asset is the sub standard asset. But whenever you talk about the doubtful asset
the doubtful asset is basically that asset. Where this particular assets is required to be
classified as doubtful if it has remained NPA for more than 12 months. If it again considered
or it is defined as an NPA for more than 12 months we call them the doubtful assets. So,
remember this is for more than 12 months this is equal to 12 months up to 1 year. It is
considered as a sub standard asset more than 12 months it is considered as the doubtful asset.
Then whenever it is a final one is a loss asset the loss asset is one where the loss has been
identified by the bank or the internal or external auditors or by the cooperation department.
Or by the Reserve Bank of India inspection, but the amount has not been return off wholly or
partly at the time of auditing some of the loans amount can be return of for any particular
reasons. Due to the government some because of it with a proper approval from RBI and with
the proper approval from the government some amount of loan can be return off.
But the loan is particular kind of asset is a doubtful asset. So, again at any point of time it is
consecutively for a longer period of time it is considered as remainder as an NPA. But even if
it is remained as NPA still it cannot be written off there is no such kind of guidelines such
kind of clause, such kind of reasons by that the particular loan can be written off. In that
particular point of time that particular loan is considered as a loss asset. So, this has to be the
loss has to be identified by the bank or internal or external auditors or by the cooperation
department. So, these are the different types of assets whatever we have. So, then already I
told you that what those reasons are for NPA.
If you talk about the reasons for NPA there are two things you have to keep in the mind; one
is your ability to pay and another one is your willingness to pay. Somebody is able to pay
which the bank is able to really measure that. So, because of that the future cash flow this
particular person or particular individual particular company can generate they can pay the
money. And for some reason they are not able to pay because maybe they could not generate
that revenue over the period of time. Another is willingness to pay which is mostly driven by
the behavioral issues that if somebody might have the revenue, but they are not willing to
pay. So, that aspect it is very difficult to measure.
Because how we can measure that whether really the bank is able to generate or the recover
the money from that person who has money, but they are not ready to pay. And second thing
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is whenever you talk about the NPA there are various reasons. The NPA is sometimes the
credit assessment of the loan is not proper sometimes then we can see that the economic
conditions also creates a problem because the companies or other organizations may not be
able to create that kind of revenue.
There are some other factors like farm loans in all these things farmer loans and all this things
the monsoon in other things are also the responsible factors there are many factors which can
create. But here I just wanted to highlight broadly there are two factors. The factors which are
affecting ability to pay, but we are discussing which the tangible factors are.
And there are some factors which are related to willingness to pay and if it is because of the
willingness to pay is the factor then it is very difficult to recover that loan. because the person
is able to pay, but they are not willing to pay. So, these are the things what very important
from this perspective these are the new dimensions. But always we should consider whenever
we are providing the loans to any kind of customers.
Then we have a capital base which is your total capital. This is your total capital total capital
means total equity capital and the debt or the bond divided by the risk weighted assets. And,
it should be more than 9 percent in the context of India according to Basle Norms.
So, here if you see your total capital is a tier I and tier II capital and tier I capital is related to
the share capital and the reserves and surplus. And tier II capital is consisting of this
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subordinated debt or the equity capital. That particular ratio this risk weighted assets which
are risk what at given on the basis of different kind of risk over the bank can face.
So, that ratio basically measure the stability of the bank. We will discuss more about this
whenever we discuss about the Basle Norms. I have just introduced this particular concept
what is the discussion on capital base value, we will discuss more about the Basle Norms in
the following sessions.
Then we have another issue you see the performance or everything it depends upon the retail
business mostly in India. There are varieties of retail business has grown up in the Indian
context. And what are those factors which affect the retail banking in India. Economic
prosperity, changing consumer demography, which indicate that vast potential for growth in
the consumption because, people taste and preference has change because of the demographic
change.
Technological innovations, anytime online trading, online shopping, is very easy there is no
need to go to the market place that increases your consumption that is why it increases the
importance of the banking. Decline in the treasury income of the banks sometime because of
this thing the income of the bank’s get affected.
Retail loans have put comparatively less provisioning burden on the banks. You see that retail
loans whenever we are taking this loan credit assessment policy of the bank is relatively more
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robust that is why the credit risk of the bank is relatively less. So, that is why the provisioning
also increases, provisioning declines for the banks as banks are not keeping much provisions
against any kind of retail loans.
So, because the appraisal policy is relatively very stringent and they have more information
about the retail investor with the thorough monitoring process. These are the different factors
which drives this retail business in India and commercial banks play very significant role in
that particular process.
Further we will be discussing on other issues related to the Basle Norms and as well as how
the particular commercial banks manage their risk. And what are those different type of risk
with the commercial banks. Please go through this particular reference for this particular
session.
Thank you.
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Lecture – 24
Basel Accords
In the previous class, we discussed about the bank performance and as well as the
financial statements of the commercial bank. Today, we will be discussing about the
Basel norms or the Basel Accords on which the supervisory or regulatory norms of the
commercial banks were based upon. Whenever the crisis has taken place or at different
kind of financial crisis which affect the performance of the commercial bank; keeping
those things in the mind since 1988, the Basel committee has recommended certain
things on which the commercial banks can operate in a smooth way by that the financial
stability of the system can be maintained.
So, that is why the basic objective of the Basel was to maintain enough capital to observe
the losses without causing any kind of systematic problems in the system and also to
avoid the competitiveness and conflicts in the international scenario. That means, the
competition should be healthy or the process of regulation also should be very much
uniform across the different type of banks which are operating across the globe.
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So, considering those things the committee has been formed in 1988 and there are 27
countries which are the members of that particular committee or particular Basel to form
this Basel accord. So, in this context they have started this process since in 1988, but the
actual effect has come into 1992. And it was started in India little bit late, but the actual
implementation of the Basel I has come to the market in the year 1992.
So, already I told you that the basic objective of the Basel norm is to maintain enough
capital to observe the losses and as well as to make this market competitive, but in a
healthy way that mean the uniformity in terms of regulations should be there across the
countries. So, whenever the Basel I was started the Basel I was based upon the four-
pillars. There are four different dimensions four issues what the Basel I was trying to
discuss or trying to always explore on which the banks can operative or banks can
basically be regulated.
So, according to this the first one is the Basel has given a very formal definition of the
capital or the capital ratio, but in our term what we call it. Then what is the Basel
committee has said that the particular capital ratio of a particular bank or in our language
we call it the capital adequacy ratio. So, the capital adequacy ratio should be always
minimum or should cross a particular limit and every banks should target that particular
capital adequacy ratio to minimize the probability of failure in the future.
So, that is why the capital adequacy ratio is formally basically considers as a stability
ratio for the commercial banks. So, here they have defined there are two types of capital;
one is your tier 1 capital, second one is the tier 2 capital. So, whenever you talk about the
tier 1 capital; tier 1 capital is basically the common stocks. The common stocks are
basically the tier 1 capital whatever the bank has and also some disclose reserves and
surplus what is the commercial banks have.
So, these are basically the part one of the tier 1 capital. Then whenever we come to the
tier 2 capital; tier 2 capital mostly consists of the undisclosed reserve, revaluation
reserves and the provisions. Particularly the provisions in the previous class we are
discussing the provisions the commercial banks made to get rid of any kind of losses,
what they may incur against the loans what they have provided.
So, the loan loss reserves general loan loss reserves is a part of the tier 2 capital which is
considered for calculation of the capital adequacy ratio and there are some subordinate
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debts and some hybrid instruments like the preference shares. So, preference shares and
subordinate debt these are the part of the tier 2 capital and common equity which is a part
of the tier 1 capital.
These are the different definitions where the Basel I has provided and accordingly what
the bank has to do. The bank has to basically calculate the risk weighted asset and the
capital adequacy ratio in general term is defined as let your CAR is equal to capital
adequacy ratio, this is your total capital upon the risk weighted assets. The total assets or
whatever the commercial banks have, the particular asset should be given certain weights
and the Basel has given certain weights.
There are some assets which has 0 risk. So, that is why those particular has part, we are
considered about the 0 percent weight is; some assets have little bit a higher risk than
that, so, we are getting 10 percent, 20 percent, 50 percent and 100 percent depending
upon the nature of the asset the weights can be given to the different type of assets of the
commercial bank then finally, the weighted average of that particular asset can be
calculated and once the weighted asset average of the asset can be calculated that
basically can be used as to calculate the risk weighted asset.
So, that is why the total capital to total risk weighted asset should cross a certain limit or
should be equal to a certain limit. Then what is that limit? So, that is why they have
defined this target standard ratio the target standard ratio is basically 8 percent. That
means, according to Basel I your CAR should be greater than or equal to 8 percent and
CAR is nothing, but the total capital of upon the risk weighted assets and another
condition what they have said of which the core capital element has to be at least 4
percent the core capital element in the sense we are referring to the common shares.
The tier 1 capital which is called as the core capital for the commercial bank of the return
earnings which is the core capital of the commercial bank that should be minimum 4
percent and the total capital adequacy ratio should be more than or equal to 8 percent.
So, that is the first thing what the Basel has provided in this particular context. Then we
have the transitional and implementation arrangements and transitional and
implementation arrangement means they talking about the supervision, they talk about
the market discipline and the amendments from time to time what this particular
calculation needs to observe any kind of future losses for the commercial bank may face.
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So, this particular foundation was started since 1988 and after that what has happened the
implementation was started in 1992 and although this was made for certain countries. So,
every country was trying to follow as a guideline for them to minimize their instability in
the financial system.
So, then if you see that how basically this Basel accord from time to time has changed
and what are those different things which are involved in this. Already I told you that the
risk weighted asset basically consist of the sum of risk weight times asset amount for on
balance sheet items and the sum of risk weight times credit equivalent amount of the off-
balance sheet. There are some asset which are off-balance sheet items like derivatives
instrument, stocks and all this things. These are all the services what the commercial
banks in valuation of intangibles and all those things which are coming under the off
balance sheet items and there are some assets already what we have highlighted there
coming into the on-balance sheet items.
So, the weights are given to the respective items on the basis of these four categories or
four ways; 0 percent, 5 percent, 0 percent, 10 percent, 50 percent, 100 percent like this
then accordingly the risk weighted asset can be calculated and the risk weighted assets
should be divided with the capital to find out the capital adequacy ratio. Then after that
the due to certain issues time to time there are certain amendments were required for the
preliminary norms what the Basel has recommended.
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So, that is why this amendment process was started in 1996 and this was implemented in
1998 and here what basically the amendments were given you see whenever we are
providing the risk weights to the different assets the risk weights were given on the basis
of the credit risk. The credit risk already we have defined, the credit risk is nothing, but
the probability of default what that particular loan may incur or particular asset may
incur in the future period due to the nonpayment of the cash flows to the particular
commercial bank.
So, the credit risk is basically a probability of default what we have to consider or the
probability of not repayment or probability of not getting that particular asset in the
actual time period or in a specific time period. So, the weights were given on the basis of
the credit risk, but because of the fluctuations in the market fundamentals the banks are
also exposed to the market risk. So, whenever in 1998 the amendments were made in the
amendment the commercial bank were instructed to give the weight for the market risk
also.
So, in addition to the credit risk whatever weights were given to the assets see the
weights basically not only to be given on the basis of the exposure towards the credit risk
the weight should be also given on the basis of the market risk. So, that is why the
market risk is the addition in the amendment. So, market risk should be considered while
calculating the risk weighted asset for the commercial bank after these amendments are
made on the Basel I.
So, then every two months the committee basically always sit for the discussion and try
to find out that what are those loopholes and they try to recover they tried to implement
certain kind of new guidelines to make this particular system more robust or more
stronger.
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So, in this context what has happened the Basel II was implemented since 2007. And,
particularly whenever the Basel was started implemented after the Basel I due to certain
issues, so, in the Basel II we have three pillars. So, this pillars are first of all as per the
Basel norms whenever we are talking about the minimum capital requirement this same
minimum capital requirement concept was state by this Basel II. So, because that is
basically the stability ratio what the Basel committee has recommended. So, because of
that in the Basel II they have said that the minimum capital requirement should be
retained and that particular amount is basically 8 percent. But, only one difference has
been observed.
So, previously what we have seen in the beginning the credit risk was considered to
provide the weight second they have added the market risk in the amendment and
whenever they have started the Basel II accords as a Basel II norms, in the Basel II
norms the operational risk was introduced. So, while calculating the capital adequacy
ratio we have to consider also the operational risk. So, that is the guideline what the
Basel II committee has recommended.
And, your second pillar was the supervisory review process and what is the supervisory
review process it is basically intended to ensure that the banks should have enough
capital base to support all type of risk associated with the bank in the business process.
Then, whatever risk the bank has that sufficient amount of capital should be there with
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the commercial banks to observe any kind of risk or any kind of instability which may
arise in the future. So, that is basically the measure theme of the supervisory review
process. Then to make this particular system robust then what the Basel also has
recommended the Basel committee has recommended also the concept of the market
discipline. So, what do you mean by the market discipline?
The market discipline is the disclosure of the bank’s capital and risk taking position from
the time to time to all the market participants and it should be made public; that means,
the people who are linked to this commercial bank, they should have enough idea that
what is the amount of capital the commercial banks have and what is the amount of risk
weighted assets they have. And what is the capital adequacy ratio of the commercial
bank and all other financial information which are supposed to be required for
participating in the investment process and as well as the business dealing with that
particular commercial bank should be made public.
So, the market discipline is the third pillar in the Basel II norms. So, on the basis of this
three norms the Basel two recommendations were implemented for the commercial
banks and across the globe or across the world all the commercial banks or the regulators
of the commercial banks were trying to impose or trying to use this Basel II norms since
2007; particularly in India also we have started it since 2007.
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Then if you see that what are those things basically required for this. So, here also what
the Basel committee has recommended how the capital can be defined. Here again they
have written this tier 1 capital plus tier 2 capital, already we have explained what do you
mean by the tier 1 capital and what do mean by the tier 2 capital.
So, here how the risk weighted assets are calculated. The risk weighted assets are
calculated by this way Basel has given certain kind of guideline for this. You multiply
the capital requirements for market risk and operational risk by 12.5. You calculate the
operational risk, you calculate the market risk and you multiply 12.5 to that and add that
particular thing to the sum of risk weighted asset for the credit risk.
So, whenever you have because you are exposures to market risk and the credit risk so,
Basel has estimated that 12.5 should be multiplied with respect to the market risk and
operational risk and that has to be added with the risk weighted asset for the credit risk.
So, previously it was only credit risk and market risk after the amendments in the Basel I
and now, they have added the operational risk and their giving 12.5 multiplier for the
market risk and the operational risk and obviously, the credit risk were calculated on the
basis of the different weights which were already decided by the Basel I.
Then, another recommendation what the particular committee has given; the tier 1 capital
to total risk weighted credit exposure should not be less than 4 percent. They have
written whatever way the Basel I has recommended, the core capital concept what they
are talking about the core capital concept also was return by the Basel II committee and
they have according to that particular norm the tier 1 capital to total risk weighted assets
or risk exposure should not be less than 4 percent.
Then, here again the capital standard or the target capital adequacy ratio should be 8
percent or more than that; that particular thing what they have discussed in the Basel I
that basically they have retained it. But, that varies from country to country in Indian
context we have added some extra premium to that so, that is why for India it is 9
percent. The capital adequacy ratio for Indian context should be 9 percent because
according to Basel it should be 8, but depending upon the different risk profile of the
different system financial system the commercial banks or the regulator can impose
some extra amount of ratio or extra amount of capital with respect to the risk exposure
whatever they have. So, in this context we have 9 percent for the Indian banks.
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And, the tier 2 capital may not exceed the 100 percent of the tier 1 capital which was not
there before, then whatever capital base we have the tier 2 capital and tier 1 capital may
be equal the amount of capital maybe equal the different types of capital over the banks
have, but it should not exceed 100 percent or the tier 2 capital should not be more than
the tier 1 capital.
So, because tier 1 capital is actually the safe capital what the banks have because this is
their own money, their own return earnings, their own equity and whenever we are
talking about the debt subordinate bonds and all other things that basically is not the
owner’s equity what the commercial banks can use whenever they want. So, because of
that at any point of time the tier 2 capital should not exceed the hundred percent of the
tier 1 capital. So, that is the extra recommendation whatever they have given whenever
they have started the concept of the Basel II.
Then after that basically what has happened that other pillars already I told you that this
the supervisory review process and market discipline though under the supervisory
review process what they have said the banks should have a process for assessing and
maintaining their overall capital adequacy ratio.
Then, the supervisors or the regulator should review and evaluate the banks internal
capital assessment or capital adequacy assessment and this strategies; whatever strategies
this banks are adopting to maintain that capital adequacy ratio or to smooth operation of
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that particular bank that also should be always reviewed or evaluated by the regulatory
bodies or the supervisors in that particular system.
And the supervisor should expect banks to operate above the minimum regulatory capital
ratio. It is always ensured that the minimum capital adequacy ratio already we have
discussed that is 8 percent. But, the regulator or the supervisor always should ensured
that every bank has minimum 8 percent, but it should be more than that and already I
told you that for Indian context it is 9 percent or can be more than that. So, the whenever
we talk about the at any point of time this would always ensure the capital adequacy ratio
should not go below and if there is any possibility that capital adequacy ratio can go
below then the regulator or the monetary authorities can intervene into that to make this
particular ratio to a particular level by that the risk profile of the commercial bank can be
maintained.
So, the purpose of the pillar three which is the market discipline the market discipline is
basically your pillar three. So, market discipline is to compliment the pillar one and pillar
two, because if there is no discipline than there is no such kind of market discipline will
be imposed on them then what will happened that the commercial banks may not be able
to the substance that minimum required amount of capital adequacy ratio what the Basel
committee has recommended.
So, therefore, they have to they said according to this norm this would disclose all the
requirements to access or to allow the market participants to understand or to assess the
information about the banks risk profile and level of capitalization whatever what kind of
risk the bank is facing and how much capital the bank has and whether this amount of
capital is good enough to observe the shocks observe the losses if there is any because of
exposure towards the risk. So, all this things are basically always done by through this
market discipline.
So, time to time the market discipline concept or market discipline guidelines may
change or the regulatory policies may change, but the basic objective is to ensure that at
any point of time the capital adequacy ratio should not go below the 8 percent. So, that is
basically the concept of the market discipline in the context of the Basel II norms.
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Then Basel III the operation was started since 2010, but it was schedule to introduced in
2013 particularly in the Indian context some of the banks were complying with that or
some of the banks may not be although it was started in 2010 and 11 and was scheduled
to be introduced from 2013 but, India also which trying to adopt the Basel III. But, there
are certain kind of regulatory norms which were started in the concept of Basel III; we
will be discussing certain major points what the Basel III is trying to explain or what
kind of new changes which have taken place whenever the Basel III norms were started.
So, here the basic objective of Basel III was to observe the stocks arising from the
financial and economic stress and to improve risk management and governance of the
commercial bank and to strengthen the banks transparency and the disclosure. So, these
are the major objectives of the Basel III.
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So, keeping these objectives in the mind Basel III has talked about certain things; one is
they have introduce the much stricter definition of capital. Better quality capital means
the higher loss absorbing capacity, so that is why they have given much focus on equity
and they have started a concept of capital conservation buffer which is above this
regulatory norms that is 8 percent. So, that is why the banks have to required to hold a
capital conservation buffer of 2.5 percent which is above this regulatory norm of 8
percent.
And, this would also have a countercyclical buffer because of changes in the market
fluctuations and all this things. So, buffer can range from 0 percent to 2.5 percent which
should consist of common equity or any other the instrument which can absorb the full
losses if there is any in the system. So, overall what basically we are trying to say that
over and above the 8 percent of capital adequacy ratio there are certain other buffer
capital ratio or the buffer capital has to be maintained by the commercial bank to absorb
any kind of losses due to the cyclical changes in the economic system and other kind of
risk what the commercial banks may face.
So, another thing they said also the minimum requirement for common equity which is
the highest form of loss absorbing capital has been raised from 2 percent to 4.5 percent
that amount of equity mandatory. Equity capital has also increased to 4.5 percent
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according to Basel norms. So, that means, above the 8 percent it at least 4.5 percent
should come from tier 1 capital and mostly from the equity.
Then they have said that there is a leverage ratio. So, leverage ratio is basically what it
basically as the relative amount of capital to total assets not the risk weighted asset. So, 3
percent leverage ratio of tier one will be tested before a mandatory leverage ratio is
introduced in January 2018. So, that means, the capital ratio also should be at least 3
percent; the capital ratio means you are not providing the risk weights, the total capital
upon the total assets that should be a minimum 3 percent of the total capital what
basically the Basel III has introduced.
Then as part of the macro prudential framework, systematically important banks will be
expected to have loss absorbing capacity beyond the Basel III requirements.
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In another important thing what the Basel III has say they have added the concept of
liquidity risk. So, on the basis of this what they have defined they have basically given
two definitions of liquidity risk to or to measure the liquidity risk that is your liquidity
coverage ratio and net stable funding ratio. And, if you see the net stable funding ratio is
nothing, but or the it is a defined of proportion of capital and liabilities expected to be
reliable over the time horizon.
And, the amount of stable funding required; that means, the amount of funding actual
funding available stable funding whatever the banks have divided by the required
funding that is basically you called the stable funding ratio it should be greater than or
equal to 100 percent. But, the banks should always ensure and the required stable
funding is a function of other liquidity characteristics or different kind of asset what the
commercial banks have already have and liquidity coverage ratio is the ratio of high
liquid assets to the total net cash outflows over the 30 calendar days what the commercial
banks have.
That means enough liquidity the commercial bank has to maintain to fulfill the
requirement of the customers in the short period of time. So, liquidity risk is an extra
concept which was added in the Basel III.
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So, if you compare the Basel II and Basel III there are certain differences. Minimum
ratio if you see here it was 8 percent, now it is 10.5 percent because there are some
buffer capital we should have. Previously they said common equity to risk weighted
asset was 2 percent, this was become 4.5 percent, but this can also change up to 7
percent. Tier 1 capital to risk weighted asset it was 4 percent it has become 6 percent.
Tier 1 capital to core tier 1 capital to risk weighted asset was 2 percent it has become 5
percent.
Capital conservation of a conservation buffer was not there before, but it has become 2.5
percent now. Leverage ratio was not considered now it is 3 percent, countercyclical
buffer it is 0 percent to 2.5 percent, minimum liquidity coverage ratio was not required
according to Basel II, but it was there in Basel III minimum net stable funding ratio was
not there in the Basel II. But, it was there in Basel III and systematically important
financial institutions as it was not there in the Basel II, but this was new feature which
were added in the Basel III.
So, these are the major difference what basically we have observed in the Basel III
norms. So, what basically we have discuss this is the overview of the different norms
Basel I, Basel II and Basel III and we are just briefly discussed about that how this
particular norms are basically implemented and or maybe designed for the betterment of
the commercial banks to manage their risk or to increase their sustainability in the
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market or to make this particular financial system more stable or to capture or to observe
the probability or expected losses what they may incur in the future.
So, next class will be discussing about under these norms how the different type of risk
basically are measure. So, how the risk are measured, different type of risk like credit
risk, liquidity risk, your market risk are measured and what are the different methods are
used for this.
Thank you.
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Lecture - 25
Risk Measures in Commercial Bank
So, after the discussion on the different Basel norms. So, in this session will be discussing
about how the different type of risk, what we have discussed that are measured for the
commercial banks. So, already we have discuss there are four type of risks; one is credit risk,
you have market risk, you have operational risk and you have the liquidity risk. Depending
upon the different norms the different type risk, which we were consider for measurement of
the risk weighted assets, what the commercial banks are using.
We will be discussing today what are the different approaches, which are used to measure to
this kind of risk and whether in the practical sense it is possible to measure all type of risk in
a adequate way or in the perfect way or not.
Then what are those approaches we use for the measurement of the risk. Particularly, we can
start with the discussion with the credit risk whenever, according to Basel the credit risk can
be measured using the standardized approach and they can use a foundation IRB approach,
internal rating based approach, then you have an advanced IRB approach. There are different
approaches which can be used to measure the credit risk for the commercial banks.
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So, if you see how this particular approaches work. If you see the standardized approach,
whenever the banks use the standardized approach to measure the credit risk, the banks
basically may use the assessments by the external credit assessment institutions. On the basis
of the different type of bonds or different type of assets what the commercial banks have, the
different external agencies the credit assessment agencies, they have given the weights for
that.
So, already the weights are calculated by the external agencies. So, the basic job of the
commercial bank is to follow any of the particular external credit assessment institutions
approach and they can use that thing for calculation of the credit risk of the commercial bank.
So, how they calculate? They get that particular weightage from this.
Let for example, the commercial bank has triple A rated bond, there is a double B rated bond,
that is a B plus rated bond like that. So, for different type of asset whenever we are talking
about the risk weights, the risk weights are different.
Let for, if it is triple A rated bond the risk weight can be 10 percent, but is a double B rated
bond, there may be risk weight will be 50 percent. So, depending upon the different type of
asset the so, for higher the quality the risk weight maybe always less.
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So; that means, assignment of the risk towards the high quality asset is always lesser than the
risk weights which are given to the low quality assets. So, once we have use those things, we
have the assets which is already available with us. So, we can multiply that particular with
weight with respect to the book value of the asset what the commercial bank has and finally if
the risk weighted asset can be calculated or the credit risk of that particular bank can be
calculated. So, this is the standardized approached, approach what the commercial bank can
use.
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Then we have another approach that is called the IRB approach in the IRB approach the bank
basically calculate the credit risk on the basis of different inputs internally. The internal rating
based approach is basically combines the quantitative inputs provided by the banks and
formulas specified by the committee.
There is a committee which the bank can formulate and the bank can use that are already the
Basel committee has recommended as given certain formula or bank can also use their own
approach, to calculate this particular kind of inputs and those inputs can be used to calculate
the credit risk of the commercial bank.
Then what are those input what the commercial banks need for the calculation of the credit
risk, then it the probability of default, this should need the loss given default then the
exposure at default then the maturity of that particular asset. So, if all those four dimensions
are available then what the commercial banks can do? The commercial banks can use these
particular inputs to calculate the credit risk the calculation of probability of default, loss given
default and exposure of default little bit needs more statistical derivation.
So, we are not discussing in detail about this, but these are the inputs which are required to
calculate the credit risk of the commercial bank, if they are going for the IRB approach and
those kind of components can be generated by the bank itself or they can use the formula,
which is specified by the Basel committee already.
So, once those things are considered, those data is available then you can use those data for
calculation of the credit risk of that particular commercial bank or what is the probability that
the loan may not be recovered or there is a probability that there is a counterparty default. So,
those things are basically calculated, once those inputs are available with the banks.
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Then we have another thing is the market risk. Already, if you remember in the beginning of
the discussion, whenever we started this discussion about the different type of risk, what we
have discussed, the market risk is basically systematic risk.
The market risk is basically a systematic risk. We have two types of risk; one is systematic
and another one is unsystematic risk and already we have discussed that the systematic risk
cannot be reduced through the diversification with, but unsystematic risk can be reduced by
the diversification, because unsystematic risk is nothing, but the idiosyncratic risk, which is
confined or specific to the specific entities, a specific organizations.
So, whenever we are discussing about the bank from the banking prospective, the market risk
is nothing, but the interest rate risk, because once the interest rate changes, because of certain
factors already we discussed in this particular course, that once the interest rate changes there
is a probability the value of that particular asset will change, because every value is
calculated on the basis of certain discounted way. So, interest rate change will affect the
discount rate and as well as the cash flow. If the discount rate and cash flow, because the
CF t
value already we know that P= t
( 1+r )
So here, because of change in interest rate your cash flow may change your r may change, r
is nothing, but the discount rate. So the, because of that if the value of that particular asset get
changed. So, depend then; obviously, the particular total value the portfolio will change. If
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the total value of the portfolio will change then what basically will happen the bank will be
exposed towards more risk in terms of the interest rate fluctuations. Here, I just wanted to
highlight certain things, that whenever we are talking about the interest rate risk.
The interest rate risk has two component; one is your price risk and another one is the
reinvestment risk. What does it mean? For example, the bank has issued a bond, one bond is
there, bank has invested in the bond and there is a coupon involved in that bond. So, what is
happening? For example, the par value will explain more, but here for example, the par value
of the bond is 1000 rupees. The par value of the bond is the coupon is equal to 10 percent, par
value of the bond is 1000 rupees, then what is happening? The coupon is paid annually, then
what will happen that every year you will be getting 100 rupees.
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So, if every year you are getting 100 rupees then what is happening, that 100 rupees already.
CF t CF t
The price already you know. P= + +… Let the term to maturity of the bond is 10
( 1+r ) ( 1+ r ) t
years then final year it is your c f 10 divided by 1 plus r to the power 10. So, this is the way it
is calculated. So, what is happening, if this r is nothing, but the interest rate in the market or
the discount rate.
So, in this example what we are doing 100 divided by 1 plus, let the market interest rate is 9
percent then this is 1.09 plus 100 divided by 1.09 to the power 2 so on and final year you will
be getting back your par value, then you will be getting 1100 cash flow divided by 1.09 to the
100 100 1 100

power 10. + 2
+…+ 10 So, this is the way the price of the bond can be
( 1+ 0.9 ) ( 1+0.9 ) ( 1+0.9 )
calculated, but once the particular 9 percent has changed then; obviously, what will happen?
Let the 9 percent has decreased to 8 percent.
So, if it has become 8 percent value the bond will increase, that if the value of the bond will
increase then what is happening the price risk will go down, because the value is increasing.
So, in terms of price risk it is going to be down, but whenever this particular investor this 100
rupees what they get in every periodical basis whenever they want to reinvest that particular
amount in the market, because the market interest rate has gone down, the reinvestment risk
which basically will go up.
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So, that is why the price risk and reinvestment risk do not go together. The price risk is
increasing, the reinvestment risk will increase. If the price risk is increasing then the
reinvestment risk will decline. So, because of that what is happening, the total value of the
portfolio value or total capital value or total asset value of the particular bank is highly
exposed towards the change in the interest rate in the market. So, that is why in general sense
from the banking perspective, we call it the market risk.
So, now what is happening, there are different approaches Basel has recommended to
calculate the market risk; one is your standardized method, another one is the internal
method. One standardized approach they have given. This is the formula, this is the way the
market risk you can calculate and another one is the internal models. You can also formulate
on the basis of the banks, internal assessment and the method what they are calculating, they
can use the value at risk method. What exactly the value at risk method is?
The value at risk method basically shows you how much maximum loss one particular
organization can incur due to certain changes or due to interest rate changes, what is the
maximum loss one particular organization can incur at a certain confidence or the
significance level in a certain time period.
What is the maximum loss the organization can incur at a given confidence or significance
level at a specific or given time period? I hope you understood, what do you mean confidence
interval and significant level in the statistics. We use the confidence and significance level
and if you are following a standard normal distribution then the values are basically fixed for
example, if it is 10 percent we use the value 1.64, if it is 5 percent significance level, we call
it, it is 1.96 like that.
So, here what we are trying to see using the value at risk, whenever the interest rate changes
what is the maximum loss what that particular bank is going to incur due to the fluctuations
in the interest rate, that you can calculate using the value at risk method and use that
particular calculation to calculate the overall market risk, what that bank is basically expose
towards. So, that is basically the standardized approach or the internal model the Basel has
recommended.
So, the bank can go for already calculated formula what the Basel has given or they can use
their own internal assessment to calculate this. There are different stock index approach and
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other approaches or it can be used and as well as they can, because the stocks the particular
banks beta also can be calculated. Already you know that what do you mean by the beta?
So, beta is basically the covariance between the return from the bank stock with the market
return divided by the variance of the market return. So, this is the correlation between
individual stock return of the bank with the market into standard deviation of the stock return
into the standard deviation of the market return divided by the variance of the market return.
COV i ,m ρ ℑ, σ σ
β= = i m
Varm σm
So, one standard deviation can be cancelled out the finally, you will find the correlation
between market return and the individual stock of the bank into your sigma i m m will be
cancelled sigma i by sigma m standard deviation of i f divided by standard deviation of f and
another way also you can calculate it.
σi
ρi , m .
σm
You can run regression the your depended variable is individual stock return of the bank is
equal to a function of the market return and here I have already told you the market return can
be any kind of market portfolio, it can be BSE 30 or BSE Sensex, it can be NSE nifty or also
it can be any kind of stocks or any kind of index which are constructed on the basis of the
bank stocks.
So, any kind of proxy you can use for the market portfolio then run the regression whatever
slope coefficient you find. So, this is the way basically, you can specify the function
R i=α + βR m +uand here, we have beta, once the slope basically is the beta. This is basically
also considered the market risk of that particular bank.
That is basically you called at the stock index approach, that can be applied to any company
in that also that can be applied to the bank or you can use this all, those method value at risk
and other method to find out the exposure towards the risk. Then we can move into the other
type of risk, what the commercial banks always face.
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And the most important type of risk in today’s context is the operational risk. Very difficult
to measure, but it has a very significant role, for the banks, because banks are highly expose
towards the operational risk. Then what do you mean by the operational risk? The operational
risk is nothing, but the risk of loss resulting from an inadequate or failed internal process
people or the system or from the external events.
So, any kind of way it is if the, any kind of loss has been incurred by the banks due to certain
kind of failure in terms of the process in terms of the people or in terms of the external
events, which cannot be predicted before. So, then that particular bank is or that particular
organization is exposed towards the operational risk.
So, there are three approaches for the Basel has recommended one is basic indicator approach
standardized approach, then internal management approach. These are the three different
approaches which are recommended by the Basel committee to measure the operational risk
of the commercial bank. And what are those approaches basically we always see.
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So, you see if you go by the basic indicator approach according to Basel what this basic
indicator approach is the operational risk in terms of basic indicator approach is here if you
see G I × alpha. So, here what do you mean by the G I. G I is equal to the average annual
gross income, basically three years, the expected negative amounts into alpha. Alpha is fixed,
which has been given by the Basel committee that is 15 percent ok.
Except this negative amount we do not consider, this is alpha is equal to 15 percent. So, then
if you multiply that then, because of this alpha is basically shows the operational risk. So,
because of this how much annual income is getting affected. So, that basically is one of the
quantifiable indicator what the Basel has already recommended. Another approach they have
given that is standardized approach.
So, here what is the standardized approach the same thing they the given that average annual
gross income from business line from 1 to 8, that is again three years average multiplied by
the beta. So, again we also the beta is fixed by the 15 percent little bit G I is different, but
again the beta component, because from the bank prospective it is 15 percent for the retail
companies, it is different for other companies, it is different on the basis of the nature of the
business, the beta value gets changed.
So, that beta value was recommended by the Basel committee, only you have to calculate the
average annual gross income from the business line from 1 to 8 for the 3 years. It is not the
total annual income. It is the average annual gross income from business line from 1 to 8 and
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then finally, what you can do you have to define those business lines and 1 to 8 business lines
whatever income we are generating, that has to be considered for this analysis and you
multiply with respect to that multiplayer that is beta, that basically, give you that what kind of
way the particular bank is getting affected, because of the operational risk.
You can use the internal management approach. Under this approach the regulatory capital
requirement we recall the risk measures generated by the banks internal operational risk
measurement system, using both the quantitative and qualitative criteria, but whenever you
are using your own criteria to measure the operational risk, which is more practical in nature,
whenever you are doing it you need the approval from the supervisory bodies in the context
of India, we have to take the approval from RBI that what are those different approaches or
different indicators you are using or any commercial bank is using to measure the operational
risk of the commercial bank.
So, this is basically your internal management approach. So, whenever we are using internal
management approach, it is very much required to understand, what are those different
sources through which the operational risk arise and what are the reasons that the banks are
exposed to the different type of operational risk.
So, if you see the different sources of operational risk, there are many. One is wrong and
delay decisions and lack of accountability. It is mostly we have, we can say that ethical
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practices. There are some unethical practices if some employees will follow, that also lead to
any kind of loss to the organization in the future. Already we have the examples.
There are, whether it is a financial fraud or non financial fraud in Indian market, also we have
certain frauds which have taken place that is also part of the operational risk or any decision
which needs immediate attention, which has a policy decision from within the bank has to be
taken, to increase the efficiency of the operations.
If there is a delayed in the decision, it has a time value impact, there is a lack value impact
that also finally, will affect the total overall performance of the banking system and finally,
the operation risk may arise. Second is inadequate MIS; that means, management information
system and obsolete policies. There are certain policies which are not at all existing or there
are some new things, which have come into the existence in terms of accounting rules of,
accounting standards and all this things.
Let the banks are using the old standards or old policies for their operations and they do not
have proper I T system, which is in place which can increase the efficiency, then also this
total efficiency gets affected and, because of that that is a loss of the value of the total profit
or total kind of business what the banks are doing.
So, because of that also they are exposed to the more operational risk incompetency of staff,
some staffs are efficient they may do the job in a less time and there are some staffs which
are incompetent they may not understand the integrity of the operations, integrity of the
complexity of that particular mechanism. So, in that context what is happening that also lead
to inefficiency or lack of the proper training.
They may not have actually trained to make this particular thing possible in a small time
period and as well as with a less time period, they can increase that particular or provide that
kind of services to the customers. Lack of succession planning and development of second
line if any kind of authorities is going to be retired like CEO, CFO and all this things and how
the succession planning of that particular employees is made, whether adequate for suitable
person is placed in that or not and whether really he is trained enough to make that particular
business or not.
So, those things can also increases the operational risk of the bank. Non compliance with
circulars policies and regulatory requirements you know that a for everything there is a
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penalty if you are not able to comply all those kind of guidelines what RBI is giving or any
central bank is giving, then you have to be imposed by high penalty and that also leads to the
increase in the operational risk of the commercial bank.
Involvement of staff in frauds and forgery in Indian context also we have seen like PNB cases
and some other cases where the frauds and all this things have taken place, because of that
that has also the loss in terms of the market value of that particular company and as well as
other things failure of the technological equipment. Sometimes you might have gone to the
bank you say that this system is down, there is no internet and all this things.
So, that will also decline this performance and, because of that the bank is more exposed
towards the operational risk. Then natural calamities, a non anticipated changes that can be a
theft. There can be anything any kind of crisis which may taken place which is beyond the
control of the human being. So, that also will lead to the operational risk deterioration of
banks image the brand value of the bank has gone down due to the poor services, behavior of
the staff or the frauds or any kind of news related to the NPAs and all this things.
So, if those kind of thing has a filling among the customer, this bank is not good, that bank is
good, because the services in that particular bank is good that bank is providing, better
customer services. The work is done in a better way and work is done by taking less time to
complete your work and other banks may be the process is lengthy or they are not that much
attentive towards a customer requirements or customer needs. So, in that context also that
lead to the operational risk.
So, if you observe all those points are highly subjective. So, measuring those kind of
variables using a internal based approach is really a tedious job for the commercial bank and
that is why operational risk is basically arise due to more on the behavioral factors or some
factors which is uncertain and really difficult to measure from the banking perspective, but it
is a very significant role for the total profit or the efficiency of the commercial bank.
So, because of that the importance of the operational efficiency or operational risk, in this
banking system has gone up by many faults and people are much more concentrated or much
more now, trying to analyze how the operational risk can be measured, considering all those
sources what we discussed just now and try to find out how much the total gross income of
the bank or gross profit of the bank is getting affected due to the more exposure towards this
operational risk. So, this is the idea about the operational risk.
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Then we can move to another type of important risk that is the liquidity risk which was
introduced in the Basel three. What do mean by the liquidity risk? Liquidity risk arises,
because if the bank is unable to meet the banks liability as they become due, whenever you
have to pay this money, if you are not able to pay then customers demand is not entertain or
could not be possible.
Then that leads to liquid risk unable to generate cash to meet the fund withdrawals,
commitment, credit or increase in assets, you do not have enough cash. Whenever anybody
goes to withdraw their money what about they have deposited with the bank is not able to pay
them or they have committed to provide the loan to somebody, but they could not provide
that loan that leads to the liquidity risk and mismatches in the maturity pattern of the assets
and liabilities.
Because if you observe the liabilities are mostly short term and the assets are mostly long
term. So, the banks, there is basically you called the inter temporal gap with the commercial
bank. So, the bank always try to match that asset and liability using the different methods, but
sometimes if the bank is not able to match this assets and liabilities then they are exposed to
more liquidity risk.
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So, there are basically different approaches, we use to understand and to estimate this
liquidity risk or to manage this liquidity risk. we have working funds approach, we have cash
flow approach, we have to first understand how much is the own funds, then the liquidity
requirement will be nil.
When the deposits we have to see how much is volatile, how much is very much vulnerable,
and how much are the stable. Then the liquidity requirement will depend upon the maturity
profile. The float funds in that case then liquidity requirement is highly sensitive like your
current account in all this things.
So, in this context what we have to do, we have to estimate the anticipated changes in the
deposits by looking the past data, estimate the cash flows by way of loan recovery, estimate
the cash outflows by way of deposit withdrawals and credit accommodation, forecast all these
variables in the end of each period and find out the estimate and try to calculate the liquidity
needs in a particular planning horizon.
Every commercial bank has a policy to calculate how much liquidity they need in a particular
time span and accordingly that much amount of money at that amount of cash has to be kept
with them by that the liquidity requirements of the commercial, of the customers can be
fulfilled and as well as the commercial bank will be less exposed towards the liquidity risk or
they can manage this liquidity risk.
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So, in this context how they can manage this? they can first see that, what is the reserve
requirements, they have over the period they have to estimate that one. Then already this
Basel committee has recommended to different ratios or can also use their own different
ratios, current ratio and all these things. They have to see or net stable funding ratio and
liquidity coverage ratio has to be estimated periodically, to see that whether we are really able
to manage that liquidity risk or not, and degree of asset and liability mismatch.
How much is the mismatch we have, what are the possible strategies we can adopt to match
that asset and liability that plan bank has to do and the degree of diversification of borrowing
facilities and contingent loan commitments. If they have committed something, but they feel
that they are not able to do that then for that whether they may do that or they may not do
that, but before that they have to ensure what kind of contingency plan they have in their
hand.
So, if you see all those things the regular forecasting of the liquidity requirements and
maintaining the adequate amount of liquidity ratio, within the commercial bank can reduce
the liquidity risk and by that the commercial banks are able to manage that and as well as the
fulfill the customers’ requirements. So, this is what basically the overview of the different
type of risk, what the commercial banks face and as well as how those particular risk are
measured or may be analyzed from the Basel accord prospective or Basel norms prospective.
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So, this is about the different issues which has related to the commercial bank and we have
just discussed about the different themes or different major things, which are related to this,
but in depth discussion maybe if somebody will study the commercial banking or
management of commercial banking they will read more about the methods and all this things
or quantification method and all. That is beyond of scope of this particular subject.
But this is the overall idea what you can generate on yourself to understand the banking as a
aggregate prospective or we can say that, the prospective which can encourage the more
discussion on this and this is what about the commercial banking and further we will discuss,
will be discussing about some other important institutions which work in the financial system
and more particularly with reference to India.
Please go through this particular references, for this particular session. Thank you.
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Lecture – 26
Provident Fund and Pension Fund
So, in the previous class, we discussed the different issues related to commercial
banking, which deals with the financial statement, performance of the commercial bank,
then we also discussed the autonomy, then we went to the Basel norms. Then finally, we
discuss certain things related to risk management of the commercial bank or the
measures of the risk of the commercial bank.
Today, we will be discussing about another important institution what we can say or
important instrument, which is available in the market or always we are much more
concerned about that is basically your Provident Fund and the Pension Fund, because
that is a buzzword or maybe common things, what always people are concerned about
whenever anybody works or anybody started earning the income.
So, let us see that what exactly this pension fund and provident funds are and how those
things work in the Indian financial system. So, whenever we talk about the provident
fund, it is basically what, it is basically the contractual obligation for financial security
without any motive of the capital growth. What does it mean? It means that why the
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people basically go for a provident fund or the government ensures that we should have a
provident fund, it is not to maximize the return or we are not expecting that a regular
flow of income, what we can expect from this.
But, we always go for the provident fund, the basic reason is the provident fund is
basically financial security for you and as well as for your family members. So, we go
for small savings through this provident fund, and end of the retirement. Once your job
will be superannuated or you will be getting your retirement, then that particular money
can be accumulated to a certain amount, and finally, that can be useful for your
retirement life for you and as well as for your family.
So, the basic objective of the provident fund is, it is a forced kind of savings that the
investor or the person always does, to get certain kind of security, after the retirement.
So, if you talk about India, in India mostly there are different types of provident funds
work. One is your GPF-General Provident Fund which was there before, but nowadays it
is not existent, but still, there are certain employees, who are coming under this GPF
scheme.
And we have the Contributory Pension Fund-CPF, then we have the Employees
Provident Fund scheme that is EPF, then finally the Public Provident Form that is PPF.
One by one if you see, what do you mean by the general provident fund? The general
provident fund feature is basically dealt with after the person gets superannuated or
maybe gets his retirement. Then whatever existing salary he was getting, every year or
every month some amount of salary was deducted from that particular monthly salary,
generally, it is 10 percent, and that money is deposited in the account which is called the
GPF account.
And after the retirement, he gets that particular money or all the accumulated money
with a certain interest. And that interest rate is basically decided by the government. In
between the GPF, money can be withdrawn for some specific reasons some either it is
health-related issues or any social issues if you have that is already defined. So, the GPF
money also can be withdrawn, if the particular person wants.
Within that, we have another scheme, which was available that is called CPF
contributory pension fund. What this contributory pension fund is and in the contributory
pension fund after retirement, the person does not get the pension on the basis of his or
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her last salary. In the contributory pension fund, the person contributes certain money or
certain percentage of the monthly salary, and the minimum matching amount a 10
percent or 12 percent that will be contributed by the employer, and that money will be
kept in a particular account which is called the CPF account. And that also carries certain
interest. And after retirement, that person will get back that particular money with a
certain interest, whatever money they have accumulated.
An employee provident fund, it is basically a small income group. So, everybody should
have the EPF account. And whenever the particular person gets his or her salary, a
certain percentage of the total salary of that particular month will be deposited in the EPF
scheme. And the accumulated money can be withdrawn, whenever this person gets his
retirement.
And public provident fund, this is basically a way of making your investment or maybe
tax saving instrument. Some of the commercial banks are entitled to provide these public
provident fund services like the state bank of India. And the maximum amount, what you
can save through the public provident fund that is 150,000 per month. And the person
can deposit that money in one go or they can deposit the money also two in a different
installment basis, but that has to be deposited within that particular time gap, so that is
basically a tax-saving instrument what people call it. And it is a very long term
instrument, generally, it is kept for 15 years.
And the money cannot be withdrawn, before that or before the maturity of that particular
fund which is basically 15 years time period, so that is basically you call at the PPF
scheme of the public provident fund. So, these are the different provident fund schemes,
which are existing in the Indian market. And different people are coming under maybe
falls under that particular scheme, depending upon that reference or depending upon the
type of the job, what they are doing, and as well as whether they are the lower income
group or they are the higher income group.
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So, if you talk about why the provided fund is very important or it is very growing
because there are different reasons for that. One is your, that is adaptation of statuary
measures, because it is a mandatory, it is a force saving kind of thing, it is mandatory for
everybody to open the provident fund account, because to make that particular retirement
life safer and as well as your family protection.
And another one is increase in the commercial establishment because of development in

the business sector. Nowadays, there are some organized and unorganized employees,
which are available. For both organized and unorganized employees, this particular
provident fund services are available or may be mandatory, so because of that thing is
basically growing in the Indian market now.
Then we have the expansion of industrial and service sector, which is growing rapidly.
Introduction of the different type of schemes because we have just now, discussed the
four type of schemes. There are different schemes available under this; the people can
always go for depending upon their characteristics. And also the provident fund provides
the tax benefits.
So, whatever money is deposited in the provident fund scheme, that basically is a tax
deductible instrument whenever we are giving the income tax in a particular financial
year. And also increase in the minimum rate of contribution, the government time to time
make it mandatory that how much money has to be deposited towards the pension or
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provident fund, so because of that also that amount are available to the money in the
circulation above in terms of the provident fund account is also increasing.
Changes in the pay structure, because time to time the pay revisions are happening. One
is the income level of because a particular person increases, then automatically the
amount availability towards this provident fund also increases. And increase in the
income level. So, these are the major factors, which drive the growth of the provident
funds in India or the amount of money which is circulated through the provident funds in
India. So, these are the things, not the ultimate things, but these are the some of the major
factors, which drive the growth of provident funds in the Indian financial sector.
Then we have if you see that, we have some data related to the rate of interest what we
get. If you see the GPF, PPF, and EPF rates, there is not much fluctuations in comparison
to all these three types of funds which are available, but more or less it varies between
eight percent 8.7 or 8 percent to 11 percent. But, if you see there is a trend in 2000, it
was 11, but after that this particular rate has come down 9.59 9, then it has come down
even 8, then there are some in there is a fluctuating trend.
But, when up to 2000, if you see 2000 to 2001, the rate was quite high 11 percent
interest; but, in the year 2015, 16 data, whatever we have now. If you see that GPF
provides 8.7 percent interest PPF 8.7, and EPF provides the 8.8 percent interest, and that
always subject to change depending upon the government policy.
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So, where this money, which is coming to the provident fund are invested; so, whenever
the money comes to the GPF, the GPF funds are basically invested, because they provide
the interest the whatever money is given to them. The money under this particular
provident fund scheme is always invested in the market or the different kind of financial
instruments. So, if you see the restrictions, there are different limits has been provided by
the government. So, if it is mandatory that the 45 to 50 percent of the money has to be
invested in the government securities.
Depth other depth securities and term deposits of the banks, they can invest up to 35 to
40. Money market instruments like certificate of deposits commercial papers, treasury
bills, all these things can be invested up to 5 percent. Equity related investments which is
relatively riskier than the other type of investments, you can go up to 5 to 15 percent.
Exchange traded funds or the index funds, if they have which follows the buy and whole
strategy on the passive strategy for the investment, there they invest 5 to 15 percent.
And you have of the asset backed securities or real estate, infrastructure are all
investment trusts, and all these things, then you can go maximum up to 5 percent. So,
these are the limits which are given by the government that where the money can be
invested to attain some return from this, and finally these interest payments can be made
to the particular provident fund holders. So, these are the different investment pattern, we
can observe in terms of the provident fund in the market.
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Then we can come to the pension schemes or the pension plans, you see theoretically the
pensions are divided into three parts or three types of the plans, which are existing across
the globe. One is your defined benefit pension plan, and you have the defined
contribution pension plan, then you have pay as you go pension plan. What does it mean,
if you see one by one, what do mean by the defined benefit pension plan which basically
is related to GPF.
So, here what happens that the person basically after getting the job, certain amount of
the money is deposited as a GPF account, and with interest the person gets back that
particular money, after the retirement and as well as the person gets the pension on the
basis of his last drawn salary, so that means it is a defined benefit pension plan. So, if
you see that in the Indian context, how it happens that if for example the last salary of a
particular person, whenever he got his retirement or he was retired from his job was let
100,000 rupees. So, then what will happen, his pension amount will be calculated in this
way.
The pension amount for the basic amount will be 100,000/ 2 that means, 50% of that
particular last drawn salary that is 50,000. Then after 50,000 he or she will be getting the
DA, whatever DA dearness allowances available in that particular point of time. Then
that 50,000 plus let in that particular point of time, the existing employees are getting
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10% of the DA. Then the 10% of the 50,000 that is 5000 will be added into that then
55,000 will be his or her pension.
And once the pay revision takes place, the pension amount also changes. And
accordingly, they also get the revised pension that means, it is defined and assured that
that person will get the pension up to his death. And after his death his or her nominee
will get the half of the pension, so that is basically we call it defined benefit pension
plan, which was existing in India before up to 2003.
Then we have another plan, we have that is called the defined contribution pension plan.
Then what do mean by the defined contribution pension plan. So, in this case, the
particular employee basically always a certain percentage of his salary, certain
percentage of the money will be deducted. And same matching amount will be provided
by the government or any employer, who was given him the job. Then that particular
amount will be deposited in that particular account, and or the pension fund account.
And from that pension a certain percentage of the money can be withdrawn, and certain
percentage can be kept and from that certain percentage this person gets the pension.
And that particular money can be invested in an annuity, and from that annuity periodical
return will be realized. And from that periodical return the pension will be paid to that
particular person, so that is called the defined contribution pension plan. Then we have
an India, now we are following this defined contribution pension plan, after 2003,
December which is popularly known as NPS. We will discuss more about NPS in the
future slides.
Then other one is the pay-as-you-go pension plan means, your pension amount will be
paid by the other employer. The person who is working now, they provide or they
contribute certain thing certain kind of percentage of the total salary for their future
generations that means, whenever you are working, you are paying something, but from
that you may not get the pension, that pension amount will be paid to your future
employees, who are coming to that or future generation, who will be coming to work in
that particular organization.
So, most of the foreign western countries; sometimes they were following that pay-as-
you-go pension plan. To provide that pension for a long time a long period that means,
you are paying for the pension, but that pension amount you may not go, you may not get
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that pension amount basically will be given to your future generation. But, whatever
pension you will be getting, that money was contributed by the previous generation, who
was already worked in that particular organization, so that is basically called the pay as
you go pension plan, which also works in some of the countries.
Then we have already I told you in India we are working with NPS. The NPS is very
popular in the Indian context, not popular it is now mandatory for the all government
employees and as well as it is also open to the private employees, and other kind of
organizations, this what is called this new pension system, which was started in 2004,
January.
So, any person who has started working after 2003, December he or she is basically
coming under this NPS. Already I told you that NPS is based on the defined
contributions, and represent a market linked retirement investment product. Just like it is
a mutual fund instrument like a mutual fund instrument. And the return from that
particular fund return from that particular NPS is related to the market, I will explain one
by one, what are those features basically we have.
Any individual who are aged between 18 to 60 can be a part of this NPS subject to all
kind of KYC norms, they have to fulfill. They have to be citizen of this particular
country, and details information should be available for that particular employee, who is
basic who is interested to open that NPS account.
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After he or she attains age 18 and after attaining 60 years of age, which is supposed to be
the retirement age for India, you will be permitted or you will not be permitted to make
the further contributions to the NPS account. A NRI can open an NPS account.
Contribution made by the NRI’s are subject to the regulatory requirements as prescribed
by the RBI and the FEMA from the time to time. All how basically you can contribute it
or contribute your pension fund account, you can contribute through the existing network
of the bank branches or the post offices, and anywhere basically the NPS account can be
opened up.
The new pension system will be voluntary, it was voluntary for the other employees, but
it is mandatory for the central government employees except this armed forces. Still this
armed forces are coming under the GPF, and there is a kind of defined pension benefit
they always get, after the retirement. But, whenever it comes to the other employees
other kind of jobs, this NPS is mandatory for them, if he or she is the central government
employee. Some of the state government also have adopted that, but it is mandatory for
the central government employees.
The state government can choose to join this new pension scheme that already I told you.
The investment in NPS is independent of your contribution to any provident fund. So, if
you are contributing any provident fund, that is nothing related to NPS. NPS account can
be operated from anywhere in the country, irrespective of individual employment and
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location or the geography wherever you may be, but the NPS account can be operated
through the post offices or the banks.
The NPS account can be opened through the point of presence, and who will assist the
subscriber in opening the account including the filling of the necessary forms, providing
the information about NPS, and any other relevant information in this regard. So, as it is
mandatory. So, we have the point of presence it can be a bank, it can be post office, it
can be any other organization, who has the license to provide this kind of services from
there the NPS account can be operated or you can open that particular account with
them, and finally the money can be contributed to that.
But, what exactly happens to that particular account. There are two types of account in
NPS; the one is tier-1, another one is the tier-2. The tier-1 account is mandatory for
opening, but tier-2 is optional. It can be decided by the subscriber, if they want to open it
or there is a requirement for the tier-2 account. However, the tier-1 account is the pre-
requisite for opening the tier-2 account.
Somebody can open the tier-2 account, if he or she has the tier-1 account. So, what
basically here happens every customer or every individual after opening the account, he
or she will be issued one permanent retirement account number or the PRAN, which has
a 12 digit unique number. And wherever you are working that particular account will
remain that particular number will remain, and through that particular number all kind of
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transactions, and all kind of information you can gather through this for this particular
NP account.
A subscriber has to contribute a minimum annual contribution of 6000 that means, per
month minimum five 500 rupees they have to contribute to the tier-1 account. And if you
are not able to contribute, then your account will be frozen account will be closed, so that
is what basically this thing, and how basically if the contributions are made.
The contributions are nothing but, it is the 10% of the total salary. The basic salary and
the dearness allowances that is DA to be paid by the employee and the matching amount
will be given by the central government or the employer that means, the 20 percent of
your total salary will be deposited in this NPS account. And another feature we have, this
particular money cannot be withdrawn, before your retirement. Whatever money you
have deposited, that money will be kept there up to the year of 60, because unless this
person got retired at any point of time, retired before the unless he got the retirement this
particular money cannot be withdrawn.
And then what will happen, the subscriber once the money has basically has been
deposited in that account, what the subscriber has the option to select any of the
following pension funds like ICICI Prudential, Kotak Mahindra, Reliance Capital, SBI
Pension Fund, UTI Retirement Solution Pension fund, HDFC Pension Management
Company, DSP Blackrock Pension Fund Managers, any of the pension funds they can
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choose and the money can be invested in that pension fund. And this particular pension
fund managers can be changed in between if they want. They can move from one
pension fund manager to another pension fund manager if they want.
And what do you mean by that pension fund, the money is deposited and every pension
fund has certain assets where the money should be invested. From that asset certain
money is related to debt instrument, certain money is related to equity instrument. Once
the money has been deposited there; it is the responsibility of the pension fund manager
to invest that money in certain kind of financial instruments to maximize the return. And
out of these pension fund managers, you can choose anybody and if you need or if you
want, then you can change them also in between.
So, there is a default provision what the government has assigned, how much money can
be invested where, and also you can select that how much money can be invested in what
kind of instruments depending upon your age. The limits have been given. And once
your age goes up, then if you are going towards the more risky investments that is not
available. Maybe amount of or the percentage of the risky assets in your portfolio will go
down once your age will be increasing. And the amount of government securities and
other secured bonds will be increasing.
So, that is why you can go for the investment options on your own or you can go for a
default option where already it is designed by the government or the pension fund
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managers. So, then accordingly your money whatever you are contributing that can be
allotted to those funds, and the investment have been made.
So, if you see already I explained that NPS offers two approaches to invest the
subscribers money, either it is active choice, here the individual would decide on the
asset classes in which the contributed funds are to be invested and their percentages, E, E
means equity that is maximum 50%. Asset class C and G which is basically related to the
government bonds in the other corporate securities G is.
And the auto choice which is basically lifecycle fund, this is the default option under
NPS and where the management of investment of funds is done automatically based on
the age profile of the subscriber. And whatever age you are depending upon already I
told you the E will go down and the C and G may go up, because the risky investments
or risky instruments in your portfolio will be going down, and other kind of relatively
less risky assets in your portfolio will be going up so that is what basically the default
options, may be you can choose or you can go for your own choices for the investment in
the portfolio.
You can appoint up to 3 nominees for your NPS tier 1 and NPS tier 2 account, but tier 2
account you can withdraw whenever you want because that is apart from the 10% if any
extra you want to deposit, then you can deposit, but there is no matching amount you
will be getting from the employer or the government. And that amount can be invested
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by the pension fund manager. And whatever money you have, if you want you can
withdraw that money whenever you need.
So, in such cases, if you are they have 3 nominees and the share percentage across all
nominees should be collectively 100 percent, obviously, it cannot exceed that. So, you
can divide that particular percentage of the total money what you are supposed to get
after retirement among maximum 3 nominates.
Already I explained these individuals who are employed and contributing the NPS would
I enjoy the tax benefit on their own contributions as well as the employers’ contributions
and under this section 80 CCE. And employer contribution the employee is eligible for a
tax deduction up to 10% of salary contributed by the employer under section 80 CCC 2
2. Over and above the limit of 1 lakh provided under a section 80 CCE.
So, nowadays if you are under the NPS, then you are deductible tax whenever you are
paying that is 1.5 lakh which was there for the people where they get the tax rebate out of
the total income. If you are extra 50,000 tax rebate also you can get fifty thousand
income tax rebate also you can get if you are a NPS subscriber, and that money has been
contributed to NPS. That means, overall the person who was under NPS, they can get the
tax rebate up to the 2 lakh rupees for other employees, it is 1.5 lakh rupees, but for the
NPS subscriber this has basically 2 lakh rupees according to the government.
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So, here individuals can exit from the scheme at the age of 60 years, but they would have
to invest mandatorily 40 percent of the pension wealth to pursue an annuity from the
IRDA regulated life insurer. That means, after your retirement what basically will
happen, the 40 percent of your total sum which were there on the basis of the market
rate, you will be getting back that money; and 60 percent will be invested in an annuity
at any point of time the money cannot be withdrawn by this particular employer. And
that money can be invested in an annuity, and from that annuity will be getting the
pension.
Only if the person dies or the subscriber basically dies, then the entire accumulated
pension wealth would be paid to the nominee or the legal heir of the subscriber, and there
would not be any purchase or annuity or monthly pension after this. So, only the 100
percent money can be withdrawn by the nominee, it cannot be by the subscriber himself,
only subscriber can withdraw 40 percent or can get back the 40 percent after the
retirement, and 60 percent has to be invested in an annuity to get the periodical pension
per month.
So, these are the guidelines which are given for the government employers that where the
money can be invested. It is government securities up to 55%, debt securities up to 40%,
money market instrument up to 5%, and equity up to 15%. These are the maximum limit
which was given. And whatever money has been paid to that particular account that
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money can be invested either of these securities, and the limits are basically fixed
accordingly.
There are certain challenges, the challenges are basically that the people have less
financial, there is a problem of financial literacy. The attitude of the household towards
the financial savings, risk and retirement planning also pose a challenge the people may
not be that much inclined to go for a long period of investment without any withdrawal.
Creating awareness about these reforms and gaining the confidence of the people also the
part of this movement; the single most important challenge, so what the policymakers are
facing, people may not be that much convinced.
And at present the NPS is subject to EET - exempt-exempt-taxed system, where

whenever the 40% amount will be paid to you, you may pay the tax against that.
Although that is still on the debate that is still going on, but in the existing structure you
may not get the tax rebate against that although your GPF amount and CPF amount is
totally tax free. So, that is another challenge whatever always we have or the PPF
amount is also totally tax free, but whenever we talk about NPS that particular tax
problem is related to whenever you are getting the final amount after the retirement on
the basis of the market fluctuations or the market rate of return what is available on that
particular point of time.
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This is a new scheme which was started by this current central government which is
called the Atal Pension Yojana. So, everybody who has a savings bank account, they can
go for this. Minimum is 18 years, it can go to 40 years. Here government will contribute
50 percent of the total contribution or 1000 per annum whichever is lower. And to the
eligible subscriber for a period of 5 years, and who join a APY before this 31st
December 2015, and who are neither the members of any statutory security scheme and
nor the income taxpayers.
Basically this scheme is you can see the features, this scheme is basically provided only
to those people who are less income people, and they are not coming under any income
tax bracket. So, this is basically a new scheme for providing the social security or the
retirement benefits to the people who may not be highly organized employees, but they
also need some social security or the kind of security for their family. So, this is about
the overview of the pension plan or the pension system in India and as well as the
provident funds which are available in the Indian context.
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Thank you.
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Lecture – 27
Insurance Companies
So, we discussed about the provident fund and pension fund which are the most
important financial instruments, which are available in the Indian financial system. And
today we will be discussing about another most important institutions, which work to
minimize the risk of the market participants that is basically the insurance companies.
Because in the risk management process the risk can be managed in various ways. One is
you can manage the risk through hedging using the derivatives kind of instruments or
using the gold and other instrument which are available. You can also minimize the risk
through the insurance policy. Here managing risk means basically you are transferring
the risk from one individual to another individual, so that is why for risk management
prospective the role of insurance companies are quite large and the insurance companies
basically play very significant role in the growth process of the particular economy.
So, let us see that there are different concepts we use in whenever we go for the
insurance policy, then what are those kind of concepts how we define those concepts.
Already I told you that insurance is a form of financial risk management tool, in which
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the insured transfer the risk of a potential financial loss to the insurance company, which
is insurer, which mitigates in an exchange for a monetary compensation popularly known
as insurance premium, that means we regularly pay this insurance premium and why you
are paying the insurance premium?
We are paying the insurance premium if there is any kind of uneven situation can arise at
any point of time through that particular insurance premium whatever we have paid, the
insurance company has to pay the amount of losses what the particular insured has
incurred. So, in this context, the insurance premium is basically a kind of money which
is deposited to the insurance companies to get the benefit for the risk mitigation for any
kind of unforeseen circumstances.
So, there are different type of premium, one component to the pure premium. The pure
premium is nothing but the present value of the expected cost of an insurance claim. And
since there is a lag between payment of the premium and payment of the claims, there is
generations of investable funds which are insurance reserves. So, insurance company can
use that concept called the insurance reserves.
And insurance policies basically what, it is a contract between the insured or the
policyholder and the insurer, which is basically the insurance company. And this is the
way the insurance policy that is why we should always get a policy document or a
particular contract whenever you go for any kind of insurance policy or we buy any kind
of insurance policy from any type of companies.
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Then we have another concepts which are related to insurance that is sum assured, you
might have seen in your policy document there is an amount which is written that is
called the sum assured. Then what do you mean by the sum assured? The sum assured is
basically nothing but if the amount that is promised by the insurance company, in case of
a claim either by maturity or by a loss to the insured subject matter. For example, you
have a life insurance policy, you are paying 5000 rupees per annum and your sum
assured is basically 500000s and the policy is for let 10 years or 15 years.
So, if you have paid that premium regularly there is no such kind of default within that,
then the sum assured will give you the idea that after the maturity or before if there is
any kind of mishappening happens, then the particular insurance company has promised
to pay that sum assured amount to the person, who has gone for buying this insurance
policy. The sum assured is a very important concept or important notion which is used,
whenever we go and invest in the insurance market or we buy the insurance policy for
any specific reasons.
Then we have another concept called the surrender value. If you go and read your
insurance policy document, you will find all those concepts which is basically provide
you with the example that how these concepts work whenever we are buying this
insurance policy.
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We have the surrender value, which is nothing but the amount that the insurer pays, if the
insured discontinues the policy to the insurer that means for example, you want to stop
your insurance policy after 5 years, but let the maturity is 15 years; you are not able to
pay that premium and you want to close it.
If you want to close it, then there are certain kind of agreements which are already
designed or already made that what should be the surrender value for that particular
insurance policy. And that surrender value or surrender amount will be paid to you and
with that within that particular regulations, whatever already mentioned in that particular
policy document.
Life of the policy means, it is the time period where the insurance policy is in running
positions or in the vogue that means, that is working. At any point of time if you do not
pay the policy premium also that can be stopped for a temporary period of time and
again as for the rules and regulations or terms and conditions which are mentioned in the
policy document, you can again start or renew that particular insurance policy whenever
you need. So, because of that what basically here we are trying to see that the life of the
policy always work up to the maturity period.
Then another concept is the moral hazard, which refers to the mala fide intentions of
either of the parties of the contract in fulfilling their obligations with respect to their
performance of the contract. There are sometimes some kind of moral hazard issues
happen, if any kind of parties or any other parties will create certain kind of or they will
get away from their obligations and try to create certain kind of problem, which may
create the inconvenience either to the policyholder or maybe the insurance companies.
So, those kind of things are very much important whenever you go for the insurance
policy, also to understand how this insurance policy basically works in that particular
system. So, these are the different concepts which are used and mostly this sum assured
this surrender value, then your premium these are very important concepts whenever we
go for any kind of insurance policy or to invest the money in the insurance policy.
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So, there are a different kind of principles of insurance, whenever we go for any kind of
insurance we follow different principles or both the parties follow the different
principles. On different principles, the insurance policy basically best. What are those
principles? The first one is the principle of utmost good faith that means, both insurance
company and the insurance policy holder enter into the contract in a good faith that
means, here what we are ensuring the insured or the policyholder voluntarily disclose, all
the facts related to the subject matter of the contract. And the insurer should also provide
all the details regarding the insurance contract, there should not be any hidden kind of
rules and regulations imposed in that.
For example, somebody is going for a health insurance. If the insurance company or
agent will ask you that are you a chain smoker; let you are a chain smoker, but you have
hided you basically hide that information, they said I am not a smoker, but if there is any
probability that you are suffering from any heart attack or you are suffering from any
disease which can be created due to the smoking, then that means you are basically not
following the principle of at most good faith.
The insurance company believes that whatever information you are providing that is also
correct and one whatever information they are providing in the policy document that is
also correct, so that is why the both parties enter into the contract with a good faith that is
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the first principle of the insurance. The good faith is very important here you have to
keep in the mind.
Then another one is the principle of insurable interest that means what? The policyholder
should be able to establish a monetary relationship between him or her and the subject
matter of the insurance that means what? So whenever basically this principle of
insurable interest is designed, in that case what we are trying to do the policy holder can
say that okay, this particular thing or this particular information is correct and there is
some kind of monetary values what I am disclosing that is also correct.
So, if there is something wrong with that maybe, who are the particular person who has
going to get that benefit that also should be given to the policy holder to the insurance
companies and such that the insurable interest will be intact that means, there is a
monetary relationship which can be established between the insurance company and the
policyholder, unless that particular contract may not work.
Then we have the principle of indemnity. The indemnity means it refers to the assurance
given to put the one person who buys the insurance in the event of the loss, in the same
position that he or she occupied immediately before the happening of the event of which
indemnity is sort for. That means for example, there was some damage, let there is a
general insurance you have ensured that particular event and there was some damage to
that.
So, immediately as per the indemnity clause, the person let you are organizing the
function and there was some mishappening has happened and the organizer has signed
the agreement with that particular company, who is basically performing there. And if
any kind of mishappening or any kind of damage happens to that, then it is organizer
who basically pays that particular money through that insurance.
So, the principle of indemnity and whatever information we are providing in terms of
that particular damage and all that also should be correct and that damage had happened
at one particular point of time and that should not be a periodical damage which has
already occurred and we are trying to mix up the damage with the existing damage to get
back more money from the insurance company that is basically called the principle of
indemnity. Then we have the principle of subrogation.
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Then what do you mean by the principle of subrogation? Here, it refers to the right of
the insurer to stand in the place of insured after the settlement of a claim and it gives the
insurer right to recover from an alternative source which involved in this case. Let, who
is responsible for this? Whether this particular damage has happened because of my fault
or the damage has happened because of something else, it is not available or it is not
applicable for the life insurance.
So, if any kind of damage which can happen to a particular event or particular thing, then
who is responsible for that if there is somebody else who is responsible for this, then that
person also we have to recover the money from that and the insurance companies may
not be that way burdened by that, so that is we call it the principle of subrogation.
Then we have another principle that is called the principle of warranties. The warranties
basically what? The warranties are the conditions that are written by the insured in the
insurance contract that state the truth by forming or denying the existence of a particular
state of facts, what does it mean? If you see for example, a bank has gone for insurance
or there was some fire which was happened to that particular bank and because of that lot
of wastage or lot of damage has been made.
But whenever the bank has gone for a insurance, to ensure that particular office or
particular kind of place what they supposed to do? So, in that document you see there are
certain kind of provisions are mentioned what are those, the provisions are the bank
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should installed a fire alarm or if there is a let there is a theft. So, there also the bank has
to go for kind of proper alarming system, a security of 24 by 7 should be deployed there,
and there is some kind of proper locking system is available to that particular office or
particular place.
So, all those things all those precautionary measures the bank has to take. So, under this
circumstances if still something has happened to that particular thing, then this particular
thing is insurable or the insurance company has to pay for that, but if all this kind of
conditions are not satisfied or you have not done anything because of this.
Then what is happening or another thing is that if you have not followed this kind of
conditions, what the insurance company has signed in that or written that contract, then
there is no point of or in that particular point of time you are missing this principle of
warranties. And the insurance company may deny that you have not followed these kind
of thing and because of that the money cannot be paid, so that is very important from the
insurance point of view, the principle of warranties.
Then you have the principle of cause proxima. What do you mean by cause proxima?
The proximate cause refer to the immediate cause that resulted in the loss, what does it
mean? Let there is a fire in your house or anybody’s shop, what is the cause of the fire?
Let the cause of the fire is a short circuit. So, whenever the cause of the fire is a short
circuit, then we have to understand whether the wiring system is proper there or not.
So, we have made that agreement with the insurance company that our wiring system is
full proofed or there is proper safety measures has been taken whenever we have gone
for the wiring. Then only if everything is still there are some malfunction has happened
in that particular place and the fire there is a fire, then there is no problem, but still what
is the cause proxima, nearest cause is what that actually we have to always ensure.
And we have to ensure that all these things are properly maintained and all these things
proper care has been taken to look after those kind of issues, which may have the impact
upon these kind of damage, so that also we have to always keep in the mind that is called
the principle of the cause proxima.
Then the principle of contribution; under this principle insured cannot make profit by
making claim for some loss more than once. People sometimes do they have made a
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claim, there is some vehicle accident they made a claim. Some kind of claim, they made
in they go for some kind of they do some kind of forgery. And the same claim they are
doing again and again, so that also again is breaching the trust between the insurance
company and the policyholder, so that is another principle through which the insurance
basically is based upon that is called the principle of the contribution.
Then the principle of loss maximization what does it mean whenever there is a fire, let
there is a fire. So, have you informed the fire station immediately? So, if you would have
informed the fire, then loss would have been less. Then the insurance company would
have been paid less amount in comparison with the loss what just now have been made
for that, so that also always is written or always we have to ensure that whether the
principle of loss minimization is working in that particular contract or not.
So, whether if somebody has died because of some reasons, then whether he has been
shifted to the doctor or not, immediate medical attention has been given to them or not or
already I have given the example that if there is a fire, whether the fire station was
informed or not. So, all kind of thing also should be always ensured whenever we are
going for the insurance policy and the policy document is based upon all kind of eight
principles on the insurance. So, this is the way the designing of insurance policy always
made, whenever we are going for buying the insurance policy from the insurance market.
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Then we will see that what are the different types of insurance which are available,
already you know this. So, broadly if you see there are two types of insurance; either it is
a life insurance or it is a general insurance. And the basic objective of the insurance is
protection to the investors that means, accumulation of the savings in channel and one
what this insurance companies do, they take the money from you they invested in the
market in the different kind of assets, a different kind of investment alternatives and
some returns are realized from that. And finally, what has happened if there is any kind
of loss any kind of damage, then the money can be paid accordingly.
So, there are two types of insurance, we have life insurance and the general insurance.
And life insurance covers the insurance of life and covers the risk related to the death of
a person. And then if you are going for a general insurance that includes the different
type of insurance, at all those kind of insurance contract that cover non-life subjects.
Non-life subject include the motor insurance or the vehicle insurance, marine insurance,
property insurance, liability insurance, commercial business insurance.
And nowadays we have also we can insure our loans. Your house loan and other loan
also can be insured, if there is any kind of or there are some certain reasons if you are not
able to repay the loan or the person who was taken the loan he or she has died, then in
that context that our insurance company who pay that loan or that money will be paid by
them, so that is why there are financial alternatives or financial investment alternatives
are also insured nowadays, because the insurance sector is going up and more
diversification is taking place in that.
Health insurance is also a part of the general insurance. The medical insurance basically
the mediclaim policies, they are not a part of the life insurance, they are a part of the
general insurance. So, this is the way the types of insurances are designed. Life insurance
is mostly covered in terms of the life and the risk related to the life.
And the health insurance is related to your disease and all these things, which may occur.
And you have the general insurance, which includes all type of rest of the insurance
whatever we have. So, these are the two broad type of insurance, but again the sub
classifications can be made whenever we are going to use in the practical sense for the
different reasons.
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So, what is the objective of the life insurance companies? What this life insurance
companies basically do? So, the life insurance companies basically provide the life
insurance protection to the masses at a reasonable cost. And the basic job of the life
insurance corporation of India, if we talk about India, they mobilize the people savings
through insurance linked saving schemes.
Already I told you, the insurance companies are the biggest mobilizers of the savings in
the Indian market. Whatever money is deposited through this insurance policy that
money is basically goes to the market for the better investments and it is useful for the
once this particular money is used in the productive investment alternatives, it has lot of
implications for enhancement of the growth or the output.
Once the output increases, because this is used for different productive projects,
productive investment projects and those things can always help to maximize their
output. If the output is maximized, then automatically what happens the growth rate of
the economy will be increasing or can be increased. So, in that context it is basically a
major source of the savings or major source of money for the output maximization of the
economy.
To invest the funds to serve the best interest of the both policyholders and the nation,
because the policyholder also to get that money whenever they want. So, because of that
for the survival of the policyholder and as well as the for the insurance company and as
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well as the betterment of the economy they invest that money in a larger variety of
alternative investments, which alternative instruments are available in the market. To act
as a trustee of the policyholders and protect their individual and collective interest, if it is
a group insurance, they go for a collective interest; if it is individual insurance policy,
they will go to protect that individual interest.
To involve all the people working in the corporation to ensure the efficient and courteous
service to the insured people or insured public. You see, efficiency is very important
from the insurance point of view. Sometimes you might have seen in the advertisement
in other places, after the retirement or any kind of maturity people are facing lot of
problem to get back their money or maybe this insurance companies are reluctant to
justify the terms and conditions which are already mentioned in the document.
So, nowadays the insurance companies are very much concerned about the services that
they provide the efficient services to the public. And as well as whatever things, they are
promised through the offer document that basically come to or may be reach to that
particular public in a amicable manner, so that is also another objective of the insurance
companies in the modern era. So, these are the different objectives what we can see.
So, if you see the nature of the life insurance, the life insurance policy or life policy is a
claim or a future payment of either lump sum or a stream of income. You can pay your
money as a lump sum amount, there are different kind of policies. So, you can have the
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you can pay your money as a lump sum amount or you can also pay in the periodical
basis, it can be monthly, it can be quarterly, it can be yearly.
So, there are different type of policies, which comes under the life insurance policies like
term insurance, whole life insurance, endowment policies, annuity contracts, individual
insurance, group insurance, pension plan, children’s plan, there are some plans which are
equity linked plan, there are some plans which are only income linked plan or income
fund linked plan, which are mostly gives you relatively less return, but the return is
assured.
And there are some plans which are highly linked to the market or equity linked plan. So,
there the fluctuations of the return is relatively higher, but there is a probability that you
may get more return if you are investing the money in that particular policies.
So, there are certain policies where we get this benefit the life risk coverage is there,
after your insurance policy got matured also. So, there that kind of insurance LIC are
other companies like Jeevan Anand policy and other type of policies what they were
providing. Those kind of policies your life coverage will be there up to your death, even
your insurance premium you are not paying on the coverage of that particular or the time
period of that particular policy is over. So that is why there are different kind of policies
which are there, on the basis of the requirement of the persons and as well as the basic
necessity or the kind of requirement what this policyholder always have.
So, the life fund is build up out of excess of premiums and investment income over
claims and expenses on revenue and the life fund is valued from time to time, the
valuation being based on the method of discounting of the future income and expenditure
back to the present. So, these are basically how the funds value is calculated, whenever
the fund has been invested in the different type of investments. So, this is the way the life
insurance policies work in the market.
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If you go by the nature of the non-life insurance policies, what are the things we can
observe? The essence of general insurance is collective or pooling of risk arising from
the fortuitous occurrences, which may happen because of certain events. The general
insurance companies do not collect savings, yet they do accumulate pools of the funds
from premium and investment income, out of which they made the claims under their
policies. And this if you go by the non-life insurance policies, mostly the liabilities are
normally sort out. Let vehicle insurance there must be small damage, which can happen
in a periodical basis.
So, if you have a motor vehicle insurance policy, then you can claim your insurance. So,
whatever liabilities the insurance non-life insurance companies face they are basically
normally short term in nature. And claim against them are very unpredictable, because
when you met the accident, when somebody met the accidents. So, when somebody
basically any kind of thing got fire or got fire for some reasons. Nowadays, these people
are also insuring all kind of festivals and all these things whenever there is any kind of
bigger festival happening.
So, anything can happen to that, so that is why the claims against the general insurance
or the non-life insurance is very unpredictable. So, therefore most of the time the
insurance companies held their assets in the relatively liquid form. So, the investment
made by the non-life insurance companies on the different assets are relatively, more
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liquid in comparison to the life insurance policies, so that is why the assets whatever they
choose for that investment, it is relatively more liquid in comparison to the life insurance
part.
So, this is what and already I told you this liabilities in the non-life insurance policies are
general insurance is quite short term. This is about the nature of the non-life insurance
policies, which can work.
If you talk about India, in India as on 31st March 2016 whatever data I have, we have
one public sector insurer that is life insurance corporation of India and 23 private life
insurance companies which are operating in India.
So, we have one public sector unit that is basically LIC, then we have 23 different
private companies whether it includes HDFC life, there are different companies. So,
which are basically providing the life insurance services, a life insurance policies to the
customers or we can say that nowadays from there what you are trying to say that the
insurance companies are nowadays more open.
And there is a proper development has taken place in terms of insurance companies,
because private sector is open to make this insurance business in Indian market which
was not there before. So, because of that the number of private companies providing the
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life insurance services has been increasing continuously, so that is why we have 23
private life insurance, but 1 public sector insurance which is working.
And as on 31st March 2016 the same day, there are thirty non-life insurance companies
in India, including one reinsurer and this reinsurer is basically the GIC. Out of them 5
private sector insures and a registered to underwrite policies exclusively in health,
personal accident and travel insurance segments exclusively they provide the health
insurance.
So, the companies there are certain kind of companies who provide only the health
insurance policies or provide the health insurance to that particular customers they do not
provide any other kind of thing, but health insurance is already we discussed that health
insurance is a part of the general insurance. So, more or less if you see GIC is the
national reinsurer, providing reinsurance to the direct general insurance companies in
India.
So, here what overall if you see both in terms of the life and non-life insurance coverage,
there is a huge development in terms of the private sector entities, so that is why the
alternatives for the customers are quite large, they can choose any of the investors or
sorry any of the insurance companies they want depending upon their necessity or
depending upon their requirements.
So, in this context once the sector has become open and it is not only concentrated only
on the public sector units, then obviously it is a one of the best instrument or best kind of
organization which provides this small savings to the aggregate economy or provides
that particular money to the general circulation by that the investment can go up. So, end
of the day it can have the positive impact on the output and the growth rate. So, this is
about the insurance companies in India.
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So, if you see the insurance penetration and density, insurance penetration is basically
nothing but the percentage of the insurance premium to the total GDP an insurance
density. If you see this is your percentage of insurance premium to GDP is called the
insurance penetration and insurance density is calculated as there is insurance premium
to the total population that means, per capita premium.
If you see the Indian data that both life insurance and other insurance, 2001 it was 9.1
insurance density and penetration was 2.15%, but if you go to 9.1 US dollar and 2.15
percentage in terms of the penetration in life insurance.
Now in 2015, it was 43.2 and 2.72. And whenever non-life insurance if you see, it was
2.4 it has increased to 11.5. Then in terms of the insurance penetration it was 0.56, it has
become 0.72 that means, there is a clear increase in terms of both penetration and density
which has happened in the Indian market.
So, overall if you see it has become 54.7 total industry and the penetration has become
3.44 as per the IRDA annual reports, this is the information whatever we have in terms
of the development of the insurance sector in the Indian market, so that is basically is one
of the already we told that this is important resources which provide the finance for the
investment and as well as the output in the economy.
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So, this is all about the insurance sector, the overview of the insurance sector which is
operating in the Indian context and this is the way the insurance companies help to the
policyholder and as well as the national economy as a whole.
Please, go through this particular references for this particular session.
Thank you.
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Lecture – 28
Mutual Funds - I
So, in the previous class, we discussed about the two major Financial Institutions which
operate in the financial system that is basically your insurance companies and as well as
the pension fund and the provident funds. So, today we will be discussing about the
another most important financial organization, which works in the financial system that
is Mutual Fund.
So, all of you know that mutual fund investment is one of the most important investment
alternatives, which is available in the existing system. The basic reason is that if anybody
has money to invest it in the market, but he or she has not much time to devote for the
actual active investment in the equity market or the debt market. So, then those kind of
investors can participate in the mutual fund which is professionally managed by a fund
manager and as well as they can also participate both equity and debt market together by
taking the position in any of the mutual funds at a particular point of time.
So that is why what we can say that the mutual fund is one of the we cannot say that
traditional instrument, but this is basically one type of instrument, which has emerged
over the period and has been consider as one of the prime investment alternatives,
whenever we talk about the investments in the financial market.
So, before going to the structure and the kind of advantages or disadvantages of the
mutual funds. So, let us first discuss certain things or certain kind of issues related to the
mutual fund in terms of their structure and as well as the different type of concepts,
which are used to define the mutual fund in any financial system including India.
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So, let us see that first of all how do define mutual fund? What is the meaning of the
mutual fund? So, whenever we talk about the mutual fund, mutual fund is basically a
trust, which pulls the savings of number of investors who share a common financial goal.
Some of the investor wants to maximize the return some of the investor wants a regular
flow of income over the period of time, so that for that is why depending upon the
requirements of the investor the positioning of the investors are different or the
participation of the investors in the different markets, financial market more particularly
are different. So, therefore whenever we discuss or we think about the mutual fund,
mutual fund is basically try to pulls the savings of a number of investors who share a
common goal.
And finally, what happens whatever money is collected that can be invested in the
different type of instruments like shares, debentures or corporate bonds, debenture means
the corporate bonds and etcetera to maximize the return. So, therefore the basic job of the
mutual fund is basically to invest the money on behalf of the investor to maximize the
return at a particular point of time. And already what I told you, the person who have the
persons who do not have much time to actively participate in the equity market or debt
market. So, they can go and invest in that mutual fund to maximize their returns.
So, then the income which are earned through this investments and the capital
appreciation realized are shared by this unit holders, proportion to the number of units
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owned by them. So, the mutual funds are basically represented in terms of units and for
example, per unit cost is 10 rupees and if you are to invest 1000 rupees, then you can
have 100 units with you.
And each unit is consisting of different kind of instruments. So, depending upon the
price appreciation or depreciation the value of the total units basically will change. And
accordingly this whatever return or the income what you are realizing from that will be
basically given to or shared with all kind of unit holders of that particular mutual fund.
So, therefore mutual fund is one of the most suitable investment for the common man, as
it offers the opportunity to invest in a diversified portfolio and as well as it is
professionally managed. Because already I told you as this particular mutual fund is
comprised of different kind of instruments like you have the equity, you have the debt,
etcetera.
Then obviously, different type of equity and different type of debts whenever we
consider, then obviously this particular fund is well diversified. And the diversification
principle already you know why we want to diverse why we want to invest in a
diversified portfolio, because we want to reduce the unsystematic risk. The basic
objective of diversification is to reduce the unsystematic risk and mutual fund, because
there are many assets or many stocks, many bonds are included in that particular
portfolio. So, we can ensure that the total amount of unsystematic risk in that particular
market can be diversified through this mutual fund investments.
And another thing is choosing the stocks or bonds is also done by the professional
manager. So, because of that this particular fund is also professionally managed. So, the
person who takes the positions to manage that fund, they are basically well acquainted
with that particular investment strategy and as well as they have enough financial
knowledge to decide that which are the funds or which are the instruments are beneficial
or can helpful for that investor to maximize their return.
And relatively the fund manager fee also it is relatively less, so at a lower cost if
anybody wants to maximize the return from a common man prospective, the mutual fund
is one of the lucrative investment alternatives whatever we have availability we have in
the financial system. So, this is what basically the concept of mutual fund whenever we
discuss in the financial system.
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Then we have to see what is the structure of the mutual funds in India. How the mutual
funds are structured? So, you might have heard there are so many mutual funds Reliance
mutual fund, SBI mutual fund, HDFC mutual fund there are different companies who
basically do the mutual fund business.
So, whenever we discuss about the different type of mutual fund business, we have to see
how the structure of the mutual fund looks like; what are those different ways or
different kind of participants who work on behalf of the mutual funds. So, if you see that
according to SEBI, because mutual fund is regulated by the securities exchange board of
India that is SEBI and according to SEBI, mutual funds are established in the form of a
trust to raise money through the sale of units to the public under various schemes for
investing in different securities that already we know.
So, here if you see the mutual fund is basically has a different kind of stakeholders,
different kind of participants or the components of the mutual fund is designed or the
structure of the mutual fund is designed in such a way that which has a sponsor or it has
a sponsor, it has the trustees, it has an asset management company and the custodians.
These are the different kind of parties which are involved in the construction of the
mutual fund or the operations of the mutual fund for a particular company.
So, the sponsors basically set up the trust, sponsors are basically the promoters. And the
trustees hold the property in trust for the benefit of the unity holders. The trust basically
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always works on behalf of the unit holders or for maximization of the returns of the unit
holders. And the basic job of the trust is they monitor the performance of the asset
management company and they should always cross check that whether the SEBIs rules
are complied by this mutual fund managers or not or asset management company or not.
So, the basic job of the trust is or trustees are to look after AMCs performance or a Asset
Management Companies performance and compliance with the SEBI regular, whether all
the regulations are complied by the AMC or not. So, the basic job of the AMC is to
manage the fund and the custodians basically hold the securities of the fund in their
custody. So, these are the different four parties which are involved in the mutual fund
business and they always work on behalf of the equity holders or to maximize the return
of the equity holders.
If you see one example that is SBI mutual fund. So, if you are talking about the SBI
mutual fund, let this is the SBI mutual fund. So, whenever you talk about the SBI mutual
fund. So, who is the sponsor? The major sponsor is SBI; SBI is the sponsor; then who is
the trustee? Trustee is basically there is a company, they have established that is SBI
mutual fund trustee company private limited.
Then we have the asset management company, which is AMC. The AMC is basically
what the AMC is basically the SBI fund management private limited, this is basically a
joint venture between SBI and AMUNDI this is basically a French company, who are
basically the fund manager they manages the fund on behalf of the unit holders. And
these are basically the asset management company for the SBI. Then the custodians,
there are many custodians that is bank of Nova Scotia, HDFC bank, SBI-SG Global
Securities Services Private Limited. So, these are basically the custodians.
So, this is one example that means, here whenever it is SBI mutual fund, SBI is the
sponsor. Then you have the SBI mutual fund trustee company private limited, who is
basically the trustee which was formed on the basis of the sponsors requirement. Then
you have the asset management company, which is SBI fund management private
limited.
Then you have the custodians, you have basically the different type of custodian. So,
basically gives this securities or the funds in their custody. So, this is basically the
structure of the mutual fund and this is the way the mutual fund basically is designed.
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If you see that there are certain issues related to the different kind of parties, who are
involved in this mutual fund. So, here if you see that two thirds of the trustees of a
mutual fund must be independent persons and not associated with the sponsors in any
manner.
For example, if you go back SBI is the major sponsor or the main sponsor for the SBI
mutual fund. So, whenever you talk about the trustees, there can be a many, but the two
third of the trustees should come from the outside or there should be the independent
persons. They should not be any way associated with SBI, they may not be the employee
of the SBI, this should not be in the management of the SBI; that means, mostly this 60
percent of the governance is always related to the outside independent directors by that
the investment objective of that mutual fund may not be synonymous with the business,
what the SBI is doing.
So, this is independent and that particular fund manager should work on behalf of the
benefits of the unit holders, who are holding that particular fund within that particular
mutual fund, so that is what basically the first point we have to keep in the mind. Then
another one is the trustees should enter into the investment management agreement with
the AMC for the purpose of the making the investments and the trustees would have the
right to obtain from the AMC all information, concerning the operations of the various
schemes of the mutual fund managed by it.
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So, the trustees have the right. So, they because the practically the asset we are dealing
with the asset management company or the company who is basically managing the
funds on behalf of the different investors to the equity holders. So, in this context the
trustees have the right, they have the right to obtain all type of information related to that
mutual fund from this particular AMC.
And they have to ensure that how this particular AMC is operating and whether this
particular operations of that particular AMC is in line with the benefits of the unit
holders, who are investing in that particular mutual fund. So, this is what basically this
the there are certain issues which may arise with respect to the structure of the mutual
fund in India.
Then we have to see some other things a sponsors of the mutual fund would appoint the
AMC with the approval of the SEBI. And SEBIs approval is required, whenever they are
appointing any kind of AMC for the business. And its appointment can be terminated
also by a majority of the trustees, if majority of the trustees want that this particular
AMC is not working properly or not working on behalf of the benefits or the interest of
the unit holders.
Then their service or appointment can be terminated, if majority of the trustees want to
terminate or 75 percent of the unit holders of that particular scheme, will vote against
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that AMC or will see that or will always be interested to terminate the service of that
particular AMC at a particular point of time.
So, this is the way this termination can be possible, but the eligibility criteria for the
appointment of an AMC include that there should have a soundtrack record, they should
have adequate professional experience, they should not have punished for any kind of
unethical practices in the financial system. And they have not violated any laws security
laws. And this would ensure that inclusion of the 50 percent independent director should
be there in that AMC and the net-worth of at least 10 crore. The minimum net worth of
that particular individual AMC should be minimum 10 crore.
So, you know that what is net worth, net worth is nothing but the total assets minus
liabilities that will give you the net worth that means, it is the owners equity, so that is
why this net worth of the company should be greater than 10 crore. So, this is what
basically the basic notion we have to keep in the mind or we have to ensure that the
condition should be satisfied, if any trustee wants to appoint one AMC for that particular
mutual fund.
Then we will see that what this AMC do? What are those AMCs do? The AMC can
undertake other business activities in the nature of the portfolio management services.
Advisory services to the pension fund, venture capital fund, management of insurance
fund financial consultancy and all these things. On a commercial basis they will charge
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the money for that and they can do also, apart from managing that fund the AMC can
also provide this kind of services that should not, but there should not be any conflict
with the activities of the mutual fund.
So, any kind of services what this AMC wanted to do? They can provide that, but it
should not have any kind of conflict with the activities of the mutual fund whatever we
have. The major business of the management of the mutual fund should not be disturbed
because of the other financial services, what the AMC wanted to give. So, here it is
ensured that the AMC is following all the rules and regulations and all the provisions of
the SEBI regulations, they are basically following. The norms what the regulations what
is mandated by the SEBI. The AMC is basically following all kind of regulations and the
norms, which are imposed by the securities and exchange board of India.
The AMC can launch the new mutual fund within that particular company, after its
approval from the trustees and filling the offer document with the SEBI. They should
provide this information to the SEBI that this is the new mutual fund what basically the
mutual fund scheme, what we are going to start. There are different type of schemes, we
will discuss these things further. So, any new mutual fund scheme also they can start or
they can launch, but for that they need the approval from the trustees of that particular
mutual fund and as well as the securities exchange board of India.
The offer documents should contain adequate disclosures to enable the investors to make
an informed investment decisions. About the mutual fund whenever they provide the
information to the common public, they should always ensure that all kind of financial
information and non-financial information are disclosed to them by that the investor will
be in a good position that whether they will be interested to invest in that particular
mutual fund scheme or not that actually they should ensure that.
The mutual fund should appoint a custodian to carry out the custodial services, just now
we have seen for SBI mutual fund we have the 2, 3 custodians. So, mutual fund can or
the AMC can appoint a custodian to carry out this custodian services. And a mutual fund
cannot appoint a custodian in which 50 percent or more of the voting rights is held by the
sponsors or the companies.
So, they cannot do that thing if the sponsor’s stake in that particular company is more
than 50 percent. So, for any kind of thing they need the approval from that particular
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board or approval from those trustees, whenever they start this kind of business in the
particular system. So, therefore that what we can see, here we are trying to see how the
different kind of parties which are involved in the mutual fund business they are
basically linked.
We have sponsor’s, we have the trustees, we have the AMCs who are obviously, the unit
holders, who are the major stakeholder who participate in the mutual fund business and
as well as they take the position for the investment or to maximize the return over a
period of time. So, this is what basically the structure of the mutual fund looks like in
India.
Then there are whenever we go for investing in a mutual fund, we come across different
type of concepts and those concepts are their own meanings and those concepts are used,
whenever we participate in the investment process with respect to the mutual fund. So,
you might have heard there is a word called entry load. What do mean by entry load?
How does entry load is defined?
The entry load is nothing but it is the sales charge that investor pay, when they buy some
units of a mutual fund scheme. It is basically the fee or the sales charge what this
investor pay to the companies, whenever they have started investing in this kind of funds
in the mutual fund scheme.
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Then we have exit load, if the amount of money that is investor needs to pay to a mutual
fund companies, it is the amount of money the investor needs to pay to the mutual fund
companies, then when they intend to exit from the scheme it is also called as the back-
end load or the or the repurchase load. At any point of time if the investor wants to get
out of that particular scheme and that particular point of time they also pay certain kind
of charges to the mutual funds and that particular charge is called the exit load.
Entry load at the time of buying or at the time of investing whatever money you are
paying and at the for the exit load or exit fees whenever we are paying at that time we are
basically leaving that particular scheme or we are exiting that particular scheme in that
case we call it the exit load.
Then we have another concept called sale price. It is the price paid by the investors at the
time of investing in an investment tool or investment scheme or in other words it is a
purchase price for the investors and it is also called the offer price. Sales price is nothing
but the offer price at what price the investor basically starts investing or buys that
particular fund or particular security or particular kind of financial instrument from the
AMC, so that is called the sale price.
Then you have the systematic investment plan, there is another key concept which
always used. Like Recurring Deposit, RD account in the bank it is an investment tool
offered by the mutual fund, which helps the investors to make a regular investment of a
small amount for a certain period of time. So, what is happening some people may be
invested in the mutual fund, some people may not be, some people is aware about the
different kind of benefits what we can get from the mutual fund, somebody may not be,
so because of that the SIP plan was started.
In SIP what happens, this is just like a RD account kind of operation which happens, a
particular amount fixed amount will be debited from your account every month and that
basically will be used in the investment for a certain period of time in the mutual fund
that is basically we call it the systematic investment plan, what we can make whenever
we are trying to invest in the mutual funds through a small savings which can be paid
periodically that is called the SIP or the Systematic Investment Plan.
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We have a systematic encashment plan, this plan facilitates the investors to withdraw the
specific amount of units from the invested fund at a pre-determined interval that means,
here what is happening whenever you talk about the systemic investment plan, we are
investing their specific amount in a periodical basis. And from that plan we are basically
trying to invest that money in the mutual fund in the different kind of instruments and get
certain kind of return.
But whenever we are talking about the encashment plan, here this plan basically
facilitates the investors to withdraw a specific amount of units from the invested fund at
a pre-determined interval, so that means you have already invested and it is mentioned
that in a pre interval basis, how much unit’s money can be encashed. Let you have 100
units, so every 6 months or every 3 months, you can encash 5 units, 10 units like that and
against that you can receive the cash or you can receive the money or whatever money
you have invested by encashing that particular units whatever you have.
Then you have the switch, it is mechanism by which the investor can shift from one
investment scheme to another investment scheme. For example, somebody has invested
in one type of scheme, they can move into another type of scheme, what are those
schemes we will discuss that. So, there is a possibility of switchover, whenever we go
the concept of switch basically is used in that context.
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Then you have the monthly income plan, this is a special type of scheme again where a
part of the fund is invested in equity and another basically in debt. And investor who
wants to always on regular stream of income or they want to regularly invest in a
particular schemes which can give you the regular flow of income, they can go for the
monthly income plans and those kind of plans already available, which are basically
linked to the mutual funds in India.
There are another concept, which is NAV – Net Asset Value of the particular fund. So,
this is nothing but the total market value of the assets minus the liabilities whatever they
have divide by the number of funds outstanding. So, the NAV is calculated for the funds
periodically. So, depending upon the NAV this investor may be interested to invest in
that particular security.
Then we have another thing we have the sale price it is nothing but the market value of
asset minus the liabilities. The market value of assets minus liabilities excluding
contingent liabilities, initially share capital reserves and unit capital plus the brokerage
charges, commission tax, stamp duty, etcetera divided by the number of units
outstanding; so that is the price at which the particular funds are sold.
And what is the repurchase price? It is basically the market value of assets minus
liabilities excluding contingent liabilities, this initial share capital, etcetera divide by the
number of units issued or the outstanding. Then if you want to calculate the return on
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units; the return on units nothing but NAV net asset value of the time period t minus the
net asset value of the time period t minus 1 plus if there is any dividend is paid against
that units or the mutual fund scheme plus the capital appreciation or the capital gains
divided by the lagged value of NAV.
So, this is basically the way expected rate of return on units can be calculated. So, here
NAV is the net asset value and t is equal to the period at which the particular NAV or
RRU is calculated. So, these are the different concept, which are used in the mutual fund
investments.
Then we can move into the advantages of the mutual fund, because it is professionally
managed that part already we have discussed, it is professionally managed. This is
diversification, so many instruments are available, the risk is spread across the different
instruments, liquid and flexibility is there because you can switch from one type of
scheme to another scheme
It is simpler to invest, because you do not have to do anything the fund manager looks
after this investment. It incurs low transaction cost, sometimes in comparison to the
investment in the equity market directly. It also related to tax benefit, you get some tax
benefit you have invested in the mutual fund.
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And there are different varieties of the schemes which are available, on the basis of your
requirement you can choose that and what are those schemes that will recently we will
discuss that in this class. So, these are the different ways the choice of the schemes are
available that is why, it is advantageous to invest in the mutual fund.
Mutual fund have lot positive impact on the economic growth, because it helps to utilize
the resources whatever the public has and this helps to circulate the money in the
economy. And it is also the utilization of the resources in the economy by providing the
structure clarity and transparency, not just a vehicle to invest, but a vehicle to invest
wisely, because it is managed by the fund manager.
And it basically the total amount of money availability in the system increases, because
the small savings can be circulated through this particular system. And it provides the
opportunities to save for the retirement, by the house and finance to children education,
because it is a small savings which can be utilized to make the investments for the future
requirements of the individuals. So that is why it has some kind of positive impact on the
growth process of the economy.
So, in the next class, we will be discussing about the different schemes, which are
available related to the mutual funds and how the mutual funds are different from the
hedge.
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Please, go through this particular references for this particular session.
Thank you.
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Lecture – 29
Mutual Funds - II
In the previous class, we discussed about the structure of the Mutual Fund and there are
different concepts which are related to mutual fund and as well as the relevance or the
significance of the mutual fund investment of a particular financial system. Now, today, in
this class, we will be discussing about the different type of schemes, what the mutual funds
provide. And as well as we can discuss certain things that how the mutual fund is
performance is measured and also that what are the basic difference or the similarity between
mutual fund and the hedge fund.
If you see that whenever you talk about in the previous class again and again we are
discussing about the mutual fund schemes. So, let me explain that what do you mean by the
mutual fund schemes. Already, you know mutual fund is nothing but a portfolio, which is
comprised of different kind of financial alternatives, which are available in the financial
system. It includes equity; it includes debt and other kind of resources, whatever we have.
But if you categorize the mutual fund schemes, the mutual fund schemes can be categorized
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by different ways. One is it can be categorized by their structure or also it can be categorized
by the investment objectives.
So, either of these way, the mutual fund schemes can be categorized. So, whenever you are
categorizing on the basis of the structure, you have two types of funds; one is open-ended
fund and second one is the close-ended fund. And whenever you are going by categorizing
them on the basis of their investment objectives, we have a growth fund, we have an income
fund, we have a balanced fund, and we have a specialized fund. So, this is the way the mutual
fund schemes are categorized. Let us explain one by one, what do you mean by the open-
ended fund, what do you mean by the close-ended fund, growth fund, income fund, etcetera.
So, then if you see what do you mean by the open-ended fund. Open-ended fund is basically
a collective investment, which can issue and redeem shares at any point of time. There is no
such maturity period of that particular fund. This fund can be issued or can be redeemed at
any point of time that means, it is totally open-ended. There is no such kind of specific period
before that this fund cannot be matured, the fund cannot be sold fund cannot be bought
etcetera. So, this is totally free anytime the fund can be sold, anytime the fund can be bought
and that is basically we call it the open-ended fund.
But whenever we are talking about the close-ended fund, the close-ended funds can issue the
shares only in the beginning and cannot be redeemed or reissued till end of their fixed
investment duration. That means, there is a fixed maturity period it is basically issued from
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the beginning and redeemed in the end whenever the particular maturity period is over. And
that is basically, we call it the close-ended funds in between the particular funds cannot be
bought or cannot be redeemed at any point of time in the market.
And another thing you keep in the mind that the close-ended funds are listed in the stock
exchange. So, this particular close-ended funds are traded in the market, but the open-ended
funds are not traded in the market. In the stock exchange, these are listed and these are traded
like the shares and all these things in the market. Where open-ended market are basically not
regularly traded in the market or they are not listed in the stock exchange that is the basic
difference between open-ended fund and the close-ended fund.
Then we have the other funds which are designed or may be categorized by investment
objectives. Whenever we talk about the growth fund the growth funds are basically made out
of the stocks, because already we know that the mutual fund is basically a portfolio. So,
already you know what do you mean by the portfolio? This is basically your combination of
the assets. If it is a growth fund then all those asset is basically stocks or the equities. This is
basically equity that means, only different type of equities are there, but there is no other
assets, which are involved in that growth fund. It is mostly comprised of the stocks, why the
basic objective of the growth fund is to maximize the return.
The basic objective of the growth fund is maximize the return that is why the composition is
mostly based upon the equity by that they are exposed to more risk even if they are exposed
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to more risk, there is a probability of high return. The expected return from this kind of funds
are relatively higher than the other type of funds. So, that is why the composition is mostly
from the risky assets and stock is one of the risky asset among them. That is why it is only in
stocks and mostly it is invested for a long period of time 3 years or more that is what
basically we call it the growth fund.
But whenever you talk about the income fund income fund is mostly comprised with the debt
or the fixed income securities. Fixed income security means this is basically your debt. So,
the instruments which are a part of the income fund these are basically mostly the debt
instruments and their maturity period is relatively less than 3 to 10 months. And who are
basically trying to invest in these kind of securities, who wants to always receive a steady and
regular flow of income. Whenever anybody invest in the income fund, they get a regular and
steady income, but the possibility of capital appreciation is relatively less limited, because it
is not comprised of an equity.
So, because of that possibility of capital appreciation is relatively less, but the regular flow of
income will be there, there is an assurance that definitely there is a positive income flow the
particular person will be getting over the period of time. So, that is why steady income will
be there, but capital appreciation probability is relatively less. And it is suitable for the retired
people, who needs regular flow of income or the person who is less risky or highly risk
averse towards the investments in the market. The risk averse investors refer to invest in the
income fund, but relatively risky investor always prefer to invest in the growth fund, so that is
the basic difference between the growth fund and the income fund.
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Then another type of funds which are also categorized by investment that is balanced fund.
There are certain places or certain investors are available in the market they want both, they
want capital appreciation, they want also some steady flow of income. So, in that context,
what happens, we have a balanced fund. So, the balanced fund whenever you talk about, the
balanced fund is comprised of both equity plus debt that means here they are getting income
from the debt component and they are getting capital appreciation from the equity
component. So, it can be 60 percent 40 percent or 40 percent 60 percent or it can be also 50
percent, 50 percent.
So, if the investor is little bit more biased towards the capital appreciation, then they can
prefer 60 percent of the equity 40 percent of the debt. If the investor is more bias towards the
income generation, they can go for 60 percent of the debt and 40 percent of the equity of their
unbiased about both return component and the capital appreciation component and/or income
component, then they can go for the investment both 50 percent and 50 percent. So that is
basically the way the balanced fund is defined which comprised of both debt and equity
whenever anybody invest in the equity market mutual fund market.
Then we have some specialized funds. And what are those specialized funds? The specialized
fund means the funds can be a sectoral fund. What do you mean by the sectoral fund? The
particular investor can choose those assets which are coming from a particular industry or a
particular sector, it maybe banking sector, it may be IT sector, it may be manufacturing
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sector. The particular stocks or bonds which they have chosen mostly they are concentrated
or they are basically always based upon a particular sector, so that is why the composition or
the portfolio has been made on the basis of those companies, which are operating in that
particular specific sector, so that is call the sectoral fund.
Then we have another fund called the money market fund. The money market fund in the
sense we are referring to the funds like treasury bills. The particular fund a particular mutual
fund is comprised of instruments like the instrument, which coming from the call money
market and a mostly the treasury bills and all these things. Mostly, it is the money market
means the treasury bills which are short term in nature, because money market deals with
those securities which are short term in nature. So, these are the money market instrument
which can be used there.
Gilt fund; the gilt fund means it is the government securities, government securities mostly
the long term securities it maybe 10 years to 15 years maturity. So, all those bonds which are
comprised of these kind of a funds these are coming or issued from the government. And
India on behalf of the government it issued by the reserve bank of India that already you
know. And the gilt fund is designed by all kind of long term securities, which have been
issued by the government. So, gilt means government in this particular context, so that is call
the gilt fund that is specialized fund we have in the mutual fund market.
There are some funds which are designed on the basis of the real estate stocks or the
particular bonds, which are issued by the real estate company little bit more risky, but still
there are some kind of specialized funds which are basically based upon that. Offshore fund
means the companies which are basically operating in the foreign countries and they are also
issuing those kind of instruments and these particular funds are designed on the basis of
instruments issued by them.
So, these are defined as the specialized fund, this specialized fund can be an equity fund or
the growth fund, it can be income fund. But why it is called specialized? Because, it has
certain specific character, which is not available with the common portfolios or common
mutual funds, which are available in the financial system. So, it can be specific to the
industries, specific to the markets, specific to types of securities. So, once we are talking
about those kind of thing, then what basically we can do that is why it is call the specialized
and is follow certain kind of specific characteristics by that particular fund can be categorized
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as the specialized funds. So, this is the way the different type of mutual fund schemes are
defined in the financial system.
And we have another type of fund, which is called index fund. And what do you mean by the
index fund? The index fund basically attempt to design a portfolio to replicate the
performance of a specific index. For example, I will give you example in this case. For
example, BSE sensex; BSE Sensex has 30 stocks. Because we are not allowed to invest in
BSE sensex directly.
So, what basically somebody can do? Somebody can make an index fund, index fund of all
those 30 stocks which are considered for construction of the BSE sensex. So, the allocation of
the fund should be made on all those 30 companies, which are a part of the BSE sensex and
as well as the weights also can be given in the same way, whatever way the weights are given
to calculate that BSE sensex index.
But maybe there are some deviations, the deviation arises, because of the cash flow the
company mergers and bankruptcy. There is some unusual situation may arise, some
adjustment may take place because of that, some differences may arise, but that differences is
basically what we call it they return from the benchmark index. Their benchmark index is
basically, we call it BSE sensex. And we have our index fund which comprised of all those
30 stocks, which are a part of the sensex.
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And there is a difference let your benchmark return is BM r and your index fund return is IF
r, then always, what we want to do? We want to see that the return differences or fluctuations
of return differences between, these two should be minimum, this should be the objective of
the investor. So, how you calculate that we take the difference between the return of your
fund, return from the benchmark return and we are trying to minimize the tracking error.
Now, what do you mean by the tracking error? The tracking is nothing but it is the standard
deviation of the return differentials between the benchmark index and your index fund. So,
the basic objective of the investor is to minimize the fluctuations of the return differentials
between your index whatever you have constructed and as well as the benchmark index
return what this particular market index is giving or the benchmark index is giving, so that is
another type of fund, we can construct on our own.
There are different method through, which this particular construction is possible, but the
basic logic is the index fund can be calculated by taking the same stocks in that particular
portfolio and trying to see that how it is performing against the benchmark index what
already it is constructed or formed in the market. So, that is basically another fund, which can
be available in the financial system.
So, if you see the risk return relationship between the different types of funds, on the basis of
the risk profile the liquid funds. The liquid funds means, we are basically referring to liquid
funds are the money market fund. The money market fund and debt funds are basically
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maybe your gilt fund and your income fund. Balanced fund already, you know it is debt plus
equity. Index fund, it can be comprised of equity only or but relatively more diversify.
And equity funds which is nothing but the growth fund. Sectoral fund, which is a specialized
fund which is specific to industry and that is more risky. So, that is why if you go by the risk
return profile. So, this is the way basically it is design. The more the risk more the return in
that concept this is the hierarchical order of the different funds we can observe in the market.
Then we have to see that how the performance of the mutual funds are measured. As you
know that mutual fund scheme is also a portfolio. Then what you do, we use the same
performance measures whatever way we measure the performance of the portfolios. We have
different measures, but here there are three popular measures which are used to measure the
performance of the portfolio and including the mutual fund performance. One is your Sharpe
ratio, then you have the Treynor ratio, then you have the Jensen’s alpha or the Jensen’s ratio.
What it basically means how to define that what is the Sharpe ratio? The Sharpe ratio is
basically defined as the excess return to the total risk and expected return you know it is
nothing but the expected return from a mutual fund that is expected R mf. The expected
return the mutual fund can be calculated using any kind of CAPM or any other model. And
what is your expected return, what you are getting from this? Already, you know that already
we have explained it
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E ( R i )=α + β ¿
So, this is your market risk premium, this is market risk. This is the intercept or the risk free
rate which is nothing but the excess return which is alpha.
So, once you get your excess return from this, then what you can do you can calculate it,
because this is based upon the CAPM model. In the CAPM model already if you little bit
expand it, it is nothing but
( Ri −Rf ) =Rf + β ¿
So, this is the way it is defined or you can directly write.
E ( R i )=α + β ¿
So, this is the way your expected return from that particular mutual fund can be calculated.
Then finally, you can take a difference between if the R f is basically the risk free rate the
excess return divided by the total risk. The total risk means it is the standard deviation of that
particular return, it is includes both systematic and toss on systematic. So, that is the standard
deviation what you can calculate from that return series. So, that is the way what it measures
that for one unit standard deviation increase, how much excess return you are going to get
from that particular mutual fund investments that is basically defined as the Sharpe ratio.
So, what it measures, if it is this particular ratio is high, then the performance is also high that
means you are getting that particular thing, this particular denominator, numerator basically is
higher, because of that for extra unit of the risk you are able to get more extra premium from
that particular investment. Here one question was wherever Sharpe has taken this standard
deviation which is nothing but the total risk, because whenever we are constituting the
portfolio in the construction of the portfolio the basic principle is we are trying to minimize
the unsystematic risk that is why we are diversifying the portfolio.
So, because of that the Treynor measure assumes there is no unsystematic risk that means the
idiosyncratic risk is basically 0. If the idiosyncratic risk is 0 that only thing, we have to
concerned about that is a market risk that is basically nothing but the beta, so that is why the
Treynor ratio is nothing but excess return to beta ratio. For extra unit of market risk how
much extra return what we are extra premium, what you are going to get from the market or
from that particular portfolio that is basically measured as the Treynor ratio.
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And here the Treynor ratio assumes that with a proper diversification, we are able to
minimize the unsystematic risk from that particular portfolio, because through diversification
we are able to minimize that. Then we have the Jensen’s ratio; the Jensen’s ratio already, you
know that I have given you this equation here.
If you see this equation, what this equation again I am writing that
( Ri −Rf ) =α + β ¿
So, then
α =( R i −R f ) −β ¿
this is the equation. So, here alpha is nothing but basically the excess return. This is actual,
this is expected. The actual minus expected this is giving you the excess. So, how much
excess return basically you are getting ( R i −R f ) is equal to actual premium, extra premium
what you are getting this is basically giving, you the expected premium then if you take the
difference between them that basically give you the excess.
So, what is the Jensen ratio is basically talking about with respect to standard one unit of
market risk how much extra return you are going to get. So, that is why the R i is the realized
return, Rm is the realize return from the market, R f is the risk free rate β is the β of the
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portfolio, then previously people are considering that Jensen’s alpha this is popularly known
as the Jensen’s alpha.
So, Jensen’s alpha more the alpha the portfolio performs better. But if you are going for
Jensen’s ratio, there is basically the excess return or alpha to beta. So, here whenever you are
increasing your beta by one unit how much alpha unit basically is going to be affected, so that
is the way the Jensen ratio trying to measure the performance of that particular portfolio,
whatever you have constructed in using that particular assets in that particular mutual fund.
So, these are very popular measure. One is your here it is standard deviation total risk, here it
is market risk, here again market risk, but here your alpha is basically measured in this way.
So, this is the return from the mutual fund minus your risk free rate of return divide by beta, it
is return from the mutual fund minus risk free rate of return divide by the sigma. And here it
is the excess return divided by the beta. So, this is the way, these are the three measure, there
are other measures also like Fama generate selectivity and other thing, but these are the three
major popular measures which are used to measure the performance of the mutual fund in the
market.
So, then we can move into the discussion on another concept this is hedge fund, which is
quite popular in the US context although this is not that way very relevant for the Indian
context, but the hedge funds are quite popular in the US markets. More or less there are some
synonymous property to have with respect to the mutual funds, but those synonymous
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property is not exactly equal to the mutual fund. There are some differences we can observe
the relationships between the mutual fund the hedge fund.
Then what is the hedge fund first of all. The hedge fund is again a special type of investment
vehicle as an alternative to the mutual fund, which pools the fund from the investor and
invest in various investment avenues to earn high return. Note down here, one point here it is
high return. This hedge funds are basically not designed for the common investors. The
mutual funds are designed for the common investors, but the hedge funds are not designed for
the or not made for the common investors, because the mutual hedge investment in the hedge
fund is relatively more risky, but the return from that particular hedge fund it comparatively
much more higher than they return from the mutual fund, so that is why the basic objective of
the hedge fund is basically to earn the high return.
Then what are those characteristics? The characteristics if you see the minimum size for an
investor to be a part of the hedge fund is 1 crore rupees only accredited, in accredited this
well-defined investors, which are already accredited themselves to the regulatory bodies they
can invest in the hedge funds, not everybody common investors can participate in the hedge
fund investments. Hedge fund investments basically are contain all categories of investments
such as lands, real estate, stocks, derivatives, currencies everything, but mutual funds may not
have.
The mutual fund basically comprised of debt, mostly the debt instruments and equity
instruments, but the derivatives instruments and the other kind of a real estate then the, the
sophisticated or the exotic securities like CBO, CDOs and all kinds of instruments, which are
a part of the hedge fund, but this is not a part of the mutual fund. So, mutual fund employee
the leverage to generate high amount of the that is why the basic objective of the mutual
hedge fund is to maximize the returns or to generate high amount of the profit from that
particular investment alternatives, which is not the focus for the mutual fund.
Mutual fund is a collective funds which is always there to get certain kind of return, but not
in that way is a risky whenever we participate in the mutual fund investment, but hedge fund
investments are highly risky. They charge fees for asset management as well as performance
of the funds generally they charge 2 percent of the asset management fee, and 20 percent of
the generated return as a performance fee. But in case of mutual fund, it is very less it is
1.825 percent and it varies, but that is basically the fund manager’s fee.
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The performance fee is not related to the mutual fund, but the performance management fees,
there in the mutual fund, but in case of the hedge fund the performance fees involved. So, in
general, the hedge fund is not for the common man, the hedge fund is basically for the high
net worth individuals, where there is a possibility of generating high return and as well as the
expenses or the cost also relatively high and risk is also relatively very high. It is a very
popular instrument, if you talk about US market.
Then if you see the differences, then what are the differences the regulatory requirements, the
hedge funds are not that way regulated by the regulatory bodies, but the mutual funds are
highly regulated the norms are well designed that is why it is more safer to invest in the
mutual funds, but hedge funds are not. The fees are quite high just now we have seen 20
percent the performance fee what the hedge fund managers are charging, but this is not the
case for the mutual fund.
Pricing and liquidity hedge funds are less liquid, because all kind of exotic instruments are
involved in that particular portfolio, but that is not the case for the mutual fund. Investor
characteristics; the investors who are investing in hedge funds are riskier investments or we
can say the risk seekers, but the investors who are basically investing in mutual funds, they
are not that way very risky investments, mostly the investors in the mutual fund are risk
averse investors.
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And risk and diversification, if you see the hedge funds are well diversified, but the question
here is diversification as made on the different kind of instruments, which are highly exotic
and the probability of losing in the market also relatively high. So, because of that the risk is
high that is why they want to diversify that, but sometimes the diversification does not work
in the way the diversification works in the mutual funds.
So, in general the hedge funds provide high return and they are also exposed to more risk.
Mutual funds relatively less return, but they are expose to less risk. And the mutual funds is
applicable or may be open to all type of investors in the market, but the hedge funds are only
applicable to the high net worth individuals. So, these are the basic differences between the
hedge fund and the mutual funds what we have seen which works in the financial system.
Thank you.
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Lecture – 30
Non–Banking Financial Companies (NBFCs) – I
So, what we are discussing about the different kind of Non-Banking Finance Companies,
there we discussed about the pension fund, then the provident fund, then we move towards
the discussion on the mutual fund and all. So, today we can start the discussion on other non-
banking financial companies, which are operating in the Indian financial system. And how
those particular companies are providing the services, and what kind of services they provide,
and who are the regulators of those particular companies, and as well as what is the benefits
of having those kind of organizations in the financial system.
So, let us start the discussion. Whenever we talk about the NBFC, NBFC is basically a
company which is registered under the companies act. To provide the loans and advances to
the different kind of entities, to provide certain kind of services. And what are those kind of
services we are talking about, those services deals with the services like leasing, hire-
purchasing, insurance, chit business. All kind of services what basically always, we want to
get from the financial system. Those services are given by the different kind of NBFCs.
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So, they do not provide these services, what the banks generally provide, but they provide the
services in terms of the different kind of further activities. Although, some of the activities
are similar with the banks, but exactly the services of the activities are not equal to the banks.
Most of the cases, also it is observed.
Those services are typically provided from some specific reasons. Either the services or the
particular activities can be confined for the agricultural activity; it may be only confined to
the industrial activity or to provide certain kind of services in terms of purchasing, and selling
of any kind of goods. Particularly, the physical goods we are referring, then also the services
can also be provided to create certain kind of fixed assets.
So, the basic nature or basic job of NBFC is basically to provide the services, although the
services are also given by the banks, but the services are basically very much specialized in
nature. And for specific purpose, these organizations exist in the financial system. So, here
we have a concept called principal business, you see whenever the particular financial
companies or non-banking financial companies work in the system, they can provide the
different type of services or various kind of activities, they can perform in the system, but
they must have some kind of principal business.
Principal businessman means in the sense, that those kind of companies this non-banking
companies provide certain services in a larger way that means, around 60 percent of the total
income or 60 percent of the total profit of that particular companies should arise from that
particular type of business. So, here basically we talk about that is why what we can say, it is
a company and has a principal business of receiving deposits under any scheme or
arrangement in one lump sum or in installments by way of contributions or any other manner.
And there are some non-banking companies they are called also residuary non-banking
company. So, this residuary non-banking company has some kind of specific business that
will be discussing in this particular session.
So, overall if you want to conclude, the conclusion is the non-banking companies are
registered under the Companies Act 1956 in India. And those existence or the basic objective
of those companies are basically providing the services in terms of some specialized
activities. So, this is the way the NBFCs are defined.
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And let us see that how this NBFCs are categorized, and who are basically the regulator of
this NBFC, and how it is different from the banks. So, whenever we talk about NBFC, the
major operation of the bank always works that the bank always accept the deposits, the
demand deposits. Some of the NBFCs also accept the deposits, but mostly if you see the
deposits are not basically the demand deposits or we cannot save our money, and get the
interest from that kind of institutions or those kind of organizations, which is the major job or
major function of the commercial bank that is basically number-1.
And NBFC is also do not be a part of the payment and settlement system and cannot issue
any kind of cheque. Because, whenever you are depositing the money in the bank, you see
that what do you mean by the payment and settlement, because any kind of transactions
always whenever we do in the market, particularly in the financial market or any other
market. The transactions and the settlement everything are carried out through a commercial
bank.
But, whenever you talk about the NBFCs, the NBFCs are not a part of the payment and
settlement system that particular job is only done by the commercial banks or the banks as a
whole. And bank against your deposit bank can issue the cheque to you, and the cheque can
be used for withdrawal of the money or for the depositing the money etcetera.
But, whenever you talk about the NBFC, NBFC is not allowed or NBFC cannot issue the
cheque, on particular deposits whatever the customers have, so that is why, there are some
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specific kind of services for the NBFCs can provide or NBFC can always contribute to the
system, but not like the banks whatever way we always operate or we get the services from
the commercial bank.
And another thing the deposit insurance means what, the deposit insurance means whenever
you have the deposit in the commercial bank, that deposits are basically insured. Insured in
the sense, if there is any kind of failure of the bank or the bank is going to be liquidated, then
in that particular point of time, if you have the deposit in that bank, you can get certain
amount of money or your deposits are basically insured. But, the question here is in India, the
deposit insurance is not very strong. And the maximum amount of money what you can draw,
against the deposit insurance is 1 lakh rupees.
So, if there is any failure, even if your deposit is more than 1 lakh, you cannot get more than
1 lakh rupees from the bank against your deposit whatever you have. So, the deposit
insurance market in the context of India is not very robust, but still some amount of deposit
insurance always we get, if you have the money or you have the deposit with the commercial
bank, but those kind of services are not available for the NBFCs.
And another thing is the credit guarantee corporation, the credit guarantee corporation is
basically what, they provide the guarantee against these kinds of credits or whatever loans we
take. But, those kind of services are also not applicable to the NBFCs or NBFCs do not get
this kind of services, in terms of the credit guarantee or in terms of the deposit insurance that
already we have discussed.
And another thing already you know that the commercial banks are basically regulated by the
Reserve Bank of India. The regulatory body for the commercial bank is the central bank of
the county, which is for our case it is the reserve bank of India. But, whenever you talk about
NBFCs, the NBFCs are not only controlled by or only regulated by the Reserve Bank of
India.
So, there are some NBFCs, they are regulated by the Reserve Bank of India. There are some
NBFCs which are controlled by or regulated by the Securities Exchange Board of India.
There are some regulatory some NBFCs which are basically regulated by the insurance or the
IRDA insurance regulatory body that is Insurance Regulated Development Authority. And
there are some kind of NBFCs, which are also regulated by some other kind of agencies like
NSB and all.
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So, therefore on the basis of the functions, on the basis of the services they provide, the
regulatory bodies are different. But, whenever you talk about the commercial banks, the
commercial banks are only regulated by the Reserve Bank of India or the central bank of that
particular country, so that is basically another difference what we can observe between a non-
banking financial company and a bank.
So, in this context what we have observed, more or less the services we get it, whatever way
the banks provides. Some amount of services is similar with the commercial bank, but in the
true sense or in the complete sense we cannot say the services what the NBFCs provide, and
the services of what the commercial banks provide they are same, because NBFC services are
confined to some for some specific purpose. So, this is the basic difference between the
NBFC and the bank.
Then you see why there is the existence of NBFC, what is the importance. First of all you see
our financial system is a very diverse system. And if you talk about the whole country, it is
not possible only by the commercial banks to cover up all kind of savings, what the people
have and as well as, they also have not that kind of expertise or that kind of ability. To go for
mobilizing all the resources, whatever we have or whatever the people can accommodate.
So, in that context and because there is a diversified business also available in the market. So,
for specific reasons, the banks may not be able to provide all kind of incentives or all kind of
loans for the investment in the particular sector or particular purpose. So, in that context what
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is happening the role of NBFCs are quite large. So, the mobilization of the resources or
financial resources is one of the basic reason for having the NBFC in a financial system.
Second thing is because the NBFCs provide the long term financing, they play significant
role for the capital formation. You know that basically the investment is created through the
capital formation; the investment is basically defined as the change in the capital. So, if your
k is the capital of the time t, then K t −K t −1 . This is basically change in capital. If you want to
go for the growth, then you can take a t-1.
Then this one basically what, this one basically tells you that how much investment or what is
the growth of investment takes place in that particular segment or particular sector or for that
particular company. So, in that sense the capital formation is important for the growth
process. And the capital formation can be made or the physical capital formation what you
can say that can be made whenever you have enough kind of financial capital available with
you. And who can provide this financial capital, only banks may not be able to provide that
financial capital, so because of that the role of NBFC is also quite important in that particular
context.
And already I told you, because they are the specialized organization. They and also they
provide the long term credit, and that is why the NBFCs role is very much important, because
they provide the specialized credit either you want to invest it in the physical asset or you can
go for investment for buying any kind of commodities, which is very much long term in
nature. So, because of that the NBFC is only able to provide that kind of finances for that
particular kind of activities in the system.
It also created the employment generation, because if the capital formation will be there or
the investment will be there, it also plays a significant role for the employment generation.
Overall, it helps in developing the financial market, and also it helps in attracting the foreign
grants. The foreign grants in the sense the foreign aids FDI and FDI’s also can come to this
particular sector, because this particular financing or particular thing which are created in this
particular segment that is basically for the long term region. And the physical set ups are
created in this particular method or through this particular way.
So, as the physical infrastructure is created through this particular financing, may be the
foreign investors may be interested or the foreign brands will be easy to always arrive in this
particular part or particular sector for the development of the economy. It helps in breaking
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the vicious circle of the poverty by serving as the government’s instrument, you know what
do mean by the vicious circle of the poverty, because we are poor that is why we are poor.
The country is poor, because it is poor.
In that particular concept means, we are providing certain services, we are heavily dependent
on some particular entities to get the finance for the investment. So, in that context what is
happening to get that particular loan, again we have gone for another loan. So, in that process
it becomes vicious cycle, so that vicious circle can be broken or it can be destroyed by the use
of the alternative sources of financing, where alternative instruments for the financing. So, to
create that kind of situation in the market, always we take the help from the NBFCs. And
NBFC basically cater to that particular demand in the larger way, by providing the alternative
financing or the long term financing to the system.
Then last one is quite important that is basically what we called the financial inclusion. To
some extent NBFC, there are some NBFCs which basically play the role for the financial
inclusion. What do you mean by the financial inclusion, the financial inclusion is nothing but
providing the financial services to everybody in the country, so that means, everybody should
have the bank account or everybody should provide this loan services, so get this deposit
services. And all kinds of things can be possible, whenever you have more type of financial
instructions exist in the system. Only commercial banks may not be able to provide or cater
the demand for a large country like India.
So, in that context, if you want to make this or increase this financial inclusion in this
particular country, then always we need the help from the different kind of financial
inclusions which exist, because they for some specific purpose, whenever we are providing
the loan. Then in these context the NBFCs provide or cater that particular services into the
system, and because of that the financial inclusion may take place or the financial inclusion
may increase.
So, in those process the financial inclusion also can happen in the system, you know why we
are considering the financial inclusion is important. But, if you go by the Keynesian theory,
there is a concept called if you remember that is called the propensity to save or propensity to
consume. So, whenever you talk about the propensity to save, so whenever you can gather
this, and whose propensity to save is more. The propensity to save is always more for the
retail household sector.
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So, once this you can cater the demand for the household sector, and the services can reach to
all the household sector. Even if because the propensity to save is more for household sector,
then there is a possibility that the total amount of savings in the economy can increase. If the
total amount of savings in the economy can increase, then what will happen whatever money
the household sector saves, then basically where the money goes, it goes to the business
sector for the investment. So, once the money which is collected from the household sector
goes to the business sector, then that money can be utilized for the investment. And finally,
the output can increase number-1.
Number-2, because it provides certain specific kind of services and if that particular kind of
organization exist in their particular system, then it is very reasonably easier for those kind of
customers, who wants that particular loan or particular kind of financial services to increase
their business or maybe increase their kind of activities, what they want to do. So, because of
that it is quite important that we should have a proper development in terms of the NBFCs in
the financial system as a whole. So, this is about your importance or why we need the NBFC
in the financial system altogether.
Then we will see that how those NBFCs are categorized, what are those different kind of
NBFCs, which exist in the system. So, whenever you talk about the types of NBFCs, so there
are different type of NBFCs already told you. If you categorize the NBFCs in terms of the
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registration, some NBFCs are registered with RBI, and some of the NBFCs are registered
with other financial, other regulatory bodies like SEBI and IRDA and other bodies.
So, there we will talk about the other kind of entities further, like the venture capitals
capitalist, then you have the merchant banks, you have the credit rating agencies, you have
also the kind of organizations like a other specialized organizations like NABARD and all.
So, those things as separate all together in terms of the common NBFCs. So, those merchant
bank, venture capitals, and all these things are basically regulated by SEBI, so that we will
discuss later. So, what basically here we are going to discuss, it is basically the NBFCs which
are registered with Reserve Bank of India.
So, if you see according to Reserve Bank of India, the financial activity of a principal
business, whenever you talk about there we have they have to satisfy certain conditions. What
are those conditions, the condition is this the 50 percent of the total asset. The company’s
financial asset constitute more than 50 percent of the total assets, and the income from
financial assets constitutes more than 50 percent of the gross income, whatever business the
companies doing.
And when both the criteria are fulfilled by the company, they are basically registered as
NBFC by RBI. And this some of the NBFCs are deposit taking, some NBFCs are the non-
deposit taking. And again the non-deposit taking NBFCs are two types. One is your
systematically important, and other is basically the other is non-deposit holding companies
like your NBFC-NDSI and NBFC-ND, and which is called the systematically important?
The particular NBFC, which asset size is more than 500 crore, according to the last edited
balance, these are basically called the systematically important NBFC in this particular
system. And you can also categorize those NBFCs in terms of activities or services they
provide, what kind of services the NBFCs provide on that basis also the NBFCs can be
categorized.
So, they can be asset finance companies, they can be investment companies, they can be loan
companies, they can be infrastructure finance companies, they can be core investment
companies, they can be in infrastructure debt fund non-banking financial companies, then
they can be also the microfinance institutions, they can be NBFC factors. So, there are
different kind of NBFCs which exist, and they are all registered with reserve bank of India.
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And already we have discuss that some of the NBFCs are deposit takers and some of the
NBFCs are not allowed to take the deposits, so that means they call the non-deposit accepting
NBFCs, but generally the NBFCs are more discussed in terms of the activities. So, we have
to be more concerned that what kind of services the NBFCs provide, and those services
basically how we can define it.
So, in that context, we have to more concerned about the NBFCs, which are providing the
specific kind of services to the financial system like your asset financing invest companies,
loan companies, etcetera. So, we will be discussing more about this classification than the
other classification, because within that classification, they also provide the same kind of
services in the financial system as a whole.
Then you can start with there is an asset finance company. So, what do you mean by asset
finance company, the basic job of asset finance company is which principal business is
financing of the physical assets, which support the economic activity, productive economic
activity. And mostly the companies finance to the automobiles, tractors, machines, generator
sets, earth moving machines, material handling equipment, moving on power and general
purpose industrial machines.
And the 60 percent of the income of those companies are coming from this business that
means, these companies are basically exist in the system to provide the credit, to provide the
loan for those kind of companies, who are related or those kind of individuals or those kind of
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entities, who want to invest their money in this kind of activities. So, mostly those companies
provide the services for creation of the physical assets or the fixed assets in the system. If you
see the example, we have the power finance corporations, Bajaj Capital, Tata capital,
financial services. So, those kind of companies provide the money for buying the different
kind of assets on which asset basically contribute for the economic activity.
So, they are basically used to create certain kind of value addition to the economic activity,
and this kind of asset finance companies major business is to provide the capital or loan to
them. The financing activities are basically carried out, through this asset finance companies.
It can also be done by the commercial banks, but mostly the specific purpose of asset finance
company is to provide the finance for this activities. So, this is about your asset finance
company.
Then if you see that, there is another company called the hire purchase credit. What this hire
purchase credit company does or what kind of NBFC, it is what do you mean by the hire
purchase, the hire purchase is basically a system under which the term loans particularly the
long term loans are given for purchase of the goods and services in advance. And they are
fractionally liquidated through a contractual obligation that means, what, if you want to buy
any kind of vehicle or you want to buy any kind of asset, which for that we need more
money.
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So, in that context, what we do, you can go for this kind of entities or this kind of companies,
who provide this particular finance to go for this kind of buying, this kind of goods. And
fractionally you can pay that money over the period of time that is why, the hire purchase
means buying the good on an installment plan. This means the hirer can buy the commodities
in exchange for the regular installment payments; it may be principal amount or the interest
over a period of time.
So, this is basically we called the hire purchase credit, which is given by the NBFCs. And
some NBFCs are specializing in that, and they provide this kind of services to the consumers.
The main source of funds for the hire purchase company are retailers, wholesalers, hire-
purchase finance companies, banks and financial institutions. They provide this kind of
services to the economic system.
Then we have lease financing. What do you mean by the lease financing, it is basically a
form of financing employed to acquire the use of the assets that means you are not going to
own that asset, but you are taking that asset as a lease. And then this process every lease
involves two parties the user of the assets which is known as the lessee, and the owner of the
asset which is known as the lessor.
So, the periodical payment made by the lessee to the lessor is known as the lease rental. For
example, there is a warehouse corporation. So, they have taken the warehouse on the lease,
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and they pay the rent periodical basis to use that particular warehouse or to get that services
what the warehouse can provide.
So, therefore under this lease licensing or lease financing, the lessee is given the right to use
asset, but not the ownership. And the ownership lies with the lessor. And at the end of the
lease contract, the asset is return to the lessor or an option is given to the lessee either to
purchase the asset or to renew the asset agreement. So, this is basically for a specific period.
And once the period is over, then the option will be given to him, you can own that asset, you
can buy that asset or if you want you can renew that particular contract for the another period
that is basically we call it the lease financing.
Then we have another entity call the investment company. What is Investment Company, the
principal business of this particular company is to provide the finance for the acquisition of
the securities. So, most of these companies provide the loans for consumption, commerce,
and trading purpose in the market.
So, the interest basically what they charge, these are basically the financial assistant which
are higher than the charge of the commercial banks. And the other organized financial
institutions, investment companies interested is little bit higher. Whenever we are not able to
generate the capital or generate the financial capital from the commercial banks or other
organized financial institutions, then we can go to the investment company to lease that
money and loans are unsecured, but procedures are very simpler in comparison to the
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commercial banks, so that is why the importance or the dependency on investment company
is also there, whenever anybody wants to do the business or anybody wants to buy something
for the commerce or the consumption.
Then we have another company called Systematically Important Core Investment Company.
These are the company, which basically carrying on the business of acquisition of the shares
and securities, which satisfies some specific conditions. What are those conditions, these
conditions basically what, it holds not less than 90 percent of its total assets, in the form of
investment, in equity shares, preference shares dept, or the loan in the group companies.
Its investment in equity shares including instruments, which can be converted into equity
shares within a period not exceeding 10-years from the date of issue in a group companies
constitutes not less than 60 percent of its total assets. It does not trade in its investment in
shares, dept or loans in group companies, except through the block cell of the purpose of
dilution or the disinvestment.
It does not carry on any other financial activity, except the investment in bank deposits
money market instruments, government securities, loans to and investment in department
issuances of the group companies or guarantees issued on behalf of the group companies.
And its asset size is 100 crore or above, and it accepts the public funds, so that they deposit
taking NBFC, which exist in the system. These are the condition which has to be satisfied to
make that particular or to define that company a systematically important core investment
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company in the financial system, so that is basically another kind of NBFC, which exist in the
system. Then we have the other NBFCs which basically provide the other type of specialize
services to the system.
We have the loan company, they provide the loan to wholesale and retailers, small-scale
industries, and the self-employed person. The loans are mainly short term, and these are
unsecured. And these are basically provide the other services like discounting the post-dated
cheques, collecting dividends for the customers, and purchasing the discounting of the
Hundis. So, these are the services which is given by the loan companies.
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Please go through these particular references for this particular session. So, these are some of
the companies what we have discussed, then we have the other companies like microfinance
institutions factors, and all these things that will be discussing in the next class.
Thank you.
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Lecture - 31
Non - Banking Financial Companies (NBFCs) – II
So, in the previous class we discussed about the importance of NBFCs and there are
different type of of NBFCs work in the Indian financial system. And, there are some
NBFCs which are regulated by the Reserve Bank of India, registered with RBI and there
are some NBFCs which are basically registered with the SEBI and other kind of
regulatory bodies which exist in the Indian financial system.
Then we were discussing about those NBFCs which are basically exist in the or which
are registered with Reserve Bank of India now. And, there are many kind of NBFCs
which provide their services and those NBFCs are categorized on the basis of their
activities. So, we discussed about certain NBFCs like you have the asset finance
company, you have the loan companies, you have some of the NBFCs systematically
important NBFCs and all these things. Then we can open to some other NBFCs which
also play the significant role in the financial system for providing the services.
One of the company is infrastructure finance company and what do you mean by
infrastructure finance company. The infrastructure finance company is NBFC or the non-
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banking financial company which deploys at least 75 percent of the total assets in
infrastructure loans. Whatever loans the company provide out of them the 75 percent of
the loans are given on the infrastructure. It has a minimum net owned funds of 300 crore
and should have a minimum credit rating of A or equivalent and the capital adequacy
ratio of 15 percent.
So, the IFC the Infrastructure Finance Company is basically what which deploys at least
75 percent of the total assets in infrastructure, loan has a minimum net owned funds of
300 crore, has a minimum credit rating of A or equivalent and a capital adequacy ratio of
15 percent. So, these are the required conditions or necessary conditions to consider or to
define a company called the infrastructure finance company. So, what do you mean by
the capital adequacy ratio? If you remember the capital adequacy ratio is nothing, but
this is your total capital divided by the risk weighted assets.
The total capital includes your tier I capital and plus the tier II capital and the tier I
capital is basically what; the tier I capital is your equity. And tire II capital is basically
your what your subordinate debts. So, equity and the subordinate debt these are two
different capitals which are available in this particular part of the tier total capital. And,
the risk weighted assets are basically what, the total assets and always this particular type
of weights has been given to this particular assets. And, the basis of the type of loans
what this particular bank or particular NBFCs has given.
So, the minimum and that particular thing is basically measure the stability, that basically
the CRAR basically measure the stability of the bank or stability of the NBFCs. So, if the
CRAR or the capital adequacy ratio is 15 percent and credit rating is A, minimum net
owned funds of 300 crore and 75 percent of the loans are given for the infrastructure then
we can call that company the infrastructure finance company. And which is a very
reputed NBFC which work in the Indian financial system..
And what do you mean by the infrastructure loan? The infrastructure loan is basically
nothing, but providing the credit facility to a borrower for exposure in the infrastructure
sub sectors like transport, energy, water, sanitation, communication, social and
commercial infrastructure. In this particular entity or particular company or particular
individual who is taking the loan for this specific sectors or for this specific industries;
then and the loan is basically disbursed against that then we call that the infrastructure
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loan. And, another thing is already we have said that the basic job of the infrastructure
company is to provide the services for creation of the assets in the system.
And, that asset may be includes the roads, buildings and all these things; it can be
creating some kind of avenues to create the energy. It can be provide certain kind of
incentives to provide the better water facility, water supply and sanitation facility. Or, it
can also create certain infrastructure to enhance the communication facility in the
country or any kind of commercial infrastructure if you have. But, in every cases we are
creating certain kind of physical assets which is helping us to create some infrastructure
for the development of the economy.
And the 75 percent of the total loans what the particular NBFC is giving that is basically
belongs to this category loan or this category credit. Here another thing is within that we
have an Infrastructure Debt Fund Non-Banking Financial Company that is, it is called
IDF NBFC. It is registered as NBFC to facilitate the flow of long term debt into
infrastructure projects and NBFC IDF NBFC raise resources through issue of the rupee
or dollar dominated bonds of the minimum 5 years maturity. And, the infrastructure
finance company is the sponsor for this; mostly the loans which are given by this
company is long term in nature or the minimum term to maturity is 5 years.
So, that is basically we call the infrastructure debt fund and the major sponsor of the
infrastructure debt fund is basically the IFC or the Infrastructure Finance Company. That
is why the basic job of the infrastructure finance company is to create the infrastructure
in the economic system which overall increase the product can help to increase the
productivity.
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Then we can move into the other kind of NBFC which are working. Another most
important type of NBFC we have that is called the NBFC microfinance institutions. All
of you might have very much acquainted with this word, this microfinance institution.
And, the microfinance institution is basically one NBFC and this NBFC is a non-deposit
taking organization.
This NBFC does not take any kind of deposit from the public and having not less than 85
percent of its assets in the nature of qualifying assets which satisfy the certain specific
criteria. And what is the basic job of this? The basic job of the kind this microfinance
institution is to provide the small loans to some specific group of the people to create
certain kind of business for their survival or we can say that to create certain kind of
employment opportunity.
So, these organizations provide small-small loans and these small loans are used to
create a small business by that particular group or by that particular individual which can
create certain regular cash flows in the future. So, the basic nature of this particular kind
of company or basic kind of asset whatever the company has this is basically nothing,
but the loans the small-small loans what they have given. So, what are those criteria they
have to satisfy to be considered as a microfinance institutions? The loans disbursed by
the MFI to a borrower with a rural household mostly they are confined to rural areas, the
annual income not exceeding 100000.
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And if it is urban areas or semi urban areas then this annual income of that household
should not exceed 160000; that means, the loan should be given only to those kind of
households whose income level is very low. Loan amount does not exceed 50000 in the
first cycle and 100000 in the subsequent cycles; that means, the disbursement of the
loans the amount of loans which are given against this microfinance institutions are quite
low. Then total indebtedness of the borrower does not exceed 100000. That means
whatever loans the customer is taking the MFI should ensure that the total amount of
loan at a particular point of time should not exceed 100000.
Total loan indebted means whatever existing loan they have and whatever new loan they
are taking all together at a particular point of time the total loan amount should not
exceed or total debt amount of that particular person should not exceed 100000 rupees
the tenure of the loan not to be less than 24 months for the loan amount in excess of
15000 with prepayment without penalty right. So, minimum 2 years the tenure of the
loan, it cannot be less than that if the loan amount is exceeding 15000 rupees that
actually this MFI has to ensure. Loan to be extended without collateral; whatever loans
the m f is are giving they cannot take any kind of mortgage collateral against this loan.
These small loans have to be given to that particular individuals or particular households
without any kind of collateral.
So, the loans are basically unsecured loans. The aggregate amount of loans given for
income generation is not less than 50 percent of the total loans given by the MFIs. The
loans which basically they give they are given for the different kind of purpose, different
kind of reasons, but the MFI has to ensure that whatever loans they are given that loan
amount should not be less than 50 percent of the total loans which are given for the
income generation that actually they have to ensure. Loans are repayable on weekly,
fortnightly or monthly instalment are the choice of the borrower. You see generally the
whenever we take the loan from the banks, the banks basically recover the loan
minimum frequency is monthly.
Whenever we talk about the NBFCs like MFI they can recover the loan minimum
frequency is weekly. So, they can take the money from the borrower or they can recover
the loan from the borrower with interest in weekly basis or fortnightly basis or monthly
basis. So, the loans are basically always recovered from the small borrowers who have
taken the loan from the MFI. But, if you consider from the banking prospective even a
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bank provide the small loans; they do not recover the money and the weekly or
fortnightly basis.
They recover the loan from the customer or from the borrower in the minimum monthly
basis. And, another thing you see the amount of loan or the amount of interest what the
MFI charges that is relatively higher than the interested charges by the commercial
banks.
Because, the revenue generation or the financing of MFI are done through banks only or
some kind of entities who provide the loan to cater this kind of services in the economy.
It can be SIDBI or any other organization who provide the loan for this kind of activities.
So, then the MFI basically pay the interest to them and from there they get the money
and cater the demand for the small customers or the small borrowers. So, because of that
the interest rate on this kind of loan is relatively higher than the loan rate of the same
maturity which are given by the commercial banks. But still it has its own reasons
because, of that the MFI importance in the Indian economy is quite large or quite
important.
And they also cater the demand for the small customers and as well as also fulfil the
requirements of the financial inclusion. So, MFI plays a very significant role for the
financial inclusion in the economic system in India.
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Then we have another kind of NBFC who provides the services like factoring then; that
means, what NBFC factor is also is a non-deposit taking NBFC and their principal
business is the factoring. And, the financial asset in the factoring business should
constitute at least the 50 percent of its total assets and the income derived from the
factoring business should not be less than 50 percent of the gross income. That is why we
call that the principal business of this organization this kind of organization is the
factoring.
So, 50 percent of the total assets is related to the factoring business and the income what
they are generating from the factoring business should be minimum 50 percent of the
total gross income what are the companies basically generating from the business. What
is factoring? Factoring is basically a financial service in which the business entity sells
its bill receivables to a third party at a discount in order to raise the funds. It is a financial
service in which the business entity sells its bill receivables to a third party at a discount
in order to raise the funds.
Let us explain that what did exactly means for example, the seller makes the sale of the
goods and services you somebody one seller you are some buyer has buyer have gone to
a seller they have bought some commodities from the seller and the seller has sold these
commodities to that particular buyer. And against that the seller generates the invoices;
the invoices are generated. Then what will happen that is the buyer may not make the
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payment to the seller immediately. In that particular point of time what happens the seller
sells its invoices to a third party called the factor. The seller goes with that invoices to
the third party and pays some kind of factoring fees or factoring services.
And, it is the job of the factors who basically will collect the money from the buyer. And
once the invoices will be received by the factors from the seller immediately the factor
pays the seller after deducting some discount on the invoice date or invoice value. The
invoice value whatever let 500000 is the invoice value, the discount it may be 10 percent,
5 percent whatever it may be. They discount that and whatever remaining money will be
there they try to give that money to the seller. Seller gets back is money and the discount
is varies from 2 to 6 percent. Thus, you see what whenever the discount the invoices they
basically charge from 2 percent to 6 percent. But, one thing is the factors may not pay all
100 percent money to the seller.
They pay 75 to 80 percent of the invoice value to the seller and another 20 to 25 percent
they keep it and they will pay this whenever the buyer will pay the money to the factors.
So, the remaining 20 to 25 percent of the invoice value is paid after the factor receives
the payment from the seller’s customers. So, it is the job of the factor who will collect
the money from the buyers. So, this is not job of the seller to collect the money, seller
gets around 75 to 80 percent of the total invoice value. And, for that they have to pay 2 to
6 percent charge to these particular factors and it is a job of the factor who will collect
the money from the buyer.
And, once they will collect the money the remaining 20 to 25 percent they will pay to the
sell. So, that means, it is not the obligation; this is not the responsibility of the seller who
can collect the money from the buyer if any kind of commodity has been bought on the
credit. That is what basically the measure job of the factors, that is the concept of
factoring what we can explain. What generally the factors do? They maintain the sales
ledger account, they sometimes also plays the role for the financing. They protect their
credit, credit protection is done by these factors and on behalf of the sellers they also
collect the money.
So, this is the job of the factors who can collect the money from the buyers. So, the
responsibility of the seller is less whenever they have paid the giving that invoice and the
invoices are discounted by the factors and factors pay the money. But, it is the job of the
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factor to collect the money from the buyers and end of the day whatever remaining
money will be there they can pay to the seller in the end. So, that is where the factoring
works in the system.
What are those advantages of the factoring? Obviously factoring reduces the credit risk.
The working capital cycle runs smoothly as the factor immediately provides the funds on
against the invoice; whenever you are submitting the invoice this seller gets back its
money. So, the working capital cycle of the seller runs very smoothly. Sales ledger
maintenance by the factor reduces the cost of the seller relatively the cost of maintaining
that ledger account of this particular seller is less, if they are getting the factoring
services.
Improves the liquidity and cash flow in the organization because, immediately getting
back your money. It also leads to improvement in the cash in hand of the seller which
helps the business to pay its creditors at the timely manner, which helps in negotiating
also the better discount terms. It also reduces the need for the introduction of the new
capital in the business because, the cash is readily available and the factors are able to
pay that particular thing and, factors of the expertise to collect the money and to manage
that particular business in a better way because, they have the expertise to deal with this
kind of business.
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So, all the sellers may not have that kind of expertise to deal with this particular
collection of money and discounting this invoices and all, but the factors are responsible
for this kind of business they have the clear expertise for doing this. And because, of that
it is advantageous for both factors and as well as the sellers for creation of the liquidity in
the system and to make this working capital cycle smoother. So, this is basically the
advantages of the factoring, but there are some disadvantage also whenever you go for
the factoring.
It is observed that the cost of factoring is relatively high. The discounting what the
invoices they do sometimes the seller feels that the cost of factoring is very high, the
service cost of the factoring is high. Factors often avoid taking the responsibility for the
risky debtors and factors collecting the money on behalf of the company can lead to the
stress in the company and the client relationship.
Sometimes the factors may not be that kind of way behaves with the customers whenever
they collect the money, because anyway they are not the business entities; their job is
only to collect the money. In that particular point of time if the relatively harsh or their
approach for collecting the money is basically not that way working better, then it can
create the conflict between the buyers and sellers which may affect the business of the
seller in the future. So, there are some disadvantages what we can observe whenever we
are using the factoring services or the factors are coming into the picture for the business.
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But they have their unique role in that; then we have another company called mortgage
guarantee companies MGC. So, what is MGC? The MGC are basically a financial
institutions for which at least 90 percent of the business turnover is mortgage guarantee
business or at least 90 percent of the gross income is coming from the mortgage
guarantee business out of the total income and net owned fund should be 100 crore and
above. What do you mean by this mortgage guarantee business basically for example,
what is happening, you have taken a home loan.
Then your home loan, the mortgage is the home and you are obliged to pay your interest
and finally, your principal regularly. But what is happening for some reason if you are
not able to pay the interest or you are not able to pay the principal either the person has
died or the person has some kind of critical illness. Something may arise while paying
the interest to that particular financial organization or financial entity at that particular
point of time what happens the role of the mortgage guaranty companies comes. It is
basically an insurance.
So, if your home loan is insured the companies basically provide the services for this
kind of business or this kind of purpose. If it is insured then what will happen that there
is if there is some kind of uneven situation arises, then it helps this financial institutions
to cover the home loan. Or, they can cover the risk of default without affecting or
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without making any kind of arrangements for the liquidation of the home. That means,
what the customer will not face any difficulty; the loan amount will be paid.
And as well as the customer who could not pay the loan because, of certain reasons the
insurance company will basically is able to cater the services on behalf of the customers
or that means, the loan is insured. And, this kind of services are provided to the banks
and housing finance companies. The companies are the banks who provide the housing
loan, the loans are basically always insured nowadays which is given by this mortgage
guarantee companies. And, that is the way basically the loans can be insured and the
probability of default or the risk of default declines in this particular process.
Then we have another one is NBFC non-operative financial holding company this is an
institution which promoter groups will be permitted to set up a new bank. It is only one
fully one non-operative financial holding company and why we are basically half this
company is to separate the several financial services carried out by the same holding
company. And, the prudential norms of these companies are same with the banks. I can
give example in this case for example, the Bandhan the microfinance organization who
has got this license for doing the banking business. So, now Bandhan is basically known
as a microfinance companies.
So now, this Bandhan bank is a separate holding company who will provide these
services in terms of the banking and their operation in terms of MFI is different. That is
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why this financial activities will not be overlapped. Same holding company, but the
services or activities are totally differentiated. There should not be any kind of
overlapping for this kind of activities what they do or this kind of services what they
provide. But the norms and everything would be similar in that of the banks, the
regulatory norms what basically we follow for this is basically the always same with this
commercial banks. So, we have this kind of setup in the Indians financial system to
overcome any kind of crisis which can happen to this.
Then we have last one is the residuary non-banking company. Its principal business is
the receiving of deposits under NBFC a scheme or arrangement or any other manner not
being investment asset financing or the loan company. This RNBC offers or these
companies offer a rate of interest of not less than 5 percent per annum on term deposits.
And, 3.5 percent on daily deposits both compounded annually; cannot accept deposits for
a period less than 12 months. They cannot accept the deposit for a period less than 12
months or more than 84 months cannot offer any gift or incentives to solicit deposits
from the public. Accept deposit only against the issue of the proper receipt.
The receipt should bear the name of the company and should be signed by the authorized
official of the company. The receipt should mentioned the name of the depositor. The
amount in words are as well as figures, the rate of interest payable on the deposit amount
and the date of repayment of matured deposit along with the maturity amount. So, this
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particular company more or less provides the all kind of NBFC services what are they
supposed to provide. And, offer an interest rate not less than 5 percent on the term
deposits and 3.5 percent on the daily deposits and both are compounded annually.
Then we have a new regulatory framework of NBFC registered with RBI; there what
RBI has defined the minimum net owned fund for the existing NBFCs has been
increased to 20 million. In order to strengthen the deposit acceptance regulations across
all deposit taking NBFCs, the credit rating has been made compulsory for all unrated
asset finance companies by March 31st 2016.
Tighter prudential norms have been prescribed, minimum tier I capital requirement
raised to 10 percent. Then the non-deposit taking NBFCs be categorized into two broad
categories: one is NBFCs ND those with assets less than 5 billion rupees and NBFC SI
Systematic Important NBFC whose asset will be more than 5 billion and above which is
known as systematically important.
And, regulations will be applied accordingly; regulations for NBFC SI and NBFC ND
these are relatively little bit different, but they are defined on the basis of their total
assets value. So, these are time to time the regulatory things are changing, but these are
the framework which is existing now for all the NBFCs registered with the Reserve Bank
of India. So, this is about all the regulatory bodies which are registered in RBI. Then will
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be discussing other NBFCs which are basically controlled or regulated by the other
regulatory bodies in the Indian financial system in the next class.
Thank you.
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Lecture – 32
Venture Capital
So, in the previous class, we discussed about the non-banking financial companies. There
we have seen that there are some companies which are registered with Reserve Bank of
India and on the basis of their activities those are characterized into different ways or in
the different categories. Then the another venture or we can say that other organizations,
which are also work in this particular sector or particular domain, but these are not
regulated by Reserve Bank of India these are regulated by the other regulatory bodies
like SEBI and IRDA.
So, today, we will be discussing about another important financial organization or

institutions which exist that is Venture Capital, which is quite important in today’s
world. The reason is because the business sector is growing and we are dealing with lot
of risky business and new companies are basically going to start their business and there
is a problem of getting the funds from the different organized sector, in that particular
point of time the importance of venture capital is quite large and quite important.
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So, in this context let us see that what exactly the venture capital is. If you see that the
venture capital is basically your venture capital fund. It is basically a fund which is
established as a company or a trust which raises money through loans donations issues of
securities or units and proposes to make investment in accordance with the regulations of
the SEBI.
What this SEBI regulation 1996 is? According to SEBI regulation 1996, the venture
capital basically is established as a company or as a fund which can raise the money
through loans, donations, issue of securities or units or it may be any kind of instrument
which are available in the financial system. So, this is basically what this is a private or
institutional investment made in early stage or for the start-up companies or for the new
ventures.
Why basically we were doing this? For example, if somebody wants to start a new
company and you do not have enough fund available with you then what is happening
then already we know that there are different sources of finance; we have some finance
which is in terms of depth and some of the finance which always we raise in terms of
equity; that means, for debt financing you can go to the bank and for equity financing we
can go to the public.
But, the question here is whenever the company was not properly set up and it is a new
venture and there is no such kind of regulation or such kind of reputation already exist
for this particular company that time it is relatively difficult to raise the money from the
bank. And, if you are going for a very risky proposition or the particular business what
you are going to make that is a relatively risky business then sometimes the banks are
reluctant to provide the money.
So, in that particular point of time the venture capitalists basically play a significant role
who basically provides this loan provide this debt financing to this particular entity and
the new start up can start the business by using that money whatever the venture
capitalist have invested in that. So, therefore, this particular organization is quite
important in terms of the setup of the new business in any financial system or any
economy. That is why it is basically in the early stage or for the new ventures it is
inevitable or it is very important who provides this necessary financing to make this
business possible.
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So, that is why it is the capital that is invested in business, that are small or exist only in
at an initial stage. So, initial stage here is quite important because in the initial stage it is
very difficult to raise the money from the market or from the banks which are organized
financial institutions which exist in the system. So, venture capitalists basically what,
they do not look at whether what kind of business you are doing, but they look at the
whatever business you are doing that business should have high growth potential. So,
they look at the growth potential and accordingly the financing has been made by this
venture capitalists. So, that is why the venture capital or venture capital funds are
defined.
So, then moving towards the different issues or different ways, how the venture
capitalists work in this particular system. Let us see, what are those different
characteristics of a venture capital fund. If you look at the venture capital fund, venture
capitalists do not invest the money for short term. Venture capitalist invest their money
for a longer term horizon at least more than 3 years they basically put their money in the
investment.
So, that is why the funds which are invested in that it is not a very liquid instrument or
you cannot encash that, basically you cannot liquidate that particular money whenever
you want, because that money has a very long term objective or the use of that money
has a long term objective. So, because of that the liquidity is very less in that particular
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funds. There is huge risk; venture capital always take huge risk because they put the
money in this particular business which is not properly set up and it is not proved that
whether the business is going to be a success or not and maybe there is a probability of
growth potential, but further the growth potential is really able to be materialized in the
future or not.
So, those things are not known from the beginning and no such reputation was already
available for the company whenever the company has started to the business. So, keeping
those things into the mind what has been observed that the venture capitalists are highly
risky investors in the market and the venture capital funds which are invested they are
basically invested in the risky or in the initial stage of the business.
They can contribute in terms of equity also and they largely participate in their
management. So, whenever the company makes the board the one of the venture
capitalists member anybody any representative for venture capitalists will become a
board member. So, they basically participate in the policy decision making process. Why
they basically interfered in the policy decision making process? The reason is whatever
profit this particular business can say, venture capitalists also said that profit with them.
So, because of that the arrangements have been made in such a way that the venture
capitalists also make this participation in terms of the strategic decisions for the company
takes.
So, that is why they participate largely in their management or they become the board
members are appended if were there in the board and the look at that how the business is
going to be better off for that particular new entity which was funded by this venture
capitalists. So, that are the different characteristics what we can see whenever we are
talking about the venture capital funds.
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So, what are those functions? Already we have defined some of the functions. So, the
finance new and speedily growing companies that already we have discussed that they
can acquire the equity shares. They also finance in terms of the development of the new
product or the services. The existing company if they are going to float a new product
and they are going to provide the new services venture capitalist also help in that. So,
some kind of venture capitalists are there, some category or some class classified venture
capitalists are there they also finance if any company wanted to develop the new
products and services in the market.
So, they support the development of not only the finance the new start up or the new
initiation taken by any kind of business unit, they also support the development of new
products or the services if at all the particular company is going to make. And, they add
value to the venture by providing active inputs because they are highly experienced in
this particulars kind of activities and they have the idea that how this particular business
can better off even if it is in the initial stage. So, because of that the better inputs this
founder of these particular companies can get if the financing are made by the venture
capitalists.
And, venture capitalists already we have discussed that they always love to invest in
those kind of projects which are risky, but the growth potential is relatively higher. So,
because of that their experience or the inputs whatever they provide that is very much
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helpful for the growing business of that new entities which are basically have started the
business for the first time in the market.
So, these are the major functions, what the venture capitalists always have whenever they
do their services and they provide their services in the financial sector.
Then how does VCF basic venture capital fund work? If you see already we have
discussed that venture capital can be formed either in terms of a trust or in terms of a
company. So, there basically who are the people who are invested or who can be acted as
the venture capitalists in the market, so, they can be a financial institutions, they can be
any banks, they can be any pension fund, they can be the corporations or they can be also
the high net worth individuals.
So, the venture capital funds can be created by any of the financial companies or any
kind of financial entities which exist in the financial system. It can be a company; private
company, it can be a pension fund, it can be a bank, it can be any other financial
institutions not a problem, but also it is a high net worth individuals. So, the venture
capitals can be fund or can be always designed by or this particular services can be
provided by any of the financial organizations of the institutions which exists in the
financial system.
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So, the venture capitalists basically act in the advisory capacity of the company and
render their professional expertise to the venture apart from the capital investment. They
invest the capital they provide the financial capital for the business and as well as also
they act as an advisory body who provides the different kind of inputs in terms of the
investment or in terms of the spending the money or in terms of the decisions what the
companies were trying to take whenever they want to start the business in that particular
sector.
Typically the funds which the venture capitalists gave they are pooled in for a period of
around 10 years and investing it in a venture capital undertaking for a period of 3 to 5
years with an expectations of the high returns. Already we have discussed that the funds
which are invested or spent under the venture capitalists there basically always put for a
long period of time. So, that is why what we can see that the investment which are made
by the venture capitalists they look at the investment for a reasonably undertaking for 3
to 5 years and it can go up to also the longer period of time in that particular context.
Why basically we can go for venture capitals or the money can be raised from the
venture capitalists? So, that is another question. You see venture capitalists basically of
venture capital funds infuse the long term equity finance already we know that because
the funds are in long term in nature provide a concrete capital support for growth in the
future. As there provide the long term finance; that means, a long term capital support
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can be realized whenever we are investing or the venture capital funds are used for the
investment.
Venture capitalists give realistic guidance and assist the companies on the basis of their
past experience. As they are providing the finance to the different start ups so, different
companies over the periods they have huge experience that how this money is
productively utilized or can be better utilized in the market for their success of the
business. So, because of that what is happening they basically provide that kind of
experience or past experience helps the companies to get a better input for that.
They have a good networks in various areas which adds to the value to the company in
terms of consulting, in terms of risk management or in terms of finding out a good
customers. So, those kind of network whatever the venture capitalist have that also helps
the companies to make their business stable and as well as successful. So, that is also
another advantage what we can get it whenever the venture capitalists fund or invested in
that particular business.
And, if it is required then the venture capitalists have funded something, but they find
that the business is going to do well, but the business is not able to prosper because of the
lack of the funds then there is a possibility they can also raise some additional funds or
they can provide some additional funds for the if it is required at all they realize that
there is a growth potential, but the business is not able to do well because of the lack of
the funds. So, in that context they can provide the additional funds to finance the growth
if at all required by that particular company.
And, venture capitalists are well versed with the process of listing and initial public
offerings if at all the company has been established and for that they want to raise the
money from the public they can go for the IPO. We will discuss more how the IPOs are
issued in the market whenever we discuss about equity market or the stock market in the
future sessions, but if at all the company wants to be listed in the stock exchange and
they want to raise the money from the public first time which is we call it the initial
public offerings in that context also the venture because of their experience the venture
capitalists can help them in the IPO process and also in the listing process. And, once
this listing is done also whenever the company goes to this trading in the secondary
market that time also the venture capitalists can help them in terms of the trading.
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So, there are various advantages what we can observe or what we can find whenever we
talk about the different kind of services what we can find from the venture capitalists or
venture capital funds whenever their money is put on that particular business or the
money is invested in that particular business. So, these are the major advantages what we
can realize or what we can get. So, the major thing is they provide all kind of a financial
services in whatever area they have the expertise.
So, in that context also the companies get some kind of benefit to make their strategy
better and can generate the better amount of the profit or this business can be successful.
Then, let us see that whenever the venture capitalists basically finance the capital to the
companies, so, there are different stages through which the financing of venture capital
funds are done. What are those stages? First of all if anybody has a plan as planned to
start a new business they have a good plan, they have a good project, but the question is
they do not have the money.
So, in that context what they can do they have a good idea that how this business can
prosper can grow, but still there because of the lack of the funds they are not able to start
this particular business. So, for the seed money purpose they can request or they can get
the kind of funding from the venture capitalist what we call it the seed money , but let
one firm is already established because of some private money whatever private fund
whatever they have or own fund they have and now, they want to expand that particular
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business for the marketing purpose or the development of the more product etcetera for
that also they can get the funding from the different kind of venture capital funds and
that is basically we can say that start up stage.
So, the venture capital funds can finance them as a seed money, they can also finance if
the company is already started, but they are not able to do the proper marketing and they
cannot make the proper product development because of the lack of or because of
scarcity of money so, then that particular point of time this particular funding of from the
venture capitalists also possible.
Then, we have the first round; that means, the initial sells in the manufacturing process
they fund it that means, the company is established they are sold they have started
producing the product, but how basically they can sell the product or how they can
increase their manufacturing or the quantity of the product for that also, they can take the
help from the venture capitalists because venture capitalists already know that how this
business is going to be and in that process they help us or the help that company to make
that particular business successful in terms of the selling and manufacturing.
And, further there is another first stage that is basically sometimes the companies also
want money for the working capital financing. The working capital for the early stage
companies that are selling the product, but have not started earning profits. They are
selling the product, but they have not reduced the break even.
So, if they have not reached the break even then what is happening; the working capital
requirements cannot be finance by them that mean day to day requirements cannot be
finance by them because they are not able to generate any profit out of this. So, that time
also the venture capitalist can help them to provide some money by that the company can
run the business, company can run and as well as the manufacturing of that particular
product will continue.
So, for working capital financing also venture capitalists can fund the money sometimes
also the funds the venture capitalists get for the expansion of a newly profitable
company. Already the company is basically established they are producing, but they
want to have a new in it or they want to expand their business. So, in that case already it
is profitable, but still they need money because they want to expand it. They want to
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have a new profitable company or they want to go for expansion of that particular
company in that time also the financing of the venture capitalists can be possible.
And, finally, the venture capital is also fund for the going public process. If at all you
want to raise the money from the public for the initial expenditure whatever is required
for the company to go to the public those kind of funding also sometimes made by the
venture capitalists. So, there are different ways for different purposes of our different
reasons the venture capitalists can finance those business in the different stages.
So, this is the way the venture capitalists basically plays a very significant role in the
business process.
So, if you see there are different periods whenever the lock in period basically we are
talking about and the risk perception about that. So, whenever they provide the seed
money the lock in period is around 7 to 10 years; risk perception is quite high excessive
and it is basically to support the new idea or the R&D of the product development and
start up stage the lock in period is around 5 to 9 years; risk is considerably high.
For initiating in that why the finance is made for initiating the operations are developing
the prototypes of that particular product and in the first stage lock in period 3 to 7 years
risk is relatively high for starting the commercial production and marketing purports to
finance. In the second stage lock in period is 3 to 5 years; this is also risk perception is
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relatively high and this financing is done for market expansion an announced working
capital requirement.
And, third stage the lock in period 1 to 3 years risk is relatively less which is very
average, it is for the market because it is already the company is profitable. So, they are
going for the market expansion, takeover and product development for profit making
company. So, in that case the risk level is relatively low. And, finally, we have the fourth
stage where the risk is very less because the company is already established in there also
generating profit and all kinds of thing so, in that case basically the finance can be made
for going public.
So, these are the risk perception and on the basis of the risk perception also the periods
are defined and as well as the reasons for financing are also clearly explained. So, these
are the different ways the different types of financing for different reasons we can always
get it from the venture capitalists for the development of the business.
Then, how they basically finance? They can finance either in terms of shares, they can
finance in terms of the loans, they can also finance in terms of the participating the
debentures means if the company at all raising the one to invest the money in terms of
the debt financing or the bond financing they can participate in to that, also they can
finance in terms of the preference shares. Quasi equity means we are referring to
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preference shares where the particular shares basically has the kind of both bond and
equity features.
So, these are the different instruments through which the finance of the venture
capitalists are done or the venture capitalists finance those kind of entities in the different
ways.
So, if at all ones venture capital is any venture capitalist wants to be out of this particular
company if as company has gone for IPO and as well as then if it has gone for IPO they
can raise the money from the public in that particular point of time they do not have to
they can go out, they can sell their shares and go out of the company. They can also
selling their equity in the secondary market if the companies are already gone for public
and also traded in the stock exchange, they can do that.
The buyback of the shares by the promoters of the company is possible from the venture
capitalists whatever shares they have and also if the company is acquired by another
company. If the companies are acquired by another company and that particular point of
time whatever equity conversion and all these things will happen in that process also the
venture capitalist can exit as the owner of that particular company or partial owner of
that particular company.
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So, these are the different exit routes or different ways of exiting in that particular
company if at all the venture capitalists want or in some cases the venture capitalist has
to go if the companies acquired by another company and all the equities whatever the
existing shareholders have those things those kind of transactions and all these things
will be decided by the acquiring company who is basically acquiring that particular
acquired company.
So, because of that what is happening in that process the exit route will be or the venture
capitalists can exit from that particular business.
Then if you see that how the venture capitalists capital funds are developed in India. You
see this venture capital fund was formally introduced in India in 1987 by IDBI; then,
after this 1996 regulatory norms of SEBI venture capital regulation norm 1996 and
venture a foreign venture capital investor regulation, 2000 on the recommendation of the
Chandrasekhar committee the development of the venture capitals in the Indian context
has grown or the development of the venture capital basically has taken place in the
Indian financial sector.
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So, now if you see that how the venture capitals funds can be registered or they can
register themselves for their business.
So, they are already we know that this can be established as a trust under the Indian trust
act or a companies act which as defined in 1956 companies act. So, what is the process?
The application, an application for grant of certificates should be made to SEBI; SEBI is
the regulator of the venture capitals in a form along with a fee of 25000 rupees paid
through a draft. Then the application for registration will be complete in all respect, all
the information will be provided.
If SEBI discovers any discrepancy the applicant will be given a time of 30 days to rectify
the application and if you they could not rectify that application in the provide they
cannot provide that adequate information then the particular form will be rejected or the
application will be rejected. Then if everything will be given all the information are
severely satisfied with all those information what that application contents then the after
finding the eligibility the SEBI will inform and after that the applicants shall tender the
SEBI the registration fee which is 5 lacs and subsequently SEBI will issue the certificate
of registration.
So, every venture capitalist has to register themselves with SEBI and with proper kind of
regulatory norms once all these things will be scrutinized, SEBI is able to provide that
kind of registration certificate to them.
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So, foreign venture capitalists also can operate in India and there are certain guidelines
for them this should disclose their investment strategy and the life cycle to the SEBI and
at least 66.667 percent of the investable funds we invested in unlisted equity shares or
equity linked instrument. Not more than 33.33 percent of investible funds may be
invested by way of either subscription to initial public offer of a venture capital
undertaking.
Debt or debt instrument of the venture capital undertaking in which the foreign venture
capital investor has already made an investment by way of equity or preferential
allotment of equity shares of a listed company subject to a lock in period of 1 year. Or
the equity shares or equity link the instruments of a financially weak or a sick industrial
company whose shares are listed. And, a foreign venture capital may invest, it is total
corpus into the one venture capital fund in India.
So, these are some of the regulations, the regulations are very lengthy, but the venture
capital funds foreign venture capital funds also can operate in the Indian financial sector.
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These are the some of the examples of the venture capital funds which are existing in
India. We have the Punjab Infotech Venture Fund, Gujarat Venture Finance, Kerala
Venture Capital, Canbank Venture Capital, SBI Capital Market Limited, IL&FS Trust
Company Limited, Infinity Venture India, then HSBC, ICICI Venture Funds, IFCI
Venture Capital Funds, SIDBI Venture Capital Fund. So, these are some of the funds are
also sponsored by the government and some are highly private companies, some are
funded by the state governments.
So, these are the ways the different kind of venture capital funds which operate in the
Indian market who cater this demand for the business over the years.
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Thank you.
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Lecture – 33
Merchant Banks
So, in the previous class we were discussing about the venture capital funds and how
they are contributing into the business in Indian financial sector and as well as in the
other economies. And, another type of organization which also contributes almost in
every economy in the financial system or financial market that is basically your
Merchant Banks.
You might have heard about this word again and again because, this organization is very
much mandatory whenever we also participate in the equity market. And, as well as also
they are very much important in terms of the financing activities or investment activities
in the financial sector as a whole.
So, here if you see that merchant banking; this merchant banking concept is not new. It
was there in the 17th 18th century in the Europe, but in India relatively this concept is
not very old. But, although it is relatively old now because, it as well started in 1967
through this Grindlays bank in 1967. And, SBI basically floated its merchant banking
division in 1972. The Grindlays less bank which was started this merchant banking
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operation in India, after that it has certain kind of implications and it was realized that
this particular services is very much required for the financial sector.
So, keeping that thing in mind SBI, State Bank of India has floated this merchant
banking division in 1972. Why basically it is required because, the business or the
financing activities or the investment activities in the market has been diverse. And, the
requirement or the services required are totally different whatever way the business was
running maybe 100 years back or 50 years back. So, keeping those things in the mind the
merchant banking as a service came into the existence in almost all the financial system
across the globe.
So, India is also following the same pattern and where the merchant banking has a
significant role. So, what exactly the merchant banks are, what do they do?
If you see there are various definitions. So, if you see the merchant banks is basically an
organization which provides the underwriting services or which act as the underwriter.
They act as an advisor in terms of the risk management services, in terms of mergers and
acquisitions; any other commercial ventures pricing of the equity. So, all kind of
consulting services always we get from the merchant bankers; merchant bankers in the
real terms is nothing, but the investment bankers. So, any kind of services what we get it
from the merchant bankers there are in terms of the financing, in terms of the investment
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services, in terms of the risk management services, in terms of the valuation services and
as well as in terms of the underlying underwriting services.
So, all kind of services we always get from the merchant bankers. So, that is why
merchant banking or merchant banker has their unique positions in the financial system.
And that is why always we can call them as a consultant, they can be called as advisor,
they can be called as the risk manager, they can be called as we can say that underwriters
etcetera. So, any definition if you look at every definition comprises all these aspects
whenever we discussed about the merchant banking.
So, now the question here is that if this is the way the merchant bank works then what
kind of services they offer. Already I told you the merchant bankers provide services in
terms of the project counselling, in terms of the management of debt and equity
offerings, in terms of the equity issue management. They can also provide services in
terms of consulting or the advisory services. They provide services in terms of
underwriting; they provide services in terms of the portfolio management process.
They also provide services in terms of restructuring strategies; this or they also provide
services in terms of valuation, mergers accusation, joint ventures etcetera. And, as well
as if anybody wants the offshore financing they want to raise the capital from abroad in
that particular context also the merchant banks basically provide this assistance to
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provide the services. So, the importance of merchant banking is quite significant in any
financial systems across the globe.
So, one by one let us see what kind of things they do. First of all the merchant bankers
perform functions as a promotional activities. How they help in the promotional
activities? Because, merchant bankers helps the entrepreneur in conceiving the idea,
identification of projects, preparing the feasibility of the projects, even the help in
obtaining the government approvals, incentives etcetera.
All kind of reports whatever way the projects should be money should be invested, in
which projects should be invested, in whatever way the project should be carried out all
kind of activities promotional activities.
They always carry out which this company whenever company needs them or company
basically tries to take the help from the merchant bankers. Issue management: issue
management in the sense the management of issues refers to effective marketing of the
corporate securities. For example, somebody whenever you go for IPOs how the pricing
of IPO is done, how the price of the corporate bonds will be done, how it will go to the
public. How the public will know about and what kind of marketing or what kind of
steps should be followed or should be take in where the public will be interested for this
kind of investment in IPOs or the bonds which are issued by the company.
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So, for every cases the merchant bank basically acts as an intermediary and what is the
main job. The main job is to transfer the capital from those who own it and to those who
need it. They help in that process, they cannot transfer it, but they help in that process
that how particular equity can be issue to the public.
How the money can be raised from the public either it is through the equity issuance or
the debt issuance and whatever it may be. So, they always help in the issue management
process in terms of all types of financial capitals which are available in the system; that
is basically one thing they provide. Then the next is basically what they provide many
services.
What is the next service? They also act as this credit syndication. What do you mean by
the credit syndication? Credit syndication basically refers to obtaining of the loans from
single development financial institutions or a syndicate or a consortium. Merchant banks
basically help the corporate clients to raise the syndicated loans from the commercial
banks. Because of their reputation, because of their guarantee, because of their kind of
market secure they help always the companies to get the loan. Or, get the kind of debt or
from the different kind of financial institutions including banks.
They do the project counselling, all kind of preparation of the project reports, deciding
the financing pattern, appraising the project related technical commercial and financial
viability. All kinds of services basically the help to the company whenever the company
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needs they also provide the service in terms of the acceptance of credit and credit and bill
discounting. What are those activities? The activities basically relates to the acceptance
and discounting of bills of exchange, besides the advancement of the loans to business
concerns on strength of such instruments. The information collect the information in
terms of the credit, they also help in the rating process.
Whatever way the business should perform, what are the things should be strengthened
by that the rating of the companies can grow. In that way also they provide the services
that they provide certain kind of advisory services to the companies.
Then we have major advantage or measures service they provide, the major function of
the merchant bankers at the portfolio management. The merchant bankers basically help
the investor in matters pertaining to investment decisions, in the taxation. And, also in
terms of buying and selling of the securities which are the securities or which are the
stocks which are the bonds which other derivatives instruments should be bought, which
other things should be sold which are the instrument should be hold on.
So, all kinds of services in terms of the portfolio management they always get it from the
merchant banker. The investments basically what did they insure, the investments should
be done in such a way that they can maximize the return with a given amount of risk or
they can minimize the risk with a given amount of the return. So, either they can
maximize the return with a given amount of the risk or they can minimize the risk with a
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given amount of the return. Either of these two ways basically the portfolio management
process, goes on or in this process merchant bankers play a very significant control.
So, that is basically one thing they provide that is why the portfolio management is quite
important. Then we have the working capital finance, already you know, what is working
capital finance, which fulfil the short term requirements. So, here what are the merchant
bankers do? The merchant bankers provide certain services as a part of working capital
finance. What they do? First of all the assets how much working capital the company
needs over a period of time; assessment of working capital preparing the application for
the sanction of appropriate credit facilities for the company.
Who makes the working capital financing into the commercial banks and they provide all
kind of assistant in terms of a negotiation with the commercial bank; that how the
commercial banks will be ready to provide that working capital requirements of the
companies. Advising on issue of debenture for augmenting the long term requirement of
working capital; debenture are basically the corporate bonds which are long term. So,
how the debenture can be issued which can be an addition to the working capital
financing as a long term financial capital. In that process also the merchant bankers help
them to get that one or to raise the money from the public.
So, this is the way they basically contribute in terms of the working capital financing for
the company.
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This is the major service what they provide in the practical sense that is your mergers
and acquisitions. This is a specialized service they provide, who basically arrange for
negotiating the acquisitions and mergers by offering the export valuation regarding the
quantum and nature of the considerations which includes many things.
One is undertaking management audits to identify the areas of strengths and weakness, in
order to help or formulate the guidelines for the future growth. Conducting the different
studies on a global basis to locate the overseas opportunities where the joint ventures,
mergers, collaborations all these things can be carried out with that particular company.
If there is any issue arises in terms of the conflict between managers and shareholders
then they always help the managers for the approval from the shareholders or depositors
or creditors or government or any authorities if at all it is required because, whenever the
company is acquired by another company or any company acquiring another company
all the stakeholders consent always taken. So, convincing or approval from the
stakeholder is a very big issue whenever we think about the mergers and acquisitions.
So, all these process basically taken care of by the different stakeholders: shareholders,
depositors, creditors, government authorities all are basically the stakeholders of the
company.
So, whenever any merger or acquisition takes place all the approval from the every
stakeholders are required. So, those for getting those kind of approvals the merchant
banks or merchant bankers play very significant role. Identify the organizations with
matching character which particular organizations will be occurred, what is the growth
potential and how whether it is profitable for the company or not, how much money
should be paid, what is the valuation.
So, all kind of thing basically always done by the merchant bankers; all these services
basically are provided by the merchant bankers. How the capitals will be restructured
after the acquisitions that also that kind of services the merchant bankers provide, then
they also advise in terms of the legal compliances.
Because, any acquisition and all these things if it is a cross border acquisition then their
legal aspect and home countries legal aspect all these things will be considered. And, all
these considerations are taken care by the merchant bankers which are operating on
behalf of the companies for this acquisition process. So, these are the different services
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which basically merchant banker provide in terms of the mergers and acquisitions. Then
let us see that, what are the other things this merchant bankers do.
They also provide leasing and financing facilities; some of them maintain the venture
capital forms to assist the entrepreneurs also because, they are highly diversified and
they also help the companies and raising finance by way of the public deposits. They
also provide services in terms of distributing the dividends or the interest for the
debentures because, anybody has invested in the corporate bonds the interest will be paid
periodically. So, for the payment of the interest for the distribution of the dividends so,
all kind of services basically they are ready to provide which comes under servicing the
issues. So, there they also help in the tax matters, recruitment of the executives and cost
management of the audit.
All kind of services if you find the workers, the consultant or the advisor to the company
and provide all kind of services in terms of risk management, in terms of investment, in
terms of legal issues, in terms of merger acquisition issues etcetera. If you observe over
all the merchant bankers really contributing significantly for the development of the
business of that corporations.
Whenever you talk about the different activities or different kind of business related
activities what these companies always face. Either in terms of writing the project or
finding the growth potential or the projects were enough growth potential is available.
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Or, in terms of the mergers acquisitions whatever it may be all kinds of services always
we receive from the merchant bank.
So, that is why merchant banking services is quite important or the role of merchant
bankers are quite important for the development of the financial system as a whole.
There are some SEBI guidelines with respect to the merchant banking in India. So, if you
see the guidelines what did the SEBI said; there will be one equity merchant banker the
existing multiple merchant bankers will not be there; multiple categories of merchant
bankers, it may be abolished in the future. The merchant banker is allowed to perform
the underwriting activity. Already we know that we are talking about India. For
performing portfolio manager the merchant banker has to seek the separate registration
from SEBI. If they want to work as a portfolio manager for the company then the
separate approval from the SEBI is required.
The merchant banker cannot undertake the function of a non-banking financial company
such as accepting the deposits, financing others business etcetera; they cannot do that.
The merchant banker has to confine themselves or himself only the capital market
activities either it is the long term bond market or equity market. Or, they should not go
for to another market which is related to real sector and other things. SEBI basically
gives the authorization for a merchant banker to operate for 3 years only. And, without
SEBIs authorization merchant bankers cannot operate in India; after 3 years again they
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have to renew it. And the minimum net worth of merchant bankers should be 1 crore
rupees.
Merchant banker has to pay the authorization fee, annual fee and renewal fee regularly.
All issues of shares must be managed by one authorized merchant banker; it should be
the lead manager of the company multiple merchant bankers should not be there. The
responsibility of the lead manager will be clearly indicated by the SEBI, the lead
managers are responsible for allotment of the securities, refunds etcetera. The merchant
bankers has to submit the SEBI all returns and send the reports regarding the issue of the
shares whenever the company is going for IPO and other things.
A code of conduct for merchant bankers always given by SEBI which has to be followed
regularly by them. Any violation of the merchant of the code of conduct will lead to the
revocation of the authorization by the SEBI for the operation of that merchant bank in
India. So, these are the some of the guidelines. There are many guidelines what the SEBI
has given for operation of the merchant bank some of the summary view about the
guidelines for the operation of or the business of merchant banking in the Indian capital
market.
So, if you see the different categories of the merchant bankers which are existing we can
categorize them into 4 on the basis of the different services what they provide. If there
are category I merchant banker they provide services in terms of issue management,
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advisory services, consulting services, they can work as a portfolio manager, and they
can work as an underwriter etcetera. But, if you go for the category II, what basically we
have seen. They can work as an advisor, they can work as consultant, they can work a
joint-manager, they can work as underwriter, they can work as portfolio manager; was
issue management they cannot do.
Category III they can work as adviser, consultant, underwriter but, the issue management
operations they can do. And finally, the category IV they can only play the advisory role
or the consulting role and the other roles basically they cannot play. So, on the basis of
the services what they provide or types of services what they provide the merchant
bankers have been categorized into 4 categories in India. So, what are the other
differences in terms of the 4 categories if you see.
So, they are categorized on the basis of their capital adequacy norms in terms of its net
worth. Category I minimum net worth should be 5 cores, category II the minimum net
worth should be 50 lakhs, category III the minimum net worth should be 20 lakhs.
But, whenever they are in the last category only the advisory services of the consulting
services; no net worth is required. Basically in terms of net worth if they do not have,
what do they have the financial expertise to provide this kind of services they can do it is
not mandatory. So, in this context in terms of their capital adequacy and the net worth
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the categories are defined. And, on that basis their services are also defined that is what
basically the categorization of the merchant bankers in Indian context.
Then if you see already we have said that this merchant bankers play a very significant
role in the issue management, like your issuance of equity into the market from the
market and pricing of the initial public offerings. So, because of that the company has to
make a prospectus. The prospectus should contain all kind of information about the
company and through that they have to create demand about that particular product in the
market.
There is a process what we call it a book building process that will explain or will
discuss more on the equity market part. But, here I just wanted to give you some idea
that whenever the prospectus is prepared the merchant banker on behalf of the company
basically prepared that prospectus. And, they are basically all kinds of details the
merchant bankers would have certain obligations, they have certain kind of duties what
they have to do whenever they prepare this prospectus before this issuance.
And, whenever the particular company goes to public has generate the money from the
public, has generated the equity from the public. First of all they have to make the
prospectus, what kind of instrument it is, what kind of the price band they have to be
reported. They have to appoint the underwriters either they themselves worker the
underwriter or somebody else can be the underwriter. Who is the syndicate bankers that
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is appointed by the merchant banker or the particular merchant banker who works on
behalf of that particular company. They also appoint the resisters who keeps the records
everything about this process the IPO process. And finally, the appointment of the
brokers also is done by the merchant banker.
So, these are the things done by before this issuance and whenever the company is going
to the public for issue in the equity. This is what basically the steps what are the
merchant banker always follow or has to follow whenever they want to raise the equity
from the market.
Then after this issuance they have also certain obligations. What are those obligations?
They have to appoint a compliance officer, they have to appoint this other intermediaries,
preparation of offer documents or prospectors and filling them with the register stock
exchange and SEBI. Due diligence report, they have to prepare; allocation are the
responsibilities of the different stakeholders that has to be done by them. Pricing
coordinating with the stock exchanges for book building process including software,
bidding terminals everything.
Collection of application from the bankers and statement of amount received. If is there
any investor grievances in that process, if there any complain or anything that also has to
be addressed by them. And, once this bidding and everything will take place their job is
basically monitoring the post issue which is screening the applications, deciding the
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allotment procedure, mailing of the allotment letter, providing the share certificates and
refund orders. If somebody will not be allotted to the IPO then the money also has to be
refunded them. And, that refunding process also will be taken over by or will be taken
care by the merchant bankers.
So, the merchant banker has the primary role for both post and pre-issuance of the equity
in the market; mostly they are basically called as the book runner lead manager. In this
process they are called the Book Runner Lead Manager; in short we call them BR LM.
And, whenever any company goes for IPO their first job is they appoint somebody who
will act as the BRLM. Then this BRLM will provide all kind of necessary services for
the pricing of IPO and all those things which are related to the pricing of the IPO or the
issuance of the IPO; that is what basically the obligations the merchant bankers have.
Just now we are talking about the code of conduct, SEBI has made it mandatory. What
are those codes of conduct what SEBI has made for the merchant banker? The merchant
bankers should make all efforts to protect the interest of the investors, they should not
always act only on the behalf of the companies.
Should maintain high standards of integrity, dignity and fairness of conduct of the
business, should fulfil all obligations in a professional and ethical way. Should not
discriminate among the clients, should endeavour to ensure that the enquiries grievances
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are adequately dealt with in a timely and appropriate manner; whenever any kind of
issuance is carried out.
Should ensure that the prospectus or letter of offer is available to investor at the time of
issue; to the information about the company or everything that is not job of the company
it the job of the BRLM or the merchant banker. They have to provide all kind of
information and the basic job because; once the BRLM is appointed that information
goes to SEBI.
SEBI approval of the SEBI is required for that issuance who is the BRLM, let company
A has appointed somebody as the BRLM or the any investment bank which can act as a
BRLM. Then that information has to send to the SEBI and SEBI approves that. And
now, say we has the idea that who got the information who is the merchant banker for
them and whether this merchant banker is following all kinds of requirements or not; that
is basically under the SEBIs regulation. That is why this kind of code of conduct has to
be followed by the merchant bankers.
Then what are those leading merchant bankers in India, if you see we have a SBI Capital
Market, Punjab National bank also has a merchant banking division, IFCI financial
services in terms of the public sector. In terms of the private sector we have ICICI
securities, Axis bank, Bajaj capital, Tata capital market, Yes bank, Kotak Mahindra,
Reliance securities all can be act as a merchant bankers.
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But, if you see the key foreign players always people have more faith on them because,
the size is quite large. And, they are the big names which exist in the market they are
Goldman Sachs India securities private limited, Morgan Stanley India company private
limited, Barclay securities India private limited, Bank of America, Citigroup global
markets India private limited and DSP Merrill Lynch.
So, these are the major players. So, you might have observed that whenever any
company in India is going for IPO either of these any of the merchant bankers will
always act as the book runner trade manager for them; whose responsibility is to look
after all the pre and post issue obligations for the pricing of this ones. So, this is the way
the merchant banker plays a very significant role in the Indian financial system; for in
terms of the financing, in terms of consulting, in terms of other services into risk
management values and etcetera.
So, that is why the significance of the merchant banker is quite large in this context. So,
there are some other organizations or other entities which also provide the services which
are they consider as the non-banking financial companies. So, we will be discussing like
your credit rating agencies and all that will be discussing in the next class.
Thank you.
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Lecture – 34
Credit Rating Agencies
So, after discussing about the merchant banks and the venture capital which are the most
important or non banking financial companies which play the significant role for the
financial development. We can discuss about the credit rating agencies today whose role
is quite significant in terms of the investment in the financial market and as well as from
the investor point of view to look for certain companies who are good for the
investments or who are basically eligible for the investment in the financial system.
So, let us see that what do mean by the credit rating and what do you mean by the credit
rating agency. Whenever you talk about the credit rating it is basically what? The credit
rating is basically a process it is basically an evaluation of the credit worthiness of a
debtor, especially it can be for a company or the corporation or for a government. So,
you see that basically what; whenever we are trying to find out the credit worthiness of a
particular entity whether that entity belongs to a company or it belongs to a particular
organization or particular country. So, whether that particular company is able to repay
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the loan or not arrive the company is issuing the debt whether what kind of credit rating
is involved with that particular company.
So, those things can be judged on the basis of the whatever rating the company has; so
credit rating basically gives you kind of qualitative idea about the company what kind of
that company is and whether the company is able to repay the loan in the future or not.
So, whatever debt the company has issued whether the company is able to pay the
periodical coupons and as well as the principal in the end or not.
So, that is basically measured through a process which is called the credit rating and the
ratings are basically given in the alphabetical sense or we can say that a b c kind of
process the ratings are always provided. So, here that is why these are the numerical
alphabetical or the numerical symbols always we give for the different type of ratings
what we give to the different company or the country.
And who gives the rating? The ratings are basically given by the credit rating agencies.
So, here the rating agency considers certain kind of factor and follow certain kind of
process and using that factors and following that process they try to find out that what
kind of rating the company will get or they try to give a particular rating which measures
the qualitative measures of the credit worthiness of that particular company.
So, here what basically it try to make or try to always measure, they try to measure the
debtors ability to pay back the debt and already you know that whenever the company
has gone for the debt financing or the one financing always there are 2 major
components one is your interest payment and another one is the principal. And they
consider whether the company is able to repay the interest in the periodical manner or
not that is number one and what is the probability of default the company might have or
may have to pay that particular interest in the future time.
So, this is what basically the basic job of the credit rating agency. So, in India we have
different kind of different types of agencies or there are many agencies which go provide
this kind of ratings and internationally also we have many credit rating agencies which
provide this kind of ratings to the company. So, according to CRISIL if you see CRISIL
is a credit rating agency, which gives the credit rating an unbiased and independent
opinion as to issuer’s capacity to meet its financial obligations. It does not constitute a
recommendation to buy, sell or hold a particular security.
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The CRISIL rating agency, basically it does not give or credit rating does not mean that
you invest in that company or you buy then that company or you sell in that company.
So, sold that particular stock or buy that particular bond or sell that particular bond those
buying and selling of a security provided by that particular company in terms of debt
financing or equity financing. That is not basically the rating tells, what the rating tells?
The rating tells that whether the issuer has the capacity to pay this financial obligations
whatever they have.
If they have issued the debt, if they have issued this bond whether they are able to repay
this coupon and as well as the principle in the future or not that thing basically you can
judge on the basis of the rating what the company gets. But it never says that whether
you should buy that particular stock or you should sell that particular stock or you buy
that particular bond or sell that particular bond. So, those kind of things are not basically
always we judge whenever we get this credit rating.
So, according to Moody’s which is a global player what this Moody’s tells the ratings are
designed exclusively for the purpose of grading the bond according to their investment
qualities. So, there are two types of broad categories of the bonds always we observe or
we find in the market, one is investment grade bonds and other one is not investment
grade bonds.
So, investment grade bond means up to a certain rating the bonds are considered as the
investment grade bonds which are eligible to be traded in the market and from those the
investor can participate in the trading process of those types of bonds. In another type of
bonds are those which are basically not eligible for the trading in the financial system or
the financial market.
So, therefore, whether you want to buy this particular stock or buy this particular bond or
you sell this particular bond that is not basically we can judge from the rating, but we can
get this overall idea that what kind of the company it is, whether the companies has the
credit worthiness to made it is financial obligations in the future or not. This is what
basically the rating agencies job or the objective of the credit rating what we can say.
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Why we need a credit rating already we say that the basic views of rating is to get this
idea to or to get this kind of information whether the company is able to fulfill the
financial obligation or not. So, this is what basically the financial obligations are
basically always made by this particular company in the future or not that is basically
judged by the credit rating, rating from that particular company. So, why we need the
rating? Basically if any company gets a good rating the confidence of the investor to
invest that company increases or the probability of the investors’ confidence on investing
in those kind of bonds or those kind of companies stock increase.
So, that basically always helps us to create the confidence in the investors mind that
whenever they are going to take a position in the financial market for a particular bond or
particular stock. Then whether the particular stock is going to do well in the future or not
that particular kind of implications they can draw if the rating of the company is better or
it is a good rating the company has got. So, the investor’s confidence is always
maintained, if are anybody gets a good rating of that particular company acquired the
investor in that.
It protect the interest of the investors because all those information the investor may not
get. So, all those always investor feel that all those investor inform whatever information
the investor want to get for investment, they may not have all those information, but all
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the information are reflected through the rating for the company has to because of that it
protects the interest of the investors.
Then motivate the savers to invest because if there are certain people as relatively risk
averse a nature and they do not want to take much risk in the financial system. In that
particular point of time, if they realize that one companies rating is better and the credit
worthiness of the company is quite high.
So, in that contest there may be motivated to save more and that savings maybe
sometimes those savers can be converted into investors in the market and they can
participate in the capital market for the investment, both in terms of stock investment and
as well as the bond investment mostly they will be at least they will be interested to
invest in the bonds. So, that is basically motivation which is created in the mind of the
savers to become the investors. So, that is another thing what you can judge whenever
we talk about the credit rating, this is the requirements or reasons for the credit rating
always you can say.
So, there are certain advantage always the company get the rating is required from both
investors prospective and as well as the company’s prospective and what are those
advantages of credit rating for the company. Why the company wants the credit rating?
What is the basic reasons behind that? First of all it helps us to create the image within
the corporate sector, any company gets good rating or rating is good then it creates a
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good image in the market and there are certain companies there are not quite popular
their information about the company is not available to the common man or the common
mass.
So, in that particular point of time if the investors are little bit reluctant to invest in those
kind of companies or the particular bonds and stocks issued by these companies then
how basically they can get this information how that the company is good or bad. So,
that information basically they can always realize or always you can get, they can get
from the ratings of that particular company.
If the rating is good it creates an impression that the company must be good, it is a good
company that is why they will be ready to invest in that particular company. Then also it
acts as a marketing tool some company always uses that rating as a marketing tool
because they always feel that my company is a triple A rated company or my company is
a double A rated company. So, it is A rated company so, that basically always they can
use to market themselves in the financial system or to attract the investors that this
company is a good company and this company is better for the investment in the future.
Reduces cost of borrowing, because of good reputation because of the good brand value
because of less probability of default; the borrowing cost of those companies basically
reduces. And another one is easy to raise the resources, if the company wants to raise the
money from the market and they want to raise the money from the public and if it is a
good rated company then always it motivates the people to invest.
And as well as whatever bonds this company will issue and it is easily described in the
financial market or the investors will be ready to buy those kind of bonds whatever thing
are issued by these particular companies; the bond issuance will be relatively easier and
this company basically gets the good price for that particular bond and it will be easy for
them to raise the resources from the system.
And it also helps in growth and expansion, because the companies rating is good what
can happen in that process it is then easy for raising the capital, say it is easy for raising
the capital particularly where referring to the financial capital because the financial
capital increases relatively better than the company can grow and they can expand in a
better way because the announcement of the financial capital lead to the announcement
of the physical capital. They can create the infrastructure, they can create the machines
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and all these things to growth themselves or to make some expansion plan for that
particular company so that is why it also helps in the growth and expansion. So, these are
the major advantages what we can realize, we can observe from the company’s
prospective that why the company needs the credit rating.
From the investor prospective it helps in the investment decision it helps that which
company they should choose, they can easily understand the investment proposal and
they can always find out what is the credibility of the issuer. The qualitative credibility
whether the issuer is really able to pay the coupons and principal in the end or not and
because the credit rating companies or credit rating agencies rate this companies
periodically whatever rating the company gets there is a valid period of this particular
rating.
So, whatever rating the company gets may be that is valid for 1 year or 6 months and
after that again the rating will be done and the same process will be followed and the
rating may sustained, rating may increase, rating may decrease that is why what this
investors always feel that if the companies rating is consistent or the rating is getting
better and better than maybe it is good for them or; that means, it is continuously monitor
on the company’s performance is going to be better off.
So, if they are going to take part in the investment processes with respect to that
company maybe it is better for them or profitable for them to maximize their returns.
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That is why it basically act as a continuous monitoring process because credit rating is a
continuous monitoring process; the investor can rely that whatever on the basis of the
rating they can charge that whatever company it is whether it is a good company or it is a
bad company.
Then which are those credit rating agencies in India and abroad if you see; we have 5
major rating agencies, one is CRISIL already I was just telling about this thing Credit
Rating and Information Services India Limited. There we have Investment information
and Credit Rating Agency Limited that is called ICRA. Then Credit Analysis and
Research Limited that is called CARE, then you have the Brickwork Ratings India
Private Limited that is another rating agency, then SME Rating Agency of India Limited
that is called SMERA; S M E R A.
There are some global players we have Moody’s already I told you we have standard and
poor, we have the Fitch ratings these are the companies or these are the rating agencies
who give the ratings across the globe to the companies and as well as to the country. The
country governance and all these things or the rating of the company for the investment
all kind of things are done by the global players and they also do the rating for the
corporates for their bond is ones, these are the different kind of agency.
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So, if you see that rating process, how this rating process basically works. The rating
process means any company who wanted to be rated. So, let any company bonds that I
should get some credit rating for the credit rating agency, then what they do the client
basically who wants the rating or the company who wants the rating they send a request
to the rating agency for the rating. And the rating agency what they do they sign an
agreement all those with the all those information rating fees because they will give the
rating to the company that is why some rating fees they will charge and one agreement
will be sign.
Then once those things got over then what will happen that the rating agency in this case
we are talking about CRISIL, the CRISIL basically assigned a team and the team
basically collects the information from the company. Whatever product the companies
producing and whatever financial strength the company has all those preliminary
analysis basically they will do. Then after getting all those information by this team they
can interact with their top management people with the rating agency and as well as the
company. Then after that all those analysis whatever they will make that will be
presented in a rating committee.
And they finally, on the basis of the different parameters that we will discuss the rating
parameters one rating will be assigned and that particular rating will be given to the
issuer. If issuer will accept this rating then that will be published in the website that this
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is the rating what the company has. If the issuer does not accept this then what will
happen? The issuer or the particular company can appeal against this rating and then
what will happen again this rating agency may look at those things, but still the details of
unaccepted ratings disclosed on the website. And what about rating the company got that
also will be reflected in the website, but this rating basically kept under surveillance
during the tenure of the instrument.
Because the rating has been given for 1 year or so, the rating agencies also always
monitor the situation of that particular company the look at because the company’s
performance and everything should be under surveillance to ensure that whatever factors
or the parameters they considered to provide is rating those parameters affect us
everything should not be changed frequently at this should not be deviate from the target
level by a larger extent. So, because of that the regular monitoring also happens true that.
So, finally, one rating was being has will be given to that company and the rating will be
always shown in the website.
Then how the company is basically give the rating, the ratings are basically given to the
company using the different analysis different factors they consider, what are those?
They do a business analysis, they do a financial analysis, they go for analyzing the
management, geographical analysis also they do, regulatory and competitive
environment of that particular company, then some of the other fundamentals. So, these
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are all type of analysis the rating companies always do, whenever the ratings are
provided ratings are given to the different entities or the different type of companies.
Then how it is basically done one by one if you see, in the business analysis what they
do. All of you know that the business means what all of you know that the business
means what how they sell the business risk if you consider the business risk is nothing,
but how the sales as sales figure of that particular company or sales income of that
particular company is going to be affected.
So, if this is the sales is the parameter through which the business risk of that particular
company can measure then which are those factors which affecting the sales? One is the
industry risk of that particular company under which the particular company belongs.
The market position; the market share and all these things whatever the company’s
position is now and how the company is going to grow in the future.
What is the operating efficiency of the company, is there any kind of legal battle the
company has or is there any kind of bigger cases in terms of fraud or in terms of other
activities which is already going on with the company that is legal positions. What about
the legal position the company has? Size of the business, what about business the
companies doing, then what kind of business, what is the turnover in all these things, that
also has to be looked upon in terms of the business analysis.
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So, they look at the risk aspect in terms of industry risk, they look at the market share,
they look at the efficiency of the company, operating efficiency of the company, they
look at the legal aspect whether the company is busy with or may be involved any kind
of fraud or any kind of legal cases are going on for that particular company that thing
basically look at. And finally, the size of the business also obvious looked upon which
are the part of the business analysis.
Then we go for the financial analysis, in the financial analysis mostly the look at the
different ratios, what are those different factors or different ratios which measure this
financial performance of the company that also has to be looked upon. They look at the
accounting quality, profitability ratios means we are referring the ROA or ROE, ROCE
all these things they look at what is the profitability.
They look at the cash inflow and outflow and you know that there cash flow are many
times, cash flow from the financing, cash flow from the investment and cash flow from
the operations, operating cash flow, financing cash flow and investment cash flow. These
are the different type of cash flow; they do the cash flow analysis of the company.
Financial flexibility that is basically measured through your debt equity ratio, mostly if
debt equity ratio is more and flexibility of the companies relatively less, if the debt
equity ratio is low then the flexibility of the companies high. So, these are the different
mostly I already told you these are the ratio analysis the companies do sorry the credit
rating agencies do in terms of the financial analysis.
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Then we can see that what are the other things evaluation of the management, what is the
goal of the management, what are the strategies management is going to adopt in the
future or whatever strategies they are now adopting, is there any kind of capacity they
have to overcome the unfavorable conditions. There is any business cyclic fluctuations,
any kind of recession or any other thing which can happen in the market, whether they
have capacity to overcome back.
Planning and controlling system, whatever planning plants their making and what is the
control system they have. Then in terms of geographical analysis they look at whether it
is a domestic company or a multinational company, even if it is a multinational company
whether the geographical advantage; the company is enjoying or not or they have chosen
a particular region whether the region is basically providing good subsidy for the
business in that particular place or particular domestic path so, these are basically a part
of the geographical analysis.
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Then we have the look at the competitive environment of the particular country
regulatory environment of that particular country like structure, the regulatory
framework, licensing policy, taxes on policy and all these things has to be looked upon.
Then the fundamental analysis the always look at the manage look at the liquidity
management, asset quality, what is the quality of the asset most latest the applicable for
the finance companies, profitability and financial position, interest and tax sensitivity.
How the interest and tax that will change how the profitability and other things of the
companies are going to be affected so, that sensitivity also they tried to check.
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Then if you divide this kind of thing into two part; one is rating for the financial
institutions and another one is for the manufacturing and other companies. If they are
going for the banks and financial institutions rating the rating agencies, look at the
capital adequacy ratio that already you know capital upon total risk asset, whatever
resources raising ability the company has or the bank has, asset quality; that means,
already we have discussed that, whether the asset as standard, substandard, how much
NPA and all this things.
Management and systems evolution the look at earnings potential in the future how much
cash flow the particular banks and all these things can generate and how their asset liquid
or asset liability management they are basically making. These are the part of the banks
or financial institutions; these are the parameters they look at whenever they give the
rating to banks and financial institutions.
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But while coming to the manufacturing companies, the whole process has to be followed,
industry, market position, operating efficiency look at it is business risk, competency,
integrity, risk appetite it is a part of the market risk, accounting quality, financial
position, cash flow and financial flexibility these are comes under the financial risk.
So, once you have add up everything then considering all those factors then they look at
how the company is going to perform or how their performing now, the overall rating
will be given accordingly.
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So, if you see some of the example the CRISIL is giving the CRISIL AAA; that means, it
is the highest safety, AA high safety like that then, if you go by the CRISIL D it is a
default bond which is the most of sell bond which is available in the market. So, this is
the way the ratings are given by the different companies or different rating agencies give
the different symbols.
So, then if you want to know more about this, then you can go through these references
and the website of the CRISIL for the better idea about the utility of the credit rating.
Thank you.
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Lecture – 35
Non – Banking Statutory Financial Organization
So, after now we have discussed about the different kind of non-banking financial
companies, we discussed about the how the non-banking financial companies are
NBFC’s are contributing the economic growth process and how they are different than
the commercial banks and the other financial intermediaries which are existing in the
system.
Then there are some specific financial organizations we discussed about the venture
capital sponsor banks, credit rating agencies etcetera. And in the Indian financial system
we have one specific group of the financial organization what we call them the non-bank
statutory financial organization and those organizations exist there to provides certain
kind of specialized services for some specific regions.
So, these are the statutory body which provide the kind of services for a particular cause,
it is not for a common cause they provide the benefits, they provide the services for a
particular cause and those kind of organizations are many. There are many organizations
which exist, but we will be discussing certain specific organizations which are really
contributing to the development of the financial system and overall as well as the overall
economic growth of the particular country.
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So, let us see that what do you mean by this non banking statutory financial organization.
So, that whenever we talk about these statutory financial organizations they are mostly
always recognized historically, they are always mostly recognized as the development
banks or the term lending institutions or specialized or development financial institutions
or the organizations. They are not the financial intermediaries because, they generally do
not mobilize the savings from the ultimate surplus spending units and instead obtained
the resources primarily from the government and the RBI.
But, now some of them have started mobilizing the public savings directly or indirectly,
but mostly the basic objective of this thing is not to mobilize the savings; the
establishment of the statutory financial organizations are not to mobilize the savings that
basically to provide the assistance for betterment of a particular unit or particular sector.
So, mostly they have been made by or set up by the government, but there are some
private participation also we can always see whenever we talk about the NBSFOs or Non
Bank Statutory Financial Organizations.
So, these are; that means, overall this non-bank statutory financial organizations are
existing to provide certain specialized benefits to particular sectors or for some specific
regions.
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Then what are those major NBSFOs which are operating in India, if you see the major
NBSFOs which are operating in India their categorized into 2 parts. There are 4
prominent institutions or organizations which are registered with RBI or controlled by
RBI and there contributing a lot what we call them the all India financial institutions
AIFIs. And there are many other NBSFOs or non banking statutory financial
organizations, but here we are going to discuss some specific.
And NBSFOs like IFCI, IRBI, IL and FS, SFCs State Finance Corporations,
warehousing corporations, tourism finance corporation of India, you might have heard
about all these things, but there are other many kind of NBSFOs which work in the
Indian financial system. There are permanent which are what we called the all India
financial institutions which are directly controlled by the Reserve Bank of India and
Reserve Bank of India has strong role for the development of this all India financial
institutions which exist in the Indian financial system.
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Then you see one by one if you see one is your EXIM bank you might have heard about
this that is export import bank. It was it is fully owned by government of India bank
which was set up on January first 1982. And what were the objective of having this? The
objective of having this EXIM bank is for financing, facilitating and promoting the
foreign trade, to increase the foreign trade to provide certain benefits for the export and
import business they have established or this particular bank was setup in 1982 by the
government of India.
Currently this board has a 12 members or 12 directors which are appointed by the
government of India, including the chairman and managing director, which also include
the 5 nominees which are from the government of India functionaries, 3 directors from
the scheduled commercial banks and 4 industry or the trade experts. So, this is the way
basically the board always for the EXIM bank. And, where the EXIM bank gets the
money because they are not raising the money from the public, it is not like a
commercial bank who takes the deposits and gives the loan. And already I told you that
all kind of all India financial institutions are contributing in terms of the development a
particular sector.
So, here the EXIM bank is contributing in terms of development of the trade. So,
because of that the major sources of fund what they get they get it in terms of equity, in
terms of the loans from RBI and the bonds and also there is the money from the
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government, bond the only they can issue in the domestic and foreign capital markets
and also sometimes they get the loan from the international financial institution
institutions like IMF world bank etcetera Asian development bank and so on. So, these
are basically the major funding agencies to EXIM bank and EXIM bank gets money
from them and try to utilize that money for the development of the trade in the system.
So, that is what always the basic job of the EXIM bank or basic role of the EXIM bank
in the financial system.
What kind of jobs and what kind of functions the EXIM bank do what kind of services
we can always get from the EXIM bank if you see. Already we have discuss that the
existence or the set up of the EXIM bank is to promote the trade to develop the trade
sector. So, then how basically they do that. So, if you see they provide the post shipment
term finance, term finance mean long term finance they provide for the post and pre
shipment or the pre shipment credit also they provide. They give the loan for the export
oriented units anybody who are trying to do the export business the EXIM bank can give
them the loans to start the business or do the business.
They also provide the finance for the overseas investment, they also finance for the
export marketing, then re-lending facility to banks abroad, export they also rediscount
the export bills any finance the export credit and all sometimes also they provide a bulk
amount of finance for the import they provide the loan or the finance for the import. And
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also, apart from this they also provide the research, analysis, advisory and information
services to the different kind of units or different kind of customers on the basis of their
requirements. So, mostly they provide the term lending. It is a term lending institutions
or a lending institutions we provides the financing or provide the necessary finance for
the development of the trade in the economy.
Then we have another all India financial institutions we have always heard; however,
about this word that is called NABARD National Bank for Agriculture and Rural
Development is a popular name. This was also set up in 1982 July 12 under the act of
parliament as a central or apex institution for financing the agriculture and rural sectors.
This particular organization was set up for the development of agriculture and rural
sectors with a special focus on the agricultural sectors or the rural sectors.
And again there was amendment in 2001 that NABARD act which basically classifying
it as a “Development Bank” and permitted in to enhance its capital subject to the
minimum holding of 51 percent of the Government of India and the Reserve bank of
India. Because, it was set up by government then more than 50 percent of the share the
government always enjoys with a NABARD and mostly this particular holding is either
direct from the government and the Reserve bank of India.
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And what the NABARDs do, what the NABARD basically do, if you see the functions
whenever we ask this questions what NABARD does in what kind of functions the
NABARD has. Then always from the beginning overall what we have seen, we have
seen NABARD provides a finance for the betterment of the agricultural and rural sector.
So, it is a coordinating agency in respect of agriculture and rural deployment activities

which coordinates between central and state governments and the other institutions in
terms of investment and the financing activities. Also, it is always undertakes
responsibility of the inspection of the cooperative bank and regional rural banks without
the prejudice to the powers of RBI. Although RBI is the apex body, but still they always
look at whether the cooperative bank because this sometimes also they finance to the
cooperative banks and the regional rural banks.
So, because of that it is also the responsibility of the NABARD to see whether this
particular cooperative banks and regional rural banks are performing better or not. It
provides credit for the development of agriculture, small scale industries cottage and
village industries, handicraft and other rural crafts and allied economic activities in rural
areas. Any kind of small activities whether it is agriculture, whether it is small scale
industry, whether it is handicraft or any other thing which are basically happening in the
rural sector. There is some employment generation can be created, some income can be
generated through that particular kind of industry and particular kind of business
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NABARD is always responsible to provide the finance for that. NABARD there is a
provision to finance those kinds of activities by NABARD.
It also provide the short term finance, refinance assistance for a period up to 18 months
to state cooperative banks, commercial banks and regional rural banks for a wide range
of activities in the areas of production, trading, marketing and storage. Trading,
marketing, storage also if it is done by any kind of cooperative banks and regional rural
banks, at that particular point of time also NABARD helps them providing this necessary
finance for this kind of services.
It also provide the long term loans up to 25 years maturity to different kind of
cooperative banks, state cooperative banks SCBs, regional rural banks RRBs, then state
lending development banks these are basically the different kind of commercial banks
also and some other approved institutions for the purpose of making investment loans. It
also gives loan to state governments up to 20 years maturity to enable them to subscribe
to the share capital of cooperative credit societies to take the ownership of the state
cooperative credit societies, it can also provide the loan to the state governments whose
maturity period is up to 20 years. So; that means, overall it tries to finance those
activities which are related to agriculture or any kind of activities related to rural
development. So, in that context if you see NABARD specific role is for the
development of the rural sector and the agriculture in the economic system.
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Then they also provide the refinance measures for irrigation, plantation, horticulture,
land development, farm mechanization, animal husbandry, fisheries, for all kind of
activities, because all the activities are also link to agriculture and the we can say that
development with respect to rural sector so, they are also refinance to these activities.
They also finance for the seasonal agricultural operations, marketing of the crops,
purchase procurement distribution of agriculture inputs all these things.
Medium term loan facilities for the approved agricultural purposes and also working
capital refinance for the handloom weavers. Also one thing here you remember that this
is basically marketing of crops, purchase and procurement distribution of agricultural
input. They also provide the working capital, for the working capital handloom weavers
and refinance for the financing government sponsored programs as IRDP, Rozgar
Yojana all these things they provide also finance for this kind of thing.
So, these are the major functions major job of NABARD and overall already I told you
that the basic if you see all these functions mostly they provide the finance for the
development of the agriculture and all those issues related to agriculture and the rural
sector development.
Where the NABARD gets the money to provide this kind of finance? NABARD gets the
money from RBI major loans from the central government, world bank they can get, then
they can get some money from the other international agencies Asian Development Bank
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or they can also sale the bonds and debentures direct borrowings they can do like that.
So, this is the way mostly they get the funding from the RBI and the central government
and also in certain cases they try to raise the money from the different funding agencies
which are globally available like World Bank and other kind of organizations.
It has been associated with implementation of a number of projects with financial

assistance from the World Bank and International Fund for Agricultural Development.
Number of projects NABARD does on behalf of them and the country for the
development of the agriculture betterment of the agriculture and as well as the betterment
of the rural sector development. So, that is what the basic way of raising the money by
NABARD from the different sources.
Then we have another organization which are also all India financial institutions that is
NHB, it was a establish 1988 for the housing finance and it is a wholly owned wholly
owned subsidiary of the Reserve bank of India. So, the basic motto or basic objective of
having this NHB was to finance this housing loans housing activities. And the explicit
and primary aim of the NHB is to promote housing finance institutions at local and
regional levels in the private and joint sectors by providing financial and other support to
such institutions.
It also refinances housing loans under it is refinance schemes for scheduled banks and
the cooperative banks, housing finance, companies and cooperative housing finance
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societies. So, that also refinances the housing loans to different other entities which exist
in this particular system. So, therefore, in overall this particular organization always
ready or always the basic job of this particular organization is to provide this finance for
the development of the housing in the economy so, that is called the NHB.
And we have another organization we have that is SIDBI which is very popular name
and the basic job of the SIDBI was to develop the micro small and medium enterprises in
the economy. So, this was set up on second April 1990 under an act of Indian parliament
and it acts as the principal financial institution for promotion, financing and development
of the micro, small and medium enterprises as well as for coordination of functions of
institutions engaged in similar activities. Any kind of organization which linked to this
kind of small or medium or micro enterprises for all those kind of thing they should be is
ready to finance them.
So, the basic job of the SIDBI is, to promote or develop this particular MSME sector and
MSME companies which can largely contribute to the development of the rural sector
and as well as the economic growth as a whole. So, that is why the contribution or the
significance of the SEBI India in the Indian financial system is quite larger quite robust.
And therefore, always we should look at that what is the functions of SIDBI is doing the
function of the SIDBI is basically the development of the small sectors in the economic
system.
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That is why keeping those things in the mind what if you see formally what are those
objectives of SIDBI, the objective of SIDBI is to promote the marketing of the products
of small scale sector, to upgrade the technology and also undertaking modernization of
the small scale units for everything the finance them they might not have the technical
knowledge, but the basic part of the financing is always done through SIDBI. And they
also provide the more financial assistance for the small scale ancillary and tiny sectors by
small sectors.
And also they encourage the particular sector which employment oriented the primary
sector particularly whether it is small scale industries or handicrafts or it is any kind of
thing where relatively the employment opportunities higher, the SIDBI is always trying
to finance them. Even SIDBI is finance also what we call them the microfinance
companies they also give the loan to the microfinance companies for providing the loan
for the self help group and other bodies that what we have already discussed.
Then the basic another job of the SIDBI is to coordinate all the institutions involved in
the promotion of small scale industries. It is not only finance it also coordinate in the
different activities what these other organizations are doing for the promotion or the
development of the small scale industries in India. So therefore, the importance of SEBI
because India is a rural best economy and the importance of the SIDBI is quite large in
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the sense it creates the nexus between the financial sector and the real sector at a time,
that is why the role of SIDBI is quite significant in this context.
So, what are those functions, they do the refinance to the small scale industries small
scale sector existing in the country. Discount the bills for them, they sometimes also
offer the assistant for the export in this particular sector. If any kind of product what the
small scale industries are making and those products are qualities exportable, the
exportable product for them also SIDBI can offer then the assistance. They provide the
seed capital and soft loan assistance to the different entities who always deal with this
development of the agriculture and rural development.
Apart from all kind of financing activities they also do some non financing activities like
they provide the service in terms of the factoring, in terms of the leasing and also they
have purchase finance. SIDBI also provide these kind of services that already we have
discussed the what do mean by the leasing, what do mean by the factoring, what do mean
by this higher purchase, that part already we have discussed. But, those are the basically
the financial services and those services also are given by the SIDBI whenever
somebody does the business in this rural or the agricultural sector.
Then also they provide the assistance to other financial institutions if they can have the
surplus funds they can always help to the other financial institutions, automatic finance
scheme and the venture capital. They also sometimes act as in venture capital through
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which they want to motivate they want to sponsor certain kind of businesses in this
sector which are really doing well or they are going to while in the future or there is a
better scope for those kind of industry or those kind of projects for making this finance
agricultural or rural sector more efficient and as well as they can contribute more for the
growth rate of this particular economy. So, these are the non finance services what the
SIDBI always provide for this is the way the SIDBI basically functions.
Then we have some other financial institutions that already told you one of them is your
Industrial Finance and Corporation of India. So, what is this industrial financial
corporation of India, it was set up in 1948 very long very old organization if you think
about Indian prospective by the government of India act IFCI act 1948 and what was the
basic objective of this, the basic objective of this is to provide the medium and long term
loans to the large industrial concerns in the private sector.
The constitution of IFCI was changed the 1993 from a statutory corporation to a
company under the companies act to ensure the greater flexibility with effect from
October 1999 the name has been changed to IFCI limited. And, from August 2007
onwards it being regulated as a non banking financial company and IFCI become a
government controlled company subsequent to enhancement of equity shareholding off
to 55.53 percent by the government of India in December 21 2012. So, this is the history
about the development of IFCI.
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And here if you see what are the primary business what they IFCI does it provide the
medium to long term financial assistance to the manufacturing, services and the
infrastructure sector. IFCI also diversified into different range of other business like they
provide broking service, venture capital service, advisory service, depository service,
factoring service all these things. Also then provide the loan both direct rupee and
foreign currency loan for setting of the new industrial projects and for expansion
diversification renovation and modernization of the existing units.
It also underwrites and directly subscribes to industrial securities provides financial

guarantees, they also provide merchant banking services, lease financing services also as
a development financial institutions, a major portion of the financial assistance of IFCI
was being made to Greenfield projects in India and to the projects in underdeveloped
states.
Major funding where they get the resources of money what basically they will raise that
basically loans from RBI, they can also increase to equity capital, they can raise equity
earnings or retained earnings, repayment of the loans, issue of the bonds, loan from the
government, then they can also get the line of credit from foreign lending agencies, also
the commercial borrowings in international capital markets. So, there are many sources
of financing of IFCI and this is the way the IFCI works in the system.
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We have IRBI which is called the Industrial Reconstruction Bank of India it provides the
financial assistant as well as to revive and revitalize the sick industrial units in public and
private sector it was set up in 1971 with a share capital of 10 crore. It was converted into
a statutory corporation called the Industrial Reconstruction Bank of India in March 1985
with an authorized capital of 200 crore rupees and paid up capital of the 50 crores.
What the IRBI does, it provide financial assistance to the sick industrial units, provides
managerial and technical assistant to the all those units which are not performing better.
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It also provides assistance to other financial institutions and government agencies for
reviving the sick units. It provides the merchant banking services for the merger
reconstruction etcetera, consultancy services also it provides to the banks and the matter
of the sick unit and also they do the leasing business. So, almost all type of business the
IRBI does in the Indian financial system.
Then we have another one IL and FS which is a device which was in the news for some
days in might have hard all this thing about this. The ILFS was set up in 88 jointly by the
central bank of India CBI, UTI, HDFC, international finance corporation, ORIX
Corporation from Japan and credit commercial de France and state bank of India. And
what are those basic objective what are those kind of assistance they provide, the finance
the large infrastructure projects like highways, bridge, power plants, they provide the
equipments for the leasing for the infrastructural development, for pollution control,
transportation and communication.
They also provide investment banking services including the promotion of the mutual
fund and the extension of the venture capital, they also act as a member of the stock
exchanges with focus of the development of the secondary markets.
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So, many services is provided by IL and FS which was established 1988 then we have
state finance corporations. The main function of the state finance corporation is to
provide long term finance to small and medium scale industries which concerns the
public or private limited companies and with a maximum period of 20 years maturity. It
also grants loan mostly for acquire this fixed assets like land, building, plant and
machinery.
They act as an agent of the central and state governments or some industrial financing
institutions for loans to the small scale industries. So, this is the way the state finance
corporation works.
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There we have warehousing corporations, the warehousing corporations was very old
1957, they provide the logistic support to the agricultural sector. The activities include
food grain warehouses, industrial warehousing, custom bonded warehousing, container
freight station, inland clearance depots and air cargo complex.
And all these things, it also offer services in the area of clearing and forwarding,
handling and transportation, procurement and distribution, this infestation services, then
fumigation services and ancillary activities they provide. It also offers the consultant
services training for the construction warehousing, infrastructure to the different
agencies, the consulting services is one of the services the warehousing corporations also
always provide.
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Then Tourism Finance Corporation of India this is another body and it is a specialized
financial institution for the growth of tourism infrastructure in the country and which
provide the dedicated line of credit for the tourism related projects in the country.
So, this was there, they also offers other kind of services which are related to
entertainment in tourism all kind of services we can always find from the TFCI.
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So, all those details if want to study you can go through these references and this is all
about the non banking financial companies or non banking financial organizations which
operates in India.
Thank you.
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Lecture - 36
Call Money Market - I
So, after the discussion on the different financial institutions which exist in India which
includes; commercial banks, mutual funds, insurance companies, then non banking
financial companies, credit rating agencies, venture capitals, then we have the merchant
banks etcetera. The other part of the discussion on this course it is basically the market;
and if you see that whenever we define the market the market is divided into different
parts.
Mostly, if you divide the market on the basis of the assets which are; traded in that
market, or the term to maturity of that particular asset in that particular system, the
market is divided broadly into two categories; one is your long term market, one is short
term market. But whenever you talk about specific categories the market on the basis of
different financial institutions and as well as maturity then we have categorized them in
this way.
We have money market, we have a debt market, long term debt market, that we can say.
Then we have the stock market, then we have the derivatives market, then we have the
foreign exchange market. So, these are the different markets which exist in the system.
And every market has their own segments some markets are both primary and secondary
segments. And now the major objective of our discussion is to see that how the market
works.
What are the different issues which are related to this particular type of markets? And
how the trading takes place in this particular market? Who are those major participants in
this market? What are those different types of markets within that particular market? So,
these are the different questions we will address whenever we discuss about the different
markets. So, before going to discuss in detail let us first start the discussion on the money
market.
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So, if you go by the money market already if you know the money market is divided into
different parts. Because money market deals with the short term securities; mostly the
maturity period in the money market is maximum up to 1 year. Whatever instruments are
traded in the money market the maturity period can go from one day to one year. one day
means this is a overnight basis that market and the trading can take place or it can go up
to maximum one year.
So, the money market is mostly divided into various parts; one is your different types of
money market we have, we have a call money market mostly these are the short term
market only. We have a treasury bill market, then we have the markets for certificate of
deposits, then we have the markets for the commercial papers, we have also a market for
the commercial bills. So, these are the different type of market which exists in Indian
system.
So, our objective is to discuss one by one; what is that market is? Or what kind of market
it is? Who are those participants in this market? And how the market works? And what
are those different instruments which are traded in this market? So, we can start the
discussion with the call money market which is one of the most important markets in the
economic system; which plays a significant role in the monetary policy process.
So, first of all let us see what do you mean by the call money market. So, whenever you
talk about call money market; here mostly the call money market is a day to day market
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it is an overnight market. And whatever surplus funds are available in a particular day
these are transacted in this market. And mostly the transactions or the trading takes place
between the banks. The common investors are common retail investors do not participate
in the call money market in the overnight basis.
Mostly the market is confined to the banks or it we can call that it is an interbank market.
So, one bank can borrow from another bank, one bank can lend to another bank on the
basis of their requirements. So, that is why the call money market basically is applicable
for the Commercial Banks or banks which are operating in the financial system. And the
basic necessity or use of the call money market is; it helps the banks to borrow the
money without any collateral.
Call money market for trading in the call money market banks do not have to give any
collateral. The money is borrowed for one day, or for overnight basis from another bank
on the basis of the requirement of that particular bank. And the bank does not have to
pay any collateral to another bank from which they take the loan. And mostly the loans
are taken to maintain this CRR, the cash reserve ratio. You know what do you mean by
cash reserve ratio?
The cash reserve ratio is basically nothing, but the percentage of the deposit which are
parked with or which are deposited with RBI. And depending upon the deposits if the
CRR is laid 7 percent depending upon the deposit base this CRR basically changes. So,
mostly the banks use the borrowings and lending activities in the money market mostly;
the call money market to maintain that CRR with the reserve bank of India. Because that
money fluctuates over the days; so once the deposit changes the CRR will change.
So, because of that if the bank has to maintain that CRR they can borrow the money
from another bank they can deposit that money and one bank which has the surplus they
can lend the money to the another bank. So, this is the major utility of the call money
market which tells that to maintain the CRR bank uses that. The loans which are made in
this market are very short term; already I told you that whenever you talk about call
money market this maturity period is varying from one day to fortnight.
The money market instruments varies from one day to one year, but whenever we are
confining ourselves to the call money market. The maturity period can vary between one
day to one fortnight that means; 15 days. So, this is what basically the concept or the
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definition of the call money market or the nature of the call money market which exist in
the financial system. Before we go to discuss about the participation and other issues
related to call money market; Let us see how the call money market in US is defined.
Whenever you talk about the call money market in US; there are two types of market
which work in the US system. One is they call it the federal funds market and another
one is call money market proper. So, whenever you talk about the federal funds market;
the objective of the federal funds market is different and the objective of the call money
market proper is different. Then what do you mean by the federal funds market what it
does?
So, the federal fund market is basically deals with the federal fund transactions. What do
you mean by the federal funds transactions? The federal funds transaction is basically
what, it is defined as any transaction between banks involving the purchase or selling of
bank deposits at Federal Reserve Bank for one business day at a specified rate of interest.
The purpose of transaction in this market is to adjust the reserves of the banks the same
thing what CRR we are talking about.
And the supply of the funds to the market arises out of the reserves of the banks with the
central banking system. That means, whatever transactions any purchase and sale of the
bank deposits happens at the federal reserve banks for one business day that is basically
called the federal funds market. And again that basically depends upon the reserves
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whatever the Commercial Banks have to maintain with this Federal Reserve Bank, that is
what basically the federal fund market is.
But whenever we talk about the call money market proper it has a different kind of
objective. So, the objective of the call money market proper is to provide the short term
loans by the banks to the security brokers. If you see this loans are given to the security
brokers and dealers for the purpose of financing their customer purchases of the common
stocks. If anybody wanted to invest in the stock market and they want to borrow from
their broker or from the dealer. Then the dealer can borrow from the market or from the
bank to provide that particular loan.
So, which is not existing in India, but this particular market is existing in US where any
kind of transactions if any retail investor wanted to do. So, they can invest by borrowing
the money from the broker also. And if broker has not enough money with them then the
broker can borrow with a certain interest from the different banks. And that particular
market is called the call money market proper in the US context. So, this is the way the
money market in US is defined. So, let us see how the market is categorized in the
context of UK.
So, whenever you talk about UK; the Commercial Banks one of the UK bank or UK call
money market is categorized into two parts. One is clearing banks loans to discount
houses and another one is the interbank call market. Whenever we are discussing or we
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are explaining about the clearing banks loans to discount houses; how it is defined? The
Commercial Banks give loans to discount houses on the call basis.
These loans are normally payable when demanded and mostly they are the secured loans.
And how it is secured they are secured by the treasury bills; that means, the bills which
are issued by the government and other bills of exchange which is used as a collateral.
So, the loans are given to the discount houses who basically discounting the finances or
providing the finances. And this particular loans whenever they take from the
Commercial Banks, so the loans are basically is the secured loans.
That means, there is the collateral against that and what kind of collateral they give?
They give the collateral in terms of the treasury bills and other bills of exchange
whatever they have. So, that is basically clearing banks loans to discount houses and
these loans are given to discount houses only by the Commercial Banks. And whenever
we talk about the interbank call market they are the lending borrowing between the
banks merchant banks, the overseas banks, foreign banks. That means, it is an interbank
market it is more or less synonymous with the Indian context; where our operation works
with the interbank transactions.
So, our call money market is interbank market and here also we have seen the interbank
call market which exist in UK, which is basically always do the business within the
different banks which are operating or which are working in that particular system. So,
that is why these are the two types of call money market which exist in the UK also. Like
us you have two types of call money market which operate in the UK market. So, let us
now go to the Indian context that how in India the call money market works.
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In India already I told you that the banks basically do the transactions in the call money
market. And they demand the money for some specific reasons either; there is a large
payments in day, as large remittances which has happened in that particular day, or to
maintain the CRR the liquidity with RBI. So, these are the basic purpose that one bank
borrows from another bank and one bank lends to another bank. Who has the surplus
they provide the lending and the particular bank who has the deficit they always go for
the barrowings.
Who are the participants in this particular market in India? Already I told you the major
participants in this particular market is the Commercial Banks. All type of Commercial
Banks; Scheduled, Non-Scheduled, Foreign banks, State, District or One Cooperative
Banks, Discount House and we have the STCI Security Trading Corporation of India
which was again established by the RBI. They also do the transactions in the foreign this
kind of call money market.
So, these are the major players and mostly we can say this particular bank is an interbank
lending market this is an interbank lending market which is more or less synonymous
with the interbank market in UK. So, these are the major participants which basically are
available in this particular call money market in India.
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Then if you see the concept of the primary dealers; what started in mostly the primary
dealers are in India we have a concept called primary dealers and mostly the primary
dealers are the Commercial Banks and there are some standalone companies or
standalone financial institutions they also got the status of the primary dealer. And they
also do the transactions in the call money market; which are those?
You have ICICI Securities, Primary Dealership Limited, Morgan Stanley India Primary
Dealer Private Limited, Nomura Fixed Income Securities Private Limited, SBI DFHI,
STCI, already I told you. Goldman Sachs Capital Market Private Limited, Bank of
America, Bank of Baroda, Canara Bank, these are the banks. And apart from the banks
there are some standalone companies who also got the license from RBI to do the
transactions in the call money market.
So, these are already I told you these; ICICI Securities, Morgan Stanley, Nomura, SBI
DFHI, then you have the STCI. It was previously called DFHI now the SBI has taken
over the DFHI so the major sponsor of the DFHI is the State Bank of India that is how it
is called the SBI DFHI; Discount and Finance House of India. This is what totally
sponsored by the state bank of India now.
There are some Foreign Banks which also participate like HSBI Hong Kong and
Shanghai Banking Corporation, you have JP Morgan, you have Standard Charted, you
have Deutsche Bank all these banks also participate in this call money market in Indian
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context apart from our own public sector banks which also got the primary dealership to
operate in this particular system.
Non banking institutions other than PDS are not permitted in the call money market or it
is also called the notice money market in the Indian context. So, that is why mostly there
are some institutions which are got the license because, but mostly these banks are or this
particular market is confined to the banks; that is why it is called the interbank lending
market in the context of India.
Then we can move into how basically this trading takes place in this particular market.
So, whatever transactions which happen in this particular market they always happen
between the two different parties maybe over the counter market. But they are all
reported to the electronic platform called the negotiated dealing system.
This transactions takes place in the OTC market, but even if the transactions which are
happening over the counter market these are required to be reported on the FIMMDA
platform within 15 minutes of the trade. And how the trading takes place? And what are
those ways the trading takes place? How much amount of the trading takes place both
lending and borrowing activities? So, those things will be reported to the FIMMDA
trading platform within 15 days of the trade whatever is happening in the OTC market.
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That basically is the regulation always there with respect to the trading in this particular
call money market. There are some restrictions, there are some kind of regulations in
terms of borrowing and lending activities in terms of the market participants. Already we
have seen there are mostly major type of investors or major type of participants in these
segments, basically we have the schedules Commercial Banks, Cooperative Banks and
the primary dealers and some of the banks are also primary dealers.
So, if it is a scheduled Commercial Banks there are two activities one is borrowing
another one is lending. So, whenever it is coming we are coming to the borrowing how
much maximum borrowing the scheduled Commercial Banks can make from the call
money market. So, if you see on a fortnightly average basis; the borrowing outstanding
should not exceed the 100 percent of the capital funds; whatever the bank halts.
The capital fund means; it is the sum of the tire one, and tire two capital already you
know what is tire one, tire one is nothing the owners own equity capital And tire two
capital is nothing, but the sovereign depths and other kind of capital whatever the bank
has. So, this on fortnightly basis whatever capital the bank has it should not exceed the
100 percent of that on an average. Someday it may be more some days it may be less
what in the fortnightly average basis, it should not exceed the 100 percent of the latest
audited balance it.
However, the banks are allowed to borrow a maximum of 125 percent of their capital
funds on any day during a fortnight. Because on an average it should be 100 percent, but
for a day may be maximum they can go up to 125 percent. But in the 15 days average;
this should if a one day they are 125 other day maybe 70 percent other day maybe 60
percent that is the different issue, but on an average it should not exceed 100 percent.
But in a single day if they need they can go up to 125 percent if they are the Commercial
Banks in terms of the borrowings. In terms of the lending if you see it should not exceed
the 25 percent of their capital. Any single Commercial Banks cannot lend more than 25
percent of their capital funds on fortnightly basis average. But they are allowed to lend
maximum of 50 percent on a single day during that particular fortnight.
In some days they can go out to 50, but on an average 25 percent will be maintained in
fortnight basis. So, that actually in terms of the lending activities and for your
information the major lender in this particular system is SBI, which participates in the
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system little bit late at 1970, but they act as the major lender in the call money market in
comparison to the other banks which are operating in the financial system.
But whenever we are coming to the Cooperative Banks. It little bit different, there are
conditions or the criteria is little bit different. For Cooperative Banks the outstanding
borrowings of state Cooperative Banks, the State Central Cooperative Banks urban
Cooperative Banks etcetera on a daily basis should not exceed 2 percent of their
aggregate deposits as at end march of the previous financial year.
Here for the Commercial Banks it is related to their capital, but whenever we are talking
about the Cooperative Banks, it is related to their aggregate deposits. It should not
exceed daily basis it should not exceed the 2 percent of their aggregate deposits, if it is a
corporative. What type of cooperative bank it may be? But the aggregate deposits what 2
percent of the aggregate deposits only can be taken as the borrowing and for lending no
limit.
But generally the Cooperative Banks do not lend they do not have enough money to lend
they only borrow. So, because of that the limit is not given in terms of the lending
activities of the Cooperative Banks, but in terms of the borrowing activities it is 2
percent of the total deposits whatever they have.
But for PD’s the criteria is a little bit totally different, if either the bank is a primary
dealer or the standalone primary dealers whatever we have; for them in every fortnight
up to 225 percent of their net owned funds that means; 225 percent of their owners’
equity can be given or taken as borrowings equity. Means it is related to tier one capital,
but it is basically one or security net owned funds whatever they have.
So, net owned funds will be 225 percent of the net owned funds on an average on
fortnightly basis can be given as the borrowings. And whenever we are coming back to
the lending in the lending activities the PD’s are allowed to lend on an average on a
reporting fortnightly up to 25 percent of their net owned funds. So, in terms of borrowing
they can go up to 225 percent on an average on a fortnightly basis.
So, whenever we are going for the lending activities they can go up to the 25 percent of
their net owned funds. So, these are the restrictions imposed by Reserve Bank of India
for the conduct or the functioning of the call money market in the Indian system. So,
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they have some restrictions in terms of the borrowing activities and they have some
restrictions in terms of the lending activities.
Then we will see that, what are those factors which basically affect the demand for the
call loans in the call money market. The call money market demand and supply can be
driven by the seasonal factors. It is observed that there is a decline in the money at call
and short notice market in the decline in money at call and short notice market should be
greater in the slack season than in the busy season.
And an increase in the money at call and the short notice market should be greater in the
busy season than the slack season. In the slack season the demand for call loans will be
less because availability to the money to the Commercial Banks will be higher because
the demand for the food loan non food loan is relatively less whenever we are talking
about the slack season. But those things are quite higher in the busy season. So, that is
why categorically these two time periods if you observe this has a lot of impact on the
operations of the call money market.
The need for call money borrowings is the highest around March every year which may
be due to the withdrawals of the deposits. In March to bid the yearend tax payments and
the withdrawals of the funds by financial institutions to meet their statutory obligations
because our financial year ends with March 31st. It is observed that huge withdrawal
generally takes place in the month of March from the commercial banks.
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Either to pay the tax or to meet their financial obligations whatever they have. So,
because of that this kind of fluctuations always arise between two different periods on
the basis of the demand for that particular money in that particular time. So, that is why
there is a seasonal fluctuation we have always observed in the call money market.
So, if you summarize there are certain factors which affect the demand for call loans.
And there are certain factors which affect the supply of the call loans. Obviously, this
supply is only from one source that is the deposit. If the deposit is more than the supply
can be more, if the deposit will be less the supply can be less because that is the only
source of raising the capital for the source of the resources whatever the Commercial
Banks have.
So, through the deposit the supply side basically always changes. And whenever the
demand side factor we will see; we have discussed about the seasonal factors. And there
are other factors if you see because the markets are highly integrated. So, any kind of
bouncy or it is observed that the stock market is booming then the demand for money
will increase. So, if the demand for money will increase then automatically what will
happen the demand for call loan will increase because there are lot of demand for the
borrowings from the from the Commercial Banks.
So, because of that the Commercial Banks has to fulfill that particular demand and then
by that time there is a kind of deficit to fulfillment of the CRR. Then finally, they will
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borrow from another bank to meet that kind of requirements. Increase in the demand for
loans for industrial and commercial purpose. If any kind of development which has taken
place there are some enough growth opportunities are available in the industrial and
commercial sector.
And then demand for industrial loans will increase. Then; obviously, same thing the
demand for call loans also will be increasing so that time it is a huge demand to get this
call loans from the call money market. Liquidation of the government securities if they
have the government securities and government securities are liquidated then; obviously,
it will have the demand for the call loans.
Subscription to the government loans if government basically is going for any kind of
loans that also will affect the demand for call loans in this particular system then policy
measures. Seasonal demand already we have discussed then another factor is the policy
measure. So, what is that policy measure we are talking about? The policy measure
means for example, the CRR has increased so; obviously, the CRR will increase then the
availability of the money to the Commercial Banks is already less.
So, depending upon that already we have provided the loan or committed to the loan then
they have to borrow from other bank by that the demand will increase. So, the Reserve
Bank of India has increased the repo rate or declines the repo rate. So, once the repo rate
will increase it will have the impact on the call loans, why? Because the normal lending
activities of the Commercial Banks or the borrowing activities of the Commercial Banks
gets affected.
If the borrowing and lending activities of the Commercial Banks get affected then
automatically it will have the impact of on the demand for and supply of the call loans in
that particular time gap. So, these are some of the factors which affect the demand and
supply of the call loans in the particular system and accordingly the interest rate in the
call money market also change.
So, how this interest rate is getting affected in the call money market? What are those
factors behind that? Why the call money rates are quite volatile in the market? And is
there any other segment? Which is available related to this particular segment? Which
are the major rates which are popularly used in this particular market? So, those
questions and those issues we will be discussing in the next class.
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Thank you.
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Lecture – 37
Call Money Market – II
So in the previous class, we started the discussion on the Call Money Market. So,
already what we defined that call money market is a short term money market, where the
particular instruments which are available their maturity period varies from 1 day to 15
days and if you consider the overall money market maybe the maturity period is
relatively longer.
And here already also we have discussed the call money market is also defined as the
interbank lending market because the banks and primary dealers are only responsible or
maybe the major participants in this particular segment or there only allowed to
participate in a segment. And apart from the banks there are some standalone primary
dealers who are also allowed to participate in this particular system.
Today, we will be discussing about certain issues related to the call money rate and how
the call money rates are determined and as well as what are those factors which
determine this call money rate or why the call many rates are relatively volatile. And
apart from the call money market is there any other market which has related to this
interbank lending market what is that still is different from the call money market which
we have discussed in the previous class.
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So, coming back to this discussion if you see the rate of interest which is paid on the
particular call loans these are basically called as the call rate or the call money rate in
short we call it the call rate. And if you see that the call rates are highly fluctuating or
highly volatile it varies from day to day or it is highly variable from day to day and often
from one hour to another hour. And it is very sensitive to the changes in the demand for
and supply of the call loans.
So, already what basically here I was trying to tell you that the call money rate is market
determined. It is market determined; that means, there is no such kind of regulatory body
who decides this call money rate. The call money rate is always sensitive towards the
policy rates and what do you mean by the policy rate? In the Indian context, already we
have discussed this part, our policy rate is the repo rate.
So, since Reserve Bank of India has the repo rate and the change in the repo rate will
have the implication on the call money rate because the intermediate target for the
monetary policy is the call money rate. If you remember that whenever we are discussing
about the corridor so, here we have a corridor here in the floor we have the reverse repo
rate, then here we have the repo rate and we have the MSF rate or the Marginal Standing
Facility rate.
And, what we have discussed that the call money rate should vary here; that means, it
should be less than the MSF rate and the corridor has to be maintained to maintain the
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price stability. So, if any kind of extra money what the banks required if they will go and
borrow this money from Reserve Bank of India, then it will increase or decrease the
money supply in the system. If they will go borrowing more money then it will increase
the money supply in the system by that the price level will increase.
But, if you go by the MSF rate, if the MSF rate will be lesser than the call money rate
then they will go to RBI, but MSF rate will be more than the call money rate then the
borrowings will be done from the interbank lending market. By that what is happening
that the amount of money supply in the system become stable or become same.
So, that is why the price level will be stable. So, that is why it is very much sensitive
towards the changes in demand for and supply of the call loans which are basically done
by the commercial banks or the primary dealers. So, previously the call money rate was
determined by the regulator, but since 1989 the call rate is predetermined by the market
forces, that already we have discussed.
And mostly the call rate in India is defined as the interbank call rate because it is an
interbank lending market, we call it the interbank call rate in the context of India
whenever we discuss about the call money market.
Then, if you see that already I told you that the call rates are highly volatile. It is one of
the highest volatile market which exist in the Indian financial system. Why the call rates
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are highly volatile? Already we told that the call rates are highly volatile because the
demand and supply of the call loans change frequently. The demand and supply of the
call loans, if they will change frequently then automatically what is happening the call
rate or the interest rate on the call money market also is going to be changed.
And how it is possible when why basically the demand for call loans and supply of the
call loans change, what is the reason behind that? The fast point is basically what already
we have seen that is your CRR requirements. Whenever the CRR requirements increases
the requirement of cash reserve ratio increases that creates the excess demand for
liquidity in the call money market.
So, for example, if your CRR will increase or Cash Reserve Ratio will increase then the
bank will need more money because to fulfill that CRR requirement because if they will
not maintain the CRR because that is a regulatory norm. So, that is why that is a
regulatory cost involved in that. So, to avoid that regulatory cost the bank always will be
interested to maintain that CRR, if it will increase then; obviously, the demand for call
loans will increase.
So, obviously, the bank will try to borrow with that particular required amount of money
from another commercial bank within that particular call money market. So, that is one
of the most important reasons for which the demand for call loans basically fluctuates;
this is number 1.
Number 2: over extended credit position of the banks. What does it mean? Already we
know that the banks basically provide the loans or the credits from the deposits. The
deposit are the only source through which the loans and the credit can be given. But, at a
certain point of time some of the banks may provide more credit than the stipulated
availability of the deposits whatever they have.
If the credit amount is relatively higher and that particular point of time again all of
sudden there is some kind of CRR requirements changed then; obviously, the
dependency of the call money market will increase or we can say that the demand for
call loans will increase or the bank also borrow from the call money market to provide
that amount of loan to certain kind of the customers whether that may be for the
industrial loans or it may be for the other type of loans what they wanted to give.
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So, to provide more loans they sometimes depend on the call money market because they
do not have enough deposit base available with them to provide that amount of loan if
there is a demand for loan at that particular point of time; that is basically another reason.
So, that is why the demand for call loans and the supply of call loans both are basically
determined by the credit position over extended credit position of the commercial banks.
Then, we have the occasional market disruptions that maybe some kind of disturbances
which can happen in the market. So, this particular disruptions are very short term in
nature. As you know that the call money market is also a short term market, so any kind
of market disruptions also will effect both the demand and supply of the call loans. So, in
that particular point of time the availability of the or the requirement of the money in the
call money market change.
Heavy withdrawal by the institutional investors; you see that whenever anybody keeps
the money in the bank they have every right to withdraw the money. For some specific
reasons if they larger depositors or larger investors of withdrawn that particular money in
a single day or for some specific reason this withdrawal amount has increased then also
to make this or to manage this short term liabilities or short term asset liability concept
the commercial banks wants to borrow the money. Because they have made the
calculations that how much money can be withdrawn.
The reserve requirements are basically already defined, the short term requirements are
already defined. So, if the short term reserve requirements already defined or how much
liquidity is there with the bank which can be kept as a access reserve to fulfill the
customers demand that is already defined, but that has been predicted or forecasted
before.
But, for some reason if the institutional investors of heavily withdrawn the money then
the availability of the deposit or availability of the money to the commercial bank
declines to fulfill the requirement of the customer or the fulfillment of the liquidity
requirements. So, at that particular point of time or short term region they want to borrow
from the call money market. So, that is why the call money demand or the demand for
call loans basically can increase.
Then you have another reason we have liquidity crisis in the money market. The liquidity
crisis means if let there is a very less money supply in the system money supply have
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less liquidity because of availability of the money in the market is less. So, that particular
point of time what will happen this Reserve Bank of India are the regulator we will
change the interest rate. So, the change in interest rate will have impact on the lending
rates because the policy rate will change.
The policy rate will change automatically the lending rates will be affected. If the
lending rates will be affected accordingly your demand for money will be affected. So, if
the demand for money will be affected automatically the demand for call loans also will
be affected. So, that is basically we call to the liquidity crisis in the money market that
will lead to the fluctuations of the call loans the demand for call loans or the supply of
call loans in the particular system.
Then another reason if you see that this longest demand in bank deposit with heavy
pressure for a non food credit in the banking sector. So, there are two types of credit
what the banks give one is your food credits which were given to buy required food
grains and another one in the non food credit which includes or different type of credit
requirements like industrial loans, personal loans, then you have housing loans all kind
of things are coming under the non food credit.
So, what is happening that if the demand for deposit is relatively less, but there is a huge
pressure on this kind of loans in the market which basically makes the mismatch between
asset and liabilities. The bank deposit is less, the demand for loans are higher. So, either
in the market the opportunities are more that is why the industrial sector demand more
loans or the market is conducive which is creating better investment opportunity that is
why this investors or people are interested to go for more loans.
So, in that particular point of time what is happening that creates a clear mismatch
between assets and liabilities. That mismatch between asset and liabilities also led the
banks to go for more loans from the call money market. So, they can borrow the money
from the call money market to cater the demand for the non food credit which are
existing in the system in that particular point of time. So, that is why that is another
reason which makes the changes in the demand and supply of the call loans.
Then already you know that all the markets are interlinked, money market, stock market
foreign exchange market these are inter linked. If any changes which can happen in the
exchange rate market for example, this rupee is depreciating against a dollar or RBI
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wants to intervene to control that particular price fluctuations in this exchange rate
market. So, that particular intervention in the foreign exchange market will affect the
total aggregate money supply. If the total aggregate money supply gets affected then
automatically what will happen it will have the impact on the call money rate. Why
because the market interest rate will be changed.
So, any kind of changes, any kind of fluctuations in the foreign exchange market or it
can be in the stock market, both the markets if there is any kind of changes which can
happen, that has a spillover effect on the demand for call loans and supply of call loans
because there is a inter linkage, the markets are highly integrated. So, any disruptions,
any major changes which may occur in one of the market that can transmit to the other
markets then obviously, the interest rate which is prevailing in that particular market gets
affected by that. So, that is why any kind of causal because there is a causality so, the
demand and supply also changes accordingly or the call loans also changes accordingly.
Then, you have the structural deficiencies in the banking sector. So, if there is any kind
of structural deficiency which happens in the banking sector to fulfill that particular
deficiency the commercial banks can go and borrow the money from the call money
market because that particular market is exclusively relevant or maybe allowed to the
commercial banks to borrow and lent. So, then whenever any kind of deficiency occurs
in the banking sector so, one bank always relies upon another bank to get that particular
financing, to get rid of this kind of deficiency which may occur in a short period of time.
So, these are the major issues or major factors or major reasons what we can say these
are affecting the demand for and supply of the call loans, and once the demand for and
supply of call loans change accordingly that will change the call money rate or the
interest rate which prevails in the call money market. So, that is why the call rates are
relatively highly volatile. I can give you a figure that in some year the average call
money rate was even 80 percent that was in 2007. So, the rate was quite high.
Already I told you that are various reasons behind that the weighted average call money
rate in 2007 was 80 percent if you go back to analyze the year 2007 data you have lot of
analysis in terms of the crisis and all these things. If you consider those kind of factors
the call money rate has been highly affected by those kind of changes which have
occurred in the economic system as a whole. So, these are the major reasons which
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basically after the demand for call loans and supply of the call loans and by that the call
money rates become volatile.
Then there are certain measures what RBI always takes to reduce the call rate volatility.
How far it was effective, that is a separate question, but there are certain measures which
have been taken. The discount finance house intervention has increased for discounting
this particular finance which are available in the system. More funds have been
channelized by RBI through DFHI.
Funds are channelized by certain financial institutions with surplus funds. Penalties on
CRR shortfalls are softened. Previously whatever penalty the banks where paying in a
particular stipulated point of time if they have not maintain this CRR that particular
penalty has been little bit softened if this particular bank shortfalls for the CRR
requirements. Liquidity adjustment facility was introduced in 2000 to manage the short
term liquidity, to maintain the stability in the money market. Interbank liabilities were
free from the reserve requirements in 1997.
So, these are some of the measures what RBI has taken to make this particular market
more stable, but in the real sense if you see because it is a market determined interest rate
or the demand and supply also driven by so many exogenous factors so, because of that
what in practical sense we have observed that the call money market is highly volatile or
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the interest rate in the call money market changes very frequently. The frequency of the
change in that particular market is quite large.
So, this is what in practical sense we have observe, but still the regulators always try to
take certain steps or measures to reduce that kind of volatility in the market because
already we know that the volatility leads to instability. Any kind of threshold limit
volatility crosses then we can say that the market become unstable. So, to get rid of the
concept of or to remove the probability of instability in the market they always ensure
that the call money rates should be volatile because it is a market determined factor what
the volatility should be within a range.
So, then if you see that there are certain measure rates which are available in the system
which always we use as the benchmark rates which are available in the call money
market.
We have a rate called Mumbai inter-bank bid rate because call money market is
determined by the location. We have call money market in Mumbai, Kolkata and
Ahmadabad. But the prominent market is Mumbai because most of the banks head
offices are situated in Mumbai. Mostly because of that the Mumbai interbank bid rate in
Mumbai, interbank offer rate these are the prominent rates which are always we use
whenever we go for the call money market.
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It is the interest rate at which banks can borrow the funds in marketable size from other
banks in the Indian interbank market and it is calculated by the National Stock Exchange
of India NSE. And how the NSE calculates this one? It is basically calculated on the
basis of the data collected from the 30 banks and the primary dealers and the they were
mixed up public sector banks including SBI, there is another bank called CBI central
bank of India; private sector banks including Axis Bank, HDFC bank; foreign banks
including Citibank, Deutsche Bank, ICICI securities limited, PNB Gilt limited which are
considered as the standalone primary dealers which are existing in India.
So, here what is happening all the rates which are charged by this entities they collect
those data and try to find out the weighted average of the particular interbank lending
rate or the Mumbai interbank rate in a particular time gap. So, that is why this is
basically a weighted rate which is calculated on the basis of the interest rate charge by
this kind of entities which are participating in this particular system.
So, that is why we can say that, this is a benchmark rate or maybe the proxy for the call
money market whenever we analyze for any kind of reasons then we consider this
Mumbai interbank rate or the Mumbai interbank offer rates as a proxy for the call money
market interest rate in the system. So, that is one of the major proxies or major interest
rate which has been prevailed in the call money market in the Indian financial system.
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Then we have there are some other rates which are globally available always we use in
our analysis in the research or this is always considered as a proxy for the international
interest rate. So, that is basically call the LIBOR rate. You might have heard about this
later again and again that this is the interest rate basically which banks can borrow funds
from marketable size from other banks in the London interbank market here.
We have a Mumbai interbank and whenever we talk about the international market we
consider the LIBOR which is basically the London interbank market and this is a highly
acceptable rate across the globe and whenever we talk about any floating rate interest in
the global scenario always it is calculated with reference to the LIBOR. Or whenever we
do any research we try to collect data in terms of any foreign lending rate or foreign
interest rate we always consider LIBOR is the first one.
Because if you see in the derivatives we will discuss that whenever you go for the swap
and all these things, the floating interest rate is always calculated LIBOR plus 0.5
percent LIBOR minus 0.5 percent like that.
So, LIBOR is a very popular rate which is used internationally as a short term interest
rate which prevails in the market. And the LIBOR is fixed on a daily basis by the British
Bankers Association. So, every day you can get the data for the LIBOR in that particular
market and that data is nothing, but the call money market in London or in UK. It
basically measures the cost of the interbank lending and setting out the average rate
banks pay to borrow from one another.
So, this is an average rate this is not like our Mumbai interbank lending rate which is the
weighted average of call money rate. So, this is basically a weighted rate or the average
rate we shows that in a particular day how much interest rate the call money market in
UK is. And as well as whether the rate is how much fluctuations in comparison to the
different rates and different days that you can always shows from the LIBOR rate
fluctuations in the UK market. That is why it is a very popular interest rate which
prevails in the system that is why always we should have some idea about the LIBOR
rates whenever you discuss about the call money market.
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Then apart from the call money market we have another two major markets which are
related to this call money market, but not relatively it is different in comparison to the
call money market. It is again a rate which is or the market which deals with the
particular assets for term to maturity is relatively larger or higher or longer; longer term
maturity assets which are traded in this particular segment; these are the term money
market and repo market.
We were discussing about the call money market where the term to maturity was varying
between day 1 to day 15; from 1 day to 15 days where whenever you talk about the term
money market and repo market little bit these are two different markets and here the
transactions the term to maturity is from 15 days to 1 year. In the term money market the
tenure of the transactions is from 15 days to 1 year.
And, the repo market in already we discussed about the repo rate and reverse repo rate,
but if you see that in RBI contexts the repo marketer two types; one is repo under LAF
Liquidity Adjustment Facility and repo outside LAF. So, here this repo market I am
talking about repo outside LAF. So, the repo rate which is decided by RBI this is
basically what? This is basically a short term liquidity management and this is the
measure instrument for the monetary policy.
But, outside LAF also we have another repo market which basically always used to
finance the money into the different financial institutions in the market and that repo is
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basically varying. It is not specific to a particular organization; it can vary from one
particular entity to another entity one time period to another time period. But, still that
provision is there that there is an outside repo market where the borrowings can possible
by one entity, but one organization and this fixations of the interest rate can be done by
the Reserve Bank of India.
Already you know that repo contract is an instrument for borrowing funds by selling the
securities with an agreement to reforces the said securities and a mutually agreed future
date at an agreed price which includes the interest for the funds borrowed. And there was
a repo rate already you know which is lending or funding against buying and securities
with an agreement to resell the said securities and a mutually agreed future date at an
agreed price which includes the interest rate for the funds lent.
Already we know that concept, but I was just trying to tell you there are two types of
repo market which exist; one is repo under LAF and another in outside LAF market. So,
here we are referring to the outside LAF whatever repo market we have those markets
are exclusively for some specific reasons, for which the RBI can always give the advice
to the commercial banks to provide the loans.
Then we have another market that is called the CBLO market Collateralized Borrowing
and Lending Obligations. Already you know that in the call money market we do not
need any kind of collaterals, but the CBLO market need some collateral and why the
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market was developed? The market was developed for the benefit of the entries who
have either no access to the interbank call market or of the restricted access in terms of
ceiling on call borrowing and lending transactions that we have discussed in the previous
class. Either they are not allowed to participate or even if there are allowed there are
some restrictions in terms of the borrowing and lending.
So, because of that another market we have developed that is called the CBLO market.
This was a relatively new market started in January 20th, 2003. And here the maturity
period ranging from 1 day to 90 days and it can go up to 1 year also in certain extent.
And this transactions or the trading takes place through CCIL Clearing Corporation of
India Limited which provides a dealing system through the Indian financial network and
also closed user group to the members of the negotiated dealing system.
We have a negotiated dealing system where all kind of transaction, money market
transactions always takes place. And CCIL provides that platform through which
anybody wants to participate through this CBLO market they can use that particular part
for their investment in this particular segment.
Then, you see that CBLO gives an obligation by the borrower to return the money
provided at a specified future date and provides the authority to lender to receive the
money lent at a specified future date with an option to transfer the authority to another
person for value received that is also allowed. It is underlying charge and securities held
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in custody with CCIL for the amount borrowed or lent. So, CCIL is responsible or
organization which deals with the CBLO operations in the Indian market.
So, CBLO mostly is used to take care of the particular organizations who have the
restricted access or have no access to the call money market. So, these are the major
three market which are related to the call money market but, not exactly. Only their
different in terms of the instruments maturity period and as well as also the collaterals
which are used to provide this kind of loans. In the call money market we do not need
any collateral, but for the CBLO or the call money market to some extent to the one bank
needs the collateral to get the loan from another bank.
Thank you.
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Lecture - 38
Treasury Bills Market
So, after the discussion on the call money market, we can move into another segment which
is a part of the money market, but mostly this kind of market is driven by the government
securities. And if you see that broadly the government securities can be divided into two
parts; one is your short term government securities another one is a long term government
securities or the long term bonds; what we call them the dated securities.
So, whenever we talk about the short term securities mostly there are different instruments
which available under the short term securities. And the most prominent instrument which
comes under the short term government securities is the Treasury Bills. And the treasury bills
is the measure instrument through which government basically always trying to raise the
money from the public or try to inject the money to the market by selling and buying the
government securities like treasury bills. And this instrument is also used for financing the
government deficits whatever the government has.
So, that is why this market has his own relevance. And as well as there are some other kind of
instruments like; cash management bill, ways and means advances which are also available
and provided by the central bank on behalf of the government.
And they are also considered as the short term securities. So, in today’s class we will be
discussing some issues related to the treasury bills and as well as some brief idea about the
other type of instruments like cash management bill and ways and means advances etcetera.
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So, let us see that what exactly the treasury bill is? If you see that already I told you treasury
bill is a short term government security. If you go for a formal definition, if you define the
treasury bill formerly, it is basically a particular type of finance bill or promissory note put
out by the government of the country to meet the needs of supplementary short term finance.
If any type of short term deficit happens in the market or for the government when
government try to finance that particular short term deficit by issuing the treasury bills to the
market or to the public and that has been always done by the central bank. In the Indian
context these are basically issued by the reserve bank of India on behalf of central
government. So, RBI basically issues the treasury bills on behalf of the central government of
India and the treasury bills; that means, is the short term security short term bond which is
issued by RBI.
Treasury bills are zero coupon securities and pay no interest you know bond. There are some
coupon bonds where every periodical basis every 6 months or 1 year you get certain amount
of coupon on the basis of the coupon rate. But here this treasury bill is a zero coupon
securities it does not basically pay any interest in between. It is issued at discount and
redeemed at par. What do mean by this? If the par value of the securities treasury bill is 100
rupees.
Then it must be discount or it must be issued with a discount then the issue price maybe 98
rupees. So, by that particular asset at the price of 98 rupees and at the time of maturity you
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will get back your 100 rupees. So, that is why it is always issued at discount and redeemed at
par. So, that is the major nature or characteristics of the treasury bill; there is no coupon
involved in between because coupons are again paid on the basis of the par value. But
whenever we are talking about treasury bill; treasury bill does not carry any kind of coupon
interest.
Then if you see that what are those other characteristics which are related to the treasury bills
highly liquid money market instrument because it is a very short term in nature. Previously it
was vary from 14 days to 364 days, but most popular treasury bills which are available in
Indian market is a 91 days.
No risk of default because government is the guarantor remember; no risk of default because
it is issued by the central bank on behalf of the government. As it is issued on behalf of the
government; that means, we are assuming there is no default risk involved in that particular
security. Readily available; gives you assured yield because already there is no default risk.
Obviously, whatever yield basically is calculated or whatever the discount price of that
particular bond and whatever the par value of the bond on that basis deal from that particular
bond is quite assured that is another thing.
Low transaction cost whenever we invest or we basically go for trading in this kind of
securities the transaction cost is relatively less. The most important thing is any bank which
basically involves in this transactions of treasury bills or they basically by the treasury bills or
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they invest in the treasury bills. This is basically a part of the SLR investments already you
know that is mandatory some amount of total deposit has to be invested in a SLR instruments
and treasury bill is the foremost important SLR instruments.
So, any bank which basically uses the money for investing in the treasury bills there a part of
the statutory liquidity ratio instruments and; that means, there fulfilling that cap fulfilling the
requirement whatever they want to further investment in the SLR’s. Negligible capital
depreciation, there is as such there is no capital depreciation because the prices or the yield is
quite assured in that particular context by that any kind of problem which may there is no
possibility of credit risk or any kind of default.
Whenever we invest in this kind of security that is why the negligible capital depreciation
may be expected whenever anybody any bank invest in the treasury bills. So, these are the
typical characteristics as it is issued by the government. So, those are the things what we can
observe or always we expect whenever any commercial bank invest in the treasury bills.
Already I told you there are different type of treasury bills; we have ordinary treasury bills,
we have the Ad-hoc Treasury Bills. Whenever we talk about the ordinary treasury bills it can
be classified in this way. It is issued to the public and other financial institutions for meeting
the short term financial requirements of the central government, that already you know that at
the basic definition of the treasury bill.
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And whenever you talk about the Ad-hoc treasury bill the concept is no more that we used in
the Indian market. The Ad-hoc treasury bills are issued in favor of RBI. There not sold
through the auction process because treasury bills are sold through the auction process. But
the Ad-hoc treasury bills are purchased by RBI and the RBI is authorized to issue the
currency note against them and they are not marketable in India.
The Ad-hoc treasury bills the measure investors are not commercial bank the transaction
always happens between the government and the RBI. And RBI basically takes the bond
from the government and against that they issue the notes. So, that is why it is called the Ad-
hoc treasury bills. So, those things are not that way applicable means used in Indian context
more, but the concept of Ad-hoc treasury bills is defined in this way.
This treasury bills are issued in favor of RBI they are not sold through the auction process
and their purchased by RBI only and RBI is authorized to issue the currency note against that.
Government issued the bond to RBI and against that RBI pays them by printing the currency
that is why they are not marketable in India. But which are popular treasury bills, which are
existing in the Indian market they are basically the ordinary treasury bills and they are
defined in this way on the basis of the term to maturity.
They have 90 days, 91-day treasury bills 182-day treasury bills and 364-days treasury bills.
These are the different type of treasury bills which comes under the ordinary Treasury Bills.
And these are popularly used in the Indian market. And we have another treasury bill which
was the 14 day Treasury Bill.
Say it this treasury bill was sold only to the state governments foreign central banks and other
specified bodies in order to provide them with an alternative arrangements in place of the 91
day tap treasury bills for investment of their temporary cash surpluses. The 14 day treasury
bills also was restricted. This was only applicable to the state governments and over the
period the use of the fourteen day treasury bills also has gone down by the reserve bank of
India.
So, these are the treasury bills which are basically applicable or which are used in the Indian
market and out of them this 91-days, 182-days and 364-day these are quite prominent in
comparison to the other treasury bills which are available. Then if you see that whenever you
talk about this who are the investors?
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It is clear that RBI issues the treasury bills. But who are the investor? Investors are basically
banks, primary dealers, state governments, provident funds, other financial institutions,
insurance companies, non banking financial companies, FIIs, NRIs everybody; these are the
different kind of investors which always go and invest in the treasury bills market. And the
treasury bills are available in the minimum amount of 25000 and a multiple of 25000.
That means, one treasury bill amount is either one bond is 25000 all the multiple of that. So,
if you are investing 100000 rupees then you will be getting four bonds. So, the minimum one
bond value is 25000 rupees and already I told you the T-bills or the treasury bills are sold
through the auctions. The auctions take place to provide the treasury bills or determine the
price and yield of the treasury bills. On that basis the treasury bills are issued to the different
investors by the reserve bank of India.
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How the auction process works? If you see that already we have discussed that the treasury
bills are issued through the auction process, then how the auction process in the treasury bills
market work. You see there are two types of auctions in the treasury bills market always
happens or in general government securities market always happen. All of you know that
what is meaning of auction.
The auction is basically a process of calling for the bids with an objective of arriving at the
market price. That means, somebody wants to sell something or somebody wants to sell some
assets and they are going for an auction. Auction means some people will go for the bidding.
And whenever they will go for the bidding one particular price will be decided in the end to
issue that particular asset or to give that particular asset to the market.
So, in that process basically what we see whenever the auctions are taking place for the
treasury bills we have two types of auctions. What are those? One is yield based auction and
another one is the price based auction. These are the two types of auctions which basically
happen in the treasury bills market or determine the yield and price of the treasury bills. And
the yield based auction is generally conducted when a new government security is issued. So,
here what is this investor’s do? Investor basically go for the bidding. Mostly the commercial
banks which are the investor for the treasury bills they go for the bidding. And they go to the
particular price up to two decimal places; two decimal places.
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For example, 7.49, 8.21 etcetera. That means, what do you mean by that yield that yield is
basically nothing, but the interest rate or the price for the reserve bank of India will pay them;
if the particular bonds the commercial bank will buy from a reserve bank of India right this is
the interest rate what the RBI has to pay them. So, then what the RBI will do? RBI will take
those biddings and after taking those biddings what they will do; they will arrange it in the
ascending order.
And how it works? For example, let RBI wants to go for auctioning the treasury bill amount
of 5000 crore. So, they have given the advertisement that this 5000 crore rupees treasury bills
will be issued to the banks or to the different investors. Let there is a bank A; who has bidded
for 7.51 and they have asked for 500 crore rupees.
Bank B, they have bidded for 6.93 they have asked for 1000 crore. Bank C, let 7.49 they
asked for another 1000 crore. Bank D, will go for 6.55 they have asked for 500 crore. Bank
E, later asked for a 6.31 asked for another 1000 crore ok. Then another bank F, they have
bidded for let 7.05 and asked for another 1000 crore. Bank G, asked for let 6.97 and they
have asked for another thousand crore. Let this much banks have gone for the bidding.
Then what is happening what the RBI will do? RBI will arrange them in the ascending order.
Obviously, the lowest one will be 6.55, D is 1. The next one is 6.93, this is 2. Then after that
6.97 this is 3, then you have 7.05 which is 4, then 7.31 which is 5 then this is your 7.49 this is
your 6 this is your 7. Then what will happen that; obviously, the one which is basically what
6.55 they have asked for the 500 crore; 500 crore will be given to them. What is 2? 2 is 6.93
they have asked for 1000 crore, it will be given to them.
And then what is a number 3? 6.97 has asked for 1000 crore they will get that 1000 crore.
Then what is that 4? They will get this 1000 crore. Then what is 5? 5 is 7.31 they have asked
for 1000 crore they will also get 1000 crore. Then 6 is 7.4 or 49 they have also asked for 1000
crore then we have to see that; 1 2 3 4 4500. So, total amount available is 5000 so; obviously,
this 7 one will not get. And this thousand crore which was asked by the last one after five
means all these people we will get that is 4500.
Then this particular bank will not get 1000 although they have asked for thousand they will
be get only 500 crore left out; so, the 500 crore will be given to them. For example, the 7.49
was also given by another bank the same what they have given. And they have also asked for
the 1000 crore then remaining 500 crore will be distributed equally between them. You will
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get 250 and that another bank we will get 250. So, that is divided on the basis of the product.
Then that is the way basically the treasury bills are always given or maybe always allotted to
the different investors on the basis of the yield.
So, bids are arranged on the ascending order in the cut off yield is arrived at the yield
corresponding to the notified amount of the auction. When the cut off yield is taken as a
coupon rate for that particular security, successful bidders are those who bid at the below cut
off yields. So, here your cutoff yield is basically the highest one which is your 7.49 and
below that whatever yield will be there everybody we will get that particular allotment. And
more than 7.49 allotment will not be given and those particular bids will be rejected. So, this
is basically the process what the RBI follows whenever they go for the yield based auction.
But whenever they will go for the price based auction that if any government securities are
reissued in the market so the price and the yield goes inversely. So, here whatever price bids
the commercial bank will do; the price bids will be done in the descending order. That means,
what do mean by this price? The price is how much money the commercial banks are ready
to pay against that particular bonds.
So, this bids are arranged in the descending order and the successful bidders are those who
have the build at above the cutoff price. Above the cutoff price and bids which are below the
cutoff price will be rejected and this much money basically the banks are ready to pay to
invest in that particular bond. So, because of that the yield end price which basically moves in
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the different direction. And this is the way the bids are basically done. And already I told you
that this particular bids are calculated on the basis of the descending order whenever it is a
price based auction.
And again if you see that the auctions can be uniform price versus the multiple price. What is
the meaning of that? The meaning is for example, if you see the prices bids are like this. Let
bank A 100.5, Bank b has quoted for a 99.8, bank C has quoted for 100.675 then a bank D
has gone for the 101.6 so like that. So, we have arranged it 101.60 two decimal points.
Then you have 100 101.60 99.67 101.23 101.56 for example. Then we will arranged it;
obviously, this is number 1, this is your number 2, this is number 3, this is number 4, let what
is the cut off? The cutoff was basically the lowest one that is basically your 99.67. So, here
the question is, but this bank has gone for bidding 101.56 this bank has gone for 100.60 and
this bank is going to get at a price of 99.67. And the question is what price will be charged on
this banks. So, if it is the uniform price based auction then what is happening?
Whatever is the cutoff price everybody will get the allotment and that price. If the cut off
price is 99.67 then even if this bank has bidded for 101 and this bank has bidded for 100 the
price basically will be charged on them is 99.67 that is called the uniform price. The
successful bidders are required to pay for the allotted quantity of securities at the same rate
and that is the cutoff rate irrespective of the rate quoted by them.
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So, once the cutoff rate is decided whatever rates they might have bidded that is a different
issue, but the particular allotment will be made on the basis of the cutoff rate which was
decided by RBI on the basis of the auction process. But if it is a multiple price based auction
then what is happening whatever price you have bidded the same price you have to pay. If
this bank has bidded 101.56 then they will get this treasury bills at a price of 101.56 and this
one will get 99.67.
So, therefore, from the beginning it should be clear that whether it is a uniform price based
auction or it is a multiple price based auction. So, if there are some issues related to both
multiple price based auction and the uniform price based auction. But these are the two ways
the auction can be taken place or these are the way basically. It is clear that whether what
kind of process we are going to follow whenever the final price allotment or price basically
will be imposed upon the securities what we are allotting that actually we have to keep in our
mind.
Then whenever we go for the bidding; we have two types of biding; we have competitive
bidding, we have noncompetitive bidding. What do you mean by competitive bidding? The
competitive bidders are the banks, financial institutions, primary dealers, mutual funds,
insurance companies. The minimum bid amount is 10000 and in the multiple of 10000
thereafter; multiple biddings also allowed and investor may put in several bids at various
price or the yield.
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One investor can go for the different price quotations that is also allowed in the competitive
bidding and why there is a concept called non competitive bidding? The non competitive
bidding are open to the individuals, Hindu undivided families, regional rural banks,
cooperative banks, firms companies institutions, provided fund trust who are not able to
participate in the process because these are basically bigger organizations who has lot of
competence in term of the bidding process.
So, certain percentage of the total fund is always reserved for the non competitive bidders.
And whatever prices are determined through the competitive bidding the same price or same
yield will be charged upon the non competitive bidders. For example, the total amount was
5000 crore let 10 percent will be reserved for them with the 10 percent is 500 crore, which is
reserve for them then whatever price will be decided from this process the competitive
bidding process the same price will be imposed upon the non competitive bidders.
Let 5.498 which was the cutoff yield then the 7.49 yield will be also always applicable for the
non competitive bidders. So, under this scheme eligible investors apply for a certain amount
of securities in an auction without mentioning the specific price of the yield such bidders are
allotted securities are the weighted average price or the yield of the auction whatever auction
price are cut off yield will be decided accordingly the allotment will be made.
And again in the product basis these are 4 5 investors who are bidded for this then everybody
we will get some chunk of that particular or some amount of that particular available
securities in that particular slot. So, this is what basically the non competitive bidding which
happens in the treasury bill market.
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The trading platform for the treasury bill is the auctions are always carried out in the
negotiated dealing system. And the 91-day treasury bills are auctioned on every Wednesday
and the treasury bills have 182 day and 364 days are auctioned on alternative Wednesday. So,
every week in the 91 treasury bills are auctioned, but every 15 days the 182 days and that is
364 days are auctioned. So, these are the auction which takes place.
How the yield of the treasury bill rate is calculated? It is basically the discount at which they
are sold the calculation is based on the difference between the price at which they are sold
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and the redemption value. So, if you want to calculate the yield of the treasury bill is nothing,
but if the pair value is 100 then it is
100−P 365
× ×100
P D
D means the days to maturity. So, P is the purchase price, D is the days to maturity and D is
nothing, but the actual number of days to maturity divided by the 365 days. So, if you see this
example then you can come to know that how this treasury bill is calculated.
Assume that the price of a 91 day treasury bill is 98.20 rupees yield on the same would be
100 minus 98.20 divided by 98.2 into 365 by 91 into 100 that is 7.3521 percent. For example
after 41 days if the same treasury bill is trading at a price of 99 in the market; then what is the
yield? The yield will be
100−99 365
× × 100
99 50
50 because already 41 days are over. So, days to maturity is only 50 days remaining because
total maturity is 91, 91 minus 41 that is 50 then the yield become 7.373 and 35 percent. So,
that actually you have to keep in the mind; on that days versus trading price and how much
day’s maturity is remaining those are the factors which is deciding the yield of that particular
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treasury bill on that particular day. So, this is the way the treasury bill yields are calculated in
the market.
So there are two other instruments already told you one is cash management bill. This is
basically issue to made the temporary mismatch of the cash flow of the government maturity
period is less than 91 days. Issued at discount and redeemed that face value same thing with
the treasury bills. The date of issue notified amount tenure depends upon the temporary cash
requirement. It is not periodical or it is not regular the settlement of that auction is taken place
in T plus 1.
And ways and means advances this is basically to help the states to cover the temporary
mismatches in their cash flow. And these are the clean advances there are normal ways and
means advances and there are special as means advances. Ways and means advances in terms
of the normal category or the clean advances the loans which are taken from RBI. And the
special agent means advances are basically secured advances which provide this the collateral
which are nothing, but the government of India dated securities.
So, the collaterals or the mortgage is basically whatever government of India dated securities
these state governments that can be used as the collateral. So, these are the some of the other
government short term securities which are available for some specific reasons or to fulfill
the short term requirements of the government. So, this is about the different short term
securities which are issued by the government or on behalf of the government RBI issues
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that. Then we will discuss the other short term securities which are available in the market in
the next class.
Thank you.
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Lecture - 39
Miscellaneous Short-Term Money Market – I
In the previous class we discussed about the two different important markets, particularly
the Short Term Money Market which works in the Financial System that is your call
money market and we have the Treasury Bills Market. Call Money Market is an
interbank market and the Treasury Bill Market is basically a short term government
securities market through which the Reserve Bank of India tries to control the money
supply in the economy as a whole.
And there is an auction process which works for the pricing or the yield determination of
the treasury bills. Apart from this treasury bills market and the call money market, we
have other market which also work in this particular system. What are those markets?
This markets include your commercial papers, it include certificate of deposits,
commercial bills then, you have a discount market. So, there are different types of other
market also work in this particular system and which are mostly related to short term
securities.
So, keeping those things in mind we will be discussing all those markets that how this
market work and who are those participants in this market, what is the maximum term to
maturity of the securities which are traded in this market and who are those investors and
who are those measures stakeholder and what kind of responsibilities they play whenever
we participate in this particular segments. So, these are the major things what we will be
discussing in this session which is basically known as and we have named it the
miscellaneous short term financial market.
And those miscellaneous certain financial market also plays the role for raising the
capital for the different entities and as well as also play the role for the money supply in
the economic system.
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So, then let us see that what is the first one. The first one is the Commercial Paper. What
do you mean by a commercial paper? The commercial paper is an unsecured money
market instrument which is issued in the form of a promissory note by the corporation
with high credit ratings to finance its short term needs.
If you see that already you might have heard about this thing. Whenever there is a
company, the company basically try to raise the financing for the investment. So,
whenever the company raises the money for financing, the investments and the financing
is divided into two parts; your long term financing and you have the short term
financing. The long term financing includes either they can raise the money from the
banks or they can go for the long term bonds, but whenever you talk about the short term
financing, here also they can raise the money from the banks or the short term bonds.
So, here one of those sources is basically your commercial paper. The commercial paper
is basically an unsecured instrument. It is one thing you remember that is unsecured.
That means, whenever we raise the money through this commercial papers, we do not
take any kind of collateral against that. That is why it is an unsecured money market
instrument and another thing also you can keep in the mind with high credit ratings.
That means the companies who can issue this commercial paper, the rating of that credit
rating of that particular company should be very high. There are certain kind of limits in
terms of the credit ratings which are given and the particular company which has this
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kind of rating or more than that rating those companies are able to raise the money
through these commercial papers as a short term financing instruments. Then the CPs
basically if you see the commercial papers these are issued in wide range of
denominations. This can be either discounted interest bearing and usually have a limited
secondary market.
Commercial paper market in India is not very developed and reasonably it is a new
market and the secondary market all of you know that there are two segments of each
market. We have a primary market, we have a secondary market. For investment point of
view the existence of the secondary market in the context of commercial papers is
relatively very underdeveloped in comparison to its primary segment and it can always
be either discounted or the interest bearing. So, both ways this particular instrument is
issued for the investment in this particular segment. That is what always you keep in the
mind.
So, this is the basic definition of commercial paper and the objective already you know
that why the commercial papers are issued. The commercial papers are issued only to
financing the short term investments of the companies and the corporations have
companies with the high credit ratings are eligible to issue these commercial papers. So,
this is the definition or the nature of the commercial paper.
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Then, we will see that what are those characteristics of this particular commercial paper?
Commercial papers can be issued a discount to the face value or on a fixed interest rate
basis.
The particular instrument already can be issued at discounted redeemed at par or it can
be issued on a fixed interest rate basis. A minimum fixed amount of interest rate can be
charged whenever anybody invest in the commercial paper and that is the way the money
is basically raised from the market and another characteristics we have this is unsecured
and this is also negotiable and it has also a buyback facility. Buyback facility means the
corporation who has issued this commercial paper, there is a possibility they can
buyback that particular instrument or buyback that particular paper from this investor.
So, it is unsecured. That means, it does not carry any collateral, it is a negotiable and as
well as there is a buyback facility involved in that and it can be issued with discount or
also it can be issued with a fixed interest rate basis. That is also possible for this
particular instruments. So, that is why it is a source of short term debt which is regarded
as a highly simple flexible and quality liquid instrument. Why we call it as a liquid
instrument? Because already you know that this is very much short term in nature. So, if
it is short term in nature, then liquidity means already you know how fast it can be easily
converted into cash.
So, the conversion to cash is very fast. So, as conversion to cash is very fast, what we
can say that is why we call it is a quality liquid instrument which can create the credit
liquidity which can create the liquidity in the market reasonably faster and it is flexible
and also the simple there is no such kind of complexity for issuing this if this particular
instrument or this particular company has the minimum amount of rating or the adequate
amount of rating which is eligible or make them eligible to issue that particular security
in the financial system.
So, that is why these are the major characteristics of the commercial papers always we
observe.
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Then we have to see that how this particular commercial papers are working in India. If
you consider from the Indian point of view this was introduced in 1990. . That is why I
said it is a reasonably new instrument in comparison to the other financial instruments
which are traded in the market and what was the objective. The objective was to enable
the highly rated corporate borrowers to diversify their sources of short term borrowings
because the companies always issue the short term debts. The companies issue the short
term debts to for financing their short term investments or the short term requirements.
So, in this context what is happening? It is basically an additional instrument with the
bank borrowings and other type of bonds what they issue to the market to raise the
money what they are called investments in the future. So, that is why the commercial
paper is considered as an additional borrowing instruments for the companies and this is
basically through that the corporate sector can diversify their short term securities or
short term financing instruments to make their investments feasible or possible and it is
also the primary dealers and All India Financial Institutions were also permitted to issue
the commercial papers to enable them to made their certain funding requirements for
their operations.
In India there are certain primary dealers, and as well as there are certain All India
Financial Institutions who are also allowed to do the business to raise the money through
the commercial paper. That is also possible in the Indian context. So, this is what
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basically the commercial paper is and this is why basically the commercial paper is used
in the market for this short term debt, fulfillment of the short term requirements of the
companies for their short term investments. That is why if you see the summary, the
corporates primary dealers and All India Financial Institutions are eligible to issue the
commercial papers in the market.
This is what about the issuance of this particular security or who are eligible to issue that
particular security in the Indian Financial System.
Then already we show that there are certain guidelines, there are certain guidelines
through which we can understand that which are those companies who can issue the
commercial papers. The first thing there are certain kind of norms, there are certain kind
of guidelines which are issued by the regulatory bodies to see that whether this particular
company is able to meet those kind of norms, those kind of conditions.
Then only those kind of organizations, those kind of companies are able to issue that.
What is the first one? The first one who has the tangible net worth of the company as for
the latest audited balance sheet not be less than 4 crore. Remember the tangible net worth
of the company should not be less than 4 crore. That is the first point, then these
commercial papers can be issued in denominations of rupees 5 lakhs or the multiples of
that. The minimum denominations of the commercial paper says rupees 5 lakhs or the
multiples of that the fund based working capital of the companies should not be less than
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4 crore rupees that is another one. This fund based working capital of the company
should not be what do you mean by the working capital.
You know that what do mean by the working capital. The working capital means the
short term capitals. The short term requirements of the companies short term
requirements of the companies it can be the day to day expenses, inventories and all
kinds of things which are coming under the working capital. So, the fund based working
capital of the company should not be less than 4 crore and every issue of commercial
papers or including renewal should be treated as a fresh issue, any kind of additions to
the commercial paper is considered as a fresh issue or even if the existing council papers
if it is again renewed, 2nd time or 3rd time that is also considered as the fresh issue in the
market.
And there is no lock in period for the CPs. The CPs have no lock in period do you know.
What do you mean by the lock in period? Whenever you invest in a particular security up
to a particular time period, you cannot redeem it. For example, whenever you are
investing in a particular kind of deposits or particular kind of instruments up to 3 years or
up to 2 years depending upon the type of instrument; even if you want, you cannot
redeem that particular security and he can get back your money, but if in the case of the
commercial papers this particular instrument has no such lock in period. So, this is more
or less more often this can be redeemed or this can be basically again traded in the
market at any point of time if the investor wants. So, that is the way basically the
commercial papers are defined in India and the companies who are eligible to issue this.
This would have the minimum rating that we will see that what kind of rating they need.
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So, the CPs maturity period is between minimum 7 days and maximum up to 1 year
already. We told you that the money market instruments in the system maximum
maturity period is up to 1 year and some cases it can go up to 3 years, but generally we
consider the maturity period of the money market is up to 1 year from 1 day to 1 year.
The maturity period varies. So, that is why in this context if you see the CPs can be
issued for the maturity between 7 days to maximum up to 1 year and this is basically
started since October 2004.
Who can invest in the CPs? Individuals, banking companies, other corporate bodies,
registered or incorporated in India, non-resident Indians FIIs, everybody can invest in CP
demand as a short term investment. The CPs basically are open to all type of entities both
retail it is applicable and it is available for retail investor and as well as the institutional
investors. It is available to both retail investor and the institutional investor. If anybody
wants to invest in that, then those kind of investors are eligible to invest in this kind of
security. The total amount of commercial paper propose to be issued should be raised
within a period of 2 weeks from the date on which the issuer opens the issue for the
subscription.
The maximum 2 weeks are given to subscribe that particular issue and to raise the money
from the market. The total window period if anybody wants to raise the money through
the commercial papers, the total period will be given 15 days or the 2 not 15 days, it is
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basically 2 weeks and within that 2 weeks the issuance of that particular instrument will
be over, then investor has to subscribe that issue within that particular stipulated period
and I was talking about the credit rating. The minimum rating what the companies would
have to issue the commercial paper that is your, it should be P-2 of the Crisil and A2 for
the ICRA.
Different rating agencies give the different names for the rating. So, we were discussing
about the different type of rating agencies which are existing in India. We have the
Crisil, we have the ICRA, we have the KR. So, these are the major rating agencies which
were functioning in the Indian Financial System. So, if you go by those kind of rating
agencies the companies who are eligible to issue that particular kind of securities that
particular kind of instrument should have the minimum rating of P-2 if it is issued by
crisil and it should be minimum A2 if it is issued by the ICRA. So, this is what basically
about the who are those investor and what is the maturity period of the commercial
papers and what is the subscription period of the commercial paper and what kind of
minimum rating the company should have to issue the commercial papers in the market.
So, this is another certain features always we observe in the Indian context.
Then here what is happening whenever the commercial papers are issued, the companies
always apparent one IP issuing and paying agent for the issuance of the commercial
paper because all of you know that India is a bank dominated economy. Mostly for all
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kind of payment transactions we always use the banks as gateway, but any of the
commercial banks are responsible to go for or is responsible for making the transactions
related to that kind of instruments or that kind of trading any scheduled commercial bank
in the country is always act as an IP. IBM means it is where we refer to issuing and
paying agency for issuance of the commercial paper.
They are actively traded in the OTC market for over the counter market and such
transactions once it is traded in the OTC market, the particular transactions details has to
be reported to the FIMMDA reporting platform within 15 minutes of the trade because
that information or trade information should come to all market participants to make the
market more transparent. If it is available in the FIMMDA platform, then everybody has
the idea that what kind of transactions, what is the demand and supply in that particular
segment everything would be clear whenever it comes to the FIMMDA platform. So,
because of that even if this particular trading takes place in the OTC market, the
information has to come to the FIMMDA trading platform within the 15 days.
The CPs can be held in the physical form and the CPs also can be held in the demat
form. We can have a demating count to invest in the commercial papers; we can also
invest in the CPs in terms of the physical bond. So, if the CPs are in the physical form,
then the holder of the commercial papers always present this instrument for payment to
the issuer through the IP. For example, if the company A has issued that particular
commercial paper and bank is B, then the investor is I, then for if this I is holding that
thing in the physical form, then the I has to contact the B for any kind of transactions and
B will deal with A.
Investor will go to the bank which act as IPA and the IPA deals with the company and
because IPA is basically recruited by or maybe chosen by the company A who always
does this IP business or IP activities on behalf of the company A. So, this kind of
transactions are all done through the bank B and the investor always contacts the IPA for
any kind of payment or any kind of repayment of that particular transactions, of that
particular security. If the IPA is held in the demat form again the holder of CP will have
to get it redeemed through the depository and receive the payment from the IPA. The
depository agencies are responsible for redemption of that, but the payment again come
through the commercial bank who is acting as an IPA for that particular company who
has issued that particular commercial payment.
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So, what we have seen, the commercial papers can be hold in terms of the physical asset
or a physical bond or it also can be held as a demat form and the IPA plays a significant
role or is an intermediary between the investors and the issuer for any kind of
transactions which may happen in the market. So, this is about the kind of how the
transactions happen in this particular segment.
Then what is this? What is the role of the issuer? What the issuer has to do? The issuer
always first of all for any kind of transactions the; if the issuer one should do with
respect to CP or the commercial paper. The first job of the issuer is they should appoint
an IPA or issuing and paying agency.
And the issuer also should disclose to the potential investors its financial position as for
the Standard Market Practice. What does it mean? The issuer should say that make this
balance sheet public, all kind of profitability ratios, structure of the board, everything all
kind of market disclosure which are required. So, everything has to be always made
public and the investor will get the idea that what kind of company it is and also the
credit rating whatever rating the company has. So, everything will be reported or
everything will be informed to the potential investor and after the exchange of deal
confirmation between the issuer between the investor and the issuer.
The issuing company always issue the physical certificate to the investor or arrange for
crediting the commercial paper to the investors account with the depository if it is in the
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demat form. So, this is the job of the responsibilities of the issuer whenever any kind of
major thing is, they have to appoint an IPA and they have to disclose their all the
financial data or the financial information to the public to the potential investor for
transparency or for making this particular system transparent. So, this is what the
responsibility of the issuer is.
Then what are those responsibility of the IPA. The IPA always ensure that the issuer has
the minimum credit rating as stipulated by RBI to issue that particular IPO.
They should also ensure that the amount mobilized to the issuance of CPs within the
limit indicated by the CRA Credit Rating Agency for the specified rating or as approved
by the board of directors whichever is lower, then IPA also has the responsibility to
verify all the documents submitted by the issuer like copy of the board resolution,
signature of the authorized executives and issue a certificate, the documents are in order
and is also certified that it has a valid agreement with the issuer. This should have a valid
agreement with an issuer and the issuer fulfills all the criteria for the issuance of
commercial papers. That is the responsibility of the IP and the certified copies of the
original documents verified by the IPS would be held in the custody of the IP.
Everything is basically the IPA is the meditating agency which works between the issuer
and the investor in the CP market.
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Then there is a responsibility of the Credit Rating Agency. They have a very strong role.
The code of conduct prescribed by the SEBI for undertaking the rating of capital market
instrument shall be applicable to them. For all kind of rating of the CPs, they have the
credit rating agencies have the discrimination to determine the validated period of the
rating depending upon its perception about the strength of the issuer and accordingly this
all at the time of rating clearly indicate that when the rating due is review.
For example the particular thing is issued on let some date and the rating is valid up to 1
year rating is valid up to let 6 months and these issuance, the issuer is trying to make this
particular maturity period 1 year. They cannot do that. The reason is the validity period
of the credit rating is basically up to 1 year, now up to 6 months. So, because the
validated period is 6 months, the maximum maturity period of the CP cannot be 1 year.
So, the credit rating will say that when the next review is over and this is the
responsibility of the investor and the IPA to see that whether this particular rating is valid
for the company up to the maturity period of that particular security, that is why the CRA
can decide the validity period of the credit rating and the credit rating agencies would
have to closely monitor the rating assigned to the issuer vis a vis their track record at
regular intervals and would be required to make its revision in the ratings public through
its publications and websites over the period of time, from time to time they always
disclosed what kind of rating the company has and whether there is a change in the rating
etcetera.
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Then if you see overall that, what are those factors which are affecting the development
of the CP market, we have the credit quality. Always we have seen that credit rating is
the major factor which decides whether the company can issue the CP or not and credit
rating also attracts the investor to invest in that particular security. If it is by a particular
issuing agent or issuing company market liquidity, the liquidity is less in the market that
has the impact because it is very difficult to raise the money from the market at that time
maybe the company can take the help from the CPs to raise the money from the market
for the short term reasons.
What are the cost of other alternative assets for financing the short term requirements? If
the cost of other instruments are relatively less, the company may not go for using The
CP as the alternative instrument or alternative borrowing instruments for them. Financial
Market Infrastructure means how far the market is or the infrastructural development is
therefore the trading in that particular type of instruments. If it is very highly developed,
then it is easier to invest in kind of security and the working capital limit of this
particular company that is also one of the other factors which decide that how much
money they need for the working capital requirements. So, these are the different factors
which are affecting the development of the CP market in India. So, this is the brief idea
about the commercial papers, then we can move on to the other markets like CDs and all
these things in the next session.
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Thank you.
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Lecture - 40
Miscellaneous Short-Term Money Market – II
So, in the previous class we discussed about the commercial papers market. In this
session we will be discussing about another major instrument, which is certificate of
deposits. So, what do you mean by the certificate of deposits? That is basically
represents a bank deposit accounts which are transferable from one party to the another
or we can say that it is a marketable and negotiable short term instruments in bearer form
and known as the negotiable certificate of deposits.
So, this is again a promissory note or kind of short term instruments in the bearer form
and it should by the different banks or financial institutions to raise the money from the
public. So, this is highly marketable and negotiable also. This is a marketable
instruments and as well as the negotiable instrument that actually keep in mind. So, you
remember this is a marketable and non negotiable short term instruments in the bearer
form and as known as negotiable certificate of deposits.
It is highly liquid because it is short term in nature and the marketability is very high it is
highly liquid. So, instrument in the market because it is easily converted into cash and
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another thing is that, it is basically issued by the banks for attracting the large corporate
deposits, rather than mobilizing the individual savings. For mobilization of the savings
we have the savings account.
But whenever we are talking about the CDs, through CDs the banks are basically trying
to attract the large corporate deposits not the small savings from the different investors.
And here you see relatively again the CD market in India is again relatively new or not
that way highly developed.
So, here whenever this CD was started, it was started in properly 1989; with the
recommendation of a RBI marking committee group report which is called the Vaghul
committee report in 1987. In the initial years the feasibility of CDs in India its object to
various constants like lack of secondary money market interest rates were highly
controlled by the regulatory bodies. The regulatory system was not very proper for the
CDs. So, those kind of things were prevent in the early stages.
And in 1989 with the recommendation of the Vaghul committee the CD market or
instrument like CD was introduced in Indian market and what was the objective for
introduction of CDs in the Indian market?
The basic objective of introduction of CD are the certificate of deposits into the Indian
market was to give the investors a greater flexibility in the deployment of the short term
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funds. The money which was available with the investor and where the money can be
invested; if they want to invest at all in the short term money market instruments. So,
although there are some money market instruments which are available like to the rebels
and all.
But still to increase that portfolio to diversify that portfolio, the Vaghul committee has
recommended the introduction of CDs or the Certificate of Deposits. So, these certificate
of deposits basically try to widen the availability of the money market instruments in the
Indian financial system.
And who are eligible to issue the CDs already I told you the banks can issue the CDs, but
not all the banks are eligible to issue the CDs we have to exclude the regional and rural
banks and the local area banks. Basically the sort we call it the RRBs the Regional Rural
Banks and we have the local area banks.
So, these type of banks are not eligible to issue the CDs to the investors. And there are
some all India financial institutions they are also eligible to issue the CDs. And there is
no such kind of restrictions, but the banks have the freedom to issue the CDs depending
upon their funding requirements. On the basis of the requirements of the banks; the
banks can decide that how much money they want to raise through the certificate of
deposits. And minimum amount of CD should be rupees 1 lakh and the minimum deposit
that could be accepted from a single subscriber should not be less than 1 lakh.
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If somebody is going to invest in the CDs the minimum amount of investment should be
1 lakh or it is a multiple of 1 lakh. The particular CD amount certificate of deposits
should not be less than 1 lakh rupees. If any kind of investor wanted to invest in that
particular type of security that basically we have to keep in the mind. Then who are the
investor who can invest in the CDs? Individuals, companies, com trust or then we have
the mutual funds, then with the associations NRIs there all are eligible to a subscribe the
CDs.
So, already in the beginning basically we are discussing the CDs are mostly available in
the market to attract the large corporations to mobilize their savings. So, major objective
is not to attract the retail investors for the individuals, but still the individuals can invest
in this particular kind of security, but the minimum amount they have to always invest in
that particular security is 1 lakh or the multiple of 1 lakhs what is the maturity period?
Because there are here if you see broadly there are two types of institutions, who are
basically able to provide the CDs or the certificate of deposits.
Who are those? 1 is your banks other 1 is the all India financial institutions. If there are
two types of entities as for the RBI norms or RBI guidelines, the maturity period of the
CDs vary on the basis of the types of issuer. If the issuer is a bank then the maturity
period varies from 7 days to 1 year. It is just like the commercial papers what we have
discussed already.
But if this particular instrument is issued by a financial institutions or the particular all
India financial institutions, who are allowed to invest or allowed to issue the studies CDs
there the period varies between 1 year to 3 years. So, there is some kind of deviation in
between. So, if this particular CDs are issued by the banks, then the maturity period
varies from 7 days to 1 year, but if it is issued by any kind of all India financial
institutions then it is basically varies between 1 year to 3 years.
So, this is the way the majority period basically different on the basis of the issuer, who
is issuing that particular instrument and the CDs are issued at a discount on the face
value. The CDs are always certificate of deposits or issued always at a discount on the
face value of that particular security that is another feature of that particular certificate of
deposit that what we see. So, this is another characteristics what you can observe in
terms of the CDs market in India.
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Then we have to see that what are those other issues related to the CDs? The CDs are
subject to the cash reserve ratio and SLR Statutory Liquidity Ratio requirement on the
issue price of the CDs. That means, the banks are always subject to or always have to
maintain this CRR and statutory liquid ratio to provide the CDs or to issue the CDs into
the market. Banks and FIS cannot grant loans against CDs and cannot buy back their
own CDs before the maturity. You remember this point any kind of loan cannot be given
by taking CDs as a collateral or any kind of loan cannot be given against the certificate
deposits whatever this investor has.
And also they cannot buy back their own CDs before the maturity; that means, before 1
year if the maturity period is 1 year, then the particular banks cannot buy back that
particular certificate of deposit before 1 year. And another feature the CD has it is freely
transferable by endorsement and delivery, that is a unique feature of the CDs that is
freely transferable by endorsement and the delivery. The maturity period minimum size
of the issue, denominations these are all always subject to RBI since it is empower to
change those kind of things from time to time.
Its not that once it is fixed that will remain for a very large period of time or long period
of time, that is not the case and according to RBI guidelines those kind of features are
subject to change that can be changed in the market. Mutual funds are also allowed to
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invest in the CDs with certain limit which is stipulated by SEBI because the mutual
funds are regulated by SEBI.
So, if any mutual fund wanted to invest in certificate of deposits, then there are some
kind of prescribed norms which are prescribed regulations which are already mentioned
by SEBI or Securities Exchange Board of India, then accordingly the mutual funds are
allowed or they will be ready or they will be basically allowed to invest in the CDs
market in the Indian financial system.
So, these are the different features which are related to CDs market. I can share one thing
with you the CDs market also not very developed in the Indian context, because of the
lack of secondary market it has very underdeveloped secondary market it has and another
thing that CDs market does not attract the investors particularly the large corporate
investors. The reason is basically there are other alternatives which are developed in the
market which basically face more return that what the CDs are giving. So, because there
are certain kind of limitations in the CDs market, but the regulatory bodies like RBI is
taking lot of steps to make this particular market more developed.
Or maybe they are making regular changes with respect to the regulatory norms to that
particular security. By that the market can be more attractive and the investors will be
more interested to invest in that particular security at least to maximize their return. This
is what basically the overview of the CDs market and this is the way the CDs market
work in the Indian financial system.
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Then we have another type of things which is nowadays not very developed or it has the
usability of this particular security is relatively less in the market. But still it has some
significance or it was the significance before, largely whenever the technology and as
well as the banking system was not that way very developed. We have another
instrument called the commercial bills now what do mean by the commercial bills? It is
used for financing a transaction in goods and services that takes some time to complete.
It shows the liability to make the payment on a fixed date when goods are bought on
credit. The commercial bills are used whenever any trader or any kind of import or an
exporter basically they go for buying of certain kind of commodities.
But the money was not paid at that particular point of time. So, that time the buyer
basically provides that particular commercial bill to the seller at a particular date the
seller can sell, that particular bill to a particular bank or particular financial institutions to
get back the money. So, it is a bill which was issued against some kind of an individual
or some kind of company to get back that particular payment, after certain time of the
transactions of the delivery of the goods.
Once the goods are delivered after that only the bills can be shown to that particular
financial institutions for the payments. So, this is what basically the commercial bills are
and they are already I told you that this particular bill will work whenever the goods are
bought on the credit. Credit means the money is not paid to buy that particular
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commodity or particular goods in that particular point of time. So, this is an asset which
is shiftable and which carries a low degree of risk of loss and the bills of exchanges the
other name of bills of exchange is bankers’ acceptances in a US market.
In Indian context we call it the commercial bills, but if you have heard about the name
called the bankers’ acceptances. The bankers’ acceptances are a popular word which is
used in the US market and there is no single fixed maturity period for bills in general.
What should be the maximum period through which that or within that period of the
money should be paid or the bill will expire those things there is no single maturity
varies from one individual or one particular company to another company depending
upon their requirement the maturity period basically varies.
So, that is why it depends upon the buyers and sellers agreement that how much maturity
period the commercial bill should have for the completeness of that particular
transactions. So, that is what basically happens, that is why there is no such fixed period
or maturity period which was been assigned whenever any transactions in the financial
market takes place in terms of the commercial bills. So, this is the why this bills are
defined.
So, then what are those different types of bills? There are different types of bills we have
a demand bill we have a time bill what do you mean by the demand bill? The demand
bill is nothing but it is a bill in which known time for payment its specified.
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Already I told you that no time or we have discussed now just now, that no specific time
is mentioned in that particular bill. So, any point of time the bill can produce before the
bank and the money can be paid against that. So, that is basically called the demand bill.
But whenever it is a time bill or the issuance bill what we call it, it is payable at a
specific or specified latter date the date will be mentioned after that. For example, it will
be valid or the money the bill can be always redeemed or bill can be used only after 3
months or after 2 months or after 1 months.
So, that will be mentioned in that bill or the date will be mentioned in that bill. So, after
that only the particular holder of the bill can go with that bill to that particular
organization to get back that particular money. So, that is why in terms of the payment
period or the time, we have two types of classifications we have the demand bill and we
have the time bill. So, in the time bill this particular is payable only after a specific date,
but whenever it is a demand bill there is no time for payment is specified. So, at any
point of time the holder of the bill can go to the financial entity to get back that particular
money or the money can be payable.
Then we have another classifications we have inland bill and we have the foreign bill.
So, whenever we talk about the inland bill mostly it is drawn or made in India and must
be payable in India, number 1. Number 2 it can be drawn upon any person resident in
India it will be drawn in India it will be payable in India and also to whom the payment
will be done that person also is a resident of India. Because it is an inland bill so, all the
parties which are involved in that particular commercial bill are basically the Indian
residents and the transactions which are happening with respect to that bill all are
happening within the country. That is why it is called the in land bill.
Then we have a foreign bill the foreign bill is basically drawn out side India and maybe
payable in or by a party outside India or maybe payable in India or drawn on a party
resident in India or drawn in India and made payable outside India. That means, here in
the foreign transactions the foreign parties are involved. So, the foreign banks also might
be involved. So, in that context we call it the foreign bill. So, any financial entity or
financial institutions who are basically is responsible for that particular payment they
have played a very significant role in terms of this.
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So, in case of foreign bill, it is drawn outside India and payable in India or by a party
outside India or may be payable in India or drawn in on a party resident in India or it is
drawn in India and made payable outside India, that actually keep in the mind. More or
less what we are saying that if it is a foreign bill then only we can say that not only this
Indian parties are involved for the transactions, the foreign transactions or the foreign
parties are involved in that, it is not only confined to the Indian residents or all the parties
may not belong to the Indian resident.
Then we will see that another market we have that is called the discount market. Those
markets are very underdeveloped in Indian context like bills market were there before,
but now those transactions are the bills or use of the bills of relatively has gone down.
The reason is basically the technological development the adaptation of new kind of
methods for the payment and as well as we have the kind of other alternative assets
which are available. So, those kind of things has always reduced the importance of the
commercial bills in the modern financial system that is what basically we have observed.
But there is some importance of that particular market, what the people are using that
commercial bill for payments whenever they are buying the commodities or the goods at
credit. This is what about the brief idea about the commercial bills market which is
working in the Indian context,, but you keep in the mind I already told you this market is
not that way very developed whenever we think in the today’s context or the current
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context or current prospective if you analyze, that market is not a government market if
you talk about the Indian financial system.
Was I just share with you that those markets were there and those markets also played a
significant contribution to the Indian financial system as a whole. Then we have another
market called the discount market the discount market is basically what? The banks if
you understand discount market what did the exactly it is, the banks borrow funds
temporarily are the discount window of the central bank because already all of you know
their banks can borrow from the central bank at the time of requirement.
They are permitted to borrow or are given a privilege of doing so, from the central bank
against certain types of eligible papers. The eligible papers are basically the collateral
and the collateral can be anything they are the commercial bills, treasury bills etcetera.
Those bills are used to raise the money from the central bank and those bills are used as
the collateral by the central bank whenever they provide the loan to the commercial
bank. And here the central bank basically is there or stands ready to discount or to the
discount what we can say for the purpose of financial accommodation to the banks.
So, those kind of bills or those kind of financing instruments which the banks are using
as collateral to get their loan, those bills are discounted or rediscounted by the central
bank to provide the loan to the commercial bank. So, that is the major objective of the
discount market. So, it has its own relevance or it has its own significance, because once
the every time the commercial banks borrow from the central bank the central bank is
always provides to loan with certain kind of mortgages or certain kind of collateral and
the collaterals are nothing, but the government securities.
And the government securities are discounted or rediscounted by the RBI or by the
central bank to provide the loan to the commercial bank. So, these kind of operations
these kind of transactions basically always dealt in the discount market. The discount
market is basically deals with this kind of transactions in the financial system.
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Then we will see that for this kind of thing we have a discount and finance house of
India. So, it was the sole depository of the surplus liquid funds of the banking system as
well as non banking financial institutions and it should basically use the surplus funds to
even out the imbalance in liquidity in the banking systems subject to RBI guidelines and
it should create the responsibility of this DFHI is this should create ready market for
commercial bills.
That is why we said that these are the things we will be discounted commercial bills, you
have a treasury bills and government guaranteed securities being ready to purchase from
and sell to the banking system or rediscounting this particular securities to provide the
loan to the bank system either in terms of buying or in terms of selling. So, this is the
major job of DFHI in India which was playing a very significant role for discounting this
different type of instrument, which are insured by the different financial organizations.
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So, if you see in the today’s scenario the DFHI basically was set up by RBI with the
objective of the activating the money market. It starts operating since 1988 as a bank as a
company, it is a joint stock company jointly owned by RBI and the public sector banks
and all India financial institutions. And all have contributed the pair of capital of 200
crore in the proportion of 5:3:2. So, mostly the major share is basically the reserve bank
of India, then we have the other parties which are public sector banks and all India
financial institutions.
Further in the 2004 the DFHI has been merged with SBI gilt limited a subsidiary of state
bank of India and now it is working as a new company which is known as SBI DFHI
limited. So, the name of the DFHI has been changed because it has been merged into the
SBI guilt limited, which is a subsidiary of the state bank of India now it is called as the
SBI DFHI limited. Now it is also considered as a primary dealer DFI is considered as a
primary dealer and it has been created by RBI to support the book building process of the
primary auctions of the government securities and provide necessary depth and liquidity
to the secondary market in the government securities.
I will discuss more on the book building process already we know that basically always
the auction process what we discussed in the treasury bills market that is basically done
through a process called the book building process. So, this is more relevant this is more
used in the equity market or the stock market whenever we go for the pricing of the
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equity in the IPO market or the new issue markets. We will discuss more on that, but
now these are the status of DFHI which is known as SBI DFHI limited and this is also
considered as a primary dealer they got the license of the primary dealer by the Reserve
Bank of India. This is what basically your DFHI or the recent developments which has
happened to the DFHI in the Indian market.
Then who are those there is another kind of organization which is basically provide the
guarantee to the system, that is a market for the guarantee which also works in the Indian
financial system and this guarantees are basically given by the different kind of entities
for the different kind of transactions.
The guarantees can be given by commercial banks for some reasons, the guarantees also
given by the insurance companies if there is a department and there is some specific
organizations which are also responsible to provide the guarantee for any kind of
financial transaction that is a market for the guarantees. So, these are the different
organizations who are basically provided the guarantee as a third party whenever any
kind of financial transactions take place.
So, there is another one is Deposit Insurance and Credit Guarantee Corporation, that is
your DICGC. Here they provide the deposit insurance with the bank deposits then also
the credit guarantee corporation whenever any kind of transactions takes place between
the banks and then one of the third parties. Then we have the export credit and guaranty
637
corporation who are basically provides the guarantee the transactions related to the
export and import for the trading purpose.
This is for the international trade, this particular organization plays a significant role in
terms of providing the guarantee. So, these are the different kind of further entities which
work in the financial system which was making this market for guarantees relevant in the
Indian financial system and they also play a very significant role for the holistic
development of the financial system in India. This is about the money markets or
different type of money market which work in the Indians of Indian financial system as a
whole.
Thank you.
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Department of Humanities and Social Science
Lecture - 41
Bond Analysis – I
So, after the discussion on the money markets or the different instruments which are traded in
the money market, we are going to discuss today about the bond market. So, already if you
remember in the beginning, I was discussing about the different type of instruments and the
market classification on the different type of instruments on the basis of their term to
maturity. Then, whenever we are discussing the money market what we have seen that, those
instruments which are traded in the money market for those the maximum time to maturity is
1 year. But within that particular fixed incomes, fixed income means the particular securities
which gives a regular periodical cash flow for that particular investment.
So, in that particular type of markets or fixed income securities market, we have two different
segments. One segment, deals with the short-term securities what we have discussed in the
money market part. Today, we will be discussing something related to the other type of fixed
income securities which are relatively long term in nature. And here in this context whenever
you talk about the long-term securities in India, if you particularly if you talk about. We have
3 types of markets; we have a government securities market or what we call it the dated
securities market. Mostly the maximum term to maturity of that market is up to 30 years. And
we have another market called the corporate bond market, then we have a public sector
undertaking bonds PSU bonds.
So, these are the major type of instruments or major type of market which exist in India. So,
before we will discuss about the different market structure or the characteristics of the bond
market in particular, let us discuss certain features or the technical aspects related to bond.
And the technical aspects related to the bond features is general characteristics of the bond
and as well as the valuation of the bond. So, then in the forth coming classes we will be
discussing the different aspects of the valuation as well as the different type of concepts
which are related to the bond.
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So, let us start the discussion; that whenever you talk about the bond market already told you,
the bond market if you talk or the basic instrument like bond if you discuss, the typical
characteristics is it gives a fixed amount of interest, periodically.
So, if you remember we were discussing about the typical bond whenever you talk little bit
about the valuation part. There we have every bond has a coupon. The dated securities has a
coupon and the coupon is fixed. And this is the coupon or the coupon rate is fixed, and in
every periodical basis. The period may be the frequency maybe once in a year, twice in a
year, thrice in a year or four times in a year that is a different issue.
So, every periodical basis you will be getting certain amount of coupon from this, coupon
payments. In that sense, we call it the fixed amount of interest. And second is, there is
another component in the bond that is basically in our language we call it the par value. So,
what this par value means? The par value means at the time of maturity, once the bond will
be matured then a fixed amount the investor gets or the bond holder gets that is basically
defined as the principal.
So, whenever we talk about a bond instrument like bond these are the two major cash flows
which are available. One is your coupon, which is fixed over a periodical over the period of
time or every period you will get the fixed amount. Then we have a principal amount or the
par amount which is basically will be given to the bond investor at the time of maturity. So,
this is the basic feature of a bond in general or the long term bond in general.
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So, let us see that, what are those characteristics that is anybody goes in bond market for
investment, what are those different characteristics the bond investor always face whenever
they discuss about the bonds. What are those characteristics? The bond has some kind of
intrinsic characteristics; number 1. And number 2, is basically what? The different type of
bonds on the basis of the category or what are the different types of bonds which are traded in
the market. Then we have the indenture provisions of the legal provisions which are involved
in the bond market investment. So, these are the different characteristics always we look
forward whenever we talked about the investment in the bond. Remember we are talking
about a bond which is a regular plain vanilla bond; here we are not talking about bond with
certain kind of options.
Either it is a call option or put option, this kind of things we have not considered in this
analysis. That we will see later that how this particular options or features is going to affect
the value of the bond.
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So, let us see what do you mean by this intrinsic feature? Already I told you, whenever you
are defining a bond there are certain intrinsic features are always available in the bond. One is
your coupon, which basically your income which is bond investor receive over the life of the
issue.
Then we have the term to maturity. Whenever you talk about term to maturity it is basically
the date or the number of years before a bond matures. Then, there are 2 types of bonds in
terms of maturity we can observe in the market. One is, single maturity date, one is series of
the maturity date. That is called the serial obligation bond where the bond certain amount of
money will be getting it after certain period of time.
So, if there is a 10 years bond, after 3 years, one particular part will be matured, then another
3 years another part will be matured like that. You will have the series of the maturity dates,
if the particular bond is a serial obligation bond.
So, we have 3 things already I told you. We have a coupon, we have a term to maturity, then
we have the principle or the par value which you will be receiving after the bond mature.
After the maturity period, the par value or the principle can be received by the investor. Then,
on the basis of ownership also the bond can be categorized into 2. What are those? One is
called the bearer bond another one is the registered bond. The registered bonds are basically
traded in the market.
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The whenever the bearer bond we are talking about, there is no particular owner of this
particular bond. Who is bearing the bond? Who is carrying the bond? Those particular
investor can redeem that particular bond with the issuer. But whenever it is registered, then
the bond will be issued in the name of that particular owner and the all the payments and all
these things will be made by the issuer to that particular registered owner of that particular
bond. And those kind of bonds are mostly traded in the bond market.
So, in terms of ownership we have 2 types, we have 2 categories. One is bearer bond another
one is the registered bond. This is the way we can define, or we can explain the intrinsic
features of a typical bond. Already I told you, the typical bond means, I refer to the bond
which is a plain bond without any kind of options.
Then if you see the issues mostly broadly there are 2 types of bonds we can get. One type of
bond is called the secured bond and another one basically called the unsecured bond. What do
you mean by the secured bond? The secured bonds are basically what? The secured bonds are
issued against any kind mortgage or the collaterals. So, either the bonds are issued against
any kind of legal claim or specified property of the issuer in the case of default.
For example, you have for the particular issuer has issued the bond and you have invested
certain money. So, there is a possibility that the bond issuer may not be able to pay the
coupon or may not be fail to pay this matured amount at the time of maturity. So, if that
particular bond issuer is not able to pay the matured amount at the end of the maturity or the
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any kind of coupon, then there is a probability of default which our language we call it the
credit risk.
So, there is some kind of credit risk involved whenever we go for the bond market
investments. So, whenever the bond market investment we are facing this to avoid or to
minimize this credit risk, most of the cases the bonds are basically backed by certain kind of
collateral or the mortgages. And mortgages are used if there is any kind of default, then those
mortgages can be liquidated and the money can be paid to the investor. That is why those
kind of bonds are basically called the secured bond or the senior bond.
And whenever you talk about the unsecured bond, the unsecured bonds are nothing but the
debentures. Other name of that thing is debentures, but some of the debentures are also
secured, but commonly it is known as debentures which is used by the long term securities
which are issued by the corporates. So, whenever we talk about the, unsecured bond the
unsecured bonds here, that is basically the question. Here there is no such kind of mortgage
or such kind of collaterals which are backed by this particular security.
So, here it is the only promise, the bond issuer has promised that he will pay the interest and
the principle on the timely basis. The interest and principal both paid on the timely basis.
There is no such kind of tangible collateral, which is involved in this particular process or
whenever the issuance of this unsecured bonds are there in the market.
So, this is the way the types of issues can be defined in the context of the bond market
investments.
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Then we will see that, what those indenture provisions are. The indenture provisions is
nothing but it is a contract. And there are certain provisions will be written in the contract
between the investor and the issuer of the bond or the bond holder and the bond issuer. So,
indenture provision is nothing but it is the contract between the issuer and the bond holders
specifying the issuers legal requirements.
So, here what is happening? Whenever we are going to buy the bond from some issuer. Then
there is always a legal conditions. There are always a legal issues, legal aspects are involved
in that. When the bond will be matured, if there is a default then what is going to happen? At
what period of time the coupon will be paid? So, all kind of details will be mentioned. So, all
these information what basically we are talking about, if all those information that you add
up, these are basically always reported in a particular contract document or a policy
document. So, that is basically called as indenture provisions.
So, whenever we write the indenture provisions, it is nothing but a contract between these
two, always it is not necessary that indenture provision is directly made by the investor or
made by the issuer. So, on behalf of the bondholders, there is a trustee or there is agent who
works, who is responsible to basically go for drafting this indenture provisions for the bond
investment. And that trustee always ensures that all the legal documents are made including
the timely payment of coupon and the principal.
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So, there are different clause, different kind of regulations, different kind of a if’s not’s but is
and everything will be mentioned in that provision. So, in that provision is always or that
agreement is always made by the bond issuer and the bond holder. But on behalf of the bond
holder, any trustee can act or they always make this provision so indenture provisions with
the bond issuer. So, this is basically about the indenture provisions in the context of the bond
market investments.
And let us see you might have seen that the bond prices are quoted in the market in the
various ways, but exactly how to read this quotes? Whatever way the bond price are quoted,
then how the quotations can be read? You remember the bond price is always quoted as a
percentage of their par value. The percentage of the par value; for example, if the bond is
selling at par; it would be quoted as hundred; that means, 100 percent of the par value.
If a bonds par value or the face value is let 10000 and it is quoted 81 by 8 then, obviously it
will be selling at 10000 multiplied by it is 80 percent 1 by 8 basically 1.125, then it is 80.125
this is nothing, but 0.80125. Then the bond will be selling at this 8012. This is 81 by 8. So,
that means, 80.125, so 0.80125 then 10000 multiplied by 0.80125 you got it 8012.5, which is
basically the selling price or the actual price in the market at that particular point of time.
So, this is the way in general the bond prices are reported in the statement or in the
quotations.
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So, when a bond price is quoted as percentage of its par, the quote is usually expressed in
points and the fraction of a point and each point is equal to rupees 1 or dollar 1 whatever it
may be. That means, if 97 point means that bond is selling at rupees 97 for each hundred
rupees of the par. That is the way basically it is represent 1 unit basically nothing, but the 1
rupee or the 1 dollar. Depending upon the currency, this thing can be quoted or can be
interpreted.
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Then we have the different fractions, it can be reported as 1/2, it can be reported as 1 by
32.for example, price quote of 97.4 by 32 is nothing, but 97.125 with a face value of 100
rupees. So, bonds also expressed in 64 or sometimes denoted in the financial database or
pages with a plus sign. For example, if it is written 100.2 plus, this would indicate a price of
102/64. That is the way basically, we interpret whenever the bonds prices are quoted in terms
of the fractions. It can go up to 64, 1/64 ok.
So this is about the use of the different fractions about the bond price quotations.
So, then we have a basis point, already you might have idea about what is the difference
between the reporting in terms of the basis point and in terms of the what we can say that
percentage. So, in a general sense, basically already all of you might have the idea that 100
basis point is equal to 1 percent; 100 basis point is equal to 1 percent. So, if any time even if
in the policy rate also you are observing in the therefore, it has increased by 50 basis point;
that means, it is nothing but the 0.5 percent.
So, 100 basis point is 1 percent. Accordingly you can interpret, 6.5 percent may be quoted as
6 percent plus 50 basis point or 650 basis point. So, increase in yield from 6.5 to 6.55 it is
nothing, but at in case of the 5 basis point like that. So, if you remember 100 basis point is
equal to 1 percent. You can interpret that particular quotations in that way. Basically that is
the interpretation of the basis point in terms of the percentage.
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Then, we will see that how the bond prices are reported in terms of the yields.
So, whenever the bond prices are reported in terms of the yields or the return. So, there are
two-way quotations the bond investors make. One is your bid price, another one in the ask
price. Bid price means, whatever the buyer is willing to pay. And the asked price is whatever
the dealer or the seller is willing to sell. At that particular price, the seller is willing to sell,
which is nothing but the ask price and whatever price the bond holder is willing to buy that is
basically the bid price.
So, whenever we talk about this bid and ask, these are quite important whenever you go for
the two-way quotations in the market. So, the bid yield is the return, expressed as a
percentage of the par value that the dealer once wants if this buys the bill and this yield is
often annualized. Yield means, we are referring the bond. And the ask is nothing, but the rate
at which the dealer is offering to sell the bids; that means, the bonds.
So, if you remember, whenever we are talking about the treasury bills we were also trying to
calculate the yield of the treasury bill. So, yield of the treasury bill that formula if you
remember this is basically the treasury bill yield the f is equal to the face value of the bond,
and p 0 is a purchase price, and this is basically your day count factor, if it is actual here you
will consider then it is 365, but if you are assuming roughly that every month is 30 days, then
you considered 360 days in a year. Because, this particular reporting is always then always
basically we do or always done on the basis of the annualized return or annualized yield.
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So, if you want to calculate annualized yield, then this is the way basically this thing can be
calculated whenever you talk about the annual discount yield for a particular bond. So, this is
about the bond price quotations.
So, let us discuss that how the bond prices or the bond value is calculated? Whenever you
talk about the bond value calculation already I told you, that the valuation of a particular asset
is nothing but the present value of the future cash flows. So, already you know that what is
the cash flow what we are going to get from the bond. The cash flow is basically the coupon
and end of the period we are getting a cash flow that is basically your matured amount or the
face value of the bond which is nothing but the par value of the bond.
So, we have two types of cash flow, one is your coupon and end of the period we are getting
a cash flow which includes coupon and as well as the maturity value. And R is the discount
rate. R is the discount rate and already you know that the discount rate can be determined by
many factors. This can be determined by interest rate in the market, this can be determined by
inflation, this can be interpreted by macroeconomic condition, and this is also can be
determined by the credit rating of the bond issuer.
So, these are many factors which can determine this discount rate of that particular bond. The
R is nothing but the required rate of return which is the discount rate for the valuation of that
bond. And once the discount rate can be calculated and coupon is known to us and as well as
the maturity value is known to us, then the valuation of the bond will be possible.
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So, these are the 3 things what we need that is your cash flow, that is your discount rate, that
is your par value, then another one also we have to know, that is term to maturity. So, M is
the term to maturity. So, if this data is available or these inputs are available, then the value
of the bond can be easily calculated. So, this is nothing, but the present value of the future
cash flow.
So, let us now divide these two components. One is your
∑ (1+CR)t
t =1
which is nothing, but the summation t is equal to 1 to M, because M is nothing but the term to
maturity. How many cash flows you are getting about the period of time? How many times
you are getting that? And how much? That is basically your C annual coupon payments. F is
nothing, but the face value. F is nothing but the face value and M is basically nothing, but the
term to maturity.
So, if you are discounting that cash flow and there with respect to that discount rate which is
nothing, but the required rate of return from the bond, then the value of the bond can be easily
calculated. So, this is the 2 components of the valuation of the bond.
So, let us see that how that particular notations or this formula is going to be changed.
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So, here whenever we talk about this particular thing can now be expanded. We can expand
this like this. This is the original formula.
C F
+
(1+ R) (1+ R)M
t
T is equal to time period at that particular point of time and M is equal to basically the
maturity period.
Then if you see now C we are taking in this side, then we have 1 by 1 plus R to the power T
plus F by 1 plus R to the power M. Then particularly this part is nothing but, the present
value of interest factor. If you go back C your present value interest factor table, then you can
find out at a particular R and particular maturity period, What is that PVIF ?
So, if you know the PVI value, then 1 by 1 plus R to the power T will automatically because
this is calculated from the expansionary formula, geometric progression formula, that we will
find out that present value of this particular cash flow multiplied by this C plus the F is
basically, the maturity value or the face value divided by 1 plus R to the power T.
So, then if you see now this is nothing, but the
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M
∑ (1+1R)t
t =1
which is nothing but the present value of the interest factor at a particular maturity period
with this discount rate. We can now, if this particular thing if you expand it, you are getting
that is 1 by 1 plus R to the power M 1 minus divided by R ok, so into C plus F by 1 plus R to
the power M.
So, then what we can do? We can find out the value of that particular bond.
So, now let us see that, if you take the example, then how it is calculated? Let there is a bond
which maturity period is 10 years, coupon payment is 9 percent which is annual. Your face
value of the bond or the par value of the bond is 100 dollar and your R, R is equal to 10
percent.
So, if the 9 percent is the coupon rate what you are getting against this 1000 par value, then
your coupon amount per year will be 90 / R is equal to 10 percent 1.1 to the power T plus
1000 which is the par value of the bond divided by 1.1 to the power 10. 10 is the maturity
period, then we can find out. You can use that formula
M
1−1/(1+ R)
[ R ] ×C +
F
(1+R)
M
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Then C is equal to 90 dollar what you are getting on the basis of the 9 percent coupon. Then 1
minus 1 by 1.1, 1.1 means R is equal to 10 percent means 0.1 to the power 10 divided by 0.1
which R plus 1000 divided by 1.1 to the power 10, then the value of the bond or that
particular point of time will be 938.55.
So, if for example, the coupon is not paid annually, the coupon is paid semi-annually.
Then how it is going to happen? How it is going to operate the value of the bond? Then, what
you can do? The convention is use the one-half of the simple annual interest rate as a periodic
interest rate to discount the cash flow. So, then if you see this example then it will be more
clear for you that for the semi-annual coupon payment, how it can be calculated?
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If you see now, every 6 months you are getting this coupon. So, per annual coupon was 90,
annual coupon was 90. Now your coupon is 90, then semiannual coupon will be 90/2=45.
Then we have taken 45 dollar divided by then your annual interest rate or required rate was
10 percent. Now, it has become divided by 2, that has become 5 percent.
So, then we have 45 /1.5T, 1000 / 1.5, 1.05 20. You see that 5 percent means, it is 0.05. So,
45 / 0.05 T + 1000 / 1.05 20. Previously it was 10.
Now, the period has increased 10 × 2 that is 20, then if you put that formula [1 – (1 + R/2)
M
]/R. Then now, it is divided by 2 everywhere and it become 2 M here, then you can find out
the value has become 937.69, which implies that little bit there is a deviation, if the coupons
are paid semi-annually.
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So, now if you now expand it little bit let periods are more, then whatever period you are
taking you can multiply the N with the term to maturity. Then you divide your coupon with
respect to that particular frequency at what frequency the coupons are paid. Then as well as
the R also will be divided into that much number to get this required rate of return in that
particular point of time or period of time.
So, now the formula will become
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A
C /n F
A T + A nM
R R
(1+( )) (1+( ))
n n
n M means, n represents how many times the coupon is paid in a particular year. Then finally,
you can use the same formula to find out the value of the bond where M is equal to maturity,
n is equal to the number of payments coupon payments per year.
So, this is the way the normal valuation of the bond is taken place. It is different from the
equity in the sense. The equity there is no maturity value, but in the bond case we have a
maturity value that is nothing but the par value. Then the periodic cash flow basically is the
coupon. So, this is the way fundamentally the valuation of the bond is done. And there are
some other issues related to the valuation that will be discussing in the next class.
Please go through this particular references for this particular session
Thank you.
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Lecture - 42
Bond Analysis – II
So, in the previous class we discussed certain features of the bond, like your coupon, you
have the term to maturity, you have the your per value extra, then we started the
discussion on the valuation. There what we have discussed that the coupon has to be
discounted with respect to a particular record rate of return which is nothing but the
discount rate.
Then finally, your par value or the maturity value will be discounted then we can find out
the value of the bond and that particular point of time. That means, in general the value
of the bond is nothing but the present value of the discounted cash flows.
So, today if you see there are certain things which are related to this valuation. What are
those? One by one if you see, first of all let us see how the concept of compounding
frequency works in that particular case.
If you minutely observe let on the previous example also we are taking the annual
interest rate was 10 percent. Then, if it is annually compounding then after 1 year the 100
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rupees or 100 dollar will become 110, but late this particular coupon you are paid semi
annually and this is compounded semi annual basis. Then there is a 5 percent we would
earn 5 percent every 6 months, and that money can be reinvested in the market for
another 6 months. You get back your 45 rupees, that 45 rupees can be reinvested in the
market again for another 6 months because that 45 rupees you may not be keeping idle.
So, in that case what will happen? First year after end of the first year you are getting
110 rupees, second year your particular value will increase accordingly whenever your
money is reinvested in the market. So, if the coupon is paid semi annually then the
money whatever you got that can be reinvested in the market for the second half, what
you have got in the first half; so in that contest how the value can be calculated? This is
nothing but 100 × 1.05 2, 1 + R 2 that is called 110.25 rupees.
So, the compound you see if it is 10 percent it is annualized compounding then you are
getting 110, but if it is semi annually compounded then you are getting 110.25. That
means, the money whatever you have received after 6 months that money also again can
be or has been reinvested in the market because of that the value of this particular cash
flow has increased of the present value of the cash flow can increase. So, the
compounding frequency has a very strong role whenever we go for the valuation of any
type of bond in the market.
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So, let it is monthly compounded. Then let 10 percent of the annual then each month
how much you are getting 10 percent divided by 12 that is your 0.8333 percent. And
every month the interest being reinvested in the market, then how the value is going to
be? 100 dollar into 1.008333 percent means 1.008333 pars 3 3 3 to the power 12 because
12 months then you are getting 110.47.
So, like that if it is daily compounding then further the value is increasing because 0.10
divided by 365 to the power 365 you are getting 110.52. Whenever it is annually
compounded you are getting 10 percent, if it is half yearly compounded you are getting
10 percent by 2, 5 percent, but the value has become 110.25. Whenever it is monthly
compounded you are getting 110.47, and whenever it is daily compounded you are
getting 110.52. So that means, the compounding of that particular interest rate or
compounding concept is very much playing the role for the valuation of the bond, that is
what basically what we are trying to discuss here.
So, you have to keep in the mind that at what period whether it is compounded or it is
simple. So, if it is compounded then obviously, we have to consider that whether this
particular money or the cash flow what you are getting in the periodical basis that thing
is reinvested in the market or not. If it is reinvested then on the basis of the frequency
your value of that particular investment is going to be changed, that actually you have to
keep in the mind.
(Refer Slide Time: 05: 28)
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Then, in that basis what basically we can discuss one thing that is called effective rate.
So, what is effective rate? The effective rate basically includes the reinvestment of
interest or the compounding concept and it is calculated at basically your 1 plus your
annual rate of interest divided by n to the power n minus 1. This R is basically those
simple annual rate of interest. So, if n is equal to 2 then R is equal to 10, then it is 1 plus
0.1 divided by 2 to the power 2 minus 1. So, this is the way basically this what we can
say the effective rate can be calculated or the effective interest rate can be calculated.
In this case if you see, another concept is it may be continuously compounded. It may be
there is a possibility that particular coupon amount or the interest amount can be
continuously compounded. So, when the compounding becomes very large then we
approach towards the continuous compounding.
Generally, whenever it is daily compounded, we can think of the use of the continuous
compounding. That mean the frequency is very small, the payment the coupon frequency
is very small, in that particular context the continuous compounding can be used. So,
how this continuous compounding basically works here? If you see the continuous
compounding if you are going to use that F basically what, the future value of that
particular asset the FV future value of that particular bond is let you have started
investing dollar A for the M years and R is equal to your rate of interest, then your future
value will be FV × Ae RM.
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And already you know what do you mean by the e? e is basically a natural exponent
which is basically a rational number with values 2.71828, the value of e is equal to
2.71828. So, that concept is used that means, anything whenever it is continuously
compounded we always go for e to the power R M. That e to the power R M means this
R is basically your rate of interest or the required rate of return and M is equal to
basically your maturity period.
So, if you go by this example let it is continuously compounded, if the 10 percent simple
interest rate were expressed with continuous compounding then after 1 year the 100
0.1 ×1
dollar will go to 110.52. So, here how it is calculated? This 100e , 1 year maturity
that is why it is 110.52. That means, in the continuous compounding process the value is
always more than whenever we are compounding it in the simple basis.
So, continuous compounding a straight basis, basically whenever we are calculating the
value that value will be different than whenever the cash flows are compounded with
respect to that interest rate in a continuous basis. So, that is what basically we want to
explain here that is continuous compounding is very much important whenever you go
for the valuation or we calculate the present value of any asset including the point.
Then now so how you can calculate the present value of that particular asset? Which is
nothing A you have to calculate, you know the future value then how you can present
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RM
value? Simply you can go by this F, your FV was Ae . So, now, here A is equal to
what A is equal to F /e RM, then it is nothing but your FV e -RM
So, now if you take this example if R is equal to 10 percent a bond paying 100 dollar in 2
years from now, the value of the bond after 2 years will be 100 dollar, then it would
currently how much is the value of that particular bond today, if you are giving a
continuous compounding. Then what is the thing? You got this future value that is 100
-0.1
dollar which is nothing but the power e × 2 divided it is basically you got it 81.87.
That means, if you want to get 100 dollar after two years and there is a continuous
compounding process involved in that then you can buy the bond at the price of 81.87
dollar.
That means, similarly if a bond paying 100 $ each year for 2 years then the value will be
little bit different, then here you have to take t is the summation t is equal to 1 to 2, 100 $
-10 -0.1 × 1 -0.1 × 2
e × t that is nothing but 100 $ e + 100 $ e then the value will be 172. So,
you have invested 172 rupees today or each year yours basically for 2 years then you are
worth of that particular investment will be 172 that means, to get 200 rupees you have to
invest 172.36 rupees. So, that is the way basically the concept of continuous
compounding always works.
So, now if you assume that there is a continuous compounding and discount rate 10
percent then value of a 10 years bond, coupon of 9 percent what example we have taken
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from the beginning. So, if you go by calculating that thing in the continuous compound
way then the value of the bond will be 908. If you remember this was something around
938 rupee point something in the case of 1 year coupon and 937 point something in
terms of the 6 months coupon or 2 times coupon. But even if here what we are getting if
it is continuously compounded then the value of the bond will be 908.82.
So, this is what that is why whether it is continuously compounded or not that we have to
examine before if it is continuously compounded then the value of the bond calculation
is different from than the straight forward discounting concept what you are using
whenever you calculate the plain vanilla bonds. So, continuous compounding has a
significant role for the valuation of the bond.
Then there is another type of bond we call it the zero-coupon bond. Then what is that
zero-coupon bond? The zero-coupon bond means it does not pay any coupon in between.
It has a purchase price and it has a maturity price. They do not make any periodic
coupon, the investor basically what they get they get the interest as the difference
between the maturity value and the purchase price on that basis the interest rate can be
calculated from these or yield of that particular bond also can be calculated from this.
The bonds also can be called the zero-discount bond, zero-coupon bond or also pure
discount bond. There are different ways there are different names of the zero-coupon
bond we can observe or we can say in the market.
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So, then how the valuation of this particular bond or the value of that particular bond in
the current market price of the bond can be calculated? So, this is basically calculated in
this way the value is equal to your F means that is basically your maturity value divided
by 1 +R M, R is equal to the discount rate or the rate of interest involved in that and M is
equal to your maturity period. So, there is no cash flow involved in that. So, because
there is no cash flow involve in that this particular value of the bond can be calculated by
F /1 +R M that actually you keep in mind.
So, then let us see that how basically it works in practical sense.
So, if you take this example a zero-coupon bond maturing in 10 years and paying a
maturing value or maturity value of 1000 dollar and the required rate of return is 10
10
percent in the same example, then you can get 1000 / 1.8, 1.1 because the required rate
of return is 10 percent. So, now 10 year is the maturity period then the value of the bond
is 385.54.
So, if the convention is to double the number of years and half the annual discount rate
that means, the semi annual rate of 5 percent and already you know what is effective
annual rate, the effective annual rate will be 1 + R /2 n - 1 that means, it is your in this
case 10 % / 2 % that is being 0.5 percent then 1.5 %, 1.05 2 -1 in the case of it is 2 times
minus 1 then that will give you the value of the bond will be 376.
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So, here also what we have seen that conventionally if you go by doubling the number
and half the annual discount rate and a semi annual rate of 5 percent. We can say that the
effective rate is 10 point 2, 5 percent then the value of the bond will be 376.89, and in
case of annual payment or in case of annual discounting we get it 385.54; so this why the
valuation of zero-coupon bonds takes place in the market.
But here another thing if let the maturity period is less than one year of the zero-coupon
bond, right. Let on March first zero-coupon bond promising to pay 1000 $ on September
1, that means, your March 1 to September 1, 184 days and trading at an annual rate of 8
184 / 365
percent. Then what is the value? That means, your 1000 / 1.08 , you remember we
are here assuming 1 year is equal to 365 days, but somebody can also use 360 days, then
your value becomes 96.19.
So, the choice of time measurement used in value of the bonds in known as the day count
convention. What do you mean by the day count convention? The day count convention
means either you can take 360 days or you can take 365 days. If you are assuming every
month as 30 days, then conventionally you can talk about 360 days, 360 days. If you are
assuming that actual the particular year is 365 days, we can go for the 365 days. So,
concept is called the day count convention.
So, the day count convention is defined as the way in which the ratio of number of days
to maturity to the number of days in the reference period is calculated. Here in this case
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majority period 184 days and we have taken 365 days in the whole year, then it is 184 by
365. So, that is why if it is actual days too much actual days to maturity to actual days in
the year it is actual by actual. If it is 30 days months to maturity to a 360 days in the
calendar it is the 30 / 60 it is 180 it can be 180 /360, it also can be 180 / 360, 6 months or
it can be 184 /365.
So, depending upon the convention what you are considering your calculation would be
different or will be varying. So, that is basically the way through which we can calculate
the value of a bond which maturity period is less than 1 year. That actually you keep in
mind the same way where we are calculating the value of the bond for the maturity more
than 1 year the same way basically, we cannot calculate we have to consider the day
count convention for this.
Then, we have let us see that what the relationship between coupon, your discount rate
and the bond value, and also the face value is. Already we know that what do you mean
by the coupon, coupon is nothing but the coupon divided by the face value. If you see
this example what we have seen 9 percent. How it you got? 90 rupees is the coupon
divided by your 1000, ok, that is basically you got it the coupon rate.
So, coupon rate is C / F. F means it is the face value or the par value. But one thing if
your coupon rate is less than R, then the value of the bond will be less than the face
value. In the previous example what we have seen? Your coupon was 9 percent C and R
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was 10 percent. So, because of that with 1 year coupon payment the value was 938, that
means, it is less than 1000 rupees. So, that is called the discount bond. But if the coupon
is equal to the R discount rate then the bond is at par it is called the par bond, the bond is
valued at par that means, the value of the bond is equal to the par value of the bond or the
phase value bond; in that contest we call it the par bond. But if your coupon is greater
than R then the value of the bond will be more than the face value, then that time we call
it is a premium bond, the bond is basically valued at premium.
So, depending upon the relationship between the coupon and the face value of the bond,
we can say that whether the bond is a discount, bond value the discount, bond is
redeemed at par or the bond will be redeemed with premium that actually bond the value
at premium par or the discount. That thing we can judge on the basis of the relationship
between the coupon and the discount rate that actually my intention, that is called the
bond price relation 1.
So, there are some other relations involved in this that let us see that how those things
work. So, here what basically we got it? When the yield in the market price rise above
the coupon rate the price of the bond adjust, so that the investors who purchase can
realize some additional return, when the yield in the market below the coupon the bond
must sell above its par value. That actually the implications what we got from the
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relationship between the coupon and the value of the bond with respect to the par value
of the bond, that is the way basically it is interpreted or this is basically analyzed.
Then, let us see that how if the required rate of return does not change then what will
happen to the value of the bond from the time the bond is purchased to maturity. Let the
discount rate does not change. If the discount rate does not change then for a bond selling
at par as the bond physically closer to the maturity the bond will continue to sell at par
that means, the price of the bond will remain constant as the bond moves towards
maturity.
But if the bond price is selling at a premium or the discount at that particular point of
time then the bond price will not remain constant. A discount bond increases its price as
it moves towards the maturity assuming the required rate does not, and a premium bond
decreases its price as it moves towards maturity assuming the required rate does not
change. So, in the beginning whether it is a discount bond or premium bond that will
decide that whether the price is going to increase or going to decrease of that particular
bond. So, a discount bond increases its price as it moves towards the maturity and a
premium bond decreases its price as it moves towards the maturity. If you see you can
observe this thing.
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So, let the yield or the required rate of return from the bond here it is a 11 percent, here it
is 9 percent, here it is 7 percent, par value is 1000, coupon is 9 percent, maturity is 10
years. So, whenever now the coupon is 9 percent at require rate of return is 9 percent, so
the bond is at par, then everywhere the price 1000 over the period the price is 1000. But
whenever you have seen that the yield rate has gone out from or the discount rate has
gone out from 10 percent to 11 percent what basically we have observed, the value have
changed then, but at the end the value basically has merged with the particular initial
value that is 1000 rupees. There is a convergence which can happen in this case.
The premium bond also the same thing whenever the coupon is basically 9 percent now
the l is 7 percent you get the value was increased and then for the decline, decline then
finally, there is a conversion that is 1000 rupees, 1000 dollar. So, years to maturity then
you will find there is a convergence basically happening here at the end. This is what
basically always how many times the cash flow you are getting and whenever the cash
flow end you will find that the price of the bond will be equal to the maturity value
whatever it is mentioned in the beginning. So, if the bond is issued a discount or bond is
issued at premium that does not make any sense if you are holding the bond up to the
maturity, that actually always happens in the market.
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Then we have bond price relation 2, what basically it means it is very clear if the rate of
interest or rate of return will increase the value will go down and rate of interest will
decline the value will go up. So, if you represent it in a change way then delta V by delta
R is always less than 0, delta V by delta R is less than 0.
You can see this thing that there is inverse relation between the value and the required
rate of return with a bond of 10 years maturity, 9 percent coupon par value is 1000, then
at 7 percent bond value is this at 9.5, at 9 percent is exactly 1000 because coupon is
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equal to discount rate, then once the rate has increased the value of the bond has gone
down that is basically we call it the price yield curve. So, that is always represented in
this way. So, this is the relationship basically what you can show. So, if your term to
maturity are the rate of interest increases then the value of the bond goes down, that is
called the price yield curve.
Then we can see there is another relation we can establish. Greater the bonds maturity
the greater its price sensitivity to interest rate changes. That means, percentage of change
in the value with respect to the percentage change in interest rate is always higher if the
maturity of the bond is very long term in comparison to a certain bond. Greater the term
to maturity greater the variations, greater the price sensitivity.
If you see this exam you can find out that for example, if you are going for a bond which
maturity period is 10 years and another bond which maturity period is 4 years, then what
you can find let coupon is 9 percent. So, here also the coupon in a coupon remain same.
Then what is happening let that time you are required rate of return R was 10 percent
then the R has let come down to 9 percent does for example, 8 percent or R has become
11 percent whatever it may be the R, R has become 11 percent. If R will become 11
percent then obviously, the value of the particular bond will go down and for 4 years
bond also it will go down other things remain same.
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But if you calculate whatever price change we have observed in case of 10 years
maturity bond and whatever price since you have observed for the 4 years maturity bond,
you will find for the 10 years maturity bond the percentage change in the price is
relatively more with respect to that 1 percent change of the interest rate than the
percentage price for the value of the bond for the 4 years maturity whenever the bond
interest rate or the required rate of return was 10 percent. So, from the base value the
fluctuations if you observe it is more fluctuating or we can observe more fluctuations in
terms of the long-term matured bonds than the short-term maturity bonds. That is
basically another observations or another relationship what we can observe.
Then another thing also with respect to that if you see smaller the bonds coupon rate
greater its price sensitivity, whenever there is a change in the interest rate. Previously
what you have seen, greater the maturity, longer the maturity the change in the price is
more, with respect to a shorter maturity bond. The same thing also can be applicable
other things remain same maturity period is same, everything is same. But if you see that
there is a change in interest rate, but there is a coupon a let were 1. 1 the coupon rate is
10 percent, another bond the coupon is coupon rate is 8 percent you will find which
bonds coupon rate is less. The price changes of that type of bond is always more.
Percentage change in the price of that bond with respect to change in interest rate of that
bond is always more than the particular bond whose coupon rate is relatively higher.
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So that means, whenever you are going for investing in the market keep in the mind the
bonds having low coupon and high or the long maturity are riskier bonds than the bonds
having high coupon and low maturity. So, the bonds having again I am repeating, the
bonds having low coupon and long maturity longer maturity are more risky than the high
coupon and short maturity bonds, it is less risky. So, from the investment perspective you
can say that always those kind of bonds are riskier than this kind of bonds. So, those
things always reflected from the bond price relations or the relationship between coupon,
maturity period, interest rate and the par value and as well as the value of the bond.
So, this is what basically about the other concepts which are related to the bonds. Then
the other classes will be discussing about the different type of yields, and returns, and as
well as the development in the bond market mostly with reference to India. Please go
through this particular references, for this particular session.
Thank you.
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Lecture - 43
Bond Analysis – III
So, in the previous class we discussed about the different concepts related to the bond and as
well as the issues related to bond valuation. And today, we will be discussing about another
important issue which is always we come across whenever we invest in the bond market that
is basically your bond yield.
So, whenever we invest in the bond market, basically the basic objective is to maximize the
yield from the market. So, whenever we talk about the yield there are the different types of
yield we come across. And today, we will be discussing about what are those different types
of yields and how these yields are basically calculated.
So, if you see that first of all, already all of you have heard about the concept of the coupon.
The coupon is also one type of yield which is basically called a nominal yield. So, the coupon
rate is basically called as the nominal yield. And the nominal yield, if you talk about the
nominal yield, nominal yield is nothing but what is the annual coupon payment? The annual
coupon payment divided by the face value of the bond or the par value of the bond.
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It may be 1000, it maybe 100; depending upon the value of the bond, we can calculate the
coupon rate and the coupon rate is nothing but the nominal yield. But whenever we talk about
the current yield, current yield is basically what? Again the same thing, it is annual coupon to
the price, the market price. If you remember, we are calculating this market price using the
discounted cash flow formula.
So, whatever market price we calculate, the current yield is nothing but the coupon divided
by the market price of that particular bond. So, the basic difference then between current
yield and nominal yield is, the nominal yield is coupon divided by the face value of the bond,
but whenever we talk about the current yield into the coupon divided by the market price of
the bond. So, that is the basic difference between the current yield and the nominal yield.
Then we have another concept that is called the yield to maturity, which is highly used
whenever we are using this concept of devaluation, the yield to maturity is quite important.
Then what is the yield to maturity? Yield to maturity is nothing, but the particular yield
which equates the price of the bond to the present value of the bonds cash flow. It is more or
less similar to the internal rate of return what we are using in the investment analysis or we
can say that project evaluation part. So, that is why, in general the yield of any investment is
nothing but the interest rate that will make the present value of the particular cash flow from
that investment equal to the price of the investment.
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So, if you go back to our previous example, if you remember our previous example, we have
calculated using an annual coupon payment where your coupon rate was 9 percent and the
maturity period was 10 years. And let, that time the yield was given that is the required rate
of return that was 10 percent, but now here let the price is given and we have calculated the
price that time 938.55.
And this 938.55 is basically if you go and discount this 90 rupees in each period and as well
as the par value of the bond is 1000, whatever if you solve this equation then whatever YTM
you will find or whatever required rate of return you will find, that is basically we call it the
required rate of return or the yield to maturity. That means the particular interest rate which
equates the price of the bond with the present value of the cash flows.
So, that is basically we call it the yield to maturity which is always we use it whenever we go
for the valuation of the bond.
Then we will see that how this particular thing works basically in the market. So, for
example, you are going the same example if you go back. The coupon payment was
semiannually again, the 9 percent coupon, but the frequency of the payment of the coupon is
semiannual. So, in that context what we find that, then semiannual coupon if you go back, our
value was 937, the market value and this 45 rupees coupon because the 90 rupees per annum.
Then every 6 months you are going to get 45, your period has been doubled, a total period of
coupon payment.
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Then finally what will find that, 5 percent which basically makes this value equal to present
value of this particular cash flow. Then your simple annual interest rate or yield if you are
going to calculate this is 2 ×0.05 that is 10 percent. And if you are going where effective
annual rate what we have discussed in the previous class that is nothing, but the 1.05; that
means, 1 + r / 2 2 - 1; that is 10.25 percent and that 10.25 percent we are getting because of
the discounting of that particular cash flow with respect to that particular period and that
payment is made basically semiannually.
So, this is what basically this yield to maturity and this is the way the yield to maturity is
calculated.
Now, we can observe that what those factors which are basically responsible for the
calculation of the yield to maturity. So, if you see those factors which are responsible for
calculation of yield to maturity, these are already we have observed. We what we need? We
want return from the coupons. We want the return from the coupon; then we have the capital
gains or losses, and the reinvestment of the coupons at the calculated YTM. So, these are
different components or we can say the different factors which are responsible for the
effective calculation of YTM in terms of the effective rate of return. This is what basically
always you can remember you can keep in the mind.
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Then let us see that, that is another concept called the bond equivalent yield. What do mean
by this bond equivalent yield? Bond equivalent yield is basically what? Most of the cases or
most of the time what we have seen the yield of the bonds are quoted as a simple annual rate.
And we do not consider the compounding part, the compounding frequency is not considered
there.
So, whenever the bond the coupons are paid semiannually, then how we can do it? The rates
can be found by solving for the YTM on a bond using 6 months cash flows and then
multiplying that rate by 2. And in that case, we call it, it is the bond equivalent yield. For
example, if you say this 10 years bond with 9 percent bond 9 percent coupon, semiannual
payment and it is trading at 937.69, then what we have, we find that we have a YTM for a 6
months period that is 5 percent and bond equivalent yield is 10 percent. But the effective rate
is 10.25 percent that we have seen in the previous example.
So, the bonds with different frequency or payment frequency often have their rates expressed
in terms of the bond equivalent yield. So, then the rates can be compared with each other on a
common basis; that means, you have to convert everything either in the simple annual rate or
you can calculate the effective rate. So, then what will happen? That this if you are
comparing a particular bond, which pays this coupon in semiannually and another bond
which is paid to the coupon annually, then for comparison purpose basically the bond
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equivalent yield concept is used. That is only a concept, but the thing is you have to only
convert everything to annual basis to find out that.
What do you see that, whenever we are calculating the yield to maturity, it is very difficult to
find out a particular YTM which can make this value of the bond equal to the present value of
the cash flows.
So in that case, we cannot find algebraic solution for that; a typical solution for that, it is not
possible. In that context what basically we do? We can basically follow an iterative process,
basically trial and error process to find out that YTM which makes that particular value equal
to the present value of the cash flows. But it is relatively difficult to go for an iterative
process every time to find out that value.
So, one of the ways to find out the YTM which may not be exactly giving you the actual
exact answer, but you can find out a closed answer with respect to that yield to maturity. That
is basically we call it the average rate to maturity. So, we are using a concept, the average
rate to maturity to find out the closed value of YTM which can make this present value equal
to the value of the bond. So, that is basically calculated in this formula.
So, here your C is the coupon, coupon payment F is the face value of the bond, this is the
market value of the bond, this M is basically the maturity period, then again this is the face
value of the bond, and this is the value of the market value of the bond divided by 2. So, if
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you take then you can find out an average rate to maturity which will be very close to yield to
maturity. It may not be exactly equal to the yield to maturity, but it will be very close to yield
to maturity. Then you can get this approximate answer from that; that which can be the yield
to maturity for that particular bond which can make this value equal to the present value.
So, in that context if you see this example what basically we have discussed.
The same thing what we have seen that in the previous example in the annual payment the
value of the bond was 938.55, that already you know. So, if you are going to calculate and
you know that, the particular rate which makes this particular value equal to the present value
that is 10 percent.
But if you see, if you are going by ARTM formula, then your coupon is 90, your par value is
1000, value of the bond is 938, then maturity period is 10 years. So, if you see then it is the
face value of the bond or par value and this is your market value. You will find a rate that is
9.92 percent. It is very close to the yield to majority, but not exactly the 10 percent what you
are getting. So, if you want to get a very exact rate, maybe once you can get a point where
you can have some kind of trial and error which relatively easier to find out an exact YTM.
So, the ARTM is a proxy which can be used for YTM, whenever it is difficult to find out the
exact YTM or yield to maturity which can make this particular value equal to the present
value of the cash flows. So, then exactly if you see now whenever it is a semiannual payment,
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you have seen that our market price was 937 or the present value of the bond was 937, then
we got it, it is 4.9633 percent; then finally, we got it 9.93. Little bit deviation, it was 9.92, it is
9.9325 which is also again very close to that.
Already I told you that, it is not exactly equal to the YTM what is you are supposed to get.
But you are getting something, which is very close to the YTM and after that if you want you
can use some iterative process to find out the exact YTM, that actually you have to keep in
the mind.
So, that is one of the ways through which the yield to maturity can be calculated.
So, then we have another bond already we have discussed about this in the previous class that
is basically the zero-coupon bond. So, zero-coupon bond means there is no such coupon
involved in that and the bond is basically always issued at a discount and a redeemed at a par
and also we call it the pure discount bond. So, for the pure discount bond, already you know
the formula. How basically we calculate it? This price of a pure discount bond is your face
value of the bond or the maturity value of the bond divided by 1 plus YTM to the power M.
You are only discounting that thing with respect to the YTM, with respect to that period.
That means, that is only one component of the cash flow and the other component of the cash
flow is not available in this case. Then if you solve it, then 1 + YTM M = F / P 0, then we have
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1/ M
F F
YTM=
√
M
P0
−1∨YTM =
P0[ ] −1
That means, your face value or the par value divided by the market value or the present value
of the cash flows to the power 1 by M minus 1 which is nothing, but the M is nothing, but the
maturity period. M is nothing, but the maturity period.
So, straight forward, we can calculate the yield to maturity of a zero-coupon bond. If you
know that purchase price and as well as the face value. If that thing is known, then the yield
to maturity of the zero-coupon bond can be easily calculated.
So, then we will see that some example of the zero-coupon bond, let the price of the zero-
coupon bond was 800 dollar, then the face value was 1000, then maturity period is 3 years
then your YTM is 7.72 percent. If the frequency is 2; that means, that is a semiannual it is, it
is compounded basically N is equal to the compound frequency; that means, if you want to
calculate it in that way, then your N is equal to 6, then your semiannual YTM is equal to this
and bond equivalent yield means 2 multiplied by this, that is 7.57 percent; but let, the
maturity period is only 182 days.
So, we are using if you remember, we are using a day count convention. Your day count
convention means, it is actual days divided by 365 or you can go by the 360, where the actual
is not considered; we consider that every month is equal to 30 days.
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So, in that context, if your maturity period is 182 days, the name is equal to 182 /365, then
YTM is equal to [100 / 96365 ]/ 182 - 1, that is 8.53 percent. So, it is a straightforward
calculation, whenever we calculate the yield of a zero-coupon bond. But, in the case of the
other bonds, you know there is a coupon involved in that. We have to always make this price
of that particular bond. We are equating the price of the bond with respect to the present
value of the cash flows.
So, if you go for a continuous compounding, then it can be used in this way. You know
already what do you mean by the continuous compounding? That means, your F is equal to in
that case P 0 e r t and; that means, your e r t is nothing but F / P 0 and; obviously, if you take log
in both the sides whatever we have taken ln e r t = ln F / P 0. Then ln e r t is nothing, but the R t
is equal to ln of F / P 0, then it is nothing but R = [ln F / P 0 ]/ t. So, that is basically the way
through which, if there is a continuous compounding, then the YTM of a zero-coupon bond
can be calculated in this way.
The example is let, price is 96, F is 100, maturity 182 days, day count convention we have
taken actual, that is actual by 365; that means, 182 / 365. Then you are, if you are assuming
there is a continuous compounding involved in this, then your YTM will be l n 100, F = 100,
your P 0 = [96 / 182]/ 365 that you are getting 8.18 percent.
So, the logarithmic return what we are considering here, this is basically the rate of return
expressed as a natural log of the ratio of the end of the period value to the current value. So,
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that actually you have to keep in the mind. So, this is the way the YTM on a zero-coupon
bond with continuous compounding can be calculated. That means, your R is equal to ln; the
F / P 0 divided by the time period which is basically the t.
Then we can move into the other type of bonds which are available in the market. You know
that there let there is a bond which has a call feature. What do you mean by the call feature?
The call feature of a bond means, if there is a call feature in the bond, it allows the issuer to
buy back that bond at a specific price known as the call price. For example, if one wants
maturity period is 10 years and the par value of the bond is 1000 rupees.
So, if the bond has a call feature, then what will happen? That, let this investor always in that
indenture provision it will be mentioned, that it has a call feature and after 3 years or 4 years,
the bond can be called back here by the issuer. And whenever the bond will be called back,
that particular point of time the issuer basically from the beginning has fixed a price. Let that
price can be 1100, it can be 1050 or it can be 1200.
So, the bond is or what they will do, they will pay that particular price to the investor or the
bond holder and can buy back that particular bond from the bond holder. And when the bond
is maybe called at what price it is already specified in the indenture provision from the
beginning whenever they bond has been issued. For some of the issues, the call price is the
same. Because, there are different call dates in a call feature there are different type of call
rates.
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So, the call dates either the called, on the basis of the call date the call price will vary or the
call dates on the basis of call date the call price may not be varying. The call price, may be
same for all type of call dates or maybe there are led after 3 years, it can be called on this
date. May be, if it is not called by that, then another call date will be there. Let there are series
of the call dates. For each call date, the particular price of the bond is fixed by the issuer. So,
either the price may be same for all the call dates or the price may be different for the
different type of call dates.
So, the call price basically depends upon when the bond is called. So, in this case if there are
different call dates of that particular bond and the prices are different in the different dates,
then there is a call schedule that specifies the call price for each call date. The bond can be
called on so and so date, the price will be this. If the bond will be called after 4 years, the
price will be this. If the bond will be called after 7 years, the price will be this. So, all kind of
schedule of that particular call price of the bond is mentioned from the beginning whenever
the particular bond was issued.
So, on that basis the indenture provision are basically the legal provisions already explained,
that what kind of call price schedule is available for that particular bond and the bond holder.
The investor is fully aware about that what kind of price they are going to get if the bond will
be bought back by the investor.
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Then given a bond with a call option the yield to call basically we have to calculate like your
yield to maturity and all these things. In case of call feature we calculate the yield to call.
Then what is yield to call? The yield to call is basically obtained by assuming the bond is
called on an identified call date.
So, yield to call can be calculated in the different call dates. So, we have to know that at
which date we are trying to calculate the yield to call. So, like the yield to maturity, the yield
to call basically can be found by solving the same thing which equates the present value of
the cash flows to the market price. But here, one thing you remember, whenever we are
talking about the yield to maturity, we are here, we are discounting the par value. This
particular discount this part is basically we are using the par value of the bond or we can say
that face value the bond.
The face value was considered in this case, but now it is the call price. It is the call price what
basically we are considering. And n is equal to the number of periods to the identified call
date. If you see this example, maybe it will be more clear for you that how the yield to call is
calculated.
For example, there is a bond whose maturity period is 10 years, coupon is 9 percent and first
callable in 5 years at a call price of 1100. And the interest rate spread semiannually and now
it is trading at 937.69; that means the market price of that particular bond at that particular
point of time is 937.69.
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Then what you have to do? Then we have to basically equate this market price with respect to
the present value of the cash flows. Then, what are those cash flows? The cash flows are
basically the coupon that is your 45 dollar, because 9 percent of the coupon rate every year;
that means for 1000 dividing 90 rupees and for every 6 months, we are getting 45 that already
you know.
But, instead of 1000, which is the face value of the bond? Here we are considering 1100.
Why we were considering 1100? Because that 1100 will be the cash flow whenever the bond
will be callable. Because it is a call feature, after 5 years the issuer will give you 1100 and
say that the bond can be bought back from the investor from the bond holder.
So, then what you have to do? We have to basically find out that YTC that YTC which can
equate this one with respect to the present value of this cash flows. So, in that context what
will happen that, we find that the YTC become 6.10575 then, you have to go for the
annualized YTC, then you multiply by 2; that is 12.21 percent.
So, here you see with the same example, we are getting a yield whenever you are discounting
with respect to the face value, we are getting around 10.25 percent whenever we are using or
10 percent, whenever we are going for the yield to maturity. But whenever it is yield to call,
the yield is 12.21 percent because that is the premium what the bond invest issuer wants to
give for to the bond holder because there is a risk involved.
Because there is a possibility, whenever the interest rate is very low, the bond can be also
called back. Although it is not profitable for investor that particular point of time, but the
bond issuer can call back the bond because they can generate certain revenue in that
particular point of time by discounting the bond we see that particular discount rate which is
already available in the market in the lower rate.
So, there is a risk involved in the callable bonds; so because of that the interest rate is
basically we have seen this way.
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Then we have another one yield to put. Yield to put means, this reverse. It gives the
bondholder the right to sell the bond back to the issuer at a specified price which is called the
put price. Putable bonds also can have a schedule. At what time the price of the put is what?
That particular like callable bonds for the putable bonds also the put prices are mentioned or
the put dates are mentioned and accordingly the yield to put can be calculated.
So, whenever I talk about the yield to put, then with what we have to do?
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Again the same logic you can apply. But here if you see, we have to discount it with respect
to the put price. We have to discount it with respect to put price. In the case of call option, we
are using the call price. In case of the put option, we are using the put price. And here, if you
see this example then it will be clearer for you.
If you see this; there is yield to put you have to find out for a 10 years bond same 9 percent
coupon paying the interest semiannually and after 5 years let the put prices 950 which has
been mentioned from the beginning. Then, you have to equate it with respect to the market
price or the price at which the bond is trading and that particular point of time, that is 937.69.
If you go and here, it is 950 other things remain same. Then what you get it, 5 years are
remaining, then you are getting that yield to put is 4.90. Then in few semi analyzed means,
you have to multiply the 2 to find out the yield to put for the annual yield to put; then it is
9.807741 percent. This is the way, the yield to put can be calculated on the differences you
have to consider the face value instead of face value, we are using the put price.
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Then there is another one is yield to worst concept. It is basically, whenever there is a
different call dates or different put dates. You have the yield you can calculate. Then the
minimum of all the yields is called the yield to worst. At which date the yield is the
minimum; that is called the yield to worst. This is available whenever there is a call schedule
for that particular put option or the call option.
Then if you are going for a bond portfolio yield, then it is not basically the summation of the
yields of that particular portfolio whatever bonds are there. This is again you have to solve
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the rate at which make the present value of the portfolios cash flow equal to the market value
of the portfolio.
So, that is why; for example, if your portfolio consisting of a 2 years 5 percent annual coupon
bond priced at par 100, in 3 years 10 percent annual coupon bond price priced at 107.87 then,
it would generate a 3 year cash flow of 15, 115, 110 and would have a portfolio market value
of this. Then what is the yield? Then the yield will be basically, this the cash flow what you
are getting that is 15 dollar, 150 dollar, then 110 dollar, then your 207 is the total portfolio
value. Then you have to discount it with respect to y (1 + y) 1 + (1 + y) 2
+ (1 + y) 3, then
finally, we got it y is equal to 6.2 percent.
So, it is not a simple summation of the weighted summation of the yield of the different
bonds this calculation of the portfolio yield is different and it can be calculated in this way;
so, this is about your portfolio yield.
Please go through this particular references for this particular system. And next class we will
be talking about certain issues related to the bond price volatility and the total rate on.
Thank you.
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Lecture - 44
Bond Analysis - IV
So, in the previous class, we discussed about the different types of yield measures of the
bond. And here the yield can be a current yield, it can be nominal yield, it can be yield to
maturity, it can be yield to call, yield to put all these things. So, what we basically here,
we have observed that the yield is nothing but whatever return you are going to or you
are extracting from that particular bond. But, investment you are making on the bond,
whatever return you are expecting that is basically represented as the yield.
Then let us see one particular hypothetical case that whenever you are holding a bond
and the maturity period of that particular bond is let 5 years, but the investor or the
bondholder need some cash in between or he or she wants to redeem that particular
bonding between. So, in that particular point of time, how we can calculate the total
return or the yield of that bond, so that is basically defined as the realized yield.
So, whenever we are calculating the realized yield, what it measure, it measures basically
how the particular coupons are reinvested in the market and as well as how much coupon
you have received, and that how much price you have sold the bond in between that
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means after your horizon period, your holding period that is why, the bond yield in terms
of realized yield is basically a measure obtained by assuming the cash flow are to be
reinvested to the investor’s horizon at an assumed reinvestment rate and at the horizon
the bond is sold at an assumed rate given the horizon is not at maturity that means, the
horizon period is not at maturity, horizon period is below the maturity period.
So, in that case, how the return of that particular bond can be calculated that means,
exactly how much return you are going to realize, if you are going to sell that bond or
you are going to redeem that bond before the maturity. So, here if you see, there are
certain factors a certain determinants, which determine this return from that particular
bond in terms of the total return or the realized return.
What are those? One is your horizon value, and what value basically you are selling that
one, then the bond price at the horizon, then total monetary value or monetary return
what you are getting. Then if you are getting that if you are going to sell that particular
bond at that particular point of time, then what is the total value of that particular bond,
and at what price you have purchased the bond. So, you have end value then you have a
beginning value or the selling value or the purchase value. So, once you have the end
value and this purchase value, then what you can do, you can find out the return from
that by simply whatever way the return from the zero-coupon bond, we were calculating.
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So, let us see that how that particular mechanism works. Suppose one investor buys a 4-
year, 10 percent coupon bond, paying the coupon annually, and selling at its par value of
1,000. Assume the investor needs cash at end of 3 years. Here you remember this
particular bonds maturity period is 4-years, but investor needs cash at the end of year 3
because of that what is happening, that means the horizon period is 3 years.
So, it is certain you are assuming that he can reinvest the coupon whatever he has
received up to that particular 3-years period, because you are holding the bond of 2-3
years, and expects to sell the bond at the horizon at the rate of 10 percent. The yield
basically was 10 percent, and that yield remain constant of that particular period of time.
So, then in that particular contest how basically we can calculate the total return or the
realized return?
We see then what basically we have to first calculate, we have to first calculate the HD
value. What is the value of the bond at the horizon period? And this value is nothing but
how you can calculate this value, this value is nothing but the price the investor obtains
from selling the bond at HD value. And the value of the coupons at the HD that means, if
you want to calculate the value of that bond at that particular point of time, then what is
the cash flow we are going to get? We are going to get the cash flow that is 100 rupees,
because 10 percent is the coupon. And we have the value of the bond, what basically at
price we are selling this one. These are the two cash flows, which are involved in this.
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Let us see how that particular thing works that in this case if you observe, the investor
can sell the bond only the bonds, maturity period is 4-years, already 3-years are gone
only one year is left out. Then how much coupon you will be getting, you will be getting
a coupon of 100 dollar though you will be getting a coupon of 100 dollar and a 1,000 par
at the maturity.
So, if you are going to calculate the price of the bond in this case, because the yield and
the coupon rate are same, then the value what you are getting that is the 1,000 dollar. 100
rupees that is the coupon is remaining or future you are going to get that is the par value
of the bond, and one year is left out. So, if you discount it, then you are getting that
particular value of the bond as 1000 rupees, why you are getting exactly 1000, because
the reason the coupon rate and the yield rate are same. The 10 percent of the coupon and
10 percent is the yield.
And now what is happening how basically you can calculate, because you are holding
the bond after 3-years. If you are holding the bond of 2-3 years, you got 1000 rupees,
whatever you are sold that bond. Then how much total value you got, because 100 rupees
you got after the first year, which is the coupon. If this 100 rupees, you got and this
market interested or yield is 10 percent, then what you have done? You have invested
that particular 100 rupees in the market right.
For another 2 years you might have invested then you got 100 × 1.1 2 that is 121 rupees.
Whatever 100 rupees, you have got in the first year. After first year, you have invested it
for another 2 years, you got 121 dollar. Then in the end of the second year, you got
another 100, so that 100, you can invested for another 1 year. Then how much you got
100 × 1.1 that basically will give you 110. So, whatever 100 rupees, you have got after
the first year from there, you got 121. And whatever 100 you have got, after second year
you got 110. Then what is the total you got, then in his third coupon up to third year you
are investing that particular bond, you are holding that bond.
So, in the end of the third year, also you will be getting 100 rupees, but you did not have
time to invest it. You have got 100, 100 dollar you got, but that money is not reinvested
in the market. Then effectively how much you got, effectively you have got 121 plus 110
plus 100, then total you got 331. You got 331, and you have sold the bond the investors
has sold that bond at the price of 1000 rupees or 1000 dollars.
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Then total the investor would have 1, 331 in the cash at the HD. So, the HD value has
become 1, 331. So, the coupon is reinvested, and whatever coupon in the end of the
period he got. So, if you add of everything 1000 + 331, it will give you 1, 331. Now, so
here what is basically happening that the horizon value of 1, 331, your basically 1, 331.
331 consists of the bond value of 1000 coupon is 300. And the reinvestment what you
got that is 31, because the coupons are again reinvested in the market, you got that
reinvestment amount 31. So, total value got 1, 331.
And now you can calculate the total return from this, then how you can calculate. So,
now if you see, the total return is calculated in this way. So, you have this is the formula
for calculation of this the coupon value at HD C × 1 + R t , t is equal to 0 to HD minus 1,
because last year you cannot reinvest that money.
Then finally, it is nothing but C into the future value of interest factor. Then total value
HD
the coupon value at HD, you can calculate any of the ways C ×[{(1 + R) – 1}/ R]. Any
of the formula you can use to find out the coupon value at HD. And here in this case, if
you put your coupon was C, which is 100 dollar, your rate yield was 10 percent. Then
1.1, you are holding it for 3 years or to the power 3 minus 1 divided by 0.1, which is the
R 10 percent. Then we are exactly getting 331 that is what we have extended, so 300
rupees we got it.
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So, now the total value we got that is basically how much 1, 331. Then what is the
return? If you see the return, now your HD value is 1, 331 if you see here, and what is
the price, that is 1000 dollar. Then 1000 how much here you are for how many years you
are holding it, 1.3, then one point to the power 1.3 minus 1 that is basically you are
getting 10 percent here.
So, here we are getting 10 percent rate on, the reason is everything remains same. Your
coupon and you will assign rate can also vary depending upon the change in the yield
rate in the interest rate in the market. So, this concept is basically called the total return
or the realized return that actually you can keep in the mind that means, the bond
investors have not hold the bond up to the maturity, but then how much return you can
expect from this.
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Then we can discuss some concepts related to the bond market or the bond instrument,
which are used for the bond investment strategy, which is not a part of this particular
syllabus. But, still you can have the idea that those kind of things are used extensively
for minimization of the risk in the bond market, so one of the concept is duration. So,
what do you mean by the duration, the duration is basically what it is a weighted average
of the bonds time period.
In the weights are basically given on the basis of the present value of the gas flows or it
is a weighted average on a present value basis of the time to full recovery of the principal
and interest payments on a bond, and it measures the weighted average maturity of a
bond cash flow on a present value. Whatever way you can define it, it is basically a
measure of the time, but it is a weighted value. And the weights are given on the basis of
the present value of the cash flows. So, if you see this, the weights are given, you are
calculating the present value of the cash flows, and here t is equal to the time. So, we are
multiplying t with respect to that weights and finally this duration is calculated.
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So, let us see one example that how the duration is calculated. Let there is a bond with
maturity period is 4-years, coupon is 9 percent per value is 1000, curve is 10 percent
means, the yield is 10 percent. So, if you see that, first year how much cash flow you are
getting 90 rupees, second year 90 rupees, third year 90 rupees, and the fourth year the
curve value is 1000 plus 90, 1090.
Then you find out this the present value of this 90 /1.1, you got is 81.18. 90 divided by
1.1 1 square, you got this 1.1 to the power 3, you got this. Then 1090 / 1.1 4, you got this.
Then the total present value of the bond is one 968.3. Then you are finding out the
weights, so this divide by total will give you, this divided by give you this the total will
give you this, this divide by this will give you this, this divide by this will give you this.
Now, what you can do, this one you can multiply with the time period, so these are the
weights now you got it. So, now 1 multiplied by this plus 2 multiplied by this plus 3
multiplied by this plus 4 multiplied by this that will give you 3.52. So for a 4-years
maturity period term to maturity 1 the duration is 3.52. And use of the duration is
basically to minimize the interested risk in the market you should hold a bond up to
where the horizon period is matching with the deviation not with the termed maturity
that is the investment strategy always we adopt. If a horizon period is 3.5 years, do not
invest in a bond whose term to maturity 3.5 years, invest in your bond which duration is
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3.5 years by that you are interested risk in the market can be minimized, so that is the use
of the duration concept.
So, now if you are calculating the duration of a portfolio remember the duration of a
portfolio is simply the weighted average of each of the bonds duration, with the weights
giving the proportion investment funds allocated to each bond. If you have 100 rupees,
you have spent is allocated 5.5 5 rupees for 1 bond, 20 rupees for another bond.
Accordingly, we can find out the weights. And each bond you can find out the duration,
if you multiply that, then that will give you duration of the portfolio.
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Duration also is used as a price sensitivity measure, so that is why, it is important

measure of the bond price volatility. Duration also can be used as a measure of the price
volatility of the bond, so that is why if you are defining in that way, duration is defined
as the percentage change in the bond prize given a small change in the yield.
Mathematically, if you want to find out the deviation, it is nothing but the first order
derivative of the equation of the price of a bond with respect to the yield, then dividing
by the bonds price and expressing the result in the equation in the absolute value.
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So, how it is basically represented, it is represented in this way. Duration is equal to
already I told you (dP / dy) / P. So, then if you are going to find out from the present
value formula, P is equal to you know what is that value of the P, the present value
formula. Then if you find out the derivatives of that, then you can find out this one. And
divided by P if you take, then this is basically the duration what you can find out.
But, one thing you remember, whenever in the beginning of the example, we are talking
about the duration that is basically this bracketed expression, if you see this one what
that basically talks about, if the weighted average of the time period define in the last
section of the duration, what we have defined.
Now, we are getting another term that is 1/1 + y, whenever we have gone for the using
the derivative concept, so that part is basically called the Macaulay’s duration, and the
overall talk whenever you are dividing 1 + y with to that it is called the modified
duration. The Macaulay duration divided by 1 + y or into 1 / 1 + y that will give you the
modified duration, which can be derived from the first order derivative of that particular
price equation with respect to a change in the yield.
Then you see that if you go by the price of a bond, which pays the coupon its period and
principal at maturity. This is the basically P, which is the formula that already we know.
And if you are taking of the first order derivative of the equation, then your modified
deviation will be this one.
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C  1  N[ F  (C / y)]
y2 1  (1  y) N   (1  y) N 1
Modified Duration   
P0b
This is the equation what you can find out, whenever we go for the first order derivative
of this particular equation with respect to y.
So, always you see the derivations are measured in terms of the years, and this is always
reported in terms of the annualized value. So, if the deviation, if the cash flow is
distributed annually, the duration reflex in years. If the cash flow is semi-annually, then
duration reflects half of the year. But, even if you are calculating this thing half of the
year so the years, finally the annualized duration has to be calculated. In the annualized
duration is nothing but duration for their bond with n payments per year divided by n that
is why, the duration are defined in terms of the length of the period between the
payments.
And the convention is to express the duration as an annual measure that actually you
keep in mind, this is always reported as a part of the annual measure. So, the annualized
duration is obtained by dividing deviation by the number of payments per year. And if it
is two times it is paid, then you find out that then finally divided by 2 that will give you
the annualized deviation that actually we have to keep in the mind.
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Then we have to see that, what are those properties of the duration because, you see the
basic features of the bond is what coupon, maturity and yield. Then on that basis if you
want to relate the duration with respect to all those born fundamentals like coupon,
maturity, and the yield, then what kind of relationship you can establish of duration with
respect to all the three variables.
What basically we have observed or it is observed, the lower the coupon rate the greater
the duration. If you are taking two bonds, the term to maturity it is same, and other the
par value is same, everything is same, but only coupon there is a difference in terms of
the coupon. Then what you will observe, which our bond the coupon rate is lower. The
duration of that particular bond will be higher.
The lower the coupon rate, greater the duration lower the coupon rate greater the
duration. Then everything remain constant, everything remains same. If you see longer
the term to maturity, greater the duration. And for a zero-coupon bond, where there is no
such kind of coupon, which are periodically available. The Macaulay duration is equal to
bonds term to maturity that means the term to maturity is equal to duration.
The term to maturity is equal to duration anywhere in between there is no cash flow
involved in that so because of that obviously in the end we are getting the cash flow,
because there is a zero-coupon bond in that context. What we can observe that it is equal
to the duration is equal to term to maturity.
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And the modified duration is equal to n / 1 + y, y is basically the yield. The modified
duration is whatever is the duration you are getting divided by 1 plus y, duration is
nothing but term to maturity, then let yield is let 5 percent of 3 percent. So, if you divide
that with respect to that particular maturity period, then you can find out the modified
duration.
Then another observation also we can find. The higher the yield to maturity, lower the
duration. Everything remain constant, everything remains same. If you compare between
the two different bonds, whichever bonds maturity period the higher yield to maturity is
there or yield is more. And for that particular type of bond, the duration will be lower
that also has been observed. So, these are the different properties of the duration.
Then another concept, which is also important from the bond investment point of view
that is called convexity. Why the convexity comes, because if you remember whenever
you are having a relationship with a price and the yield, what we have seen price and
yield curve is basically a convex curve or convex to the origin, so it bowed shaped. So, if
it is there, so there is some kind of arc which is involved in that the curvature.
So, convexity is basically nothing but, it measures the curvature. The convexity is
basically nothing measure the how the bowed-shaped the price-yield curve is or what is
the curvature of that price yield curve that is basically measured by the convexity. So,
what it then exactly in the mathematical since it measures, it basically nothing but the
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change in the slope of the price yield curve. The slope of the price yield curve basically
is nothing but the duration.
And if you are going for change in the slope of the price yield curve, then we are going
for the second order derivative of that particular equation, then we can find out the
convexity. So, duration can be calculated by taking the first order derivative of the price
equation with respect to change in the heat. And the convexity can be measured by
taking the second order derivative of the price equation, whenever there is change in the
yield that is the basic difference between convexity and the duration.
Then if you see that how the convexity can be measured, so already I told you the
convexity means that the slope of the price yield curve like ΔdP / dy get smaller as you
move down the curve or as the YTM increases. So, mathematically, convexity is the
change in the slope of the price-yield curve for a small change in the yield, and it is the
second order derivative.
So, if you trying to find out the second order derivative, then you can find this
1  N t( t  1)(CFt ) 
Convexity  
P0b 
 t 1 (1  y)
t 2 

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so that is basically convexity. If you are talking about a bond of a fixed coupon each
period, and the principal at maturity is also fixed, then what you can do, you can find out
the convexity formula with this way.
Because, if you go for the second order derivative of that equation, then you can find out
this value also
2C  1  2CN N( N  1)[F(C / y)]

1  
y 3  (1  y) N  y 2 (1  y) N 1 (1  y) N  2
Convexity 
P0b
C means it is the coupon, N means the time. I mean what is the period divided by y
square into 1 plus y to the power N plus 1 into N into N plus 1 into F minus C by y
divided by 1 plus y to the power N plus 2 divided by the price, so that is the formula for
the convexity of a coupon of a bond which pays the fixed coupon periodical basis, so that
actually we can use it whenever we go for calculating the convexity of a particular bond.
So, like duration, convexity reflects the length of period between two cash flows. And
the annualized convexity is found by dividing the convexity, measured in terms of n-
payments per year by n square. There were dividing with n, here we are dividing with n
square, because we are talking about the second order part. So, the annualized convexity
is convexity for bonds with n-payments per year 2 times, 3 times whatever frequency the
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coupon payments has divided by the n square that is the way the annualized convexity
can be calculated.
See this example of a 10-years bond of 9 percent coupon with semi-annual payment with
a bond value 100, then obviously 9 rupees is the coupon. Semi-annual means 4.5, then 2
C you have taken 2 C divide by y q 2 C 2 into 4.5, Y is equal to four point 0.045, it is
4.5 rupees, it is 4.5 percent into 1 minus 1 by 1.045 to the power what to the power n, n
means it the 10-years bond and semi-annual coupon. Then obviously, to the power 20
minus 2 CN period is 20. 4.5 into 20 divided by this is your interest rate zero point 0.45
square into 1.045 to the power 21, because it is basically N plus 1. Then plus your 20
into 21 into 100 minus 4.5, formula you can put it.
Then find out that particular value that is 225.43. And now the period is N is equal to 2
that how many time this coupon is paid that is basically two times, then you are
annualized convexity is 225.43 divided by square of the two that is 4, you can get 56.36.
For this particular one, the convexity is 56.36.
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Then what is the properties of convexity. As the yield increases, the convexity of the
bond decreases. For a given yield and maturity, the lower the coupon, the greater the
convexity, it is something with duration also. For a given yield and modified deviation,
the lower the coupon, the smaller is the convexity, so that is what basically we can
always find out in terms of the properties of the convexity.
Please go through this particular reference for this particular session.
Thank you.
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Lecture - 45
Bond Market in India
So, after the discussion on the different conceptual or the major issues related to the
instruments like bond, in this session we will be discussing certain things with respect to
the Bond Market in India.
These are the different fundamental things you have to always keep in the mind
whenever you are investing in the bond market or you are trying to understand
something related to the bond. These are the prerequisites to invest in the bond market;
prerequisites to understand the bond market. But today we will be discussing certain
things which are available with respect to the bond market in India.
So, whenever you talk about the bond market in India, the majorly there are three types
of markets are available with respect to the bond; if you are talking about the Indian
market. What are those? One is your government securities market. Already if you
remember we have discussed about the treasury bills market, then we discussed about the
some other market with respect to the government securities.
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Remember these are very short term security which is maturity period is maximum up to
1 year. But now whenever we are talking about the government dated securities, there
the government securities market is relatively a long term market. So, that is why we
have a prominent market in India that is related to the government dated securities which
are long term in nature. Then we have another market called the corporate bond market,
then we have the public sector unit bonds: the bonds are issued by the public sector units
PSU points which are popularly known as.
So, these are three types of market which exist in Indian financial system. So, what is
basically our job today? We have to understand the structure of that particular markets
who are those participants; that means, in terms of investment point of view, in terms of
the insurance point of view, who are the regulators of this market, what is the process
through which the bonds are invested in the market or bonds are issued in the market. So,
these are the different questions always comes to our mind whenever we talk about the
bond markets in India. So, that is why we have to discuss certain issues related to the
operation of bond market in the Indian context.
So, if you see from the beginning I can tell you that whenever you talk about bond
market in India, the bond market in India is highly dominated by the government
securities.
The corporate bond market is not very strong if you talk about and there is a market for
PSU bonds, but it is also not that much developed if you think from the Indian
prospective. But if you think about the bond market, then typically our mind always goes
to the government securities market governments dated securities market which deals
with the long term securities. So, what basically we are going to do? First of all let us
discuss certain things which related to government dated securities which is the most
prominent developed market in terms of the bond which are operating in the Indian
context. Then we can see certain things related to the corporate bond and the PSU bonds.
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So, whenever you talk about government securities market already you know what
government securities is. This dated securities are longer term securities already I told
you and they carry a fixed or floating coupon. Some of the government securities also
carry the floating coupon.
The coupon rate may change after a typical period of time. It is not that the coupon may
be fixed and the coupon maybe floating. In the beginning it is mentioned that at what
point of time how the coupon is going to the sense that is already defined. So, in that
context what you have we can say that the government bonds either they have fixed
coupon or they have a floating coupon and they are always paid on the face value that
already you know. Because the coupons are paid on the basis of the face value or the par
value or we can say that the value which is already mentioned in the bond indenture.
And payable at fixed time period that already you know and mostly the government
bonds coupons are paid half yearly. That means, the coupons for the government dated
securities are paid half yearly; that means, every 6 months or the total frequency of the
coupon payments for the government dated securities are 2 every year two times the
coupons are paid.
Another beauty of that particular type of bond is very long term bonds are available in
the market. The term to maturity for the government dated security can go up to 30 years
which is not in the case of the other type of bonds which are issued in the market who
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basically always deals with the government securities market? In RBI in the Reserve
Bank of India, there is a Public Debt Office which always manages the government dated
securities and RBI basically acts as the registry the Public Debt Office of RBI basically
acts as the registry or the depository of the Government dated securities. And it deals
with all kind of thing like how the government security will be issued, when the interest
will be paid and how the principal will be paid at the maturity. All kind of issues related
to the government dated securities always dealt by the Public Debt Office of the Reserve
Bank of India.
So, they are basically the custodian, they are basically the prime agency who basically
facilitate the operations of the government dated securities market in the context of India.
Then will see that how the government security market is playing a very significant role
in the financial system. What are those uniqueness of the government securities market
has which is not available with the other markets.
You see already all of us you know that the government securities market is a market
which is a highly liquid and it basically sets a benchmark for the rest of the market. Any
debt market whenever the pricings are done; the yields are calculated, so everybody
looks at the what is the price available in the government dated securities because it is
basically highly liquid market. And another thing is if you see the probability or the risk
probability of default is basically 0. Now there is no credit risk involved in that. So, that
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is why the yield from the government dated securities can be consider as a risk free rate
of return.
We take it as a proxy for the risk free rate of return. To us it is a risk free rate of return or
there is no such kind of credit risk called default risk involved in that particular kind of
securities, then it can be consider as a benchmark for all the rest of the markets. So,
whenever we calculate the return from other markets, the risk free rate can be benchmark
or if you are going to take more risk than how much extra premium we want or extra
return you want that kind of idea you can get it whenever you have the return from the
government securities market. So, that is why it is a benchmark for the pricing of the
corporate securities of the varying maturities because the government bonds also
available in the different maturity. It can be also used as a benchmark for pricing of the
corporate securities available in the market.
Another major important thing is basically what it plays a significant role for the
monetary policy because if you remember, we were discussing about open market
operations. What do you mean by the open market operations? The open market
operation is basically a process through which government buys and sells the securities
to increase or decrease the money supply in the market. If the government wants to
increase the money supply, then what they will do? They will buy the securities or sell
the security? That means, they will provide the security to the public and if they will
provide the security or the government of the public and get the money from them then;
obviously, they are reducing the money supply.
But if they are selling the security to the public that means, what? Basically they are
declining the money supply, but whenever they are buying securities from the public
through the auction process, there is increasing the money supply.
So, open market operations which is a measure instrument of the monetary policy that is
basically always done through the government dated securities market. So, increasing
and decreasing on a supply through the open market operation, the major instrument is
the government dated securities. If they want to if they will buy the securities from the
public, then they will inject the money to the economy, then the money supply will
increase. And whenever they are selling the security to the public; that means, they are
taking out the money from the public, then they reducing the money supply in the
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economy. In that process it is very much essential and the effectiveness of the
government securities market is quite important.
Obviously, from the beginning I told you, this is a risk free instrument which provide the
risk free return. There is no default risk or the credit risk and this government securities
market also facilitates the public borrowing at reasonably cost which avoid the automatic
monetization of the government deficit. Before 1997, there was a process for the
automatic monetization of financing the government deficit that thing has been removed
because of the development of the government securities market.
Because as the government securities market is quite efficient quite liquid at the time of
requirement government is able to raise the money through Reserve Bank of India by the
issuance of the government dated securities to the public. That is basically the thing what
we can observe or we can always see whenever we talk about the government securities
market.
Then another thing is it provides the flexibility to the authorities in their task of the debt
management. Because already I told you the GSM basically is a kind of instrument or it
is a kind of market which provides that kind of instrument which facilitates all type of
operations of the bond market or operations of any kind of debt management in the
system. So, that is why it provides the flexibility to the authorities in their task of the
debt management.
And as it plays a significant role in the open market operation process, it plays a very
crucial role in the monetary policy transmission mechanism. What do you mean by
transmission mechanism? Transmission mechanism basically a process you can use the
instrument, the instrument will affect the intermediate target or a intermediate variables.
And once the intermediate variables will be affected, then automatically the final
outcome variable also will be affected. So, in that process if you see, this particular
market is very important in terms of policy, it also important in terms of the bench
marking of the other type prising benchmarking for the pricing of the other kind of
securities available in this segment, then it also helps in the debt management of the
government.
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So, this is the importance of the government securities market that is why people are
much more concerned about the development of the government securities market in
India.
Then if you see the structure of the government securities market in India. How the
structure looks like? Who are those major players in the government securities market?
They are; obviously, reserve bank of India is the APEX who issues this, then you have
the commercial banks who are the participants, who are the investors.
Then you have the primary dealers some of the banks are primary dealers and already we
have discussed about the primary dealers who are not from the bank, but they are the
standalone primary dealers. And also the insurance companies; institutional investors and
the insurance companies like insurance companies. They are basically the bigger
investors who also invest in the government securities market in India.
Foreign Institutional Investors FIIs also allowed to participate in the government

securities market with a quantitative limits; when the limit always subject to change with
the approval or with the suggestion of the reserve bank of India. Corporates also buy or
sell the government securities to manage their overall portfolio risk. So, these are the
major players who always play the role in the government securities market in the
context of India.
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So, in this context, the investors who are available in this market we have divided into
three categories. Those are divided into three categories on the basis of their status. So,
we have a wholesale market, we have a middle market or middle segment market, then
we have a retail segment market. Whenever we talk about the wholesale market, the
wholesale market comprises the players like commercial banks, financial institutions,
insurance companies, primary dealers, mutual funds.
So, those are basically the bigger investors and they basically are considered as a part of
the wholesale market. What are those players, who are those players were basically a
part of the middle segment? In the middle segment, we have the provident funds,
corporates, NBFCs; Non-Banking Financial Companies and the cooperative banks.
Cooperative banks are relatively smaller in size; so because of that the middle segment,
they come under the middle segment.
But whenever we are taking about the commercial banks, they come under the wholesale
market segment. And retail segment if you see these are basically individuals and some
of the non-institutional investors. Mostly the retail segment is comprised of the
individuals and the non-institutional investors. So, this is the way the players in the GSM
market or government securities market are divided or are categorised.
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See the structure of these in terms of this. The particular holder or the investor in the
GSM market or Government Securities Market always hold their securities in the
demerit dematerialised form; It was there in the physical form also was there before, but
now it has been removed. So, all those kind of investments which are carried out in the
government securities market, they has to be in the demat form. That is basically the
mandatory thing which is working in the context of India.
So, if there is a d mart funds which are there is a process of dematerialisation in terms of
the investment in government securities market, then how it is done? So, it can be done
by two ways. According to reserve bank of India guidelines, it can be done by two ways.
So, every commercial bank who are investing in the government securities, they can do it
through SGL account or they can do it through the gilt account. Any investor can invest
through SGL account or the gilt account.
We will explain that what you mean by the SGL account and the gilt account. The RBI
offers this subsidiary general ledger account which is called SGL account that facility to
select in entities who can maintain their securities and SGL accounts maintained with the
Public Debt Offices of the Reserve Bank of India.
So, if you see in terms of the SGL account the securities or to get this kind of licence to
have the SGL account, there are certain criteria. And all those investors cannot fulfil
those criteria because the criteria are very stringent and the amount of money transaction
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through that particular kind of account also is quite large. So, because of that generally
what happens? Mostly the commercial banks and some bigger investors insurance
companies and all this things they have this SGL account with RBI and other kind of
entities cannot open the account through the SGL account.
Mostly the commercial banks open the SGL account with the reserve bank of India. So,
they can directly invest in the dated securities market through this SGL account. But
whenever we talk about because we have large group of investors who are interested to
invest in the government securities market.
So, anybody cannot open this SGL account; if they cannot open the SGL account, then
how they can invest? So, they can invest through this Gilt account. So, RBI has made the
provision that the particular entities who have not this SGL account or they are not
eligible for to open the SGL account with reserve bank of India, they can invest through
this Gilt account. So, what exactly the gilt account is? The gilt account is basically what?
You can open this gilt account with a bank or primary dealer who can or who has the
SGL account with RBI. So, you go and open this gilt account gilt account means this is
again the gilt means government.
The government securities account you can open it with this kind of commercial banks
or primary dealers and they have the licence or they are eligible. They are eligible to
open the subsidiary ledger journal ledger account with RBI and through that gilt account
whatever transactions you want to do through the for the government securities market
investment, you can do it through this gilt account and from the gilt account it can go to
the SGL account of this particular commercial bank. Through that the transactions or the
trading of that particular securities can take place. So, this is the way the investor can
participate or can go for investing the money in the government securities market.
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Then already you know there are two types of market in every segment. We have a
primary market, we have a secondary market. First time whenever the securities are
issued they are called the primary market segment or again the say first time it comes to
the market or a newly it comes to the market. And another part is this secondary segment
this securities who have already come to the market. They are traded in the market it
goes from one hand to another hand. Depending upon the demand and supply of that
particular security, the price basically changes that already we have discussed.
So, whenever you talk about the issuance of the primary market rated securities. They
are basically issued through the auction process; I have explain this auction process to
you whenever we are discussing about the treasury bills. The same auction process
works for the dated securities. The whatever auction process works for the treasury bills
market, the same auction process works for the dated securities market only some
differences in terms of the timing and the settlement period.
Here one example what if you see. Already I told you there are two types of auction; one
is yield based auction, then another one the price based auction. And yield based auction
is always used whenever you are going for a new security you are going to issue a new
security.
So, for example, there is a bond there is a dated securities. The maturity date is 6th
August 2024. The coupon is determined in the auction where we will find out how the
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coupon was determined here. The auction date is 5th August 2014, auction settlement
date is 6th August 2014 a notified amount is 1000 crore right. The settlement is done on
6th August 2014 under T plus 1 cycle. If the settlement date is the holiday under T plus 1
cycle, then the next working day will be consider as the settlement day that is the
regulatory rule or the RBI norms whatever they have decided.
So, if you see let already I have explained you that whenever this particular information
were available, then accordingly what will happen this investors have gone for the
bidding.
So, here it is already arranged in the ascending order. So, this is the bid yield what they
have basically bided. Bank number 18.19 percent, 28.20, 38.40, 48.12 and 8.22, then
8.22, then 7 is 8.23, 8 is 8.24. This is a hypothetical example that these are the bidding
which have bids which Reserve Bank of India has received. Then bank 1 has bided for
300 crore. Bank 2 has bided for 200 crore, then it is 250, 150, 100, 100, 150, 100 like
that. Then if you find out the cumulative values 300 300 plus 200 500 750 900 1000 you
see that 1000 is over here right. If the 1000 is over here, then further this particular bids
will be considered or not. If you observed here the bank number 5 has bided for 100
crore there itself the biding got over the amount got over.
But the bank number 6 also has bided for 8.22 percent as ask 400 crore. Then in that
particular point of time, what will happen? They can go they should go up to bid 5, but
since the bid number 6 is also at the same yield, then both bit number 5.6 get the
allotment in the pro data bases. That means, after the 900 crore whatever 100 crore will
remain the 50; 50 crore will be given to bid number 5 and 50 crore will be given to bid
number 6 and the cut of yield was 8.22. The cut off yield basically will be 8.22 that will
be decided. Say under the cut off rate you can find out also price already the yield and
price calculation you know that if you know the price I can calculate the yield from that.
If it is a price based auction with the same kind of security, it can be arranged in the
descending order. Then accordingly if there is a same kind of demand or same kind of
price, they have coated then it can also be divided into pro data basis. That is also there
for both the yield based auction and the price based auction. This is the hypothetical
example you can see that one.
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How the trading takes place? There are three ways that trading can take place in the
secondary market. Once this has gone into the secondary market, this can be traded
either by OTC market through the telephone. Then whatever court negotiations have
taken place through the telephones between the different banks or different primary
dealers and other people those information should go to the negotiated dealing system
platform within 15 minutes after the dealing.
Then we have a negotiated dealing system which is an electronic platform was started in
February 2002. Then all the bids are submitted electronically and finally, this auction
will take place or the pricing will take place on that trading platform only finally, the
allotment will be made or the securities are also traded in the stock exchanges both BSE
and NSE. NSE has a segment call wholesale debt market segment where the government
dated securities are traded.
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Then we have another segment corporate bond market very dormant not very developed.
There are so many committees were established like Patil committee, Raghuram Rajan
committee. There are different communities which were establish to which this
committee have recommended for the development, but still that market is not that
developed in India.
One thing you have to see here, there is no mortgage available whenever the bonds are
issued by the corporate. It is only depends upon the future cash flow what the company
can generate. In some cases companies physical asset may be used as collateral, but
generally it is not the case mostly it is based upon the expected cash flow what that
company can generate.
On that basis the corporate bonds are issued. They are relatively higher risk than the
government securities and because of that the interest rate or the yield from that part type
of bonds are higher than the government dated securities. With the same maturity, you
will observe the yield from the corporate bonds are always higher than the yield of the
government dated securities.
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So, these are the classification of corporate bonds which are available in India issued by
corporate you have the zero coupon bonds; no coupons are paid. There are short term
bonds also the corporation always issue like maturity period less than 1 year. There are
some medium term and there are some fixed coupon and there are some floating coupon.
So, these are the different type of bonds which are issued in the corporate bond market.
All type of bonds are issued, but already I told you the market is not that developed like
the government dated securities market in India.
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We have the PSU bonds which are issued by the public sector units. You see those bonds
are mostly sold in the private placement basis to the targeted investors as a market
determine interest rates. You remember these are basically sold on private privately
placed specific type of investors always invest in this and there invest rate on the market
determine interest rates. Investment bankers basically are roped in as the arrangers to this
issue. They can arrange that who can invest in this securities which are issued by the
PSUs. So, this is not that way very highly available publicly. Mostly it is always issued
or the investment is always made in the private placement basis.
PSU bonds are transferable and endorsement at delivery and are issued in terms of
issuance promissory note and they are also issued in the demat form. And to create a
certain kind of demand in the market what is happening that the PSU bonds also get the
rating. They are rated by the CRISIL, ICRA, CARE and all this agencies there basically
always give the rating because they can attract more investor to participate in that
particular trading process. So, because they can go and invest in that particular security
because of that they always try to get some weights or get some kind of rating from this
rating agencies.
And some cases it may be guaranteed by the central and state government enabling them
to get a better rating. Whenever the rating agencies give the rating to them, it is always
sometimes it is observed. This is also they also get a better rating because it is guaranteed
by the government either by the state government or by the central government, but this
is a privately placed market mostly which is common public or common retail investors
are trading in the public sector units bonds, but mostly the PSU bonds are basically
privately placed.
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So, this is about the PSU bonds. The bonds maturity period varies from 5 to 10 years
default rates are negligible. PSU bonds are two types taxable and tax free. The interest
payments on this PSU bonds are get some tax free for the tax free bonds; they get the
exemption of interest income you do not have to pay the tax for that. And the major
investors in the PSU bonds are banks mutual funds insurance companies’ provident fund
and the individuals.
They are the major players and there are two types of bonds, they issue either tax free
bonds or taxable bonds and tax free bonds means they get the investor get the tax rebate
against the interest payments. This is what basically the PSU bonds are all about and we
have also enough PSUs are investing or issuing the PSU bonds, but that market is not
that developed like the government securities market.
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Please go through this particular references for this particular session. This is about the
bond markets in India.
Thank you.
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Lecture - 46
Stock Market – I
So after the discussion on the bond market are the one of the major markets which
contribute a lot for the financial development process. Today we can start the discussion
on the Stock Market which is a buzzword among everybody’s mind or always will all
everybody thinks about or discusses about this market which is called the stock market.
And what exactly the stock market trees and what are those instruments which are
available in the stock market and how the pricing or the valuation of this particular
market is done and how the trading in this particular market takes place, what are those
different types of market we have within this stock market.
So, those are the different issues, different things always comes to our mind. So, today
we will be discussing certain issues related to the basic fundamentals of the stock market,
then you can move on to pricing or the valuation and the market fundamentals with
respect to the trading and settlement and other issues which are linked to the stock
market.
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So, before that let us see that what exactly the stock is. Whenever you talk about the
stock it is basically a certificate which represents the ownership of a particular company,
because the particular stock gives you certain ownership of the company for some certain
decision making process.
So, stock is nothing but an ownership. And against that ownership the company raised
some money from you and that money is utilized in the market and finally, some kind of
return will be realized by the investor who has put the money in this particular stock.
That is why it is basically one of the alternative sources of finance for the company
whenever company wanted to raise the money from the market or wants to raise the
money from the different sources, one of the best sources says the raising the money in
terms of equity. So, that is why we can consider this is an alternative sources of finance
which is available to the system.
And it is also consider as a long-term financing instrument which has no typical maturity
period the particular stock which was issued by the different entities, it has no specific
maturity period. The stock can be hold for a reasonable period of time if anybody wants
to maximize certain return out of this. So, the stock in general is always a long-term
financing always in the financial system we consider. And already I told you this
provides certain ownership of the company and it is one of the major sources of finance
for the company. So, these are the way the stock can be defined.
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Why we need a stock market first of all? This is a debate that whether the stock market
affects the economic growth or economic affects the stock market, there is a
unidirectional causality or bidirectional causality there is a long lasting debate not only
now, this debate is going on since 1990s. But in actual sense if you observe, but in a true
sense really whenever we look at the stock market is always a leading indicator of the
business cycle.
I hope you understood what do mean by this leading indicator. Already I think I have
explained and in some of the sessions or in one of the sessions that we have three types
of indicators; one is leading, lagging and coincidence. When we call it an indicator is a
leading indicator because our target is the GDP or the output. If you find that before the
GDP reaches the peak reaches the highest level, if that particular indicator reaches the
peak then we can say that this is a leading indicator. This first increases and that leads to
the increase in the outcome variable that is the growth of the economy.
So, therefore, in this context, lagging indicator is first economy reaches the peak or the
top whatever it may be; after that we can realize that other factors or other things are
reaches the peak or the top. Coincident indicator means both are reaching in the same
level at a same point of time these are called the coincident indicators.
So, in that context, we call that or we can define that stock market is a leading indicator.
Before economy reaches the peak or the top the stock market reaches the peak or the top
that is why it is popularly always we consider this a leading indicator. This is also
reliable guide for the performance and financial position of the company.
If you look at how the stock of the companies performing, accordingly we can conclude
that how the particular company is going to perform. We can say that this is one of the
guide or a kind of informative parameter to comment on or to say that whether the
companies doing well or not that is another way of using the stock market.
And another thing a near continuous valuation of the companies because the market price
means the market is continuously evaluating countries. The particular company is
continuously valuated by the market. Because of that whatever prices we always look at
or we always get it in the market for that particular company, this is basically we can say
that all those fundamentals of the company is reflected to that particular prices. So, that
is why that particular information can help to the different other activities like mergers,
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takeovers, all kinds of things if anything any at all we are think about any other
peripheral activities which may happen to this specific companies.
And other argument is stock market also can create the liquidity, because this particular
market has always worked with a technical really less infrastructure. And the people take
the position without going to the market literally, they do the online trading and all these
things. Then the participation in the market is relatively should be higher and as well as
the money which is floated from the different other parts of other markets within the
financial system that can easily floated in the stock market to maximize the return. So,
the stock market creates the liquidity; the liquidity mostly is created by one of the
reasons the stock market is quite important.
And another thing if you see in today’s context, one of the markets among all the market
stock market is highly integrated with other markets. There is a financial integration that
means, the Indian stock market is integrated or may be related with NASDAQ stock
exchange or maybe Bombay Stock Exchange is related to the DJIA or maybe it can be
related to any of Japanese stock exchanges or any other stock market which are existing
across the globe.
So, because this allows one companies investor to participate in the other system, other
stock exchanges or other markets, this helps in the diversification process. Already all of
you might have the idea that the basic job of the investor to diversify the risk, the
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unsystematic risk. If the diversification is the principal through which the risk can be
managed, then the stock market if anybody want to invest in the stock market, then
because the stock market is highly integrated in that particular process, it is also easy for
the investor to diversify the risk or the risk can be diversified through the international
integration, which generally happens to the stock market.
And in some cases, some of the investments are allowed in the financial sector. If you
talk about India, the foreign institutional investor, FI investments are allowed in the
financial sector. So, the stock market developments attract the foreign investments. And
once the foreign investor comes to India, then the probability of getting the return from
the market goes up which increases the savings of this particular investor within the
system, then finally, those savings helps for the investment in the economy as a whole,
and finally the growth of the economic and take place.
So, another input an stock market is this, the market which can attract the foreign
investors largely if the market basically really does well. And there is no such kind of
frauds malpractices and other things are happening in this market and market is relatively
efficient in terms of information point of view. If those kind of conditions are there, then
stock market can attract more investors, foreign investors into the system.
Then another one is inflow of foreign equity through stock market helps to avoid the
excess reliance on the debt and saves the firm from undue exposure to the debt-servicing
burden. Because you see that whenever we talk about the stock market because there is a
diversification which works in this particular system and people are ready or easily can
raise the equity capital from the market.
And because the high debt equity debt of the company, the debt basically increases the
risk higher, higher the debt higher the financial risk and that also reduces the flexibility
of the manager to take any kind of strong or risky decision in the from the company
prospective.
So, as the financial risk increases with the debt, then most of the cases what has been
observed, the companies may be reluctant to raise more debt. But if they will they are
reluctant to raise more debt, then how they can basically fulfill their investment
objectives. So, in this process the investment objectives can be fulfilled by the equity
financing.
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And the equity financing if they will go about then from where the equity can be raised if
the one of equity capital is not available in the domestic system, because the foreign
institutional investors or foreign equity is coming to the stock market, then it is also one
of the importance of the market which provides the capital for the companies and which
reduces the debt servicing burden or declines this financial risk in them in the system.
So, that is another advantage of the developed stock market of a particular country.
So, these are the major things what although stock market contributes in the different
other ways also, but these are the major contributions or major or we can say that
advantages of the having a stock market of a particular country.
Then if you see in the true sense how the stock markets are classified. The stock markets
are classified by two ways like every market we have two different market in terms of
stock market also. We have a primary market or the new issue market what we call it,
some people call it, it is IPO market Initial Public Offerings market, then we have a
secondary market.
And what is the basic difference between these two the primary market basically supply
is the fresh or additional capital to the companies. New capitals are generated through the
IPO market, but once the money basically has been floated by the company; company
has a issued that particular IPOs and raised the money from the public. Then once this is
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issues are or the particular stocks are listed in the stock exchange, they become the
property of the secondary market.
So, the securities which are already issued or floated in the new issue market or the
primary market are traded in the secondary market and some people always says that this
secondary market does not play in a direct role in making funds available to the
corporates. Because the pricing of that particular security only depends upon or only
varies due to the demand and supply of that particular stock and it goes from one hand to
another hand depending upon the supply and the availability of the demand within that
system that only changes the price level.
But this is not a new addition to the system itself, as it is not a new addition to the system
that is why some researchers always feel that it does not play a direct role and making
funds available to the corporates, but still this secondary market helpful for enhancing
the capital, but that capital maybe there is a zero sum kind of gain kind of thing that may
be lost for another company and gain for this company.
It helps to encourage the investors to invest in the industrial securities by making them
liquid that means which provide these facilities for continuous regular and ready buying
and selling of those securities in the system. That is nowadays we have the online
systems or exchange traded system through which the tradings and everything takes
place in the online system. And because of that it basically helps us to increase the
efficiency and terms of the timing and also transparency.
So, secondary market if you see that is nothing but whatever shares or whatever equities
are floated in the market for the first time through the new issue market, those particular
securities are indexed in the stock exchange and those things are invested through the
stock exchange in the secondary market. And finally, the price of that particular security
depends upon the demand and supply forces of the different investor who wants that
particular security for that investment. So, that is the basic difference between primary
market and the secondary market.
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Then we have if you see the instruments which are available in the stock market, we
have two different instruments broadly, one is your ordinary shares or the common
shares what we call it, then we have the preference shares. And all of you know what do
you mean by the ordinary share, the ordinary share means the common shares, the
common shares basically gives these shareholder voting rights.
If anybody is holding the share of a particular company, they have the rights to vote for
any kind of decisions within the company whether it is decisions related to mergers or
acquisitions or related to any other bigger decisions if the company wanted to take, then
the voting rights always the shareholder has.
And another thing is if anybody is holding the common shares of a particular company, it
is not mandatory for the company to pay the dividend. So, dividend is not guaranteed;
not guaranteed in the sense whether the company want to give the dividend or not that
depends upon this particular company. Some companies pay dividends some companies
do not pay dividend. So, if somebody is holding the common shares, it is not mandatory
that the company will pay them the dividend.
Then we will have the preference shares; preference shares always there is a fixed
payment of the dividends always the company gets. Generally there is no voting rights of
the preference shareholders, but they have the priority after the bond holder, the payment
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will be made to the preference shareholders if any time the company becomes insolvent.
And there are many types of preference shares always we observe in the market.
Then what are those many types of the preference shares always we look at or we see in
the market. One is cumulative and non-cumulative what is the basic difference between
cumulative. And non-cumulative on cumulative preference shares if dividend is skipped
at any point or any period or periods it has to be paid subsequently.
The dividend is mandatory or for some reason if the company could not pay the dividend
in some particular year or some particular period. If it is a non-cumulative dividend again
the company will not pay that dividend. What if it is a cumulative preference share, then
this particular money will be cumulated and when the company will generate the profit
cumulatively the particular dividend has to be paid to the preference shareholder.
Then you have convertible and non-convertible all of you might have known this.
Convertible preference shareholders can be converted into ordinary shareholders on
terms and conditions, fixed at the time of issue of such shares. At what point of time or
on what basis this particular preference shares will be converted into equity or the
common shares that basically will be always mentioned in the beginning of these ones of
the shares. But some of the preference shares can be converted and some of the
preference shares cannot be converted. If it can be converted we call it convertible; if it
cannot be converted we call them the nonconvertible.
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Then we have redeemable and non-redeemable preference shareholders. A redeemable
preference basically matures after a fixed period of time and but if it is a non-redeemable
preference share then it will not be redeemed with a fixed period of time this goes on
unless this investor one should redeem it. So, the redeemable preference share basically
also has the characteristics of the debenture; that means, the corporate bond so that is
why we call them the preference share is a mixture, it is a hybrid instrument, it is a
mixture of debt and equity.
Then we have the participating and non-participating preference shares. The participating
preference shareholders can always get a higher dividend than the fixed one if the
company makes good profit. If there is a possibility of increasing profit of the company,
if some of the shares are some of the preference shares basically called as the
participating preference shares, because they participate in this particular investment
process, there is a possibility they can get more dividend than the non-participating
preference shares. So, these are the different type of preference shares which are
available in the system always we look at or always we find whenever you define the
preference shares in the economy.
Then we can look at that how the valuation of the particular company is done or how the
pricing of the equity is done. Whenever you talk about the pricing, if you see in general
sense; in general sense basically this the approaches of the valuation if you see there are
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three approaches. One is discount flow approach, another one is relative valuation
approach and another one is contingent claim approach. But why we are not talking
about the contingent claim approach here because that is related to the derivative
instrument.
The valuation of derivatives whenever we use the formula or a different methods that is
basically we can define broadly a contingent claim valuation approach. But whenever we
talk about the valuation of equity, we have two approaches discount flow approach and
the relative valuation approach. And one by one we will discuss all these that what do
you mean by this different approaches.
And whenever we go for the discount flow approach or different discount flow
techniques, we have three types of cash flow always we observe on that basis we try to
find out the present value of those cash flows to find out the price of that particular
equity. And whatever price we calculate through that is called what that is called the
intrinsic value of that particular equity.
So, here if you see we have a present value of dividend can be used as a cash flow. Most
of the cases we use the dividend because dividend is easily measurable, easily
quantifiable. What is the limitation of the dividend? Because the dividend may not be
paid by all the companies. If the dividends are not paid by the all companies, then how
the dividend can be discounted to get the present value of the cash flows of the dividend
to determine the price. But still because it is easily measurable and it is easily
quantifiable in that sense and the dividend discount models are quite popular.
And another one is the present value of the operating cash flow. And here you remember
the operating cash flows are not measured in terms of equity valuations, they are mostly
always used for the company valuation. It is operating cash flow to the company. So,
what is the operating cash flow? The operating cash flow basically what we have we can
calculate an operating cash flow in this way. It is the net income plus the noncash
expenses basically noncash expenses means we are referring to the depreciation and all
plus the change in working capital. This is basically we call it the operating cash flow.
Then we have free cash flow. The free cash flow how we measure it is basically cash
flow from the operations what we got minus the capital expenditure if any company has
met lost the net debt issued, how much debt already repaid, how much extra debt the
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company has issued that is basically we call it the free cash flow. So, we have three types
of cash flow always we observe in terms of the company one is dividend, second one is
your operating cash flow and the third one is the free cash flow. These are the three types
of cash flow always we look at. Then we have to discount with respect to a discount rate
to find out the value of that particular equity.
Then whenever you talk about the relative valuation; relative valuation we have many
ratios the popular as price earnings ratio, we have price to cash flow ratio, we have price
to book ratio, price to sales ratio, but the basic job of the relative valuation is nothing to
find out the intrinsic value of the company. The basic job of the relative valuation is to
compare with another company within the industry whether the company is good for
investment or not or we can also have a link between the discount flow valuation
technique with price other kind of relative valuation ratios.
But these ratios are mostly used for comparative religions not for the absolute religions
to find out the intrinsic value of that particular equity. So, these are the approaches to
equity valuation.
So, in the discount flow or cash flow model if you see it is nothing, but the value of a
share is the present value of the future cash flows. And whenever you talk about the
future cash flows what are the inputs we required, you required a cash flow, we required
the growth rate we required the discount rate, we required the time period these are the
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four inputs always we required. You see that how basically the expected cash flow of a
company can be calculated for that we need the growth rate.
So, in general how the growth rate is calculated for any kind of cash flow the g is equal
to your Retention Ratio R R. Retention ratio means your 1 minus the dividend payout
ratio, 1 minus the dividend payout ratio multiplied by the return on equity that is the way
basically the growth rate of the particular cash flow can be calculated. And discount rate
if it is a cost of we are going to evaluate the equity, we used discount rate is the cost of
equity.
If you are going to evaluate the company, we are going to basically use the weighted
average of the cost of capital that means, we consider both the cost of equity and as well
as the cost of debt. Then finally, the time period we have to know to find out the value of
that particular stock or the intrinsic value of the particular stock.
Then how the cost of equity is calculated? Cost of equity you can use the CAPM model
already we have discussed about that. The CAPM model is basically what your expected
return which is the cost of equity is nothing but your Rf + β (Rm - R f) So, this is what so
we have we know the Rf, we know beta, beta is the market risk this is (R m - R f) is equal
to the market risk premium and this is your Rf.
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So, here basically it is not it is Ri - Rf = Rf +β (Rm - Rf,) so that part already we discussed
in the beginning of the classes. But mostly we want to calculate the expected return. And
this is the formula the Rf + β(Rm - Rf,) if you know the Rm, if you know Rf risk free rate
of return you know β and all this thing then you can calculate the risk free the cost of
equity. And that can be used at a discount factor one over you are going for a valuation
of the equity.
And the cost of capital; that means, it is the cost of equity; cost of equity let into the what
is the percentage of the equity plus the cost of debt into the percentage; the percentage of
debt; that means, if it is notation wise if you write let R is equal to the cost of equity r E
into you have total equity upon the debt loss equity plus your let cost of debt is r D into D
by D plus E. So, this is the way basically the weighted average of the cost of capital can
be calculated which is nothing but the cost of equity and the cost of debt. So, then we can
find out the discount rate for this and finally, this can be used for the valuation of the
equity.
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So, this is the reference you have to go through to know about the details the thing what
we have discussed in this particular session.
Thank you.
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Lecture - 47
Stock Market – II
So, in the previous class we started the discussion on the Stock Market. There we have
discussed about the importance of stock market and as well as the different instruments which
are available in the stock market and what are those basic differences between them. And the
next discussion about this thing is basically that how the pricing of that particular instruments
are done and what are those different methods for valuation of the equity or the stock which
are traded in the stock market.
So, if you remember in the beginning we discussed about certain conceptual issues related to
valuation. So, price of any kind of asset is nothing, but the present value of the future cash
flows. So, whenever we talk about the future cash flows and if you think about the stocks,
what are those possible future cash flows which are related to the equity or the stock if you
see, these are basically one thing is your dividend. Second thing is your free cash flow to
equity, then we have the operating cash flow to the equity.
So, these are three different cash flows which are basically available; the operating cash flow
to the equity or operating cash flow to the firm. So, generally the operating cash flow is
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always calculated with respect to the company or the firm it is not with respect to only equity.
So, there we have three types of cash flows. We have dividend we have free cash flow and
we have operating cash flow. And already if you remember we also discussed about there is
that three inputs which are required for the valuation of any kind of asset. One is your cash
flow, second one is the growth of the cash flow or the growth rate of the cash flow and third
thing we want the discount rate. And obviously, time is another factor or the time period is
another factor.
So, we have the four inputs are mostly the major inputs are these three which are quite
important for the valuation of any type of asset. So, with reference to that if you think about
the equity or the stock, we also need this four inputs we need cash flow. We need growth rate
of the cash flow, we need discount rate; we need the time. So, here already we discuss that
dividend is the first cash flow which is related to equity or the stock and we have the growth
rate of the cash flow means growth rate of the dividend. Then finally, the discount rate which
is nothing, but the cost of equity in the context of the equity because that is the expected
return what we can get it from that particular investment, then we have the time period.
So, these are the four inputs always we need whenever we go for the valuation of the equity
using the dividend as the cash flow. So, we go back the formula is basically nothing, but it is
Dt
t
(1+ R)
Your R is nothing, but the discount rate which is in this case the cost of equity and you can
expand it
D1 D2
1 + 2 +…
(1+ R) (1+R)
If you have the n number of cash flows and the period is n then it is D n divided by 1 plus R
to the power n. And finally, we can find out the P0; the P0 is nothing, but the intrinsic value of
that particular equity.
So, this is what basically the values and principles where the valuation formula which is used
for valuation of the equity using dividend as the cash flow. Then if you see there are certain
things related to this.
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One is that a different ways the valuation is done. Then one particular thing if you take
certain assumption that let the dividend is growing at a constant rate. The growth of the
dividend is not changing this is number 1 and this particular growth we will continue for an
indefinite period of time. There is no specific period is mentioned that up to what period this
growth rate will be this much. Let that is basically continue for indefinite period of time and
another assumption we are taking that dividend what growth rate we have that is less than the
cost of equity.
That means the required rate of return will be greater than the indefinite growth of the
particular cash flow or the growth rate of the particular cash flow. So, then if you see that if
you expand that particular formula if you simplify that formula finally, we are getting
D1
P0 =
R−g
Then what this D1 is equal to this is nothing, but the D 0(1 + g) / R - g. So, D0 is the initial
dividend what the company is paying and g is equal to the growth rate of the dividend, R is
equal to the discount rate or the cost of equity and this is the way in the P 0 is equal to the
intrinsic value of that particular equity what basically we are calculating using dividend as the
cash flow.
So, this is the way basically this is one particular model which basically talks about the
valuation of equity which popularly known as the Gordon’s Growth Model. Gordon has
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given this particular concept assuming that the growth rate of the dividend remains constant
for an indefinite period of time. So, let us see how this particular thing can be derived.
If you see we can start with the initial equation
n
Dt D1 D2 Dn
P 0 =∑ + +… … … … ……+
( 1+ R ) = ( 1+ R ) ( 1+ R ) ---------(1)
t 1 2 n
t=1 ( 1+R )
Then if you assume that the growth rate of g is constant and D 0 is equal to the initial
dividend. So, here if you see this D 0 which is the initial dividend g is equal to the constant
growth rate, then you can expand it and this way D 1 is nothing but
1 2 n
D 0 (1+ g) D 0 (1+g) D 0 (1+ g)
1
+ 2
+… …… … … …+ n
( 1+R ) ( 1+ R ) ( 1+ R )
Then if you take common D 0, you can take common because D 0 is involved in all the terms
in that particular equation. Then you can take the bracket then you can find
(1+ g)1 (1+ g)2 (1+ g)n

D0
[ 1
+
( 1+ R ) ( 1+ R )
2
+… … … …… …+
]
( 1+ R ) ------------------------- (2)
n
Then what you can do? Let you multiply both sides by (1 + R) / (1 + g).
1+ R (1+ g)1 (1+ g)2 (1+ g)n

P0 [ ]
1+ g =
D 0 1+ 1
+
[
( 1+ R ) ( 1+ R )
2
+… … …… … …+
( 1+ R ) -----------(3)
n ]
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Then 1 plus g 1 plus g will be cancelled in one place then finally, you are finding 1 plus R by
1 plus R then you are getting 1. Then other term will remain 1 plus g by 1 plus R plus 1 plus
g to the power 2 divided by 1 plus R to the power 2 and so on. And finally, you are getting 1
plus g to the power n divided by 1 plus R to the power n.
Then you what you can do? You subtract this equation from this equation, then what you will
find that all the terms will be cancelled and finally, what you get you are only finding that
1+ R (1+ g)n
P0 [ 1+ g ]
−1 = D 0 1−
[( 1+ R )
n
]
------------------------------------------------------------ 4)
Then as you know that R is greater than g then automatically if n tends to infinity, then this
term will be very negligible. It will be very much close to0. So, then 1 plus g to the power n
divide by 1 plus R to the power n will be closely equal to 0, then you can cancel that
particular term. Then finally, what you can find out that if you simplify that equation then
finally, you will find out P 0 ( R−g )=D 0 ( 1+ g ) then; obviously, then
(1+ g) D1
P 0 =D 0 =
(R−g) (R−g)
So, this is the way this particular formula can be derived and this formula basically talks
about where the growth rate is constant; growth rate is constant for a indefinite period of time
remember for indefinite period of time. So, this is basically very important in this context that
whenever the growth rate remains constant for indefinite period of time, then the value of
D1
equity is nothing, but the then R is equal to the cost of equity and g is equal to the
( R−g)
growth rate of the dividends.
So, this is the way the Gordon Growth Model can be derived and the constant growth model
can be derived. So, then you can move that not necessary that always from the beginning
whatever growth rate the company always gets, the same growth rate will continue for
indefinite period of time that may not be true. Let you can relax that assumption that let in the
beginning the growth rate is relatively higher and over the period the growth rate again come
down to a steady growth rate.
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So, the assumption basically here what, we can take the growth rate is constant for a
particular period of time maybe supernormal growth rate in the beginning, then it can come
down. We will see that thing further, then how the formula get change, but if you use that
equation and find out a value of that particular equity then let the dividend is 4 rupees and the
dividend are expected to grow at a rate of 6 percent; that means, g is equal to 6 percent.
Then required rate of return is 15 percent means your R is equal to fifteen percent then what
will the value then you can use directly that formula your D0 = 4, 4 × (1 + 0.06) which is the
growth rate. But you will be getting 4.24, then you can discount that 4.24 with respect to that
discount rate which is 15 percent in this case. Then 4.24 / 0.15 -0.16 that will give you 47.11
rupees.
So, this is the way basically the valuation of equity is done if the growth rate remains
constant for indefinite period of time. That is very easy to calculate because that is the way
basically we can all directly we can improve of the D 0 value, then you can use that formula
and get it this thing.
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And I already told you that is another model called the two stage growth model. There we are
assuming there are two different growth rates into different periods and there is a high growth
rate in the beginning and after a certain period of time the growth rate basically you will
reduce and it remains stable for indefinite period of time. If there are two different growth
rates which are available in one period that is a supernormal growth rate, in another period
that is a stable growth rate which is relatively lower.
So, in that context, then how we can calculate the value of the stock? The value of the stock
can be calculated you can calculate the present value of the cash flow in the extraordinary
growth phase or the supernormal growth phase, then you can find out the present value of the
terminal price. Then what is the terminal price? The terminal price is basically whatever
expected cash flow will be getting after the supernormal growth rate period will be over.
Then if you discount that particular price with respect to that proper discount rate whatever
we have in that particular period of time, then the terminal price of that particular stock can
be calculated.
So, now if you observe because we have the two different growth stages, we have two
different terms what we can use it for the valuation of that equity. One is the high growth rate
term and another one is the constant growth rate term or the stable growth rate term. So, if
you see this one this term talks about the high growth rate term and this term talks about the
constant growth rate term. And here the Pn with what we have taken. The Pn is basically
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nothing, but whatever expected dividend per share you are getting after the super normal
growth rate over.
The super normal growth rate over let are the period of n, then what is the expected dividend
you are getting and the period n + 1 then that n + 1. And we are assuming that that particular
dividend growth rate will remain constant over a period of time, then we can find out what is
the stable cost of equity or the required rate of return and what is the stable growth rate.
So, if you can do that then your P n can be calculated. So, that is the way basically the terminal
price can be calculated and the terminal price can be discounted and to find out the present
value. Then that present value and this present value if you add up, then you can find out the
value of the stock in that particular context. So, already I explain that thing here your r e is
equal to the cost of equity where hg represents the high growth period and st represents the
stable growth period and Pn is equal to your terminal price of the terminal value at the end of
year ng is equal to the growth extraordinary growth rate for the first n years.
And your g n is equal to the steady growth rate forever after the supernormal growth rate
period gets over. So, now you can see that a little bit you can expand this particular equation.
If you assume that the growth rate and the dividend payout ratio do not change in the first n
years, then the formula can be written as this way. You can use this same constant growth
rate formula the DPS 0 into 1 plus g into 1 minus 1 plus g to the power n divided by 1 plus
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your r to the power n and here the r is because if the first period the r is nothing, but the high
growth rate period r the cost of equity in the context of high growth period.
Then your r e minus g r minus g which is nothing, but the high growth period cost of equity
minus the growth rate of the dividend in that particular period plus your DPS and plus 1
divided by because you are discounting it which respect to this 1 plus r e h g to the power n
and finally, you are using the constant growth model and that is why you are getting it. That
means, DPS and plus 1 divided by 1 plus r e hg to the power n. Then whatever price we are
getting that again you are discounting it with respect to this stable growth cost of equity then
finally, the present value of that particular price or terminal price can be calculated.
So, DPS and plus 1 divided by 1 plus r e to the power n which is basically nothing, but the
value what we are getting in the end of the super normal period. So, let us see one example
then it will be clearer for you.
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Let there are two stages here we have taken; one is high growth stage, another one is stable
stage earnings per share. You assume that let for rupees dividend per share is 1.5 rupees, then
dividend payout ratio has become 37.5 percent. The return on equity is 30 percent cost of
equity is 10 percent which is your r e,hg . This is your basically your r e h g, then we have the
growth rate which is the growth rate in the super normal period. In this is your period which
is continue the growth rate high in growth rate continuous that is 5 years.
Then after 5 years, your retention ratio let become 44.44 percent that you are getting because
after that the growth rate has become 8 percent and your return on equity let for the company
is 18 percent that already you know that your growth is nothing, but the retention ratio
multiplied by the return on equity. So, if your growth is given and ROE is given the retention
ratio can be calculated that is 44.44 in this percent. This is 8 percent divided by the 18 percent
that you can get it this one. Then dividend payout ratio is nothing, but 1 minus your retention
ratio that is 55.55 percent in this case that you got it.
Then after using this data, you can use it for calculation of your value of the equity. Then
how basically you are trying to do this? If you see, then you can put those values in that
formula.
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Then 1.5 which is the initial dividend for share into 1.15 15 is the growth rate of 15 percent
with the growth rate then 1 + g, then 1.15 into 1 minus 1 + g n. That means, n is equal to 5
1.15 to the power n divided by 1 plus r to the power n; r in the first period is 10 percent in 1.1
to the power 5.
Then finally, what we are getting that divided by r minus g r in that high growth period is 10
percent in 0.1 minus 0.15, then you are getting 8.58 percent 8.58 rupees. Then expected
earnings per share after the nth period is over; that means, the first period was 15 percent
growth rate initial earnings was 4 rupees then 4 rupees multiplied by 1.15 to the power 5
multiplied by 1.081 point. Why you are multiplying 1.08 because in the 6th year the growth
rate was 8 percent.
Then what you are getting? 8.68, then you know that your dividend is 55.55 percent your
dividend payout ratio, then 8.68 into 0.555, you are getting 4.82. Then that 4.82 which is your
expected dividend divide by your next year’s cost of equity that is 12 percent which is given
minus g n which is the stable growth rate. Then 4.82 divided by 0.12 minus 0.08 what you are
getting 12.66 rupees.
Then what if you can calculate the present value of this, then you have to discount it with
respect to the discount rate that is 12 percent in the stable growth period. Then 120.66 divided
by 1.12 to the power 5, then you are getting 68.47 rupees. So, in the first period it was 8.58
rupees, next period is 68.47 rupees and if you add up, then the value of equity will be 77.05
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rupees. So, this is the way the two stage growth model works in the market. There are other
models also there are three stage model, there are h model and all this things for that you can
go for any valuation books which talks about in detail about those. But here I have just
introduced that two concepts where the valuation of equity can be carried out.
So, then already I told you there are two another kind of cash flow which is related to the
company that is your operating cash flow and how the operating cash flow is calculated that
we have explained in the previous class. You can use this same formula that you are OCF
instead of dividend you can calculate this OCF operating cash flow divided by 1 plus, but
here you remember your cost of capital is considered as the discount rate. And here it is not
the cost of equity why you are not talking about cost of equity because your cash flow what
you are considering that is with respect to the firm not with respect to the equity only.
So, WACC what already you know that what is WACC? WACC basically your Weighted
Average of Cost of Capital. So, how to calculate the weighted of cost average of cost of
capital? That is your cost of equity multiplied by the percentage of equity; that means, your E
upon D plus E D is equal to your debt plus your cost of debt let R c into D upon D plus E.
So, if you know the cost of equity, you know the cost of debt and how much percentage of
the equity the company has and how much percentage of debt the company has, then you can
find out the WACC. The weighted average of cost of capital can be calculated. These are the
weights as a percentage which is related to equity and the debt. Then what you can do? You
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can discount with respect to the WACC and the operating cash flow will be discounted and
finally, the value of the particular company can be calculated.
So, again same thing if you are assuming that there is a constant growth rate for the OCF,
then you can use the same Gordon formula what we have derived that your V is equal to or p
is equal to your D 1 divided by R minus g. In this case, your OCF 1 divided by WACC minus
g of growth rate of the OCF and your OCF 1 is nothing, but OCF 0 into 1 plus g divided by
your WACC minus the growth rate of the OCF then you can calculate the operating cash
flow.
But if you are going for the free cash flow then you can also use the same thing the operating
cash flow minus in the capital expenditure plus net debt issue that will give you the free cash
flow. Then if you have the free cash flow, the free cash flow is basically with respect to
equity. So, here again your R is equal to the cost of equity. Once you calculate the free cash
flow, you can already have the cost of equity with you and you know what is cost of equity.
Again I am reminding you the cost of equity basically you can calculated your R e is equal to
you can calculate your Rf + β (Rm - Rf ) and here your Rf is basically your risk free rate. You
can use the treasury bill rate or any other rate as a risk free rate R m is equal to the market rate.
And here your market rate is basically you can return from the sensex your BSE SENSEX,
you can take the return from the NSE NIFTY so on.
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Any kind of market index return can be calculated as considered as R f and Rf is equal to the
risk free rate and you can find out your R and once the R is calculated, you can calculate the
free cash flow. Then you discount with respect to that to find out the value of the particular
stock. So, this is another way; another way of calculation of the value of the stock. But
basically these are the formulas which are used to calculate the intrinsic value of the stock.
So, another one is basically what your relative valuation techniques and the relative valuation
techniques are used for what reason? To decide or to make a comparison between the
different stocks which are available in the market. So, whenever anybody wants to invest in
the market, then what kind of stock they should choose on the basis of their objective that
basically decided by the relative valuation techniques.
So, whenever you go for the relative valuation technique we always compare between the
similar stocks using certain ratios. So, using certain relative valuation ratios. What are those
relative ratios we use? The relative ratios can be used with respect to earnings with respect to
cash flow with respect to book value of the company or book value of the stock or it can be
also with respect to sales. Why basically, we go for using those kind of ratio analysis for
doing this, because the ratio analysis can normalize the data and that normality can help you
to make a comparison in a better way.
So, there are different ratios the most popular ratio is basically based on the price earning
ratio. You might have heard about p ratio that P E ratio is the most popular method for the
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valuation of the equity that is price earning ratio. So, let us see that how those ratios are
basically used for the valuation of that.
Then PE ratio is nothing, but the current market price the current market price upon the
expected earnings for the share. So, if you have the expected earnings per share, then you
have the current market price that will give you the PE ratio. And PE ratio means what is the
interpretation of the PE ratio. The PE ratio interprets that to get 1 unit of the return from 1
unit or 1 rupee or 1 dollar value of investment for a particular stock you have to spend 5
rupees.
So, if you are spending 5 rupees, you are getting 1 rupees. So, lower the PE, better for the
investor. So, lower the PE better for the investor because there is a growth potential of that
particular stock. You are investing less and getting more. So, that is the way the PE ratio is
interpreted in the market.
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Then we can see that there is a relationship you can establish between the dividend discount
model and the PE ratio. If you remember your P is equal nothing, but D 1 by R minus g or the
k minus g whatever way you can represent the required rate of return of the stock. Then if
you divide E in both side then you are D 1 upon a divide by k minus g or R minus g will give
you the value of the PE ratio.
Then what are those factors which can affect the p ratio the p ratio is determined by the
expected dividend payout ratio? It is also determined by the required rate of return of the
stock; that means, cost of equity then the growth rate of the dividends.
So, those factors also affect the price earning ratio of the company in already I told you that
lower the p better for the investor for investment in the market to you choose those stocks
which PE ratio is relatively low.
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So, any change of the k or g will have a larger impact. If you see the example, dividend is
constant required rate of return is 15 percent expected growth rate 10 percent D by E if is 0.5,
but k is equal to 0.15 g is equal to 0.1 then P by E has become 10. What let g has change k
has change from 15 to 16 percent. P by E become 8.33.
Let k has become 0 point remain 0.15 g has sense to 0.11, then it has become 12.5 that both
have changed let from 15 to it has become 14 percent from 10 to it has become 11 percent,
then P become 16.66. When a small changes in the k or g or R or g, will change this PE ratio
drastically. So, that is why we can say that these are the major factors which affect the PE
ratio.
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Then we have another ratio called price to cash flow some people argue that the companies
can manipulate the earnings, but the cash flow is less prone to the manipulation. So, because
of that the cash flow is very important for the valuation and as well as the credit analysis of
the company. So, you can also find out the market price upon the cash flow expected cash
flow for share of that particular firm and lower the cash flow again those particular stocks are
considered the value stocks. So, that is the way basically you can interpret this things in the
market.
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Then we have price to book ratio; the price to book ratio is a proxy for the growth
opportunity and the previous studies have shown that the price to book ratio and stock return
there is an inverse relationship. That means, if the price to book ratio is very much high; that
means, what the market value of that particular company is already high; that means, the
company is already over value.
So, in that context the expectation from that particular stock is relatively less or the return
expected return from the stock can be less because market has already overvalued that, but
the price to book ratio is very low then what we can say that book value is relatively high, but
earnings market price is relatively low. That means, market has undervalued the stock and
there is a possibility that the price of the stock will further grow up.
So, in that context lower the price to book ratio; that means, the company has more growth
opportunity expected growth opportunity is higher than it is a better candidate for the
investment in the market. So, this is the way the price to book ratio is used in the market.
Then we have price to sales ratio and ratio of basically varies with the industry, but relative
comparison using price to sales ratio should be between the firms within the similar
industries. Because those are affected by some kind of seasonal and cyclical factors in the
market.
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So, these are the references what you can go through to know more about this thing and
further we will be discussing about the markets and all this things related to the equity of the
stock.
Thank you.
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Lecture – 48
Stock Market – III
So, after they discussion on the valuation of equity are the different methods used for the
valuation of equity we can move into another session on the Stock Market. Now, in this
session will be discussing certain things related to the functioning of the market in this
financial system. So, if you remember that whenever you talk about the market, every
market has 2 segments and like any other market stock market also has 2 segments; one
is your primary market, another one is the secondary market.
So, in this session will be discussing on the primary market; and how the pricing of the
securities in the primary market is done then we can move into the discussion on
secondary market in the subsequent sessions.
You see that whenever we talk about primary market, what exactly the primary market
is? The primary market is basically what; it is the market where the securities are sold for
the first time. In India it is basically popularly known as the IPO market or Initial Public
Offerings.
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But in primary market initial offerings, initial public offerings or IPOs are not only
securities which are available or only instrument which are available. There are other
securities also available in this particular segment. There are different type of securities
which are available in this particular segment, which are those? One is your after this
IPO we have another instrument called the follow on public offerings and what do mean
by this? This is also one type of IPO.
But why we call it the follow on public offerings? Because, so this is basically offered
not for the first time. Here the company basically already listed in the stock exchange,
but the issues of new shares with the investors or the existing shareholders usually the
promoters to increase their capital base. So, already that company is not company which
is unlisted or first time they are coming to the market for the listing, but those companies
are already listed and they are already issuing the equity; already they have issued by
equity, but still they want to raise more equity from the public. So, because of that they
can go for the FPO or the Follow on Public Offerings
That is also another instrument, another process through which the instruments in the
primary market can be raised. Then we have another instrument called the right issue,
what is that right issue? The right issue is basically what, when the issue of securities is
made by the issuer to the shareholders which are existing, but on a particular date which
are fixed by the issuer that date is called the record date. So, the rights always there given
to the existing shareholders and whenever the company wants to raise the money or raise
the particular kind of resources from the market the priorities are given to the existing
shareholders the shareholders has the right to issue that security.
But, the date is fixed by the issuer and that is basically we call it the record date. Then
another thing is the bonus issue; the bonus issue basically whenever any kind of reserves
which are there in the company that can be utilized; companies tries to raise that
particular thing as a bonus issue. So, it is again to the existing shareholders as an record
date without any consideration from them, and there is no need to inform the
shareholders that this is the issue what they are trying to make and this is basically called
the bonus issue.
Then we have another issue called the private placement and when we call the private
placement? Whenever the issuer basically make the issue of the securities to a select
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group of persons, select group of investors not exceeding 49, which is neither a right
issue nor a public issue, then it is called the private placement.
That means, the equities what basically has been raised through that is private issue
placed and the number of investor in that particular security should not exceed 49. So, in
that context we call it is the private placement, this is also another type of instrument
which are raised from the primary market.
Then if you see that whenever you talk about the primary market most of the people
argue that the primary market development is the real development in the financial
system or what we can say that the importance of the primary market it quite large. Why
it is large? Whenever at a first time company has gone for IPO it increases the visibility
of the company and it also increases the alternative sources of finance for the company.
And once the company became public, there is a greater transparency, everybody will
come about will know about the company’s financial conditions and companies are also
bound to follow certain kind of regulatory norms of the regulators like securities and
exchange board of India. And as well as, any kind of shareholder or any kind of people
who are involved to that particular company they can always have the idea that what
kind of business the company is doing and what is the pricing and all these things related
to that particular company that all kind of information they can get. And I already told
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you it also helps in raising the capital because equity is another source of fund after the
debt and this other type of instruments.
So, initial public offerings or the importance of IPO market helps to raise the capital
from the market in the larger extent. And they helps basically creation of the capital for
the company for the investment. Because the capital sometimes in the equity market is
cheaper, because the price of the IPO is relatively less, it also helps for the investment
and once the investment will go up it basically helps also to enhancing the profitability.
The profitability of the company can be increased through this IPO.
Then we have a better corporate governance why we can say that raising the money from
the public increases the corporate governance, because anybody who invests in their
particular company through this IPO market in terms of equity. So, they are much more
concerned about the operations of the company or the financial condition of the
company. So, because of that the governance of this particular company will be better
off, and the manager will be much more concerned about the performance and because
of that the company’s governance system can be always judged in a better way by the
public domain.
So, this is another relevance or another importance for the development of the IPO
market, after all the IPO market basically the real addition to the existing system which
is not basically always we realize from the secondary market. So, the development of the
IPO market is quite important, because the new capital can be generated through this
development of the IPO market.
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So, how this IPOs are issued? Whether all companies can issued the IPO or all company
can go for IPO or not? These are the different questions. So, whenever any company
basically goes for IPO the basic objective of the issuing the IPO is the company wants to
raise the money from the public and as well as the company wants to be listed in the
stock exchange.
If the company wants to be listed in the stock exchange, then whether is there any
possibility that every company wants to, if any company wants to go for IPO they can do
it or not. So, there are different ways different conditions the regulatory bodies have
particularly SEBI has put for these ones of the IPO in the market. So, not all the
companies can go for IPO whenever they want they have to fulfill certain conditions and
after fulfilling of the conditions only they can raise the IPO from the market. Then what
are those kind of conditions they basically want to put.
So, let there is an entry norm and here in the entry norm one the route is called the
profitability route. So, in the profitability route what are those conditions? The company
who wants to raise the IPO the net tangible asset of the particular company should be at
least 3 crore in each of the preceding 3 full years. So, last 3 years the company’s net
tangible asset; tangible asset in the sense the fixed assets we are referring at least the
value of the tangible asset of the company should be 3 crore.
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And the company has generated the profit and that is a distributable profit for at least 3
of the immediately preceding 5 years. The company is able to generate the profit from
the market and that is why whenever the company has started the operation, there is
some kind of distributable profit is existing with this particular company.
Net worth of the company at least 1 crore in each of the preceding 3 full years, the last 3
years preceding 3 years the net worth of the company should be at least 1 crore and if the
company has changed its name in between and the company has started this operations
or it has been founded. Then within the last 1 year, at least 50 percent of the revenue of
the preceding 1 year should be from the new company. Whatever new name they have
given the 50 percent of the revenue has been generated in the name of the new company
and through that new whatever name basically they have given and on that name
basically they are issuing the IPO.
So, because on that name they are issuing the IPO, the 50 percent of the total revenue
should come from that. And the issue size does not exceed 5 times the pre issue net
worth as per the audited balance sheet of the last financial year. How much basically
they can raise from the market? How much equity they can raise? That depends upon
their net worth. So, if the net worth is 2 crore in the last financial year.
So, they can raise maximum 10 crore because it should not exceed the 5 times of the pre
issue, a net worth of that particular company whatever net worth the company has. The
maximum 5 times of the net worth, so, equity they can raise it from the public. So, that
is, these are the conditions the company has to satisfy if the company at all wanted to
issue the IPO from the market.
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Then we have another one that is your entry norm II that is called the QIB route
Qualified Institutional Buyer route. So, here what basically happens, what is the
condition the SEBI has put forth? That the issue shall be through the book building route,
that is a book building process for raising the IPO that we will discuss, and at least 50
percent to be mandatorily alerted to the QIBs.
There are some qualified institutional buyers exist in the market and whatever IPO they
want to raise from the public out of them the 50 percent should be reserved for the QIBs,
that basically they have to do and the minimum post issue face value of the capital
should be 10 crore. The face value, the minimum post issue face value of the capital
what they want to raise that should be 10 crore and that is called the QIB route.
That means, all the 100 percent money what they want to raise it from the public, that
should not be directly from the public or the capital investors, that is 50 percent of the
total money will be reserved for the QIBs and another 50 percent money can be raised
from the public.
Then we have another route that is called the appraisal route; in the appraisal route the
particular project is apprised and participated to the extent of 15 percent by financial
institutions scheduled commercial banks of which at least 10 percent come from the
appraisers and the minimum post issue value should be 10 crore. So, these are the
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different kind of routes through which the IPOs become, if the either of this condition the
company will satisfy, then they can raise they can issue the IPO from the market.
So, these are the norms which are put forth by SEBI for the issuance of the IPO by the
companies in the financial system. Then whenever the IPO s are issued from the issued
to the market or the company wants to issue the IPO to raise the money, which are those
major stakeholders who are involved in this process? So, obviously, there is a regulator.
So, in the Indian context this is SEBI, Securities and Exchange Board of India.
Then we have a stock exchange, we have the stock exchange like Bombay stock
exchange National Stock Exchange and all. So, they are basically the important national
stock exchange is responsible for the US market. And we have the national stock
exchange or we have the Bombay stock exchange they are responsible for this.
Then they have a lead manager or the underwriter they have which is called the book
runner lead manager which is basically a merchant banker. They should be there; they
have a strong rule for the IPO issue once, then we have a register of this particular issue.
Merchant banker appoints one register for this who basically keeps the records and
everything for the transactions and all kind of process which happens to the IPOs. Then
the merchant banker also appoint some Syndicate members who are registered again
with the SEBI, who works as basically one of the intermediary for creating demand and
supply situation in the market. So, these are the different kind of stakeholders which are
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involved in this IPO issuance process and they basically helpful for the issuing the IPO
from the market.
So, whenever you talk about the IPO pricing methods, there are 2 types of methods we
follow, either we can go for a book building process or book building issues or we can
go for a fixed price issues. There are 2 ways the IPO pricing is done from the market or
IPOs are issued in the market.
So, how basically it is different if you see whenever we are using the fixed price issues,
in the fixed price process the prices are known in advance to the investor at what price
the IPOs are basically they are getting. So, whenever they are buying this IPOs the initial
issues they know that at what price this IPO s are basically available for that whether the
for issue it is 50 rupees 20 rupees 30 rupees that is known to them.
And the demand for the securities, how much demand is there for that IPO that will be
known only after the closure of the issue. Once the issue will be closed, then only they
will come to know that what kind of demand the people have or the investor has on this
particular type of security. And here the payment how do they make, the 100 percent
advance payment is required by the investor at the time of application.
If the investor wants to invest in that IPO, then 10 percent of the total money they have
to pay; if they want to invest, they want to buy 100 shares of 100 rupees then total 100
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into 100 they have to pay all those 10000 rupees to them. Then we have the reservations
under 50 percent of the shares result for the applications below 1 lakh and the balance of
higher amount the applications; that means, there is some kind of advantages are given to
the small investors who wants to maximum 1 lakh rupees.
So, whatever IPOs will be issued these are basically reserved for the, if it is a fixed price
issue, then the investor who wants to invest up to maximum 1 lakh rupees for them the
50 percent shares are reserved and another 50 percent basically can be given to the other
shareholders who are the bigger share holders. Then the book building issues if you talk
about here the price band is different the offer price is not exactly mention a 20 percent
price band is offered by the issuer within which investor are allowed to bid and the final
price is determined by the issuer only after the closure of the bidding there is a bidding
time period and you can bid it there is a price band will be given their exact price will not
be mentioned.
So, within that price band you can bid for this, but exactly what price will be determined
that will be not basically known from the beginning. The demand for securities offered
and that various prices is available on the real time basis on the stock exchange during
this bidding period. What kind of demand is created for that particular IPO in the real
time basis this is all reflected in the stock exchange website you can see that one.
And 10 percent of advance payment is required to be made by the QIBs along with the
application, while the other categories qualified institutional buyers have to pay only 10
percent of the advance and other has to pay the 100 percent of the advance along with the
application whenever they want to subscribe that particular IPO.
In terms of reservations if you see the 50 percent reservations are for the QIBs, 35
percent of the small investors and the balance is for the other investors; that means, 85
percent of reserved 50 percent for QIBs qualified institutional buyers and 50 percent
reserved for the small investors who are investing less than 1 lakh rupees. And rest of the
money will be offered to the other type of investors when who are not the qualified
institutional buyers neither or neither their qualified institutional buyers nor they are the
small investors category, so, for them only 15 percent is reserved for them for the
investment.
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Then we can see that what exactly the book building processes is, how the book building
process works? That for example, any company has gone for IPO nobody knows about
the company and the company has started the business although this is there in the
market for 5 years or for 10 years down the line. But the company is not listed in the
market very less information is available about the company.
But the company wanted to be listed in the stock exchange and they want to raise the
money from the public through this IPO market to the issuance of the IPO. Then how
they decide the price and how this particular price are determined this process is
basically through which process, the price is determined and the demand for that IPO is
determined that is basically the process itself is called the book building process.
So, here what is the first step? The first step is, let any company has thought of by
issuing the IPO in the equity market, that is the first step. And once they have thought of
what is the next step they have to basically appoint one lead manager merchant banker
basically or in our language also we can call them the investment banker.
So, there is a merchant banker they will appoint they are called the BRLM, the Book
Runner Lead Manager. The BRLM stands for the book runner lead manager that will be
appointed by the issuing company. First the book runner lead manager will be appointed.
Then with the consultation of the company the book runner lead manager prepares the
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draft prospectus one prospectors will be prepared. You remember these prospectors will
not contain about the pricing of this particular equity or pricing of the particular issue.
But, it will contain about the company, about the history of the company, what are the
nature of the business the company is doing, what is the growth prospect of the company
all the details. So, once the particular prospects will be prepared the draft prospect will
be always files with SEBI for their approval. The SEBI will go through this draft
prospect it will be sent to securities and exchange board of India. SEBI will go through
the draft prospect and decide whether everything is in order or not.
And once they got this legal approval from the SEBI then what will happen that a fixed
definite period will be fixed which is called the bid period. Generally 5 days a bid period
will be fixed and this is the responsibility of the BRLM the book runner lead manager
and merchant banker and to create the awareness about this particular issue or the IPO
issuance through the advertisement they can go for the road show they can publish it in
the newspapers.
So, all type of process can happen and this is the responsibility of the book runner lead
manager who also acts as the under writer. And their responsibility is basically what, to
create the awareness about this issue once about this particular IPO and to create the
demand basically, that the major responsibilities to tell the public that this is the IPO
which is issued. And this is the price band and this is the company which is issuing this
is basically the age of the company this is the nature of the business of the company all
the details everything will be there. And there will be a proper advertisement and the
road show and that is the responsibility of the book runner lead manager.
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Once this is done, the next step is the book runner lead manager will appoint a Syndicate
member. The Syndicate member is basically what, it is a SEBI registered intermediary
the basic job of this Syndicate member is to underwrite this issues to the extent of net
offer to the public or their basic job is to basically creation of the demand among the
public. Then what will happen that once the Syndicate members will be decided
whatever the copy the draft prospectus has been prepared that book runner lead manager
will share that prospectus with the some bigger institutional investors and as well as the
Syndicate members.
Now, Syndicate members have received the copies and as well as the some of the
institutional investors also have received the copy of the prospectus. So, once they
receive the prospectus what they will do, they will share it among the different public
domain and they try to judge that what kind of demand is available with respect to this.
So, then the Syndicate members create the demand and asks each investor for the number
of shares and the offer price.
Then what will happen the Syndicate member will provide the feedback to the BRLM
about the investors bid and once the BRLM got this feedback, then what will happen that
this prospective investors may revise their bids at any time. If after knowing the
prospectus and everything they want to revise the bid also, they let they have bided for
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50 and what now they want to change it 51 or they want to change it to 49 that also they
can do.
And accordingly, what will happen that up to that bidding time they cannot exceed that
within that 5 days time period or whatever changes whatever religions they want to make
they can make it. And all the information will go to the book runner lead manager and
once the book runner lead manager will get all those information.
Then what will happen, after that the book runner lead manager and the issuer company
determine the issue price depending upon the demand of that particular issue they decide
the final price which is called the market clearing price. After the final price are
determined what we always define it as the market clearing price.
And once the market clearing price will be decided, then the book runner lead manager
then close the book in consultation with a issuer company and determine the issue size
that how much will be reserved for the specific group of investor and how much will be
given to the public. Then what will happen the allocation of the securities will be made
based on the prior commitments, investor’s quality, price aggression, earliness of the
bids etcetera.
There are different factors they can consider then after considerations what will happen
that they will allocate this particular funds or allocate this particular resource to the
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different type of investors. And finally, once the allocation is made then ROC filing of
the final prospectus will be made. The ROC means, the record filing what basically they
do it the register of companies filing of the prospectors they do that.
Then once it is done with the SEBI once it is done then the company can be listed and
the funds transferred to the issuer whatever money basically the company the investors
are bided the money will be transferred to the different issuers or the issuing company
who wants to issue this particular shares. And once it is listed then finally, this become
the capital of the company and company can use that particular fund for their
investments. So, that is the detailed step of the book building process this is the way the
price of this equity can be determined in this particular market.
So, there is another process called the reverse book building where the companies
intended to delist their shares through the buy back, they have gone for the book building
they have listed, but they want to delist themselves by backing the shares. Then what
they do, again they can appoint the book run lead manager, they can go for they again the
reverse book building process and order will be placed by the shareholders only through
the designated trading members duly approved by the stock exchange then the offer will
be again open for some days then the BRLM will initiate the final aspect acceptance
price and provide the valid accepted order file to the National Securities Clearing
Corporation Limited.
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So, all those details, it is same process, but the process is reversed. So, there the company
wants to delist itself from the stock exchange.
Then generally it is observed the IPOs are under priced in nature and why it is
underpriced there are various reasons for that you see there is one reason is winners
curse, winner curse means there are 2 types of investors available in the market; one is
informed another one is uninformed.
So, sometimes what happens that whenever the allocation is made the particular
investors who are uninformed they always feel that whatever quotations have give they
got all kind of IPOs because they deserve to get that IPOs, but maybe there are certain
things they are not aware about, that is why the bidding whatever they have made that is
relatively in the higher zone about the informed investors may not look at that.
So, in that context intentionally if the price will be relatively low then that kind of
problem will not arise in the particular system. Then sometimes also what happens this
information disclosure may happen to the pre selling period the book run lead manager
book run a BRLM basically can save this information to some specific group of the
investors and to attract them for the investment they can give that particular price
relatively low. Informational cascades; that means, basically what happens that creates
some kind of information gap between the different group of the investors which exist in
the market.
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So, because of lack of information with some group maybe the reluctant to go and invest
in this IPO to attract them for the investment, generally what the companies do they
reduce that particular price and the book runner lead manager intentionally reduced the
price or keep the price low for their investment. Then sometimes also they keep this
price relatively low which gives a signal for the future issuance and the future they can
do there can be information asymmetry between farms an investment banker or the
merchant banker because merchant banker has more idea about this IPO pricing than the
company.
So, they can use because of that they intentionally keep the price low. There are some
regulatory constant also in some of the countries, they cannot give the price to a higher
level. Then, they have political goals sometimes the companies are going for the IPO the
reason is basically they want to provide those kind of IPOs to their own people or the
party members who wants to support them and the political system. So, because of that
they always compel this companies to reduce that IPO price by that everybody can invest
in that and there are some psychological or the behavioral theories also involved in this.
The biases are to attract this investors to participate in the process sometimes also the
pricing relatively always kept low for the IPOs.
So, these are the different factors which are responsible for the under pricing of the IPOs,
because once the IPO is listed the price all of sudden goes up that you might observe 99
percent of the cases the IPOs are highly always is under priced in the market and once it
is listed you will find that the price all of sudden will go up by 50 25 to 30 percent. That
always we have seen in the market system. So, this is about the different IPOs and the
factors deriving the IPO pricing.
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So, these are the references you can go through for this particular session and you can get
the detail idea about this IPO and IPO pricing.
Thank you.
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Lecture – 49
Stock Market – IV
So, in the previous class we discussed about the primary market and how the equities
and all these things that issued in the primary market; what is the book building process;
what is the reverse book building process and in this context what are those different
instruments available in the primary market; how the primary market works; what is the
importance of the primary market and all these things.
So, in this session we will be discussing certain things related to the secondary equity
market and what exactly the secondary equity market is and how the market functions
and as well as what those different issues and all these things are related to the equity
market.
Already, what we have discussed the secondary equity market is the market where the
securities are traded after being initially offer to the public in the primary market or they
are already being listed on the stock exchange. That part already we have discussed
whenever we discussed about the difference between the primary market and the
secondary market. So, that means, any securities which are raised from the public
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through the IPO market or the primary market those markets those particular securities
are listed in the stock exchange and once they are listed in the stock exchange those
securities are basically traded by the different type of investors existing in the system or
existing in the financial market.
So, here, that means, already we have discussed. So, these are the issues these are the
securities which does not add any kind of new addition to the system, but these are the
securities which are basically creates this value addition to the system only depending
upon the demand and supply of that particular security. So, that is why these securities
are traded, they are cleared and settled within this regulatory framework prescribed by
the exchanges; that means, stock exchanges what we are referring and this Securities and
Exchange Board of India which is the regulator of the stock exchanges.
So, this is the basic notion of the secondary equity market or whatever we have. So, there
are two ways the secondary equity market works one is your through the over the counter
market or the OTC market and the other one is the exchange traded market. So, mostly
the equity market is dominated by the exchange traded market across the globe including
India.
So, mostly we will discuss certain integrity is certain issues which are related to the
exchange traded market not with the OTC market. So, our focus will be more on the
process which always take place or the process what we use for the trading of this
particular share in terms of the secondary equity market with respect to the exchange
traded market that actually we can keep in the mind.
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So, let us see that already what basically I told you that the secondary equity market
works with two ways the securities that traded, one is OTC another one is exchange
traded and but mostly the equities are traded through the exchange traded market. So,
here if you talk about India; that means, one it is exchange traded means the trading is
taking place through the stock exchanges.
So, there are many stock exchanges which exist in India. Currently, if you see there are
20 stock exchanges exist in India, but you may not have aware about the other stock
exchanges, but we are much more concerned about to major stock exchanges that is your
BSE and NSE Bombay Stock Exchange and the National Stock Exchange of India.
But, there are so the other stock exchanges are basically the regional stock exchanges.
This you have stock exchanges in Kolkata, you have stock exchanges in Bhubaneswar,
you have stock exchanges in Delhi and what kind of places we have the stock exchanges,
but those are the regional stock exchanges not most studies takes place in those stock
exchanges, but they are also exist in the system.
So, if you see that in India the BSE which is the oldest stock exchange. We can say that
it is the Asia’s fast stock exchange which was established in 1875 and from there
onwards previously it was not exchange traded market, this was exchange traded stock.
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It was not basically doing the trading through the exchanges, through the online trading;
mostly all the trading was that time was taking place in the floors. So, people used to go
to the trading floor and the trading takes place through that. But, now it is online trading
system the screen base trading system we have, we can take the positions in the equity
market sitting at home using our computers and other things.
BSE is the popular stocking index whatever equity index we have that is S and P BSE
SENSEX. BSE SENSEX is the year mark we can say that it is the year mark for the
market performance. Everybody uses that how the market works on the basis of the
fluctuations of the BSE SENSEX or the return what the BSE SENSEX provides that is
why it is the India’s most widely traded stock market benchmark index. So, it is
considered as the most used market benchmark index which is existing in the context of
Indian equity market.
If you talk about the NSE in terms of trading in the stock exchange the revolution was
started by the NSE. The basic objective of NSE was to make this particular system more
transparent and bring more people to the equity market and the trading will be related
with the transaction cost in terms of trading will be cheaper and that was the different
objective of the NSE.
So, that is why NSE was started in November, 1992 after the liberalization process and it
was from the beginning they were using the screen based trading system and they were
trying to fulfill the overall the segments, they are trying to basically cater the demand of
the equity markets largely in terms of all the segments; whether it is in terms of equity, in
terms of debt, in terms of derivatives. So, in terms of derivatives they have the largest
share around 99 percent of the turnover or the trading takes place in terms of derivatives
is NSE.
So, that is why the NSE has made a revolution. Establishment of NSE has created certain
kind of larger as created a significance in terms of equity market because those market
became quite popular in a short span of time. Those index became popular within a short
span of time and this BSE SENSEX even if it is a year mark the NSE Nifty is also which
is a popular index provided by NSE that also has its own significance and most of the
people argue that it is a better benchmark than the BSE because it has more number of
stocks and it tries to capture those stocks which are reasonably more or highly liquid.
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All kinds of issues are there, but still these are the major stock exchanges which exist in
India and all the trading takes place through these two types of stock exchange whatever
we have.
So, then let us see that already I discussed with you these are two major stock indices
whatever we have one is BSE SENSEX another one is NSE Nifty, but let us discuss
something that how this particular indices are created, how these indices are constructed.
Maybe these are the representative of a particular sample.
Let BSE there are more than 5000 companies are listed close to 6000 and NSE we have
2000 plus companies are listed, but out of the 2000 NSE has prepared index of 50
companies and out of close to 6000 companies BSE has made an index only for the 30
stocks. Now, how these 30 stocks? Why there are 30 stocks and why 50 stocks? Those
questions always come to the mind.
So, here basically what I was trying to discuss with you that how exactly this indices are
created and why this indices are created, what is the basic job of the indices. So, if you
talk about the stock market indices; the stock market indices basically always try to by
looking at the performance of the indices you can judge the performance of the investor.
You can compare that how much they return the market is giving and how much return
this investor is getting, whenever they are investing in the individual stocks.
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Also you can get how much market basically has give and they can predict that market. It
is mostly used for the prediction of the market whether in the future in the expect return
from the market will be more or the market is going to be better or the market is going to
be down. All kind of implications we can draw whenever we are looking at the
performance of the indices.
Then, whenever we construct any index then what are the things we have to see because
already I told you see there are 300 stocks out of 5000 odd companies and there are 50
stocks out of 2000 odd companies, why and how? So, then first of all whenever we are
constructing any index out of a total population. First of all the index are the sample what
you are selecting that should be the representative of the total population. Your sample
should be the total representative of the total population that is number 1.
And for every index we should always consider a base year and do you remember what
do you mean by base year? And the base year always we compare that value with respect
to that base year and you remember the base year should be normal year. Normal year
mean there should not be any kind of crisis in that particular period, there should not be
any natural calamity which has happened in that particular period, there should not be
any kind of financial market crisis on any bubble or anything which have not occurred in
that particular year; that means, the period is reasonably a normal year that actually you
have to keep in the mind.
Then, there are different ways the weights are given. What are those working criteria?
The criteria you can give once you have chosen the stocks and you know what is the base
year, what you can do? You can give equal weights to all the stocks, you can give the
weights on the basis of the price of the stock. You can give the weight on the basis of the
market value of the stock; market value of the stock in the sense the market
capitalization, total number of stocks outstanding multiplied by the price of the stock that
way you can give or a free float market capitalization.
Free float market capitalization means how much market capitalization or how much
stocks are relatively more liquid within that stocks which are outstanding in that.
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So, if you see what do you mean by the free float market capitalization? It takes into
consideration only those shares issued by the company that are readily available for the
trading in the market. That means, only the liquid stocks are considered for the
calculation of the market capitalization and on that basis the weights are given.
And basically it in excludes the promoters holding, the government holding, other
strategic holding if the company has, other locked in shares if there are some specific
locked in issues are involved in that stock and those stocks are not come in to the market
in the normal course of the trading. So, only those stocks which are available to
everybody, related to the retail investors and we can participate, everybody can
participate for buying and selling of that security.
And these are readily available for the trading in the market only those stocks are
considered as the free float stocks and whenever we are calculating the market
capitalization we should consider those stocks not the other stocks which are basically
not that liquid in the market.
So, that is why the market capitalization of each company in a free float index is reduced
to the extent of its readily available shares in the market that actually is the basic notion
of the market free float market capitalization in the context of indexed construction.
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If you see the example here this is a hypothetical example. Let we have the three stocks
in your index and quantity of the stocks are given let 60000, 20000, 90000. A is 60, B is
20, C is 90 and we have the base year which is given base year price 30, 25, 65. Then we
have the current year price that is 45, 80, 85. Then these are the free float factor which
has given 55 percent, 75 percent and 95 percent. If you are giving the equal weights to all
the stocks then what is the multiplier you can find out then equal weighted means it is
(1/3) × (45 /30) + (80 / 25) + (85 / 65) then you are getting 2.0033.
If you are giving the weights on the basis of the price then all the price 45, 80, 85 you
can add up all divided by 30 plus 25 plus 65. You can getting a factor which is multiplied
that is 1.75. If it is a market value weighted series then you can multiply 60000 ×45 plus
20000 ×80 + 90000 ×85 then what you can do divided by you can again were assuming
that quantity remains same 60000 ×30 + 20000 ×25 + 90000 × 65 then you can get 1.46.
If you go for a free float market capitalization and what you can do you can 60000 ×45
×0.55 + 20000 × 80 ×0.75 and so on. Then you can find out a factor called 1.43. But,
what is the significance of these values; that means, if your base value of the index has
been taken as 100 in the current year then the value of the index using the different
weighting criteria can be if you are going for equal weighted 100 multiplied by this it
will be 200.33.
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If you are going by a price weighted says is the value will be 175; if you go for a market
value weighted say it will be 146; if you are going for a free float market value weighted
say it is it will be 143. So, this is the way the value of the index is calculated with respect
to the base value.
So, here you are calculating the multiplier then the base value data is available with you
can multiply with respect to that then the value of the particular index in that particular
year can be calculated. So, depending upon the weights the value can be changed that
actually we can keep in the mind.
So, here I have given some information about the major stock indices which are available
in India and abroad and what a kind of weighting criteria they are using what is the base
year and what is the base value they are using. If you see the S and P our SENSEX we
have sample size is 30, our base year is 78 – 79, the base value was 100; that means, now
the index value at 25000, 26000. So, now, it has become from 100 to 26000.
So, in 78 – 79 the value was 100 and from the beginning it was valuated series; that
means, on the basis of the market capitalization the weights were given, but from
September, 2003 it uses the free float methodology; that means, the free float market
capitalization is considered for giving the weights to that particular stocks. CNX Nifty;
now, the 50 stocks November 1995 is the base year base value was thousand. Again, it
was a value weighted series only since 2009 it uses the free float methodology. Then
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DJIJ is a 30 stocks. 1938 is the base year, base value is 100 then that is they are using the
free float series. S and P composite, 500 is the sample, then we have the 41 – 42 is the
base year there are only 10 stocks and the value weighted series. Then the NASDAQ
stock NYSE the Newyork stock exchange we have the sample size is 2818, base year is
1965, there are 50 companies and it is a value weighted series.
So, these are the different examples. Then they have so many number of indices
available you can check that what kind of weights they are using and what are those base
year and the base value they are considering.
So, then another issue related to this thing how can read the stock index quotations, but
you must have reading those things from the newspaper, from different magazines,
financial magazines and all these things then how basically these quotations are
interpreted.
So, if you see generally the first is basically talks about the symbol which was given to
this company or the index later the CNX Nifty or SBI this is the data for 30th June, 2014.
At what price this market has opened, at what price, up to how much the market the price
has gone up in a particular day, the highest price in a particular day.
How much was the low and what price the market was closed, what were the trading
volume and what is the value of the trading volume means how many shares are traded
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on that day in the market, what is the value of the trades, how many stocks are traded,
what is the value in terms of the cross, what is the price earnings ratio, price of on
earning per share, what is the price to book ratio just now we have discussed about that?
What is the dividend yield, dividend per yield basically the company is giving how much
is the price in a year – 52 weeks means it is a year, what is the highest price and what is
the lowest price in a particular year.
So, this is the data either you can get it for the index or you can get it for a particular
stock. You can compare that, basic where you stand. So, this is the way basically and this
is the way the interpretation is always made for that it represents the name of the
company or the index column 1 column 2 represent the transactions or the trade on a
particular day date of the transactions. Then column 3, it is the price at which security
first trades upon the opening of the stock exchange on a given trading day. 4 and 5
basically indicates the price range at which stock has traded or throughout the day.
So, these are the maximum and minimum prices that investors have paid for the stock.
Column 6 which gives about the whenever the trading closes what is the price recorded
on that day and column 7 if you see this is the volume of total number of shares traded
for the day; column 8 indicates that means, value of the trades which is basically total
value of the trades happened on that day; that means, this multiplied by the average
price.
Price earnings ratio, this is basically current stock price upon the earnings per share; that
means, it indicates how much the investors are willing to pay per unit of the earnings that
already told you. If you want to get 1 rupee earnings on a particular or a particular stock
then how much rupee you want to invest that basically is represented as P / E.
Then, you have the price to book already I told you that lower the price to book better the
growth opportunity. The dividend yield mean is a percentage return on the dividend the
annual dividend per share divided by the price per share that gives you the dividend
yield. Then these are the highest and lowest price for a particular year. This is the way
you can find out you can compare these things with respect to the different other stocks
which are available.
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Then accordingly what will happen you can decide whether you want to invest in that
particular stock or not and how your stock is performing against this market whatever
market we have.
Then, if you see there are different type of investors which exist in the market. We can
define them in the basis of their positioning. So, if you see that whenever you talk about
the types of investor we are talking about, some groups are called the investor, some
groups are called the traders. And whenever you talk about investors, investor generally
participate in the market for a longer period of time. They do not change their position.
So, frequently and they stay in the market for a reasonable period of time and they hold
the stocks where they can maximize their return.
But, whenever we talk about the traders the trader’s objective was basically to create
some opportunity in the market and wherever there is opportunity they can take their
positions and they change the position so frequently. So, it involved, the trading basically
involves the frequent buying and selling and their objective is generating returns more
than the returns received from buy and hold strategy or they what they market is giving;
that means, they are expecting that they want to get more return what the market is
giving or the passive investors what they are basically getting.
So, for traders profits are generated through buying at a lower price and selling at higher
price which is short period of time. So, their positioning in the market is very short term
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in nature. So, there are traders can be categorized in the various ways mostly we can
define there are four types of traders what we find in the market. One is position trader;
position traders basically it change their position either from held from months to years.
There is swing traders positions are held from days to weeks, they change their position
within a week. Day trader the positions are held throughout the day and no overnight
position. They leave the market within a day then we have a scalp trader’s where
basically the positions are taken seconds to minutes. Every second every minute they can
change their positions, either they can buy or sell and there is no overnight position; for 1
day even they do not stay in the market. So, they want to create the look for the arbitrage
opportunity if there is an arbitrary opportunity and there is a chance of getting high
return, they get that return and always leave the market.
So, these are basically the scalp traders always will find they are very highly short term
traders and this they shown they change the market so frequently. So, these are the
different type of traders what we can get it from the market.
Then, we have another concept is related to market we are you should concerned about
that is the liquidity because the market should be liquid in the sense that it is easy to
trade and the transaction cost in the market should be low and because of that we can
always take the position in a better way to maximize the return.
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So, at what context or what time we can say that the stock market is liquid? The stock
market will be liquid whenever the traders can quickly buy or sell the large number of
shares with a minimal impact on the price; that means, they are changing their positions.
The trading is taking place, but the impact on the price is relatively less and the cost of
the trading in the market is also relatively less. In that context we can say the market is
liquid.
So, liquidity of the market is basically multi-dimensional. There are different dimensions
of liquidity we can measure liquidity in terms of width, in terms of depth, in terms of the
immediacy in terms of resiliency. So, what do mean by width? Width means the bid ask
spread already again and again we are telling a bid ask spread is lower market is more
liquid bid ask spread is higher than the market is less liquid. Depth is what? It is the
number of shares that can be traded at a given bid and ask prices which are available in
the market.
Immediacy means how fast or how quickly the traders of a given size can be done at a
given cost. How quickly the trading takes place that is basically immediacy without any
kind of delay. Resiliency means how fast the prices revert to former levels after they
changed in response to large order flow imbalances initiated by the uninformed traders.
There are certain uninformed traders which exist in the market and because of their
positioning and those positioning are basically irrational. Those irrational positioning
may disturb the market and that deviate the price from the equilibrium.
What resiliency, if the market is really liquid the market is more resilient then what will
happen then it will take less time to get back to the original position, even if there are
some disturbances which have occurred because of the irrational trade off which exist in
the market or on informed trade off which exist in the market.
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So, that is why investors always decide their stock for investment by comparing the
market value with the intrinsic value. If the market value is more than the intrinsic value
they do not invest and if the intrinsic value is more than the market value, they always
prefer because they feel that the price is undervalued in the system.
The intrinsic value is more than the market value; that means, price is under value. If the
intrinsic value is less than the market value, then we can say that the price is over value.
And always the decisions, the price of that particular stock depends upon the demand and
supply. So, for some of the stocks the demand is high for some of stocks the demand is
low. So, if the stocks demand is more the price of the stock will increase and the supply
is more than demand is less the price will decline.
But, one thing basically remember so, all those prices always the changes with respect to
the positive and negative news in the market. So, any news whether it is a political news
or any news related to the policies any change in the Reserve Banks govern Reserve
Banks monetary policy or any change in the fiscal policy, taxation policy or anything
related to the reform measures which are taken by government or any regulatory body
which have lot of impact on the market fluctuations.
So, that is why one thing remember that the impact of negative news on the market
fluctuations is always more than the impact of the positive news. The relative impact is
always more whenever the news is adverse or news is a negative than the any kind of
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positive news which come to the market. All the fluctuation will be there the price will
increase for the positive news, but increase relatively always more whenever the news is
negative.
Relative change; that means, if the there is a negative news the price maybe fluctuate by
20 percent, but if there is a positive news the market will change by maybe 10 percent or
12 percent. So, the impact of negative news always more than the impact of the positive
news.
Then, another stream of thing which is emerging nowadays that is called the impact of
sentiment on the stock prices. So, in this context we have different models which have
developed on the basis of the behavior which is called a behavioral asset pricing and we
have the role of different cognitive biases like your what we call it overconfidence
heuristics, representative biasness, mental accounting and all these things those are how
they are affecting the pricing this pricing decisions and as well as investment decision in
the market and end of the day price of the stock gets affected.
And there is another concept called limited arbitraries; that means, in the market always
we have some kind of limits towards arbitraries because the traditional theories believe
that in the market there are two groups; one is informed, another one is uninformed.
There are some investors which are noise traders, they trade on the noise and there are
some investors which are highly informed trades. So, even if noise traders creates the
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problem creates the arbitrage opportunity so, the inform traders take the reverse
positions. So, the market will come back to the equilibrium.
But generally the behavioral finance theories say that is not true because of the cognitive
biases and other kind of issues which are involved related to irrationality of the investors
or irrational behavior of the investors the market never comes to the equilibrium and
always the price basically always driven by certain kind of fundamental cognitive issues
or biases whatever we have or the psychological biases we have. So, that school of
thought is emerging nowadays and that as well also we have to understand that how the
biases of the investors or the behavioral issues of the investors is affecting the price of
the stocks, that is basically another issue.
These are the different issues and next class we will be discussing about the market
microstructure of this secondary equity market and for this session you can go through
this reference.
Thank you.
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Indian Institute of Technology Kharagpur
Lecture - 50
Stock Market – V
Previous class we discussed about certain issues related to Stock Market particularly the
secondary stock market. We discussed about the construction of the index how to read
the stock price quotations and as well as also we discussed about that how we can decide
the base year and the what is the weighting criteria for the construction of the index and
all these issues. Today we can discuss about the other issue related to the secondary
stock market which is quite important, that is basically the market microstructure.
Whenever you talk about market microstructure it is basically talks about the different
ways how the trading takes place, what are the different type of orders which are
available or which are existing in the market. And as well as we have to see that is there
any kind of ways the stock market can be regulated and as well as also we try to see that
is there any kind of restrictions which has been put. If there is any kind of disturbances
which can happen in the market and as well as also how the stocks are listed and the how
the settlement and the trading takes place in the market particularly in the secondary
market.
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So, here if you see that what are those issues which are broadly comes under the market
microstructure, these are basically first of all the listing of the securities, security
groupings, trading system, then you have the margin trading, then short selling the
concept of the short selling basically then the settlement cycle. And finally the one of the
ways the market can be controlled that is basically your index based market wide circuit
breaker.
So, these are the different issues for different points which comes under the market
microstructure of the stock market, in general or in India in particular. So, here let us see
that how this basically would work in this particular context.
So, whenever talk about the listing of securities if you remember whenever the IPO’s are
issued or first time the particular issue comes to the market or the company raises the
money from the public. So, then it is first of all the particular company is listed in the
stock exchange and once it is listed in the stock exchange those stocks are now eligible
for the trading.
So, first of all how the formerly the stocks are listed what are those different conditions
or criteria they have to fulfill, if they wanted to be listed in the stock exchange. So, that is
why whenever the listing of securities or listing of the stocks are listed in the stock
exchange, they are mostly governed by the provisions which are provided in the
Companies Act recently we are running with the Companies Act 2013.
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So, they have to follow certain provisions or rules and regulations which comes under
the Companies Act 2013. And as well as the Securities Contract Regulation Act 1956,
then Securities Contract Regulation Rules 1957 and as well as time to time whatever
circulars are issued by SEBI are for the particular stock exchange and the listing
agreements entered by the issuer and the stock exchange itself.
So, they have to fulfill certain conditions and once the companies fulfill those conditions
on the basis of the Companies Act, here we are not discussing in detail about all those
regulations what the Companies Act basically tries to provide or the SEBI tries to
provide to be listed. If you want to see that you can see all those things in the respective
website and as well as the Companies Act 2013.
But once the companies basically go for IPO and the IPOs comes to the market, then
they are eligible to become listed in the stock exchange and before that they have to
fulfill certain regulations with respect to this kind of provisions, which are provided in
the different acts.
So, once the listing is drawn then the different stock exchanges group the securities or
divide the securities into different categories. You see that whenever we are dividing the
securities the security groupings vary from particular stock exchange to another stock
exchange. One way the securities can be divided on the basis of the size. But here we are
not talking about the security groupings on the basis of their size, we are talking about
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the securities on the basis of certain other quantitative and qualitative parameters and
what are those, how basically the groupings are done?
Let us first discuss about the security groupings for the Bombay Stock Exchange or the
BSE. So, if you see the BSE and then BSE has divided the stocks into 4 categories A B T
and Z, there is there are A category stocks, B category stocks, T category stocks and the
Z category stocks. If any stock wanted to be a part of A category stocks or they can be
considered as A category stocks when they will satisfy certain conditions, what are those
conditions they have to satisfy?
So, they have to satisfy that this conditions, one is the companies must have been listed
for a minimum period of 3 months and companies basically traded for minimum 98
percent of the trading days in the past 3 months. Even if the company is listed about the
stocks are not traded or the particular stocks are not liquid in that context, then those
particular stocks cannot be considered to be categorized as the A category stocks.
So, that is why this should be trade in the market at least for 98 percent of the trading
days. And companies with minimum non promoter holding of 10 percent as for the
shareholding pattern of most recent quarter last quarter will be considered eligible and
the minimum 10 percent non promoter holding condition will not be applicable for the
PSUS, because the PSUS are mostly owned by the government. So, this minimum 10
percent non promoter holding that condition is not applicable for PSUS, but still PSUS
can be considered as the category a stocks.
So, that is basically relaxed for them and generally the weight age of 75 percent and 25
percent will be given to the ranking on 3 monthly average market capitalization and the
traded turnover to arrive at the final rank. Whatever final rank will be given to that
particular stock there also we are providing the weights on the basis of the size and as
well as the liquidity the traded turnover is basically nothing but one of the liquidity
measure.
So that means, mostly the stocks which are considered as the category stocks, if you
overall if you see these are highly liquid stocks because, 98 percent of the trading days
they are traded in the market and minimum 10 percent the non promoters holding that is
also applicable for this case. So, that is why the category a stock are really highly liquid
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in the market in comparison to the other stocks, so that is the condition what the BCE has
provided whatever way we can conclude.
Then if you see that what about the others the T group represents the scripts or the
particular shares, which are settled on a trade to trade basis on as a surveillance measure.
That means, that there is some issues related to that stocks, there are some kind of
grievances again this stocks what they must not be fulfilling certain criteria.
So, every time to time those stocks will be under the surveillance that whether they
would be considered in this particular category or not or they should be considered for
the trading or not. So in this context those kind of stocks although they are permanently
not divided. But case to case basis basically those scripts are categorized as a
surveillance measures that means they are under the surveillance.
But another thing is the Z category stocks it is introduced in BSE in July 1999 and here if
you see that those stocks are basically issued by those companies who are failed to
comply with it is listing requirements and also fail to resolve the investors complaints
and have not made any required arrangements with both the depositors either with the
CSDL or NSDL for dematerialization of the securities.
That means the investors grievances are not being addressed, they are not able to fulfill
the listing requirements time to time and as well as they have not fulfilled this certain
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kind of process to make all the stocks whatever they are issuing in the dematerialized
form. So, those companies or those stocks are considered as the Z category stocks.
Then we have rest of the stocks. That means, these are certain stocks we already we have
cleared these as the A category, these are certain stocks which are T category there are
certain stocks which are Z category and the rest of the stocks are basically called the B
category stocks and those stocks are traded in the market but they are not exactly
fulfilling the criteria of A, but they are not under surveillance measure or they are not
also under the Z category stocks.
Here the Z group stocks which are basically highly, we can say that the stocks which are
not eligible for the trading or maybe they are not basically fulfilling the criteria whatever
over the stock exchanges have defined. So, this is the way the stocks are categorized for
the Bombay Stock Exchange, but if you see the stock exchange in terms of the NSE.
The NSE stocks straight forward is basis of their classified on the basis of the liquidity
and the impact cost. These are 2 variables which are quite important one is liquidity and
impact cost. So, here what basically NSE has done? The NSE basically has categorized
the stocks into 2 categories; one is group 1 and the group 2. Here the stocks which have
traded at least 80 percent of the days for the previous 6 months, they can be considered
as the group 1 stocks or the group 2 stocks remember all the stocks are traded for 80
percent of the days, so they are either group 1 or group 2.
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So, within that stocks which are traded for 80 percent of the days and again we are
dividing into 2 categories; one is the particular stocks having mean impact cost less than
or equal to 1 percent as categorized under group 1. You see all are 80 percent of the time
traded that means, they are highly liquid but within that again we are dividing them into
2 one is group 1 another one is group 2, which are those group 1? The group 1 the impact
cost is less than or equal to 1 percent and for group 2 stocks the impact cost is more than
1.
So, the remaining stocks are basically considered as the group 3 stocks, so we have 3
types of stocks overall if you see one is the one group of the stocks which are listed and
as well as traded for 80 percent of the days and if out of this 80 percent of the particular
stocks which are comes under this category, wherever the impact cost is less than 1
percent there consider was group 1 and rest of them are called group 2 and whatever
remaining are there they are basically defined as the group 3.
So, these are 3 types of the stocks you have group 1 then 2 then 3 and, group 1 and 2 are
highly liquid and these are relatively less liquid. But one thing is that within that we can
say that the impact cost is more for group 2 and the impact cost is more for the group 1.
So, the next question is then what do you mean by this impact cost?
If you see the impact cost the impact cost is nothing but the impact cost is always
calculated by taking 4 snapshots in a day from the order book in the past 6 months, these
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4 snapshots are randomly chosen from within 4 fixed 10 minutes windows spread
throughout the day. There is no such kind of rules. But only any 10 minutes window
spread randomly, those snapshots are chosen from the order book and what is the impact
cost how we calculate from that? It is basically nothing but the percentage price
movement caused by an order size of 1 lakh from the average of the best bid and offer
price in the order book snapshot.
That means if for particular stock there is a transactions of 1 lakh rupees either in the
buying side or in the selling side, then what is the percentage of the price movement let
stocks A is there and in a particular time period if the particular stock is bought or the
sold and particular stock is bought or sold at the price of 1 lakh rupees, then we have to
see what is the average price basically it is changed. As we know that if you buy more
the price will go up as we sell more the price will go down.
So, if you buy and sell worth of 1 lakh rupees then how the price basically is moving
away from this previous price. So, that particular thing will give you that how this
particular cost is related to that particular stock and how the impact cost is calculated
from that. So, that is why impact cost is nothing, but the percentage price movement
caused by the order size of 1 lakh rupees from the average of the best bid on that
particular day and best offer on that particular day and bid price offer price you know ask
means it is the selling price and bid price means it is the buying price.
So, the impact cost is calculated for both the buying price and the selling side for each
order book snapshot. So, accordingly you can calculate the mean impact cost, so any
stock which means impact cost is more than 1 percent they are basically we call it their
group 2 and whose impact cost is less than 1 percent or equal to 1 percent they are
considered as the group 1 stocks. So, this is the way the NSE defined their stocks.
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And you see another thing we have whenever the stocks are traded in the market we have
2 types of trading system one is your quote driven system another one is the order driven
system. Whenever we go by order driven system here in the order driven system all of
the bids and asks were considered while the quote driven market only the bid and asks of
the market makers are considered. Whenever we go for bidding and asking or we go for
buying and selling the securities, then our orders are basically considered if your
particular market is an order driven system.
But if there are certain systems where our orders are not considered only the market
makers orders are considered, whatever quotations the market makers keep basically
generally these are the institutional investors or the bigger investors. Those investor’s
prices are quoted in the market and all the trading takes place on the basis of the price
whatever they have quoted. Another differences in an order driven market there is no
guarantee of order execution, but in the quote driven market there is the guarantee that
your order will be executed on that particular day, that means let you want to sell your
stock at a rupees 50.
But there is no matching order available anybody wants to sell the stock at a price of the
50. So, in that particular day your order will not be executed that will remain in that
particular book, but if it is order driven system whatever it is a book driven system then
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your order will be executed the price whatever the market makers are quoted and your
price will be close to that.
So, in this context what we can say your order driven market there is no guarantee that in
the same day your order will be executed, but in the quote driven market there is a
guarantee. But the order driven market is more transparent than the quote driven market
in India we have order driven system, but if you talk about US market it is a quote driven
system.
So, in the US market only the market makers order are considered for the pricing of the
securities, but whenever you talk about the country like India here the bid and asks prices
of all the investors are considered for the trading. So, that is the basic difference between
the order driven market and the quote driven market and already I told you that in Indian
context we follow the order driven market.
Then we have to see that what are the different type of orders because, already we say
that we have order driven market. Here we see that there are different orders values we
see we have a limit order we have a market price order or market order we have a stop
loss order what is the what are those basic differences or how to define this. Whenever
you talk about the limit order here it is basically allow the price to be specified while
entering order into the system, that means the investor has already specified that what
price he or she wants to buy the stock or at what price he or she wants to sell the stock.
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So, the limit is already given and once the stock price will reach that level then the order
will be executed. Let you have said that I want to buy the stock at rupees 50 then once
the order will be the particular stock price will reach 50, the order will be automatically
executed. Unless the order has reached 50 there is no chance of execution of that
particular order and there is another order of the market price, so some cases what
happens here this is the order to buy or sell the securities as the best price obtainable at
the time of entering the order.
Here the investor does not give a limit and they basically provide that whatever best
price available on that day a number they have enter into the system, they have provided
that whatever best price is available that price can be applicable for the execution of the
order; whether the particular price is there below the expected price or a higher the
expected price that does not matter, whatever best price is available on that day let they
want to buy the stock at a price to 50; the 50 is not available on that day the best price or
the best means for buying the best price with the lowest price, so on that day the lowest
price is 51, then the order will be executed at 51.
So, that is basically we call it the best price order or best market price order or only
market price order that way you can define that. Then we have another type of order
which is called the stop loss order. Here what happens that, this is the order that allows
the trading member to place an order which gets activated only when the market price of
the relevant security reaches or crosses a threshold price, until then the order does not
enter the market what does it mean? It means that they say that up to this unless the price
goes beyond this the order can cannot be executed. The stop loss price order can be a
market order after the price limit reaches for example, they have said.
So, it is a combination of both; they have given a limit that my order will not be executed
if the price is not 50. So, if it is price gone 50, its not necessary that the order will be
executed because again it will become a market price order because let the price has
gone down to 47. So, in that case the price will be basically 47 and the order will be
executed at a price of 47. So, up to 50 this particular order will not come into the market,
but once it reaches 50 then it becomes activated.
And if it is below 50, then it is good for the investor then it become a best price order or
the market price order the stop loss order basically gives kind of threshold limit or a kind
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of we can say that threshold price and once the price will not reach to that level, the order
cannot be activated in the order book and that will remain in the order book.
So, that is what basically the stop loss order is defined in the market in another concept
we have that is called the margin trading then what do you mean by the margin trading.
Here sometimes what happens that let the investor wants to buy or wants to invest in the
stock, but they do not have enough money available with them. So, then what basically
they have to do? They can borrow from their broker to invest in that. So, then in that
context they have to put some margin with this brokerage, they should open this account
which is called the margin account.
So, in that margin account there, they put some money and the some money basically
will be put by the broker and accordingly they can buy or they can invest in the stocks.
So, here the margin is basically what whatever money you have put your own money
which has been put to buy the stock.
So, the initial deposit which has basically always there in the brokerage account that is
basically called the initial margin. And depending upon the price of the shares in the
market the price will fluctuate. So, the investor’s always wants to satisfy maintenance
margin which is basically what? The maintenance margin is the minimum amount of
margin that they must maintain or the percentage of the stock’s value; stocks value
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means it is owner’s equity, whatever percentage you have put your borrowing amount
remains same.
But whatever money you have put that should be certain percentage of the total value of
the equity in the market. If at any point of time because of change in the price of the
stock the value declines or the equity value also declines, then if your equity value will
be below this maintenance margin whatever has been fixed, then you can get a margin
call from the broker; which means that the investor is required to provide the more
collateral or more cash or the stocks or sell the stocks
How it basically works? You see there are 3 concepts here if you remember if you see
we have an initial margin, we have actual margin, we have a margin call and we have a
maintenance margin. For example, I will give example let there is a stock, price of the
stock is 100 rupees.
Let you want to buy 100 shares, let broker have said that the initial margin is 50 percent;
that means, you give 5000 rupees, your broker will give you 5000 rupees and you can
buy 100 shares because the total value is 100 into100 that is 10000. So, now, here this is
your own money and this is your broker’s money right.
So, now you have 50 percent you have invested and 50 percent your broker has given
and let the broker said the maintenance margin is 30 percent. So, how this thing will
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works that I will tell you that how basically it works? For example, you have brought the
share at a price of 100 and the prices next day gone down to 90 then the total value of the
share is how much? It will become 100 into 90 is equal to 9000 and you have basically
borrowed how much? The 5000 then you are owner, your value is become how much?
9000 minus 5000 which is a borrowed amount that become 4000.
So, right, so, this 4000 divided by 9000. So, that is greater than 30 percent because this is
basically your actual margin. So, that is why the actual margin is current value of
securities minus the amount borrowed divided by the current value of securities. So, that
is greater than 30 percent, so, you will not get the margin call. So, let again further the
price has gone down to 70. So, then the value becomes 7000, 7000 minus 5000 will be
2000, 2000 divided by 7000 it would be less than 30 percent
So, in that case the broker will go for a margin call. That is why the margin call arises
when the actual margin declining below the maintenance margin and in this example we
have taken 30 percent is the maintenance margin. So, it will exactly want to get this, how
much should be the margin call at what price you will get the margin call this is the way
you can calculate the amount borrowed. Amount borrowed means in this case we have
5000, number of shares divided by 100 into 1 minus maintenance margin maintenance
margin is 30 percent; that means, 1 - 0.3; that means, 5000 / 100 × 0.7.
So, if you find out it was somewhere around 30 71 point something that is the price what
you can get at which the investor can get the margin call. This is the way the margin
concept works in the trading.
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Then can move into the short selling all of you might have heard about this. The short
selling is nothing, but who are the investor does not own the stock and but still they
invest in the stock; that means, in case of short selling basically, when the price of the
security is expected to be fall if the investor feels that the price is expected to fall then
what they can do?
They can borrow the security from the broker or from anybody and what do they do?
And next day whenever the price goes down then what they will do? Let for example,
they borrowed the stock today and next day the price has gone down they can buy the
shares at a lower price and give it to that particular thing to the broker or anybody from
who are they have borrowed it and obviously, today they have already sold the stock and
now the rest of the money whatever they have sold in the today’s price that is the profit
they can generate.
So, in the short selling it is reversed; that means, generally first we buy then sell, but in
case of short selling first we sell then we buy. First we borrow the share and sell it in the
market on that particular day let on that the price of 60; you get 60 rupees and next day
already you have expected that the price will be lesser than that, then what basically you
can do? You can buy that share in the next day at the price of let it was 60, then it has
become 70 in the next day then from the market now you have 70 rupees available with
you or 60 rupees available with you, next day the price has become 50 then you buy the
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share at the price of 50 and give that particular share to somebody from where you have
borrowed it.
So, the 60 rupees minus 50 that 10 rupees is the profit whatever you can earn and there is
some transaction cost that you can minus it from there that is the way the short selling
works.
The settlement cycle generally settlements are done by the National Securities Clearing
Corporation of India limited all the securities are being traded and settled under the T
plus 2 rolling settlement system, if today you have taken the positions your transactions
or settlement will be done in the T + 2 days. And here latest by T + 1 and forwarded
them to the same day, then the obligation the T 2 this is the process basically we have to
follow, but generally the settlement cycle is the T + 2 days.
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And another one is you have the indexed best market wide circuit breakers here what
does it mean? If in a particular day the price fluctuates the index basically the index
fluctuates by certain percentages, then the rest of the market closes. So, here if the
market fluctuates by 10 percent before 1 PM, the index basically fluctuates before 1PM
then they will close the market for 45 minutes.
If it is from 1 to 2.30 PM they close the market for 15 minutes, but if it is after 2.30, then
they will not close the market, but if it is 15 percent fluctuations before 1PM, then 1 hour
45 minutes the market will be closed if it is between 1 to 2 then 45 minutes after 2 PM,
rest of the day the market will be closed. But if the fluctuation is beyond 20 percent any
time during the market hour, then the remainder of the day the market will be closed.
This is what basically is done to control the market within their own level and try to
understand, what is the basic reason behind that on that particular day, not to create any
kind of panic or not to create any kind of disturbances for the long run. So, that is what
basically the concept of index based market wide circuit breaker works in the system.
These are basically the different things related to the market micro structure.
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You can go through these references if you want to know more details about this.
Thank you.
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Lecture – 51
Derivatives Market – I
So, after the discussion on the stock market, we have another most important market
always we observe in the financial system that is the Derivatives Market. If you see the
derivatives market is not very new, the derivatives market is existing in the system long
back, but maybe it came into the prominence in a last 20 to 30 to 40 years.
But long back the particular system was working and the contracts: the future contracts,
options and all these things were existing, and mostly the derivatives market was
confined to the commodities. If you talk about the history of the financial system, mostly
the derivative trading was applicable or maybe derivative trading were happening for the
commodity derivatives or commodity markets.
So, then over the years this has transferred to the financial market also, and nowadays
this is a very prominent security and this is basically a prominent instrument, people use
it for maximization of the return and as well as hedging the risk. But, the derivatives
market is mostly used or the basic objective of the derivatives market is basically
hedging. But it is also again people are not nowadays using it only for hedging, they are
using it for the speculation and other kind of objectives also.
So, we will be discussing certain issues related to derivatives, first of all we will discuss
what are those instruments which are traded in the derivatives market, and why the
derivatives how the derivatives are useful. And, next thing is we will be discussing
certain concepts which are used in the derivatives market, then we will go into the
mechanism of the different markets with respect to the derivatives instruments. Then we
will say a little bit about how the normal derivatives are priced in the market, then we
can think of the something related to the derivative market in India.
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So, let us see that what is basically derivative. So, the derivative is basically an
instrument or security, whose payoff depends upon more primitive or fundamental good.
How it is basically works? So, if you see that let there is a company, who basically
makes potato chips. So, let ITC makes the potato chips. So, ITC wanted to buy let 100
tons of potato to make the potato chip. And another party here there is a potato grower
farmer, who basically cultivates potato.
So, ITC wanted to buy 100 tons of potato from the farmer and ITC says analyst team
finds that let they want potato at the month of December. So, at the month of December
they feel that, if the price may be the price of the potato will be around in the market per
kg will be according to their calculation price of the potato in the market will be 12.
So, they want that if you do the market it will be 12 they feel that it is expensive for
them. So, because of that, they want to make a contract with somebody that if they want
to buy a 100 tons of potato at a price of 10 rupees. So, 10 rupees if they will pay per kg,
it will be profitable for them. So, let that is why they have sent their requirement to the
stock exchange, that we want to buy 100 tons of potato in the month of December and
so, and so, date and the price basically what we want 4 kg 10 rupees going to buy this.
That means ITC has taken a buying position or in derivatives language, we call it they
have taken a long position. And the farmer also feels that let for some reasons the farmer
calculates the price of the potato in the month of December in the market will be less
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than 10 rupees, in his calculation the market of the price of the potato and the market will
be less than 10 rupees, then what the farmer feels that, if I can get 10 rupees then my
profitability will be maximized.
Then the farmer sends his requirement to the stock exchange and they want to sell the
potato at a price of 10 rupees. Now both the orders and both the requirements are
available with the stock exchange, then it is matched. Then the contract has been made
between the farmer or the potato cultivator and the ITC and it was decided on so, and so,
date, the ITC will buy this potato from the farmer and the farmer will deliver this 100
tons of potato to ITC on so, and so, date and so, and so, place.
Then what has happened? Later on that day whenever the potato grower or potato
cultivator wants to sell that potato to ITC, let in the market actually the price is become
11 rupees. So, then what has happened? It is a loss for the potato seller. And that loss is
basically a notional loss. Why we call it the notional loss? Actually the loss is not
happening, if he would have sold the potato in the market at the price of 11 rupees, then
maybe he would have got 1 rupees extra at what price he is selling the potato now.
Now, he is selling the potato price of 10 because this is the contract what he have sign,
but actually in the market on that day the price of the potato is 11. So, in that case what is
happening? He is losing 1 rupees for kg. So, he is losing, but actually he is not losing in
the monetary term he is losing the notional in the notional talk. Anyway it is a loss for
the farmer or loss for the potato seller and it is a gain for the ITC. Because, if ITC would
have bought this potato from the market on that day; then he would have paid this 11
rupees. So now, it is a notional gain for the ITC and notional loss for the farmer.
Situation can be reverse; let in the market the price is 9 rupees or 8 rupees, then the
farmer is the gainer in that seller is the gainer the seller is getting 10 rupees which is 2
rupees extra then the because the market price is 8 piece. And, it is a notional loss for the
ITC who is basically losing 2 rupees per kg, he would have brought the potato from the
market then he would have got at a price of 8 rupees per kg.
So; that means, the contract it was made this payoff from the contract depends upon the
price of the fundamental good, here the fundamental good is price of the potato. Potato is
the fundamental good and the value of the contract basically varies loss and gain and the
payoff all these things are changing due to the change in the market price of the potato
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on that particularity; that is why what we are telling that this price is derived from the
actual fundamental price.
So, that is why we say that it is the instrument whose payoff depends on the most
primitive or fundamental good. So, this particular here we have taken the example of the
potato, but in the place of potato this can be a stock, this can be bond this can be
anything. So, if the price of that contract depends upon any kind of the payoff depends
upon any financial instrument stock, bond or interest rate and all exchange rate and
etcetera we call them financial derivative.
If the price depends upon the commodities like grain, coffee, orange, gold, silver all
these things these are basically the commodity derivatives. So, here only differences in
terms of the whatever instruments you are using, whatever fundamental good on what
basis the price of the contract is based upon on that basis we can name them whether it is
a commodity derivative or whether it is a financial derivative, that is the way the
derivative is defined.
Looks very simple, but in general sense it is not simple, because the pricing and
complexity comes whenever the different kind of further conditions come into the
picture. Anyway these are the basic concept of the derivatives whatever way we define
it.
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How the derivative is used already you have seen, that first of all the derivative is used to
has the risk because here we are hedging the risk. Here the example whatever we have
taken, you are basically hedging the risk either you are gaining or you are losing that is a
different issue, but you try to hedge the risk from the market. So, what you can do if you
can take two different positions, one position in the swat market another position in the
derivatives market if the reverse position in the derivatives market, then basically you
can completely hedge your risk.
You can speculate by predicting that how the market is going to behave. So, accordingly
if you are using speculation, then you can also get some more return what you are spot
market is giving. You can lock the profit what basically you can earn and swap kind of
contract what whenever we use, because we have the different type of instruments we
have futures of some swaps and all, the swaps are mostly used to change the nature of
liability and the asset that we will explain further that how it works.
Then the nature of an investment without incurring the cost of selling one portfolio and
buying another. So, these are the different derivatives uses so, one by one whenever we
discuss that, you can relate it that how this particular uses are basically working in the
system.
Let us see that why the derivatives market has grown in general why the hedging is
mostly required? Because you know the risk can be managed by many ways. One is
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mostly the risk is managed through hedging another risk is managed through insurance
that already we have discussed. And here whenever you talk about the insurance here
basically we are transferring the risk, but whenever we talk about hedging there is
actually you are minimizing the risk because somewhere you are gaining somewhere you
are losing. So, it is just like a 0 sum game kind of thing in the game theory, that whatever
you are gaining in one market the same way we are losing in another market because of
that neither you are losing nor you are gaining.
So, the total payoff will be 0 in that sense. So, why basically it has grown? Although
most of the people criticize the derivatives; so, they are reluctant to use the derivatives in
the market, but mostly it is a very popular instrument the reason is mostly people are
using it for the speculation. So, here the basic reason for growth of the derivatives are it
increased the volatility in the asset prices in financial market and already what we have
observed there is a pure integration which is happening between the financial market
with the international markets.
So, that is why the derivatives related to the currency swaps and all kinds of things have
grown up. And now the there is a clear improvement in terms of communication
facilities and a decline in the cost of the communication; that means, all kind of trading
which is taking place these are online and the transactions which are happening in the
system, these are basically most of the cases we are incurring very less cost.
So, because of that use of any kind of exotic instruments are also grown up in the
particular market over the period of time. Then, it is also we have a now developed more
sophisticated risk management tools and which provides the economic agent a wider
choice of risk management strategy and using the derivatives in our portfolio is also
considered as an important risk management strategy or we can minimize the total risk
whatever we are facing in the economic system.
Innovations in the derivatives market which optimally combine the risk and return over a
large number of financial assets leading to higher returns, reduced risk as well as the
transaction cost as compared to individual financial assets. You see that even if people
criticize the derivatives market the popularity of the derivatives market is growing
because it is basically used as a perfect instrument which really is able to hedge the risk
particularly if you talk about the comparison between the smart and derivatives.
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So, if you have taken the position in both the markets, then there is a possibility that the
hedging of the risk can be possible. And nowadays if you have seen there are low so,
many exotic products like structured products have been developed. So, those products
are mostly based upon the logic of the derivatives. So, that is why people call there is
some more risk, why you call it that products of the sometimes it destroys the market
sometimes its create the problem, because we are making more complex products
because the pricier price of all those complex products are based upon the fundamental
price of that fundamental asset.
So, if there is anything goes wrong with fundamental pricing, then the pricing of whole
process or the pricing of whole product makes disturbed or gets disturbed. So, if it gets
disturbed then the loss in the market is quite large. So, because of that sometimes it
creates the disturbance, but still it is used as a perfect hedging instrument and that which
contributes the growth of the using derivatives in the system. So, that is why we can call
that it is a growth driver in the economic system.
Then we will see that there are different type of derivatives instrument we see one is
your forwards, then futures, then options, then swaps. Then how do define the forward?
A forward contract is basically customized it is the contract between the two entities just
now I was explaining one example about the potato, this can be a forward contract which
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is customized it is a customized contract between the two entities, where the settlement
takes place on a specific date in the future, in the future or two days pre agreed prices.
So, in our example the pre agreed price was 10 rupees and the contract was between the
ITC and the farmer, and here the settlement place a specific date it is and it is basically
priced on a pre agreed price. Then we have the futures, future and forward that is not
much differences, but there are some differences you can we can discuss that. It is again
the future contract is also an agreement between the two parties to buy or the sell an asset
in a certain time in the future at a certain price, but the future contracts are a special type
of forward contracts. In the sense that the contracts in the former had standardized
extended contracts and future are not basically standardized.
That is the basic difference between these two, because one contract is traded in the
stock exchange and another contract is basically designed on the basis of the agreement
between the two parties maybe in the OTC market: Over The Counter market. Then we
have, the options here the options basically we can see the two types one is call option
and put option mostly in terms of theoretical sense.
The call option basically gives the buyer the right, but not the obligation to buy a given
quantity of the underlying asset at a given price on or before I give in future date. But put
give the buyer the right, but not the obligation to sell a given quantity of the underlying
asset at a given price before a given date. So, this is the basic difference between the put
option and the call option. So, call means buying, call option give the buyer the right, but
not though you are not obliged, but in case of forwards or futures you are obliged, but in
case of options you are not obliged, but you have the right to exercise that, but in case of
the put option it gives the right, but not the obligation to sell.
Put is basically provided right to sell, call is provides the right to buy, but they are not
obliged to sell or the put option holder is not also obliged to buy to same call option
order is not obliged to buy put option order is not obliged to sells. And swaps are
basically the private agreements between the two parties to exchange the cash flows in
the future in a pre arranged formula and they can be regarded as a portfolio of the
forward contracts. You will see mostly the swaps are designed to convert the asset into
liability, liability into asset and as well as this has some kind of relevance with respect to
the amount of cash flow what the company wants to basically use in the future.
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So, then we have if you see that what are those if you standardize or try to find out the
basic differences between the forwards and future already I told you, both mostly the
forward contract is a private contract and this is future contracts are exchange traded
forward contractors not standardized what future contracts are standardized here in the
case of forward we have a one specified delivery date, but in case of futures we have
range of delivery dates. You have settled at maturity, but here it may close out prior to
maturity, that provision is there and because it is exchange traded and that is some kind
of third party involved for the trading and all these things, the credit risk is not there in
case of futures, but in case of forwards the credit risk exists.
So, there is a possibility that maybe the execution may not materialize or the trading may
not be executed at a particular point of time. So, that is why there is a concept of credit
risk which exists in case of forwards, but that is not available in the case of the future.
So, these are the basic differences what we can observe, although the nature of the
contract for these two are same, but these two are not basically same in terms of the
standardization or in terms of the trading in the market. So, these are the basic
differences between these forwards and the future.
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Then if you see the difference between options and the future or the forward that already
I told you, that option basically future and forward contract gives the holder the
obligation. It is basically provide the obligation to buy or sell at a certain price, but the
option gives the right not the obligation to buy or sell at a certain price.
The option contracts may be executed may not be executed, but the forward contracts
they have the obligation to go for execution of that particular order or particular contract.
So, that is the major differences between an option contract and the future or the forward
contract.
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There are certain concepts always we use in the derivatives market or we deal with the
derivatives, these are basically quite important from the derivatives market point of view.
One is your open interest what do you mean by the open interest? The open interest is
basically a total number of outstanding contracts that are held by the market participants
at the end of each day. So, what it measures? It is basically a measure of how much
interest is there in a particular option or the future. So, if the open interest is increasing;
that means, the fresh fonts are flowing in the market, but if it is declining; that means, the
market is liquidating.
The open interest rate is basically indicator that how the people are going for this kind of
contract and whether the people are really going for trading in this particular derivatives
market or not. If it is open interest is increasing; that means, the fresh funds are coming
to the market more people are trying to take the position in the market. But whenever
you see that open interest are declining; that means, the market liquidity is basically
declining; that means, the market is liquidating. Whatever of contracts are there they are
basically did execution is happening for those contracts and finally, all kind of
transactions are happening.
So, because of that the market the number of contracts are not increasing in that context.
So, it is liquidating in that sense. In the overall liquidity the cash is available it is
increasing, but the fresh in flow towards the derivatives market is not coming out. Then
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we have another concept we have implied interest rate. So, implied interest rate is
basically what due to the cost of carry which is often cost of carry an interest rate or
implied interest rate which is used always interchangeably. And how it is used? It is
mostly used for commodity futures as by definition it means the total cost required to
carry a commodity or any other good forward in time.
So, there are some kind of cost which is involved for carrying like storage cost, insurance
cost and transportation cost financing cost and all kinds of thing. So, implied interest rate
is again for the financial derivatives. In case of equity and all these things if you see the
carrying cost is nothing, but the cost of financing minus the dividend returns how much
returns you are getting in terms of dividend and what is the cost you are incurring,
because to raise that particular equity from the market. So, in this context the implied
interest rate and the carry cost more or less similar that we will use it in the future that
how the concept is used in the market.
Then we have another concept called the implied volatility. It can be measured by
entering all parameters into the option pricing model you see that you know the
volatility, that is basically your standard deviation of that particular data of a particular
series over the time. But, here what is happening if there are certain formula which is
available for option pricing and other and of derivatives instrument. So, they are also the
standard deviation of the instrument is used.
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For example if all the data will be given to you, then you can only the standard deviation
or data will not be given to you then the price of the option will be given to you the strike
price everything will be given to you and then you can put all those inputs and to find out
the standard deviation that is basically we call it implied volatility. What is implied
volatility? That means, the volatility of that particular stock depends upon the price of
the options and as well as the other inputs which are required for the pricing of the
options that is why that concept is called the implied volatility.
Another concept we use in the market that is the basis; the basis is nothing, but the
difference between the spot price and the future price even though the spot and future
prices generally move together the basis is not constant, but in the end that basically
converges. That we will see whenever the pricing of the derivatives we will discuss.
Then we have another instrument called the contango. What do you mean by the
contango? In the normal market conditions if you see the future prices or future contracts
are priced above the expected future spot prices.
So, you see that future price is more than the spot price that should be generally the
normal market, but here what is happening if you compare between the future contracts
with the expected future spot prices, then you can define a concept called the contango.
Then you have the backwardation whenever the future price prevail below the expected
future spot price it is called the backwardation actually in the actual sense the future
price should be more than the expected future spot price, but if it is reverse then what we
can say, we can call that the market is going backward and that concept is called the
backwardation.
Two three things you have to keep in the mind; that one thing is first of all in the normal
market the future price should be more than the spot price. Number 1 if the future price
is not more than the spot price then there is a backwardation, but the future price in the
end basically should be equal to the expected future spot price. But if the future price is
not equal to expected future spot price, then the concept of the contango also comes into
the picture. You see whenever the expected future spot price is nothing, but basically the
future price it should be in the end it should be same, but that does not happen.
So, that is why we have three different prices always we observe, one is your spot price
one is your future price and third one is the expected future spot price. So, in the end the
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expected future spot price should be equal to your future price, but that if that does not
happen then this kind of concept basically comes to the picture that actually you can
keep in the mind.
Then you have settlement price: it is the closing price of the future contracts for the
trading day and the final settlement price is the closing price of the underlying asset on
the last trading day.
Then out option premium: it is the price paid for the buyer to the seller to acquire the
right to buy or sell. Strike price: it is the pre decided price or exercise price whatever
name you can give it at which the option may be exercised it also known as exercise
price. Expiration date the date on which the option expires is known as the expiration
date on the expiration date, either the option is exercised or the option expires worthless
that we will see that when it will be worthless.
Then we have the exercise date, the date at which the option is actually exercised in case
of European option the exercise date is same as the expiry date while in case of
American option the option contract may be exercised on any day between the purchase
of the contract and the expiry date. So, these are the different concepts which are used in
the derivatives market, which will be used for different kind of concepts and pricing of
the driven etcetera.
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So, these are the references you can go through for this particular session.
Thank you.
831
Lecture – 52
Derivatives Market – II
So, after discussing on the certain concepts related to derivative, and defining what
exactly the derivatives market is; we can discuss the mechanism of this Derivatives
Market and going into the different concepts or different issues related to particular
market, in terms of the different type of instruments which are traded in the segment.
So, whenever you talk about the future contract already I have discussed with you,
whenever you talk about the mechanism of the market and the mechanism basically
discussed on the basis of the different instruments. And, here we have the instruments
like futures, you have forwards, then you have the options, then you have the swap.
So, if you see one by one whenever you talk about the future contracts, in the market in
the actual sense if you see these are available on a wide range of underlying; already I
told you these are available in underlying means I am talking about the underlying assets,
the spot market assets. These assets can be a financial asset or it can be the commodity,
any kind of other goods which are available in the commodity market.
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Now, already I told you this future contracts exchange traded and whenever any contract
is designed; what are those specifications we want? We want what is the commodity
should be delivered, where it should be delivered and what date it should be delivered.
And if you see that in the contract, the future contract are settled daily on the basis of the
underlying price the particular future contracts are settled on the daily basis. So, this is
the basic mechanism of the future contract. So, that is the way the future contracts are
basically traded in the market.
Then if you see that in the contract what are the other things also is required or is
mention. We have a tick size, what do you mean by the tick size? Here tick size what
does it mean? It basically talks about the minimum price fluctuations of that particular
contract. Then you have also see the daily price limit; that means, the restrictions, how
much price fluctuations in a single day is allowed?
The restrictions for the price movement is also mentioned there; then another thing what
we can observe the strike price. The strike price means it is the pre-agreed price at which
the delivery will take place; obviously, the delivery date will be mentioned in that case.
And if you see that the sum of outstanding long and short future market positions is
always equal to zero because how many long positions are there? The same amount of
short positions are there. So, that is why the outstanding amount or outstanding of this
positions are always equal to zero, buying and selling positions are same. How many are
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bought. The same amount are sold; it is not like the equity market or the spot market it is
basically always equal to zero. So, these are the standardized contract on what you can
observe whenever you go for understanding the future market.
How the profit or the payoff we can derive from the forward or the future positions. You
see you have a strike price or you have a price already decided mutually agreed price.
Let do you know the mutually agreed price then if the particular price and you are a long
forward; long forward means you are buying it.
So, if you are buying it then if the price is going up and up the particular price of the
stock is going up and up it is increasing; then what is happening? Then obviously, the
notional profit of that particular buyer is increasing. Because if you remember if you are
you are agreed price is 10 rupees that this is 10 if it is 10 rupees, if it is 12 then you are
making 2 rupees notional profit buyer. If it is 14 let it become 14 then it was become 4
rupees.
So, unless if the price is increasing then what is happening? Your profit also going up
and up. So, the price of underlying at maturity if it is increasing if it is a long forward
contract, then the profit of the investor is also increasing let us see, what is happening
with respect to a short future contract ?
834
It is reverse. If your price is increasing, price of the underlying asset is increasing then
your profit is declining because basically you are selling it. So, whenever you are selling
you are expecting. So, these are basically your negative profit. So, once it is the price is
increasing your profit is basically declining or you are making the loss and whenever
your price is more than the strike price then; obviously, what you can do? You are
observing that in case of long the profit is increasing in case of short it is basically
decreasing.
835
If you remember we are discussing about the basis. So, in the basis what do you mean by
the basis? The basis basically explains the relationship between the future price and the
spot price. The basis is a concept which is used to examine or to establish the
relationship between the future price and the spot price. And how the basis is calculated?
The basis is nothing, but the current spot price minus the future price it is basically
nothing, but the current spot price minus the future price that is the basis.
In a normal market just I was explaining you; in a normal market the prices for more
distance future are higher than for the nearby future. So, let at future price also more than
the spot price. If I write in this way that we are here today, this is your t + 1 this is your t
+ 2 this is your t + 3. So, today price means this is the spot price, this is your future price
maybe this period is one month all their gap is one month.
So, in a normal market what we expect this spot price are the time t should be less than
the future price for the t + 1. I am not talking about the spot price of the t + 1 on that day
I am talking about if you are calculating the future price at the time t, then this is
basically let your F 1, this is your F 2, this is your F 3 this is your S 0. Then we are
assuming that your spot price should be less than F 1 in your F 1 should be less than F 2
and F 2 also should be less than F 3.
So, that basically happens in a normal market condition why it happens? Because the risk
is more the risk concept is involved in this particular case. So, this is the way basically
the mechanism works, but if you go to an inverted market it is reversed. The distant
futures prices are lower than the prices for contracts near to the expiration and future
prices is less than the spot prices it is reversed.
But when the future contract is at expiration the future price and the spot price of asset
must be same that the basis is zero; that means, there is a convergence. The behaviour of
the basis of basis over time is known as this behaviour basically is convert is considered
as the convergence; that means, if this is the time. So, the price basically move in this
way in this way. So, here if there is an expiration, then here your future price is equal to
your spot price.
So, that is basically we call it convergence. So, at the time of expiration the future price
and spot price of that particular contract is equal to both are same and therefore, the basis
is equal to 0. If this two are the same then the basis will be 0. So, this is the way the
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concept of basis basically work, but over this time this particular fluctuation always we
can observe.
Then another concept we have that is called this spread, then what is the spread? The
spread is nothing, but here we are basically trying to establish between the spot price and
the future price, but whenever we talk about the spread, spread is basically the difference
between the two future prices. Here we have if you see what you have done? We have
your S you have F 1, you have F 2. So, on we are comparing with S it as F 1 then S with
F 2 like that and a basis is nothing, but the difference between either this two or this two.
But whenever we are talking about the spread the spread is the difference between the
two future prices F 1 with F 2. If the two prices are for the future contracts on the same
underlying asset, asset is same whether a two different F 1 and F 2 two future prices on
the basis of the time with different expiration dates this spread is an intra commodity
spread that is defined as the intra commodity spread; that means, one contract is matured
after 2 months, another contact is matured after 6 months.
Let you are trying out the, but the commodity is same then if you try to find out the price
difference of the six months contract and the two months contract that is basically
defined as the intra commodity spread. But if the two future prices that form a spread or
future prices of two different commodities then that particular spread is called inter
commodity spread.
837
If this particular price or contract price depends upon the one underlying asset we call it
the intra commodity spread, if these are two different commodities what we basically
called, this is called inter commodity spread that is the way the spread is different from
the basis and this is the way the spread is defined.
Then we can see that how basically we can make the hedging using any kind of future
positions. So, whenever you go for the hedging, basically we use a concept called the
hedge ratio. So, our basic job is to find out that hedge ratio. A long future hedge is
appropriate when you know that you will purchase an asset in the future and want to lock
the price. When you can go for the long future hedge, you know that you are going to
buy the asset and you feel that the price you may go up that is why you can lock the price
now.
And short future hedge is appropriate, when you know that you are going to sell the asset
in the future and the price may come down. So, that is why you can lock that particular
price. So, this long future hedge and short future hedge is appropriate whenever you are
expecting that you know that you are going to buy or sell the asset in the future and you
are expecting the price movement in a particular direction, then only this long future and
short future hedging is applicable in that particular context.
And how the optimal hedge ratio is basically measured and how do you basically defines
the hedge ratio? It is the proposition of the exposure that should optimally be hedged to
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hedge the risk in this particular market taking the position both in the spot and the future
how it is measured? This is basically nothing, but sigma into this standard deviation of
the spot market divide by the standard deviation of the future market.
So, the standard deviation of the change in the spot price and the standard deviation due
to the change in the future price and row is the correlation coefficient between the
change in the spot price and change in the future price. It is just like the beta concept
what we use it whenever we calculate the market risk.
So, if you run the regression between the future price and spot price whatever coefficient
you get that basically is nothing, but the hedge risk. That means, that much position you
have to hold on in a particular market to hedge the risk in the other market that actually
the use of the hedge ratio, that always we use whenever we are using the derivative for
the hedging.
So, how basically you can do it? For example, to hedge the risk in a portfolio the number
of contracts that should be sorted that is basically your portfolio value β P/ A. P is the
value of the portfolio β is the β when market risk and A is the value of the asset to
underlying the future contract. So, this is the way basically the amount of money what
basically you can hedge in the other markets.
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So, how the contracts are basically chosen? Choice a delivery month, that is as close to
as possible, but later than the end of the life of hedge. When there is no delivery future
contract on the asset being hedged, then choose the contract which future prices is most
highly correlated with a asset price because you see you want to hedge the risk in the
spot market while taking the position in the future market.
So, what kind of future contract you should choose? You have to choose a particular for
example, you want to hedge the risk for five for five months or three months or two
months. So, that is why you should choose the delivery month that is close to as possible
as to the end of the life of the hedge. That means, if you are life of the hedge as five
years 5 months or 3 months accordingly you try to find out the delivery months whose
period is also 5 months or the 3 months.
But if that 5 months or 3 months contract is not available with you of that particular
asset, then you look for another asset which is highly correlated with that asset. But, the
hedging period is relatively close to your expiration of that particular contract or expiry
of that particular contract, that is the way you can choose the contract for the hedging the
risk in this particular markets.
840
Then already I told you that if you go by the option mechanism, in the option market we
have two types of options in general or some people call it there are four type of options.
So, we have divide either in terms of theoretical sense or we can say that maturity sense
or we can say that the trading sense. Call option gives the right call option holder takes
the right, but not the obligation to buy the asset and the put option holder has right to
sell, but they are not obliged to sell the asset at a given price.
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And we have an American option and we have a European option. And you know
European option is only exercise at maturity and the American option can be exercised at
any time during its life. So, this is the way the options are divided that already we have
discussed. But one thing you see that what basically here we are trying to find out in the
options we are trying to find out the option price.
And the option price is nothing, but whatever price we want to give to that particular
option holder, whenever we buy the asset that we will explain that how this thing is
related to the pricing of that.
So, here if you compare between this two let we have the call option then you have the
put option. Then these are buyers of the option either somebody is buying a call option
somebody is buying a put option that is well they are taking long position. So, if they are
taking a long position if it is a call option they have right to buy the asset, but they are
not obliged to buy the asset.
But if they are taking a long position for the put they have the right to sell the asset, but
whenever you go for the short positions their they have the application to sell the asset
and they are the application to buy the asset it is basically reverse. In that sense basically
the long position and short position of the call option and put options are defined then we
can see that the concept called the moneyness.
842
So, here if you see that if the price of the underlying asset is lower than the exercise price
of a call option, then the call would expect on exercised what does it mean? Let you have
decided that the particular day, the call basically the strike price you have decided at 100
rupees. And on that day the market price of the option is let 110 or either market price of
the option a market price of that security is 90. The market price of the security maybe
under 110 it maybe 90, but the strike price is 100 and you are the buyer and you are not
obliged to buy.
You are the right to buy or you are not obliged to buy then what is happening? If it is 110
in the market then you can exercise that option because you are getting at 100 rupees.
But if in the market is a 90, you may not exercise the option because the 100 is the strike
price or exercise price whatever has been pre agreed price you have decided and at that
day, whenever the particular thing will be exercised you have seen that in the market the
prices 110 happily the buyer will go on exercised the option get the commodity at a price
of 100 rupees.
But on that day if the market the prices is 90, there is no point of exercising that. Because
it is available at a price of 90, you go and directly buy it from the market why you will
go for exercising of the option. That is why if the price of underlying asset if lower than
the exercise price on the expiration of the call option, the call would expire on exercised.
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But when at expiration the price of the underlying asset is greater than the exercised
price, the put option also will be exercised because put option is the right to sell. So;
obviously, seller will want on that particular day in the market the price will be less and
the strike price will be more then he is gaining. And the buyer wants in the market on
that day the price will be more than strike price that is why he will be notionally gaining.
So, therefore, what basically we can see that, depending upon the situation between the
strike price and the actual market price on that particular day, we can think of whether
the option will be exercised or not exercised. So, that particular concept is defined
through the concept called the moneyness.
So, what do you mean by then moneyness already I have explained to you. That
moneyness is here you see, your S is equal to the spot price or price of that underlying
asset on that particular day and E is equal to your exercise price.
S is equal to the market price of the asset on that day and E is equal to exercise price and
here what you have seen that, if your S is greater than E; E means the exercise price
exercised price means that is the price whatever you have decided that on that price this
particular contract will be or the transaction should be taken place. Then if your s is
greater than E then if it is a call option then it is in the money, in the money means it will
be exercised. But it is a put option then it is out of the money it will not exercised right.
844
But if it is reversed S is less than E; that means, the market price is less than the
exercised price, then it is out of the money call option is out of the money it will not be
exercised and the put option is in the money then it will be exercised. But if S is equal to
E on that day the market price is equal exercise price, then it will be exercised; that
means, it is at the money it is also at the money.
So, whenever we go for a exercising the option, either we have to see whether it is a call
option the market price should be more than the strike price or the exercised price if it is
a put option then it is reversed, if both are same on that day then what we can say? Both
are basically at the money; that means, the option will be exercised the contract will be
exercised. So, that concept is called the concept of moneyness.
Through this concept we basically try to find out the intrinsic value of the option
premium and the time value of the option premium. Then here the option premium is
basically nothing, but the intrinsic value and the time value and what is the intrinsic
value? Intrinsic value basically the amount by which the option is in the money and the
option which is out of the money has a zero intrinsic value.
And for a call option which is in the money the intrinsic value if the excess of stock price
over the exercise price if the underlying asset is a stock. And for a put option which is in
the money the intrinsic value is the excess of exercise price over the stock price, because
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here we are assume that the underlying asset is the stock price. If you see this example
then you can get it clear.
You see there is the option the exercise price is 80; let the underlying asset the stock, the
stock prices is 83.5. When the call option price is 6.75 which was decided we will
explain that how the call option is explained how it is determined and let now what is
happening? If it is a call option then; obviously, your stock price is more than the
exercise price that is why it is in the money then this stock price minus the exercise price
that is 3.5 this is basically the intrinsic value.
Then what is the time value? The time value is 6.75 minus 3.5 how much? 3.25 that
basically will give you the time value of money. So, the option premium has two
components how the option premium means that is the option price and how the
premium is defined, how it is determined we have to use certain kind of models for that
we will explain further.
In another condition we have the exercise price is 85, but the stock price is 83.5 then;
obviously, if it is a call option this is out of the money then the intrinsic value is 0. But
whole premium whatever we have already paid because this money is paid to the seller
you see how it is work. Whenever you are going for the option if you have already some
premium you have paid to the seller, then that basically is called the option premium.
And, already this is paid and that thing if it is not exercised then whole option value is
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basically 3.5, only the intrinsic value is 0 and this all the 2.5 basically related to the time
value. So, that is what basically the two components of the option premium one is your
intrinsic value and other one is the time value.
You see this is a payoff diagram for the call option buying a call option. Here if you see
that option price is 5 that already I told you this one is the buyer has paid to the seller
that is why it is minus 5, already you have negative cash flow then your strike price is
100. Then after that whenever the option price is in the particular underlying assets price
is increasing your payoff is increasing at 110 it is 10 this is 20 so on. So, this is the way
basically the pay off matrix for buying the call option can be look like this is the profits
basically.
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So, then if you see that buying or selling a call option it will be reverse the seller has got
5 rupees the seller has already got this.
The seller has got the 5 rupees, then now if it is going again and again increasing the
stock price then you have a negative profit. Then finally, adjusted with respect to the 5
rupees is the only pay off what you can get from that or profit from that.
848
Then if you see another one is longer buying a put option, option price is 7 you have
already paid it, strike price is 70 when if go on stock price is increasing accordingly you
are pay off is also changing.
And if it is selling a put option, then the strike price is 70 stock price is increasing then
your profit is increasing. So, this is the way the pay off matrix basically looks like and
further we will explain that what is the difference between pay off and profit and as well
as how basically the pricing of this particular securities are done.
849
These are the references what you can follow.
Thank you.
850
Lecture – 53
Derivatives Market – III
So, we have discussed certain concept related to the options and the futures. We have
seen that the option premium has 2 components; one is your time value and other one is
the intrinsic value. And the intrinsic value is nothing but the difference between the
market value of the underlying asset on that day and as well as the strike price. Today we
will be discussing certain models which are used pricing this derivatives instruments. We
can start with the pricing of the futures or the forwards, then we can move into the
pricing of the options in the upcoming sessions.
That whenever you talk about the pricing one model always used for pricing of the future
that is basically we call it the carry pricing model. What do you mean by the carry
pricing model? In a very simplistic way, the carry pricing model is nothing but the spot
price + the carry cost - the carry return. How much cost we are incurring for this option
or the future contract, what is the spot price today and how much return we are going to
get it from this that is basically the price of the forward or the future. That is the basic
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fundamental or theoretical model what we can establish or theoretical logic what we can
establish for pricing of the future.
So, here the carry cost means what, it may be holding cost, it may be interest charges and
borrowings insurance cost. If it is commodity derivatives, then it can be considered as a
storage cost, and all these things. Then we have the carry return. The carry return is
nothing but the income what basically we are expecting from this. It may be dividends, it
may be any kind of cash flow what we can get it from that particular asset or particular
instrument or underlying assets, so that is the way basically the carry pricing model
works. So, this is the theoretical understanding, but how exactly this carry pricing model
works in the practical sense that we have to see in the actual sense how it is worked.
So, here we can observe that we have a different type of assets always we get, different
type of instruments underlying instruments we have on that basis the future contracts are
design. So, you have the different kind of assets are available in the market or we are
designing this future contracts on the basis of the different type of assets, how the
different assets are defined or different assets are classified.
The different assets are classified. There are some assets they provide no income; in
between you do not generate any income out of this. And there are some assets they
provide certain income which is given a fixed amount of dividend or fixed amount of
return periodically you are getting from that asset.
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And another kind of asset where the amount is not fixed or they know that how much
yield they can get, the return percentage is given; percentage of certain kind of value will
be given to you. So, this is the way the particular kinds of assets are classified. Then
whenever you calculate the future price of those assets that future prices of those assets
depends upon the nature of the particular cash flow what you are getting or the nature of
assets whatever we have, so that is the way the pricing of the future contracts are made
or forward contracts are made.
For examples, you see the securities which provide no income. If there is a security
which provides no income, then the how the pricing of this particular security can be
made. It is simple let here in the derivatives whenever we take always you remember, we
consider the return is always a risk free rate of return that basically you can keep in
mind.
So, let this spot price is S and the future price is F and the contract is deliverable in T,
T
then F = S (1 + r) that is why in the normal market we assume that the future price is
more than the spot price. So, for example, you are here the T is equal to 2 and r is equal
to the risk free rate of return which let in our case we have taken the 7 percent.
Let the r is equal to your risk-free rate, your risk-free rate is the r, then which is 7
percent that mean 0.07 then S = let 300, T = 2 years r = 7 percent then F = 300 (1.07) 2
that will give you 343.46. The future price will be 343.47. You remember here this asset
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is not giving you any kind of income in between directly we are calculating with respect
to the period of maturity that is your 2 years.
Here we are talking about another concept let particular interest rate is compounded. If
the interest rate is compounded, then your F is equal to SerT. Here we have taken S1 +rT.
But here if the interest rates are measured with continuous compounding, then we have
to consider your future price is equal to spot price e rT. And here already I told you that
provides more income, no storage cost that is the assumption whatever we have taken.
Let we have S is equal to 50, r is equal to 7 percent T is equal to let 6 months that means,
0.5 years, then F is equal to 50 e 0.07 × 0.5 that you got it 51.78. But here two things you can
observe, let you find that F > SerT, then what will happen? If F > SerT, then what the
investor can do that means, the future price is more than the spot price.
The investor at the time of maturity, the investor may buy the asset now by borrowing an
amount equal to S for a period of T at the risk free rate of return and take a short position
in the forward contract. Short position in the sense a sold the forward contract, he had
sold the forward contract and bought the underlying asset today let for buying that asset
does not have the money, then what we can do he has borrowed that money.
So, at the time of maturity, what will happen, the asset will be delivered for a price of F.
He has sold it, he got the price. And the amount whatever he has borrowed that will be
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SerT, then obviously, the profit he can earn that is F - Se rT. The borrowed amount is S,
interest is compounded, then how much money he will repay he will repay SerT
But already he has taken a selling position short position in the future market that is why
the contract will be matured, he will get back his price on that particular day and he will
get F. And if F is greater than Se rT, then even if he has brought that money at the rate of
interest of which is 7 percent in this case risk free rate of return, then what he can do he
can generate a profit of F - SerT.
It can be reverse also. If F < Se rT, then what the investor can do, he would sort the asset.
He may sell the asset in which the process for the time period T, with interest rate r and
buy the long period contract. And when the contract matures, the asset would be
purchased for a price of F and the short position in the asset would be closed out and
finally, the property we can generate that is SerT -F.
So, if at any point of time, this particular condition does not hold, F = Se rT does not hold,
then there is a chance of profit generation at the time of maturity. That means, the
investor can create certain profit if the identity between the condition like F = Se rT does
not hold that basically we have to keep in the mind.
Then we can see that other type of securities. We discussed about a security, we does not
provide any income. Let there is another security which is giving a known income let
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you assume preference shares. You know preference shares, which provides the certain
amount of income periodically, certain amount of dividends periodically which is known
to you.
Then how the formula basically looks like here F = (S – I)e T remember we are all now
using it in a continuous compounding case in this case. And what is I, I is nothing but the
present value of the income received from the asset for that particular period. If your S is
equal to 50, r is equal to 7 percent, T is equal to 0.5, let you I is 5 present value of this
particular cash flow what you are getting from that particular security. In that particular
period let that is 5, then your F is equal to 46.6, that means, that has to be deducted.
You remember that in the carry forward module whatever we have seen we have to the
cost underlying asset price has to be deducted the cost what you are in covering that is
the payment what you are making in terms of the dividends, so that is why (S – Ie) rT,
then you can get the future price of that particular contract. If it is a known yield, let the
investment assets provides a known yield in terms of absolute value, they are giving
certain interest certain kind of rate of return with a certain percentage. Then here
basically let these stocks with paying dividends a pattern percentage, features or
forwards on currencies like foreign risk free rate. If you are taking, then how basically
you can calculate the price of that particular contract.
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The same example if your y is equal to 0.03, then basically this formula will be this your
r-yT
F = Se . The r - y is basically the but the yield or the if it is a forwards for the
currencies and all, this is foreign risk free rate. So, here y = 0.3 if it is given, then you
can find out 50e0.07 - 0.03 × 0.505 = 51.01. So, this is basically happening of a particular
asset, where the asset provides a known yield.
Then we can see that what are those other things related to this. So, now, what we have
seen if F should be equal to Se r-yT, if there is a difference either F < Se r-yT or F > Se r-yT or
F less than does not matter then there is a chance of arbitrators.
Then how the arbitrary then works, then when F > Se r-yT, then what the arbitrators can do
r-yT
the arbitrators can buy the stocks and sell the future and when F < Se then the
arbitrators can buy the future and sell the stocks underlying the index. This particular
arbitrators involves the simultaneous trades in futures and many different stocks in the
market.
So, let us see that how basically it works. So, whenever we are talking about this
arbitrators opportunity, already we have seen that if that identity does not hold good,
then this kind of thing can be possible by taking the different positions in the market.
Then if it is a consumption assets, let it is a commodity.
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Then what basically you can do, you can go for let c is the storage per unit, then your F =
(r+c)T rTC
Se c is the storage cost for the unit or you can find out F = S + T S + Xe is the
present value of the storage cost of the period of time. So, in case of y, we are taking the
C which is per unit storage cost or here C is nothing but the cost what we are incurring
over a period of time and we are calculating present value of that.
Then if you going for a value in the period future forward contract, then if the K is the
delivery price and F is the forward price, then value of the long forward contract is let (F
–K)e -rT and the value of the short forward contract F = (K - F 0 )e - rT. And here K is equal
to the delivery price, and F is equal to the forward price that is the way the valuation of
the forward contract is done. It is (F – K) e - rT and r, if it is a short forward contract, then
it is (K – F) e - rT.
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Then if you talk about the option prices, there are many factors which affect the option
prices here the future prices are mostly affected by the cash flow and as well as the
delivery price of that particular contract and as well as the time period and the risk free
rate. And here option prices also is driven by the spot price of the contract, the strike
price of the contract, the time period, risk free rate of return, then you have the volatility
of the price that is sigma and another one dividend or any other income what you can get
it from the underlying asset in that particular period of time.
What kind of relationship we can expect between this fundamentals with option prices, a
spot with the spot price increases, that means, the market price increases, then the price
of the call option will increase that already we have seen that optional will be exercised.
And the pay offs will be positive, then the price also of the option will increase. But if it
is a put option, the price will be negative or price will be declining.
So, there is a positive relationship or direct relationship between the call option price
with this spot price of the particular asset or the market price of the particular asset. And
if it is a put option, there is an inverse relationship between these two. But if it is a strike
price, then obviously if the strike price is more, then it has a positive impact on the put
option and it will have a inverse impact on the call option pricing, because for the put
option and the payoff is always decided on the basis of K - S and in case of call, it is S -
K. So, keeping that thing in the mind, we have a negative relationship with call and
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positive relationship with put which is just reverse relationship what to expect for the
spot price or underlying assets price.
Then we have time to maturity, the time to maturity or time period increases, then
obviously, the price of both type of so and so will increase so that is why we can have a
positive relationship for the both. Then we have risk free rate, this is basically also is
used as a discount rate, so that will have a positive impact on call and negative impact on
the put. And if it is fluctuations or standard deviation, then it will be more the standard
deviation or more the fluctuations of the pricing of this spot pricing, it will have positive
impact on the option pricing, because more the volatility the risk will be more. So,
depending upon that the premium also will be more.
So, dividend is basically we are deducting it from this that is why it is a call option and I
will have a negative relationship. If it is a put option, it will have a positive relationship.
So, these are the expected relationship what we can get it from the different kind of
factors or how the expected relationship can be established between the different
fundamentals or the factors with respect to the pricing of the options. Then you will see
that how basically this particular concept works in the market in the future.
So, here you see for the option prices, we have some upper bounds, we have some lower
bounds. How much the option prices can be maximum and how much the option prices
can be the minimum? So, if an option; if an option price is above the upper bound or
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below the lower bound and there are profitable opportunities for the arbitrageurs that
always we see. And we will see that how this particular arbitrageur opportunity can be
possible.
Let there is an upper bound for the call option, how much maximum the call option price
maybe, either it is a European option or it is American option that small c represents
European option and capital C presents the American option. For both the cases, the
maximum call option price will be the price of the underlying asset, the price of the
underlying asset. So, either C will be less than the underlying assets price or it can be
equal to the underlying assets price, it cannot go beyond that.
So, if this relationship does not hold good, then the arbitrageurs can easily make the risk
less profit by buying this stock and selling the call option. For upper bound for the put
option, it can go maximum to the strike price. The put option price either less than or
equal to k for both American and European options, if this is not true then risk less profit
can be made by writing the option or by selling the option and investing the proceeds
whatever money you can get it of the sale of the risk free interest rate. Let us see how
that particular concept works.
If you take this example, let there is a lower bound for call option non-dividend paying
rT
stocks the call option is basically what you have c greater than or equal to S -Ke that is
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the lower bound. Let example is c =3 rupees, T = 1 year, K = 18, S = 20, r = 10 percent,
no dividend paying stocks we have taken. So, is there any arbitrageur opportunity?
-rT
The lower bound is basically c is greater than or equal to S - Ke that is the call option
rT
case. Then what things they can do the arbitrageur can buy the call S 0 - Ke if you can
calculate that has come 3.71. The arbitrageur can buy the call and short the stock. And
the inflow will be your 20 - 3 that is 17. Then invest for 1 year at 10 percent per annum,
then how much you are getting 17e 0.1 that is 18.78, because your T = 1.
Then if the stock price is greater than 18, K is equal to strike price is 18, if the stock
price is greater than 18, then he can exercise the option to buy the stock and close the
short position and the profit will be 18.79 -18 that is 0.79. So, that 0.79 what we consider
that is a risk less profit what we can earn from this.
- rT
For example, for put options the p is greater than or equal to K e - S. So, if that is the
case, then if you take this example, you can see how this particular arbitrageur profit is
possible p is equal to 1 we have taken suppose S is equal to 37, T = let us six months -
0.5, r = 5 percent, K = 40, and we have taken D = 0.
You can calculate K - rT - S that is 2.01, it is more than the put price p = 1. Then what the
arbitrageur can do, can borrow 38 rupees for 6 months to buy both put and stock yes, 37
0.05
plus 1. Then how much he required to pay, he required to pay 38 e into 0.0 into 5 is
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equal to 38.96. And stock price below 40, then the arbitrageur are exercise the option to
sell the stock for 40 rupees and repay the loan and makes a profit of 40 - 38.96 that is
1.04 rupees, so that is the arbitrageurs profit what they can generate out of this.
So, that is why you have our call option case, it should be if it is a dividend paid, then the
conditions should be S - D - Ke rT for call option. For a put option it should be D + Ke-rT -
S that actually you can keep in the mind.
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Then we have another condition, there is a put call parity, if you know put price you can
find out the call price; if you know the call price, you can find out the put price. So, that
the put called parity condition c + Ke -rT = p + S; c = the call option, K = strike price, p =
put price, S = spot price. And if that condition does not satisfy, then there is a chance of
arbitrage. And how it is let c = 3, S = 31, T = 0.25, r = 10 percent, K = 30 and D = 0.
What are the arbitrage responsibilities when p is equal to 2.25? Let this is the question.
Then if you want to see then what you can find out because this condition has to be
satisfied c + Ke - rT = p + S. Then c = 3, K = 30, e r = 10 percent, T = 0.25, 3 / 12, then you
can get the 32.26. And p + S =, p = 2.25, S = 31, and it is 2.25 and you get 33.25.
So, what is the arbitrageur strategy you can create buy the call short both put and stock,
and how much cash flow you can generate that is - 3. Buy call means you have paid 3
rupees which is the premium for the call option, then plus 2.25 plus 31, then your cash
flow will be 302. Then invest that 302.5 at a risk rate of return, you get 31.02. And if the
stock price at expiration of option is greater than 30, the call will be exercised; and if it is
less than 30, then the put will be exercise.
Now, either of the cases the net profit will be 31.02 - 30 = 1.02, so then that means, what
we have seen that if this condition does not satisfy in both the cases, the arbitrageur
opportunity exist. So, that is why we have to always ensure not to create an advertiser
opportunity in the put call parity conditions should holds.
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These are the references what you have to follow for the session. And another things you
keep in the mind in the future sessions, we will be discussing about the different models
used for the option pricing like your Binomial Tree mode, and the Black Scholes model.
Then we can move into the discussion on the swap. Then finally, we will discuss about
the developments which have happened in the derivatives market with respect to India.
Thank you.
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Lecture - 54
Derivatives Market – IV
So, we are discussing about the Derivatives Market. In the previous class, we discussed
about the different type of instruments which are available in the derivatives market and
as well as what is the use of the derivatives. And we started the discussion on the pricing
of the derivatives. And here also we discussed about the concept of moneyness and as
well as the intrinsic value and as well as the time value of the option premium. Today,
we will be discussing about the different models, which are used for the option pricing or
the calculation of the option premium.
So, if you see that in popular sense, there are two popular models which are used for
pricing the options; one is your Binomial Tree Model, then we have the famous the
Black-Scholes model. So, these are the two popular models which are used for pricing
the offsets. And one by one we will see that how these models basically work whenever
we try to calculate the pricing of the options.
866
So, let us see that what this binomial tree model is all about. Binomial tree model was
proposed by Cox, Ross and Rubinstein in 1979. And here what are the assumptions what
this binomial tree model always takes that the asset prices follows a random walk, and
there is no arbitrage opportunity exist in the market. What do you mean by the random
walk? That means, here we are assuming that any kind of information which is coming
to the market which drives the price of this particular underlying asset that basically is
random, so that is a prediction of the prices using the past data is not possible.
That means, if you are able to use the past information or past data to predict this future,
then we can say that that particular data series is not following the random walk. But
here we are assuming that the assets whether the asset can be stock, it can be bond it can
be any other asset that basically follow a random walk, and there is no arbitrage
opportunity exist in the market. What do mean by the arbitrage opportunity? Here we are
talking about arbitrage opportunity means the law of one price should hold good.
So, law of one price how to define the law of one price that price of a particular asset
should be same in two different markets at a particular point of time. So, if there is a
price differences, then the investor can always create the arbitrage opportunity or they
can generate some riskless profits, that means, in one market they can buy this particular
asset with a lower price, and at the same time they can take a reverse position in other
market, by that without any risk they can create certain return in the market segments.
867
So, that is why here we are assuming that the law of one price also holds good, that
means, there is no arbitrage opportunity exist in the market and as well as the underlying
assets basically is following the random walk. So, these are the major assumptions what
the binomial tree model takes. And now we will see that how this particular model
works.
Here if you see that whenever we go for the binomial tree model, we try to construct a
portfolio. And because our basic objective is to hedge the risk and we try to take the
position or try to compose our portfolio in such a way, by that the total risk in the market
can be hedged out. So, here what basically we are assuming, we are basically having a
portfolio where we have taken a long position in the spot market and we have taken a
short position in the option. That means, we are buying the delta amount of stocks here
we are underlying asset we have taken the stocks, then we are selling the options which
are based upon this particular stocks. That is why the short position, we are taking for the
options and the long positions we are taking on the stocks.
And you assume the current market price or the market value of the stock is S, and the
current price of the option on that particular stock is let f. So, our objective is to find out
the f. And also we are assuming the option is going to be matured at the time T. And
during the life of the option, the value of the underlying stock may go up to S u, or it can
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goes down to S d. So, either it can go up to S u or it can go up to S d; u means it is
increasing; d means it is declining.
So, then the percentage increase in the stock price, when it moves off is u - 1, because it
is increasing that means, it is more than 100 percent. So, here you are u > 1. And the
percentage decrease in the stock price when it is comes down, it is 1 - d, because d <1.
And here we are expecting a payoff from the option whenever the price is going off that
is f u, and whenever the price is going down that is S u.
So, here if the stock price become S u, we are finding this option price is f u; and the
payoff is f d when the price move down to S d. So, these are the notations what we are
going to use. So, if I will explain it this way, the price was s it can go up to S u or it can
go down to S d. So, here is the f that we are trying to find out. So, whenever it is going
towards S u it the payoff will be f u; and whenever it is going down to S d the payoff will
be f d. So, now using these notations, we have to see how that option prices can be or
option price can be calculated from this.
So, now, if you see using this notation, what basically our objective? We need to
calculate the value of the delta. We need to calculate the value of the delta which makes
our portfolio risk less that means you have to generate certain kind of return out of this
which is nothing but the risk-free rate of return on the particular from this particular
portfolio. If the stock price goes off, then the payoff from the portfolio will be S d Δ - fd;
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and if the price of the stocks move down, then the payoff from the portfolio will be u Δ -
f of u.
So, then the two payoff if you want to make it equal, then what basically you can find
out S u Δ- f of u is equal to S d Δ - f of d. So, now, if you solve this equation your Δ will
be f of u - f of d, that means, your S u Δ, basically it is S u Δ your S u Δ - f of u = S d Δ -
f of d. So, in both the conditions basically that should be equal. If that is equal, then what
basically you can find out here your Δ = (f of u - f of d) / (S u - S d); that means, we want
to make this particular portfolio which is riskless. And we want to generate certain kind
of return out of this which is basically your risk-free rate of return.
Here basically you see if the stock prices goes up and up or down depending upon that,
the delta value will be changed. Here if you observe, if the stock prices goes up, the
payoff from the portfolio will be s here basically it is you can make it goes up. If the
stock prices goes up, then payoff will be goes up. Then payoff will be S u Δ - f of u;
whenever it goes down the payoff will be S d Δ - f of d. So, it is goes down and it is
moves up. So, now, we have S u Δ - f of u = S d Δ - f of d that equality has to be
maintained. And here we are our objective is to find out the delta value.
Then Δ = (f of u - f of d) / (S u - S d). And what is then delta the delta is nothing but the
ratio of change in the option prices to the change in the value of the stock. So, let us take
a numerical example to understand that how that particular delta value can be calculated.
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So, before going for this numerical example, for example, the portfolio is risk-free,
already we have taken, there is no arbitrage opportunity that assumption we have taken.
Then the portfolio must earn, there is risk-free rate of return r if invested for time T. So,
then the present value if you want to calculate, then what basically you can calculate in
different conditions that is your because we this is the payoff what basically we are
getting that is S u Δ - f of u. Then if you want find out the value after the time T, and
your r is equal to your rate of return, then it is basically that already you know that (S u
Δ- f of u )× e - rT.
And what is the cost of the portfolio? The cost of the portfolio is basically how much
money we have spent on that particular stock, so that is why it is delta amount of the
stock multiplied by the price of the stock minus the premium what were we have paid.
So, now, if the particular post portfolio is risk neutral, then what basically you can see
that S Δ - f = S u Δ - f u e - rT if it is a risk neutral portfolio.
Then what you can do, already you know what is the delta, Δ = (f of u - f of d)/(S u -S d).
-rT
You can put that particular value here, then you can find out f =f u 1 - de + f d × u -rT -
–rT
1 / u - d. Then, obviously, your f = e P of f u +1 - P f of d. This P and 1 -P basically
shows the probability of increase of the price and probability of decreasing the price. The
total probability is 1, P is basically shows you the increase, and 1 - P shows you the
decrease.
rT
Then here the P, how the P is calculated, the P is nothing but P = e -d / u - d. So, now,
this is what basically we try to find out that f = e – rT P f u + 1 - P f d. So, now we will see
that how basically it works.
871
Let this is the example what you can take. Let that is the current price of the stock is 30
rupees. And it is known that at the end of 3 months, it will be either 33 or it will be 27
the strike price of the call option is 31. After 3 months if the stock price turns out to be
33, the value of the option will be 1 rupees; if the stock price turns out to be 27, then the
value of the option will be 0, that means, the option will not be exercised, because it will
be less than the call option.
The risk-free rate of return is 10 percent, then here find out the value of the call option
that is the question. So, your S stock price in the beginning is 30, T is equal to 3 months
that means 0.25 years; f of u is equal to 1 if the price goes up to 33, and f of d is equal to
0 obviously if the price goes down to 27. So, then your u will become 1.1, and your d
become 0.9.
So, now what basically you can find out you can use that equation; and that equation if
0.1 ×0.25
you use then you can find out P = (e - 0.9) / (1.1 -0.9) that is 0.626. So, the P
basically you got if the P you got, then you can find out your 1 -P then 1 - P = 1 - 0.626
that will become basically you will find out that 1 - P values. So, now, what you can do
-rT
this in this equation, you have the f = e × P × f of u + 1 - P × f of d. Then f of d =0,
then obviously, your 0.626 × 1 + 1 - 0.626 × 0 that you got it 0.6111. So, the option
premium of the option price of this particular example will be 0.611.
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So, you can have also two stage model further again it can go up to something and go
down something after a certain period. Then again whenever it has 27 it can again go up
to something go down something, then like that you can find out each node the
probability. Then if each node you can find out the probability, then the backward
calculation you can make. And finally, the f can be calculated from that, so that is the
way basically the price of the option can be calculated using the binomial tree model.
Then if you see in this context, we can have another model; we have the Black-Scholes
model. And in the Black-Scholes model, it is basically developed by Fisher Black and
Schole and Robert Merton in 1973. And here the assumption is basically they have taken
that the option is the European option. And the underlying stock does not pay any
dividend, then the asset prices is continuous and distributed lognormally. Taxes and
transaction cost are absent. The restrictions on or penalties for short selling, there is no
point of short selling here, no short selling is allowed. And risk-free rate of interest is
constant or also known to us. And there is no arbitrage opportunity exists in the market.
These are the assumption for the Black-Schole model has taken.
So, now what is our objective, our objective is to see that it needs lot of derivations in
terms of log normal distributions, then your distribution in terms of the option prices, the
process like Ito's lemma generalized linear process and all kinds of thing. So, this is
basically beyond the scope of this. But here using these assumptions what this Black-
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Schole basically has taken that general Brownian motion, this generalized linear process,
then we have the Ito's lemma, all kind of concepts are used because those things are
depends upon the properties of that particular underlying asset and as well as the options
how they are going to be distributed over the time. So, we are not discussing those
things.
But using these assumptions basically Black-Schole was trying to find out what are those
factors which affecting the call option. And here they said that the price basically
determined by the market price of the asset, price of the option, exercise price of the
option, time to maturity, market interest rate or the risk-free rate of return, and the
volatility of the asset prices. These are the factors which are affecting the price of the call
option.
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So, now what basically you can do if you see that this is the formula what basically
Black-Scholes was derived that c is equal to this is your price of the underlying asset S N
d 1 minus K e to the power minus r T N d 2 that is for the call option. For the put option
is equal to it is reverse, it is K e, K e means it is the strike price, K e to the power minus r
T N minus d 2 minus S N minus d 1.
Now, what you can do your d 1 is equal to if your d 1 also it has been derived d 1 is
equal to log of S by K plus r for r plus r is equal to rate of interest, sigma square basically
the standard deviation or the volatility of the stock or for any underlying asset divided by
2 into T divided by sigma root of T, T is equal to the time period. Then d 2 is equal to d 1
minus sigma root of T. So, here there are notation C is equal to price of call option; K is
equal to strike price; r is equal to risk-free rate; S is equal to current price of the stock;
time T is equal to time to maturity; N d 1 and N d 2 are the normal distribution of d 1 and
d 2. And your sigma is equal to standard deviation or volatility of this stock. So, these
are the notations and this is the formula.
875
So, if you see this example, let there is a non-dividend paying stock current market price
is 52 underlying asset of an option of maturity 6 months, strike price is 50. If the risk-
free rate of interest is 10 percent per annum and volatility is 20 percent, then determine
the price of the call option and the put option. So, now, your S is equal to or S 0 is equal
to 52, K is equal to 50, r is equal to 10 percent, sigma is equal to 20 percent, T is equal to
0.5, because it is 6 months, then you can find out a d 2 d 1 values already you can put
this formula ln 52 by 50 plus 0.1 into 0.2 square divided by 2 to the power 0.5 divided by
0.2 root of T that is 0.5, then you find out 0.7015.
Then your d 2 is equal to 0.7015 minus 0.141, it is basically your root sigma and root of
T, then it is 0.560. Then you can go to the table normal distribution table of d 1 and d 2,
you can find out N d 1 0.758; N d 2 is equal to 0.712. Then you can also use excel for
calculating this norm NORMDIST function for this value of d 1 and d 2. Then c is equal
to already formula the call option you know that there is S into what S into N d 1 N d 1
minus K e to the power minus r T into your N and d 2, then you can find out 5.56. The
call option in this particular case is 5.56.
Similarly, you can putting these values, you can find out the put option. And here your
put option price is 1.12. So, this is the way the Black-Schole model has been derived or
has been used. So, although the derivation is very lengthy, but if anybody wants to go
through that you can go through any books on derivatives like Hall and other books
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which talks about the derivation of this particular formula, which is used for the
valuation of the options.
Then we have another instrument called the swap; already we discussed about the swap.
Swap is nothing but it is a kind of instrument which is used to transact in terms of the
cash flows in the periodical manner. So, here we have two types of measure swaps
always we come across, one is your interest rate swap and another one is the currency
swap. So, if a company agrees to pay cash flows equal to interest at a predetermined
fixed rate on a notional principal and in return, it receives the interest at a floating rate on
same principal for the same time period, then we can call that this is basically the interest
rate swap. Then why this swaps are used, this swaps are basically used to transform the
nature of the assets and its liabilities.
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We will see this example, then it will be more clear for you that how the swap is used.
Let there is a 3 year swap started on 15th March 2012 between the companies let ABC
and XYZ. Company ABC agrees to pay an interest rate of 7 percent per annum on a
principal of 100 crore. And in return XYZ agrees to pay ABC the 6-months LIBOR rate
on the same principal and you see ABC is basically going for the fixed rate that is 7
percent, and XYZ agrees to pay 6 months LIBOR rate on the same principal. And here
the principal is not x since that is why we call it is a notional principal amount. So, this is
basically floating, and this is fixed, so that is why ABC is a fixed player and XYZ is a
floating player in this case, because XYZ is playing its paying on the basis of the floating
rate interest and ABC is paying on the basis of the fixed rate interest. So, now, you see
that what is basically how the cash flow basically here looks like.
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If you see the cash flow to the ABC; now because this is basically a 3 years contract. If
the 4 years contract, then you have the 6 cash flows started in March 15 2012, then 6
months LIBOR rate let assume, these are the LIBOR rates which are given. So,
therefore, the floating rate cash flow, what is the cash flow to the ABC first, again if you
see cash flow to the ABC basically will be getting, because ABC is getting cash flow on
the floating rate basis, and paying the cash flow on the fixed rate basis. So, in the March
15, it is basically they are getting the 6 percent of the total money that is 3, there is 3.1 on
the basis of this interest rate. These are the interest rates.
So, these are the cash flow what basically they will be receiving and these are calculated
on the basis of the principal amount that means, here on the 6 months 6 percent interest;
that means 100 crore that means, 6 crore divided by 2 3 crore, then it is 6.2 3.1, crore;
then 7.4 3.7 crore, 7.8 so like that there will be getting 7.5 3.75, 3.9, 4 like that they will
get the cash flow what they will be receiving. And how much they are paying they are
paying, it is fixed because that is 7 percent interest. So, they are every 6 months, they
will be paying 3.5, 3.5, 3.5. So, the net cash flow if you see then end of the day the net
cash flow is positive that is 0.50 for the company ABC.
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Now, if you see in this context how it is basically working or we can say that how it is
helping these two companies who are within basically going for this kind of swap
contract. So, now, you assume the ABC for ABC the swap may be used to transform a
floating rate loan into a fixed rate loan. What does it mean? Let the company ABC has
borrowed 100 crore at LIBOR plus 20 basis point from outside from any financial
institutions they have a borrowed amount, and their obligation is 600 crore and that rate
is LIBOR plus 20 basis point.
So, after entering this cash flow then how basically it is converted, let this is XYZ, and
this is your ABC. So, now, what is happening ABC is already paying LIBOR plus 0.2
percent to some outsider he is paying. And now what he is doing it pays LIBOR plus 2
percent to the outsider, it receives LIBOR from the XYZ, because XYZ is paying on the
basis of the LIBOR. Then he is paying 7 percent to XYZ. So, if that is the case then
finally, the LIBOR will be cancelled out, then what is final is happening that previously
it has a floating rate loan. Now, whenever they have entered into the swap the floating
rate loan becomes a fixed rate loan of 7.2 percent for ABC.
So, let ABC wanted that they want to pay in the fixed rate basis, then that particular loan
has become 7.2 percent after they have entered into the swap. So, the same thing can also
happen XYZ. Let XYZ its paying in a fixed rate and they want to go for a floating rate,
they want to convert their fixed rate loan into floating rate, then here if you observe also
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there is if you see they are paying 7.3 percent, getting 7 percent. And then what is
happening they are paying LIBOR, then finally what is happening, it is LIBOR plus 0.3
percent basically what finally they will be paying so that means, the fixed rate loan has
been converted into the floating rate loan. So, this is because of that this particular thing
can be converted from the fixed to floating or floating to fixed once they have entered
into the swap.
The same thing it pays 7.3 percent to the outsider pays LIBOR, it receive 7 percent under
the terms of swap, this arrangement makes the fixed rate loan to the floating rate that is
basically LIBOR lost 0.3 percent. 7 percent, 7 percent cancel, you will get 7 LIBOR plus
0.3 percent, so that is basically the conversion of the fixed rate to LIBOR plus 0.3
percent floating rate. This is the way the swaps are used in the market.
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Then you have the currency swap it involved the exchanging principal and interest
payments in one currency for principal and interest payment in another. The principal
amount in each currency as usually extents to at the beginning at the end of the life of the
swap. So, let if you take this example, there is a swap between company PQR in USA
and TUV in UK enter into the swap contract in February 15, 2012. So, it is basically
fixed versus fixed currency swap we have taken this example. Interest payments are
made in a year. Principal amount is 20 million dollar and 10 million dollar. PQR pays 20
million and receives 10 million dollar, and receives 10 million pound.
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Then how the cash flow to the PQR looks like it will be in the beginning they have paid
my 20 dollar, that means minus 20 and the positive basically they have paid this much,
they received this much. So, then on the basis of the interest rate the 6 percent and 8
percent interest what we have considered on the basis of that this is the cash flow for the
dollar cash flow and this is the pound cash flow which can happen to the company PQR.
So, here if you see in the beginning, it is the principal amount is transacted, in the end
also it is transacted in that particular cash flow statement.
So, this is what basically the basic idea about the concept of the pricing of the options,
and the use of the swap in the market. And these are the references what basically you
can use for this particular session.
Thank you.
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Lecture - 55
Derivatives Market – V
So, after discussing about the basics of the Derivatives Market or the Instrument which
are traded in the derivatives market; so, today we will be discussing something related to
the derivatives market in India. That what are those instrument which are available in the
Indian market and what are those reform measures have been taken to develop the
derivatives market in India? And as well as that sum of the facts related to this.
And in terms of the use of derivatives in the Indian context there are some critic or
critical analysis already the researchers are made, we can explain those kind of critics
what basically they are trying to explain in this context.
So, if you see that the major participants in the Indian derivatives market are; obviously,
this market is regulated by SEBI and also to some part it is RBI, but mostly it is
regulated by SEBI, the Securities and Exchange Board of India. This derivatives are
traded in the stock exchanges and the other financial institutions also play the role who
invest and as well as participate in this particular market and as well as a retail investors.
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So, these are the major stakeholder or major participants in terms of the operations of
derivatives market in India. So, this is the way these are the participant who basically
work in this particular segment.
Then let us see that, whenever the derivatives market was started, although already I told
you that the market is not very new, but it was formalized or it came to the financial
market relatively little bit in the late time. So, for the development of the derivatives
market over the years there are different committees have been established by the
regulatory bodies and as well as government, to make kind of certain changes in the
derivatives market and to find out the ways are the process through which the market can
be developed.
In this context the first permanent committee which was established by SEBI in 1997
that is L C Gupta Committee and according to the L C Gupta Committee first of all the L
C Gupta Committee has recommended the introduction of the financial derivatives. And
here the financial derivatives instrument were not traded in the financial market before
that. So, L C Gupta Committee has recommended for the introduction of that.
Then as well as this committee has recommended certain kind of instruments, which can
be traded in this particular segment. Like you have the derivatives with respect to the
stocks and as well as some kind of operational aspects that how the market can be
regulated and how the particular market can be or the transactions can be settled all kind
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of a nitty gritty always if you observe you can go through the L c Gupta Committee,
where you can find out that what are those kind of recommendations the committee has
given.
Then again further in 1998 there was another committee was established that is called J
R Varma committee, the Jayanth Varma committee which is basically was established to
explore certain issues about the risk management in the derivatives market and as well as
the concept of the margin trading, I discussed about the margin trading whenever we
discuss about the equity market.
We have the concept of initial margin, you have the concept of the actual margin, then
maintenance margin, then how much margin can be taken as maintenance margin, then
when this margin will arrive all kind of concepts or all kind of issues were discussed
with respect to derivatives market in the Jayanth Varma committee. And Jayanth Varma
committee also try to explore, that what are those methods or techniques can be used to
measure the risk in the derivatives market?
So, in this context this committee has certain kind of recommendations in terms of the
management of the risk using the derivatives in the financial sector or financial system.
Then after that again there is another committee was established in prominent committee
that is V K Sharma Committee in 2007, here according to this V K Sharma Committee
has recommended for the introduction of interest rate future market in India.
The interest rate future market was not introduced before, it was introduced to the Indian
context and as well as certain kind of regulations, certain kind of reforms which have
been taken care which have been always formulated to develop the particular market in
terms of the interest rate future segment or interested future in the derivative segment.
So, like that within that there are some other M N Roy committee and other committee,
there are small committees also there is whereas, where always form to day today may
reform to take the day today reform measures for the development of the second
derivatives market in India. But if you see all those recommendations were in favour of
the operations of the derivatives market and tried to look for the different kind of market
mechanism, through which the trading in the derivatives market can be enhanced.
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So, now if you see in today’s context the financial derivatives which are traded in India
these are mostly equity linked derivatives, currency derivatives and interest rate
derivatives. These are the three major derivatives which are traded in the Indian context.
The equity linked been either the derivatives with respect to the single stocks or they can
be related to the indexes also.
Then you have the currency derivatives, then you have the interest rate derivatives, these
are 3 major types of derivatives which are traded in India. And the major financial
derivatives instrument which are traded in Indian market mostly index future, index
options, stock futures, stock options, interest rate futures and rupee currency; currency
derivatives particularly. So, these are the different major derivatives financial derivatives
which are traded in the Indian market.
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So, now, if you see that whenever we talk about this kind of derivatives instruments.
Then after this kind of committee’s recommendation, actually derivative trading in India
basically started in 2000 both in NSE and as well as the BSE. Particularly they have
started with equity derivatives, the equity derivatives are basically used or started in
2000, already I told you that in terms of financial derivatives Indian market is relatively
very new, in comparison to the other developed markets and as well as the other bigger
emerging economies.
So, the currency derivative segment or the NSE started operations on August 29, 2018
which is reasonably quite new and basically whenever they have started this currency
derivatives they started the trading in the US dollar and rupee only, which is the most
used currency for the trading and in Indian context that is the US dollar rupee, the all
those kind of derivatives based upon this exchange rate.
Other currency pairs also have been considered, but little bit late in started since
February 1st, 2010, these are Euro rupees, then pound sterling versus rupees, then
Japanese yen versus rupees. Those kind of exchange rates also are used for the derivative
segment after 2010 in NSE.
An interest rate futures were introduced in August 31st, 2009 and the currency options in
terms of the rupee versus dollar exchange rate was started in October 29, 2010. From this
data why basically I am discussing this data, you can observe that how the immature
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derivatives market we have or we have a very new derivatives market in comparison to
the other segments other economies in the world, where the financial derivatives market
is quite strong or may be quite old quite matured in that particular context.
So, therefore, that whenever we talk about the trading in the derivatives we did not find
much kind of trading takes place in the derivative segment, may be because of the
market is immature or the people are reluctant to invest in the derivatives market because
more risk is involved in that particular segment. So, anyway that is the different kind of
issue, but with this data if you see the derivatives market is relatively a new market if
you talk about the Indian financial system.
Then within that segment if you see, that the futures and options which are traded in the
NSE they are always traded through trading system, there is a trading system NSE has
developed that is called NEAT-F&O Futures and Option trading system. And you
remember it is a order driven system, I was explaining you about the order driven system
in the previous class whenever we discussed about the equity derivatives or the market
microstructure of the equity derivatives.
We have 2 types of system option driven system, then you have the code driven system.
Here also in equity market we have an order driven system and also in the derivative
segment also we have a order driven system and the code driven system works within the
US market. And therefore, we are expecting that it provide the complete transparency, in
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terms of the operations in the derivative segment. And how basically the traits are takes
place are settled in this particular segment?
The responsibilities with the National Securities Clearing Corporation of India Limited
that is NSCCL, who undertakes the clearing and settlement of all trades executed on the
futures and options segment of the NSE. And you know why actually we are talking
about NSE? The share of derivatives trading in NSE is much higher than the share of
trading in terms of the BSE.
So, therefore, much focus is always given on the trading of the derivatives in the context
of the national stock exchange not in the context of the Bombay stock exchange. And
another thing also the index as well as the stock options are the futures which are traded
in the derivatives market in India, these are always cash settled.
The settlement as always made in terms of the cash; that means, through the exchange of
the cash whenever this particular transactions takes place or this particular contracts is
going to be matured, then all this things are basically cash settled. So, this is basically the
financial derivatives what basically always are available in this particular segment and
here this is the trading platform which is available in this.
But there are certain criteria the companies are the stock have to follow if they go if they
want to do this for futures and options trading in Indian stock market. Then how
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basically this conditions? The conditions are basically always put forth by the stock
exchange and the regulators and the every company has to fulfill these criteria if they
want to invest in the derivatives market in India. What are those?
First of all the stocks which are chosen among these 500 stocks in terms of average daily
market capitalization and average daily traded value in the previous six months on a
rolling basis. You see all of you know that, the market capitalization is a proxy for the
size and average daily traded value is a proxy for the liquidity.
That means the size and liquidity is a major factor the companies always look, always
should consider if they want to go for the futures and options trading in the Indian
market that is number one. First of all second thing is, the stock’s median quarters sigma
order size over the last six months should not be less than 10 lakhs, the order side should
not be less than of the 10 lakhs rupees.
So; that means, the order size the trading which is takes place for that particular security
that actually should not be less than the 10 lakhs rupees in the market for the last six
months. And the market wide position limit in the stock should not be less than 300
crore. What do you mean by this market wide position limit? The market wide position
limit is basically always valued taking the closing prices of the stocks in the underlying
cash market on the day of expiry of the contract in the month.
So, the market wide positions are always measured on the basis of the closing price of
that particular underlying asset on the day of expiry of the contract of that particular
month. And the market wide position limit of open position on futures and option
contract in a particular underlying stock should be 20 of the number of shares held by the
non promoters in the relevant underlying security.
So, the promoters holding should be on that particular underlying stock will be 20
percent of the total shares whatever the particular companies have. And for an existing
futures and options stock, if somebody and one companies already issuing or already
investing in the future and options, then the eligibility criteria is that the market wide
position limit of the stock should not be less than 200 crore and stock’s median quarter
sigma size over the last six months should not be less than 5 lakhs.
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So, there are some relaxation if the particular stock is already qualifying the criteria and
they have already investing or already issuing this particular kind of contracts in the
market. The stock’s average monthly turnover in the derivative segment over last three
months should not be less than the 100 crore, that actually is another criteria always the
regulator have fixed.
That means, overall if you see that the particular stock should be liquid and this
particular stock should be relatively bigger in size, then only those stocks will be eligible
for derivatives trading in the Indian market. The reason is basically because this
particular instrument is a risk instruments. So, the particular company should have
certain kind of absorbing capacity risk, absorbing capacity, if there is any kind of failure
happens in the market, then the company should not be complete liquidated at one go.
There should be some kind of precaution always the companies should take and those
even if the company will take. The precaution will be better job still the company is
liquidity and size is relatively more in the market. So, because of that there are some
restrictions because the market is relatively mature there are not much trading takes place
in the segment and also the market is highly risky.
So, because of that what is happening this regulators and the stock exchanges wanted to
take some steps, by that this particular risk in the market can be minimized. So, this is
the criteria for the futures and option trading in the Indian market.
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Then if you see that there are some other kind of criteria also we have. The exchange
may consider introducing derivatives contract on an index if the stocks contributing to 80
percent weightage of the index are individual eligible for the derivative trading.
And no single ineligible stocks in the index should have a weightage more than 5 percent
of the index and this criterion is applied for every month. If the index basically fails to
meet the eligibility criteria for the three months consecutively there are no fresh contract
would be issued on that particular index. Then which stocks are eligible for this
derivatives for options and the futures.
So, these are the different things because here basically the underlying asset is the stock
and if the underlying asset is not performing well and the companies who is basically
issuing a stock their performance and size is not that good enough to observe that
particular kind of risk in the market.
Then those particular companies are not eligible to go for issuing any kind of contracts in
the future, in terms of futures or in terms of options are anything else. So, because of that
these are the different things we have to consider, we have to look at whenever anybody
wants to go for issuing the derivatives contracts against that stocks were there issuing in
the spot market.
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So, if you see the critique of the derivatives with reference to India, so what is
happening, there are now number of papers and of number of studies have been carried
out, why the derivatives is not very popular in the Indian market, why people are not that
inclined to go for investing in the derivatives? So, globally there are certain kind of
debate which is going on and already we have discussed also relatively this market is
risky in comparison to the other markets because people are not using the derivative as
hedging instrument people are mostly using the derivatives as a speculative instrument.
So, once there is a speculation; obviously, the risk will be more, that is inevitable. So,
that is why first of all the derivatives instrument, the basic use of the derivatives which
was supposed to be the hedging now that particular objective is totally lost, but that is not
basically always the objective that we want to use the derivatives for hazing the risk and
now does there using the derivatives only for the speculation. So, this speculation is that
is basically creating the kind of risk in the market or increasing the risk in the market.
Then wherever there is speculation; obviously, the prediction increases the uncertainty
and if there is an uncertainty then that basically leads to the risk. So, that is why it creates
certain kind of risk in the market and that risk everybody was not able to absorb and all
the investors if you go by the conventional traditional theories, then most of the investors
in the market is risk averse.
So, you might have heard there are 3 types of investors we always find, we have the risk
averse investors, we have risk seekers and we have the risk neutral. And the risk seeker
and risk averse these are practically possible, but to the risk neutral investors are
practically impossible, but theoretically the risk neutral investors exist in the market.
So, that is why if you assume that the investors are basically risk averse in nature go by
the traditional or conventional theories of finance, then what we can say that derivatives
are relatively more risky in nature that is why sometimes people are reluctant to go and
invest in that kind of securities.
Then we have the instability of the financial system, you see that whenever we talk about
the financial system to capture certain kind of thing are always if you want to see that
any kind of risk any kind of shock the financial sector wants to capture, then the financial
sector should be stable. The stability of the financial system can be measured by various
ways. How this stock can be observed? Number 1.
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Now there any kind of policy fluctuations happen, then how the market is able to capture
that kind of stock in a short span of time. There is any global crisis happens that how the
market is basically ready to capture that kind of disturbances in the market.
And as well as if you see that financial system instability is an issue all over the world
that which the people are telling that because of certain kind of disturbances in all the n
markets are integrated, if one market is disturbed and one market is unstable that leads to
the instability also in other markets. So, that instability is basically again already existing
in all kind of segments in the spot market itself.
So, again the derivatives market, inclusion of the derivatives is also creating more
instability in the segment because the pricing is highly fluctuating and the investors are
using it for the speculation. So, another thing if you see, the derivative segment trading is
basically a virtual kind of trading and the total amount of trading in the virtual market is
much more higher than the actual trading value which is happening in the spot market.
So, if anything goes wrong in this particular segment that totally destabilize this global
financial system. So, that is what some people are reluctant to go for investing in the
derivatives, but still people back lot of money using the derivatives, so that is why even
if there is high risk there is a probability of high return so that is another thing.
And another thing is you see if you go by the nitty gritty, here this particular subject its
beyond that particular scope we do not have that much scope to discuss all the details
about the derivatives, but here if you see there are certain kind of products which are full
of credit risk, there is always a probability of default, the particular contract may be
exercised may not be exercised.
Again whenever that kind of provisions are there then that basically also increases the
credit risk in the market and already the credit risk in the spot market whether in terms of
the banking or in terms of any other bond market is already high. And now further
inclusion of the credit derivatives into the market further enhances the probability of
credit risk at probability of default.
So, that is why that also leads to the credit risk that is why this researcher argue that the
credit risk and the probability of credit risk can increase if there is more derivative
trading in this particular market. And there is another effect called the displacement
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effect, the displacement effect is basically what? That basically, displace certain kind of
consumers from one particular segment to another segment and that segment is relatively
risky segment within the market segmentation theory. And whenever the displacement
effect works, that displacement effect may dominate the other kind of effects which
always have a positive impact on the market stability.
So, here what basically we are trying to argue if the derivatives are introduced in the
market some of the people they may not be that much prone to absorb the risk, but there
is basically always move from one particular segment to another segment. Because of
that the displacement happens in that particular part, but they are not basically able to
capture that kind of losses in the market or they are not able to basically always tolerate
that particular lost what they are going to get in the market.
So, then finally, what has happened? That the market becomes more volatile and the
because of inequality or the liquidation of this particular assets of that particular
company or particular individuals. And some people argue that because of this particular
product is complex and there is some kind of other kind of functionalities involved in
this particular product, this also increases the regulatory product.
Because some instruments which are related to interest rate, some instruments which are
related to the other kind of assets. So, who are the regulators? Whether the regulatory
body is RBI or regulatory body is the SEBI. So, again the regulations in terms of the
different securities are different. So, once we have the different securities put in place,
then what kind of the banking we have, for all type of banks we have a different kind of
regulatory norms.
For all kind of financial other financial institutions we have a different kind of regulatory
norm, but whenever you talk about the derivatives instrument. Because the instrument is
varying in nature and as well as the complexity of the instrument is so diverse in nature,
so in that context this also increases the regulatory burden.
So, that is another issue people always discuss whenever if anybody basically is the
critique of this particular derivatives or they field that the derivatives market is not that
conducive for the development of the financial system. So, these are the different kind of
problems or may be the critique of the derivatives market what we are the researcher
always argue on this particular points.
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So, if you see the facts in terms of the derivatives up to 2013 and 14, this 99 percent of
the turnover in terms of the derivatives market was accounted by NSE this National
Stock Exchange. Only for last couple of years the BSE has improved in terms of the
derivative trading, but still it is 70 percent now it is NSE also the share of NSE is 70
percent and another 30 percent is accounted to the Bombay stock exchange.
So, mostly the derivative trading is taking place in the national stock exchange in India.
And in terms of if you compare the index futures, stock futures and index options are the
major derivatives in India at present. These 3 types of derivatives particularly, the index
future, stock futures and index options these are accounted for more than 95 percent of
the total turnover in the equity derivative segment of the derivatives market in India. 95
percent is coming from the index futures, stock futures and index options.
And all derivatives contracts are currently cash settled and the interest rate and currency
derivatives market in India have not grown in the same pace with equity derivatives.
That means, whatever developments taken place in the derivatives market in India that is
basically happening with respect to the equity market, it is not happening with respect to
the other segments. So, that is why the development is mostly towards the equity
derivatives, not with respect to the other financial derivatives which are supposed to be
developed, but they have not yet developed in the Indian context.
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Then, in terms of trading value NSE has dominated in both the segments for interest rate
derivatives is accounted for more than 90 percent and for currency derivatives also it is
more than 90 percent up to 2013 and 14, but since the year 2014 and 14; 14 and 15, the
share of the BSE has increased to 38.7 percent. So, already I told you that BSE is moving
up in terms of the derivative trading, but mostly the derivatives market in India is
dominated by the NSE.
So, here what basically we can see that we have a long way to go if you talk about the
development of the derivatives market in India, but still the instruments exist, those
instruments basically play the significant role in the diversification of the risk in the
portfolio management and also this is a kind of lucrative instrument always if anybody
wants to maximize the return, even if the risk is relatively higher in this particular
segment.
So, the basic objective of introducing this particular course they or discussing the sum of
the basics of the derivatives in this particular subject, is basically to get an idea that what
is the derivative is, although this particular syllabus is quite broad or there are so many
complexities in terms of the concepts or so many complexities in terms of the different
issues with respect to derivatives. So, here what we are trying to explain, we are trying to
only introduce that what derivative is?
How the simple models are used for the pricing of this instrument and who are those
kind of investors who participate in this particular market? And as well as to some extent
about the concepts like moneyness, like your implied volatility like your open interest
and all these things which can enhance the idea about reading more about the derivatives
market in the future.
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So, this is what about a derivatives market in India and this is the reference you can go
through for this particular session.
And thank you very much.
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Lecture - 56
Foreign Exchange Market – I
So after the discussion on the different other markets like your money market, your stock
market, than the bond market, then the derivatives market. We can start the discussion on
another type of market that is the Foreign Exchange Market. As you know that in this
globalized period the importance of the foreign exchange market is quite large in the
context the financial markets are integrated. And foreign exchange market place a
significant role in terms of trade in the financial system. That means, the export and
import business are running through the foreign exchange markets.
The operation of the foreign exchange market mostly done by the export and import.
Although there are other aspects of the foreign exchange market also there, but mostly
foreign exchange market is responsible for the trade balances. And other issues if you
take the foreign exchange market basically, talks about the how the exchange rates are
determined?
What do you mean by the exchange rate? And as well as it also talks about the factors
which influence the determination of exchange rate then as well as the mechanism of the
foreign exchange market how the people go to the foreign exchange market? And what is
the motivation of going to the foreign exchange market and the other issues related to
that what kind of foreign exchange system we have.
Then as well as also we try to see that how the foreign exchange reserves are managed
and how the central bank intervention to the foreign exchange market what is the
mechanism into that. And as well as some issues related to the foreign investments; the
foreign investments includes the foreign direct investment like FDI and FII. So, these are
the measure issues what will be discussing in this particular sessions which are related to
the foreign exchange market.
So, one by one we can discuss those issues, but today we are going to discuss that what
exactly the exchange rate is which is the measure variable, which is determined in the
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foreign exchange market and how the exchange rates are defined and what are those
different concepts which are related to the foreign exchange determination. So, this is
what basically our objective or the agenda for the discussion today.
If you see that whenever you talk about exchange rate how the exchange rate is defined
the exchange rate basically what? The exchange rate basically measures the value of one
currency in units of another currency which is very popular in the sense if you see that
everybody talks about that what is the value of rupee against the dollar what is the value
of dollar against the rupee and all these things. So, these are basically nothing, but the
exchange rate.
If you see today in the newspapers and other places we are studying or we are always
reading that the rupee value is declining and dollar value is becoming stronger and
stronger. What does it means? It means that how the exchange rate is going to be
changing or how they exchange rate is going to be fluctuating between dollar and rupee.
So, that is why the exchange rate basically is nothing, but it measures the value of one
currency in units of another currency. Among them one currency may be domestic
currency another currency is the foreign currency.
So, once we are converting our home currency into the foreign currency or you are
converting the foreign currency into the domestic currency or the home currency. Then
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that particular thing is defined as the exchange rate in a layman perspective or from the
economic perspective.
So, therefore, that is the first thing basically we can keep in the mind and second thing is
there are 2 types of exchange rates; always we can have one is in terms of the market.
One is your spot exchange rate and another one is the forward exchange rate or the
forward rate. So, the spot rates are mostly determined by this spot market factors and the
forward rates are determined by some other factors although this spot rate also is a factor
which determine the forward rate. So, that we will see later, but this is the way the
foreign exchange transactions are taking place in the foreign exchange market.
But in terms of even if it is the spot market rates, if you think about the spot market rates
this spot market rates also can be defined in 2 ways or 2 parts; one is your nominal
exchange rate another one is the real exchange rate. So, already all of you know that
what is the basic difference between nominal and real etcetera already we discussed in
the previous sessions that anything whenever you talk about the real on the economic
sense so; that means, it is the real exchange rate if you talk about the real interest rate
you talk about it is basically adjusted to the inflation.
So, nominal rate which is adjusted to inflation that is basically is considered as the real
exchange rate or real interest rate or anything. So, whenever you talk about this real
exchange rate in the context of foreign exchange market; then how this real exchange
rate is basically determined if you have the nominal exchange rates. So, already what I
told you the real exchange rate basically indicates the purchasing power of one currency
relative to another currency. So, the purchasing power whenever we talk about the
purchasing power is always measured through the inflation rate.
So, if your nominal exchange rate is adjusted for changes in the relative purchasing
power of each currency which some base year or the base period, then we can call it the
real exchange rate. So, that is why here we are adjusting this particular exchange rate
with respect to the home inflation rate; home inflation rate and the foreign inflation rate.
So, here 1 into 1 this inflation rate this is the plus then this is your foreign currency
inflation rate; foreign countries inflation rate or this is basically the home countries
inflation rate. So, your real exchange rate is the nominal exchange rate multiplied by 1
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plus the inflation rate of the foreign country divided by the inflation rate of the home
country. So, this is the way the real exchange rate is determined in the market.
So, let us see that whenever we have the multiple currencies because one country maybe
transacting with the multiple currencies. If you have the multiple currencies then how
this particular exchange rate is determined and what is the proxy we have to use for the
multiple currency?
So, here whenever we talk about the multiple currency, before that we have to know
something about the concept of the effective exchange rate. So, the effective exchange
rate is nothing, but it is a measure of the multilateral exchange rate. And again from the
nominal effective exchange rate you can measure the real effective exchange rate in
terms of the multiple currencies. So, you have the multilateral currencies we basically
calculate the nominal effective what is important here.
And we also can calculate nominal and as well as the real effective exchange rate in that
particular system. So, how this nominal effective exchange rate is calculated the nominal
effective exchange rate is nothing, but it is the weighted average of the bilateral nominal
exchange rate in the home currency, against the selected foreign currencies.
That means let we have the currencies like rupee versus dollar we have the rupee versus
pound we have the rupees versus yen. So, there are different type of exchange rate with
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respect to different currencies we have. So, if you want to calculate a particular exchange
rate which talks about the exchange rate across all the currencies. Then we calculate the
weighted average of those exchange rate with respect to that respective currencies. And
then if you want to calculate the real from that then we have to adjust the relative in
place 100 with respect to that is currency with the other foreign currencies whatever we
have.
So, then how the weights are given? For example, if you say that one Indian rupee is 1
dollar is equal to 70 rupees, let you talk about 1 pound is equal to 100 rupees. So, if you
are giving the weights, then how the weights are given already you know that how to
calculate the weighted average?
The weighted average is nothing, but in this particular context the particular exchange
rate with respect to one currency multiplied by the weight, plus the another exchange rate
that exchange rate 1, then you have exchange rate 2 multiplied by the weight and so on.
If you have the n exchange rate then your exchange rate n multiplied by the weight of
that n weight 2 weight 1 all these things.
Then how the weights are given, the weights are given on the basis of mostly the weights
are given on the basis of the trade. So, the total amount of trade with respect to that
particular country is considered as the weights; that means, you can calculate the total
trade value. Then you see that how much trading is taken place with respect to that
currency and how much trading is taken place with respect to the second currency third
currency and all these things. Then let the total trading value is a 1000 crore, then let for
US it is 500 crore for UK it is let 50 crore for Japanese yen it is 50 crore, then let there
the another currency you can take that is 100 crore.
So, then what you can do the total is let 1000, then you can go on there are other
currencies also then with respect to 1000 crore you can 0.5 50 percent weightage will be
given into dollar then fifty dollar versus rupee exchange rate. Then 50 by 1000 whatever
percentage you can find out from this that weightage will be given to the pound. And
again 50 by 1000 whatever weightage you can get it to that particular currency, then 100
by 1000 you have the 10 percent givens to this 5 percent given to this and 50 percent
given to this.
904
Then go on if you have any number of currencies then accordingly the weights can be
calculated with respect to the trade. And that weights can be multiplied with respect to
that particular exchange rate with respect to that currency then finally, the weighted
average of all those exchange rates can be calculated. And that can be considered as the
nominal effective exchange rate.
And when this nominal effective exchange rate is deflated by the relative inflation rate
of home currency with respect to the foreign currency, then the real effective exchange
rate can be calculated. So, this is the way the exchange rates both real effective and
nominal effective exchange rates are calculated in the system.
Then if you see that how the exchange rates are quoted, here you see that we are first
discussing about the concept of exchange rate and the how the quotations of the
exchange rates are made. And then further we can go to the discussion on the factors
affecting the exchange rate or the determinants of the exchange rate. So, whenever you
talk about the direct versus indirect exchange rate what does it mean? Let you have the
different currencies, you have we are living in India our currency is the rupee, then we
have the dollar, we have the pound.
Let you want to convert you have let 5000 rupees available with you and that 5000
rupees you want to convert into the pound. So, if you want to convert it to the pound then
what basically you can do? Directly you can go let for pound is 100 rupees. Then you
905
can get 50 pounds let that pound is not available with that particular money exchanger
from where you want to take the pound.
But whenever if you are going to UK and you need pound for that then what is
happening you cannot go with the pound then what basically you can do? If pound is not
available that with that particular company from where or particular agent from where
you want to exchange it.
Then what you can do you can convert it to the dollar first, then that dollar again can be
used there to exchange this particular money into the pound. So, one is you can directly
convert from rupee to pound or you can convert it let this is your rupee and this is your
pound and this is basically your dollar. So, then either you can directly converted from
rupee to pound or you can go to dollar and from dollar to pound. So, if you are directly
converting it or you are quoting that exchange it that 1 dollar is equal to 100 rupees then
we call it that the exchange rate is quoted directly.
But if you are quoting the exchange rate via dollar, that you can go to the dollar from
dollar to pound, then we can say that we are basically quoting the exchange rate in an
indirect way. So, that is a proxy practice always the companies or the banks basically
always use, let there is giving either number of home currency unit say rupees for unit of
foreign currency that is a US dollar or the number of units of the foreign currency let
dollar per unit of home currency say rupee. When banks deal with the non bank
customers.
That means, either they can convert from directly tell you rupee versus dollar they can
say that 1 dollar is equal to 70 rupees, but other way also it can be converted that 1 rupee
is equal to 1/70 dollar, both ways it can be represented. So, whether you want the
conversion per unit of the foreign currency how much home currency we are getting? Or
it can be also reported that how much foreign currency you are getting in terms of your
home currency in terms of one unit of the home currency. So, either of this way the
quotations are made or this is the way it is direct to indirect quotations always we look at
in the market.
Here one thing you observe there are sometimes also the quoting this particular exchange
rate in terms of indirect way, is sometimes beneficial for the investors. And how it is
906
beneficial? If there is some kind of arbitrage opportunity exist in the market that we will
see we will discuss it.
But one thing you can always keep in the mind, if there is no transaction cost and direct
exchange rate between any two currency let rupee and euro let rupee versus pound rupee
versus dollar, particular rupee versus pound or the euro is exactly equal to the implicit
exchange rates via US dollar that is what basically what i have explained here.
Either, if there is no such transaction cost involved in this particular market, then either
you can convert directly from rupee to pound or you can go via dollar you convert from
rupee to dollar and dollar to pound that does not make any difference you get the same
amount of pound in the end. Either you converted directly or you convert it indirectly.
But in practical sense that may not be possible or that may not be always prevailed in the
market.
So, if that does not prevail then there is a chance of arbitrage opportunity and already
you know that what is the meaning of arbitrage opportunity that the investor can generate
certain profit without taking any kind of risk. So, that is the way the indirect quotations
are made in the system.
So, that is basically we call it the cross exchange rate. So, what do you mean by this
cross exchange rate in a very practical sense or in an actual sense? That cross exchange
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rate basically represents the relationship between the two currencies that are different
from ones base currency. If you take the India the example, then the cross reference
basically or the cross exchange rate refers to the relationship between the two non rupee
currencies. So, it represents the exchange rate between the two currencies via another
currency that already I told you.
So, if the spot exchange rate between the rupee and pound that already just now I was
showing you let this is this represent as the spot this is rupee versus pound. That means,
if the denominator is the pound; that means, what I am trying to find out one pound is
equal to how much rupees?
So, if you want to convert that particular term, via another exchange rate let dollar, then
that can be represented as let here you have the rupee versus you have the pound that you
want; then what you can do? You can get it rupee versus your dollar into dollar versus
pound. So, the dollar will be cancelled and end of the day you are finding that what you
are finding the rupee versus pound.
So, that is basically the cross exchange rate. So, this is the way the cross exchange rates
are basically shown in the market. So, you can calculate the cross exchange rate between
them.
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Why basically we take this help of the cross exchange rate? There are reason behind that,
the reason is the arbitrage basically is possible in most of the time in the foreign
exchange market, whenever you are using or taking this concept of the cross exchange
rate in the trading process. So, arbitrage when it is possible whenever you are
capitalizing on a discrepancy in quoted prices to make that riskless profit.
So, there are although different types of arbitrage concept is existing in the system
financial system or the foreign exchange market also, but the major type of arbitrage
always we find or we will see that is your, time triangular arbitrage and the locational
arbitrage. These are the 2 types of arbitrage is possible and the investor can use these
quotations or to find out whether there is an arbitrage opportunity exist in the market.
If the investor finds that there is an arbitrage opportunity exist in the market, then they
can create that kind of profit without any kind of risk that is the basic job of the investor
by considering this concept of arbitrage or by exploring the probability of arbitrage
which may exit in this particular system. So, we will see that what do you mean by this
triangular arbitrage?
If you see the triangular arbitrage, when the triangular arbitrage is possible the triangular
arbitrage possible, when a cross exchange rate quote differs from the rate calculated from
the spot rate quotes. Then there is a possibility of the triangular arbitrage and how it
happens if you see if suppose you have 700 rupees, if you see this example you have 700
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rupees and you have to convert that 700 rupees into pound. And what basically data is
given to you or you know that 1 dollar is equal to let 70 rupees and 1 pound is equal to
90 rupees.
And 1 pound is equal to 1.2 dollar that conversion also you know. If you are going for a
directly converting from rupee to pound, then how much you are getting how much
pound you are getting? You are getting 700 rupees divided by 90 that is 7.77; 7.77 pound
you are getting whenever you are converting from rupee to pound.
But now we will see and you are assuming no transaction cost, there will be no
transaction cost in the market. If there is no transaction cost then what is happening, if
you are converting from rupee to dollar first, then how much dollar you are getting 10
dollar 700 divided by 70 that is 10 dollar you are getting.
Now, you are converting dollar to pound right. Then how basically you can convert it
because you have already you know that 1.2 dollar is equal to 1 pound. Then your 10
dollar is equal to 10 by 1.2 dollar. So, then finally, you are getting 8.33 pound. If you see
whenever you are converting directly you are getting 7.77 pound. But whenever via
dollar you are converting from rupee to pound and without we are assuming here there is
no transaction cost, then you are getting 8.33 pound. What does it mean? It means that
there is a chance of arbitrage, if you are going or without any risk you are basically
creating the profit here.
So that means, that time only the arbitrage opportunity will not be possible, whenever
this particular conversion will be perfectly matched to it the direct conversion what
basically we are getting between the different two different currencies. So, then there is a
chance, there will be no chance of arbitrage opportunity then when that can be possible.
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If you see let suppose same data 1 dollar is equal to 70 rupees let you assume 1 pound is
equal to 98 rupees and 1 pound is equal to 1.4 dollar. And now if you convert the same
process if you follow, then you are directly converting from rupee to pound how much
you are getting, previously the data what we have taken that is 1 dollar is equal to 70
rupees then 1 pound is equal to 90 rupees and 1 pound is equal to 1.2 dollar.
So, now let the 700 rupees you want to convert, but now in the market 1 dollar is equal to
70 rupees that remains, but 1 pound is equal to 98 rupees and 1 pound is equal to 1.4
dollar. So, now, if you are converting from rupee to pound, then 700 by 98 you are
getting 7.142857 pound. Now rupee to dollar again 10 you are getting, now dollar to
pound if you convert then will be getting the same 7.142857. So, in this context whether
you are directly converting from rupee to pound or you are going via dollar that does not
make any differences.
Here also it is 7.14 here also it is 7.14. And here; that means, there is no arbitrage
opportunity exist in this particular context or this particular data where you can generate
some profit out of this without any risk. So, this is the concept of the triangular arbitrage
always we find in the foreign exchange market.
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And another one is your locational arbitrage and why the locational arbitrage happens it
is possible when the banks buying price; that means, the bid price because in the price
already you have to one price is the biding price another one is the quoting selling price.
That means one is bid price one is ask price that already you know. So, let this same
bank when a banks buying price is higher than another bank selling price for the same
currency, you take this example let there is a bank and let 1 rupee is equal to 0.15 dollar
ask is 0.017 dollar, but bank B at the same time, the bid price is 0.019 ask price is 0.020.
Then what the particular agent can do or the investor can do buy the particular currency
from bank A at a price of 0.017 and sell it to the bank, at a price of 0.019 this is your
price at which you are buying it; that means, this is the asking price for bank and for us it
is the buying price.
And now you can this is the buying price for the bank and for us basically it is the ask
price what we are getting, after if you sell the particular currency to the bank. Then end
of the day what is happening, that you are buying at this price and sell it that price then
finally, for rupee you are generating a profit of 0.002 dollar. So, then we can say that the
locational arbitrage is existing in the system.
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Then another concept we have the interest rate parity, what exactly the interest rate parity
means? The interest rate parity basically says the forward rate and there is the difference
between the spot rate and the forward rate and that difference basically is compensated
by the interested differential between the two currencies, the forward exchange rate and
spot exchange rate. Exactly or sufficiently offsets the interest rate differential between
the 2 currencies. So, this is the calculation of the forward premium the forward premium
is equal to [(1 + home interest rate) / (1 + foreign interest rate)] - 1.
And how it can be established? Your forward price already you have a forward premium
is nothing, but the (future price - spot price) / spot price which is nothing, but [(1 +
interest rate of the home currency) / (1 + the interest rate of the foreign currency)] - 1
which is nothing but i H - i F if you divided by 1 plus i F. And if you approximately see
then the forward premium exactly what you are getting that is basically nothing, but the
interest rate differential between the two currencies. And if the interest rate differential is
very small then the forward premium can be calculated as i H - i F.
The interest rate of the home currency minus the interest rate of the foreign currency; so
that is the way if that condition does not hold good then we can say that interest rate
parity does not hold good in that particular market or between that particular different
home country and the foreign country. So, this is about the different ways how the
913
quotations are made and how the risk profit the investor can generate out of the
quotations.
So, these are the references what you can go through for this particular session.
Thank you.
914
Lecture – 57
Foreign Exchange Market – II
So, after the discussion on the meaning of exchange rate and the how the exchange rates
are quoted, now in this session we can discuss about the how the exchange rates are
determined. What are those factors which affect the exchange rate and why there is a
fluctuations or there is a change we observe in the exchange rate. So, this is what
basically the discussion what we can make in this particular session.
All of you know that the exchange rate always is very much fluctuating. The currency
value against another currency is changing in a continuous manner; sometimes the value
is increasing, sometimes the value is decreasing. So, if the currency value is declining we
are telling that it is depreciating, whenever the currency value is increasing we are telling
that this particular value against this currency value against another currency is
appreciating.
So, this is the common language always we use to define the change of the exchange rate
in the different periods and different time. But, the question here is that whenever we talk
about this there is another concept is related to this that is called the devaluation, you
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might have heard about this word that is called the devaluation. We are telling that
whenever the value is declining we call it that if there is a depreciation which is
happening for that particular currency with respect to another currency and if the value is
increasing we are telling that there is an appreciation which is happening with respect to
another currency. But then what is devaluation? Is it same with depreciation or is it
different from the depreciation, so that is basically another question always comes to the
mind to the reader.
You see the meaning is same whenever the value is depreciating or value is declining we
call it is a depreciation or the value is depreciating and another thing is the devaluation.
What do you mean by this? You see the depreciation is a process which is basically done
by the market forces, depreciation is always occurring due to the changes or the
fluctuations of the market forces. But whenever you talk about the devaluation;
devaluation is a policy measure which intentionally always done by the government or
the regulator.
The devaluation is manmade or made by the individuals made by the regulatory bodies
made by the government, but whenever you talk about the depreciation, depreciation is a
market determined factor market determined process. And, if there is some kind of
fluctuations happens with respect to the factors which are affecting the exchange rate
then there is a possibility of the depreciation. But, devaluation is always done by the
regulatory body or by the government intentionally to increase the performance of the
export for that particular country or there must be some economic reasons behind the
devaluation, but depreciation is determined by the market forces.
So, that is the basic difference between the devaluation and depreciation; devaluation is
not a market mechanism, it is a done by the regulatory body or the government, but
depreciation is a market mechanism. So, whatever it may be whether the currency is
going to be depreciated or currency is going to be appreciated thinking about the
depreciation or appreciation. How it basically measured? When we say that the particular
value is currency value against another currencies depreciating or appreciating, then we
calculate the change the price of that particular exchange or in the exchange rate of that
particular currency with respect to another currency.
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So, let S t is the exchange rate in a time period t S t - 1 is the exchange rate at the time t-
1. Then if you calculate the percentage change then we can say that is basically the
particular value let that is basically Δ the change. The change basically tell you though
whether the currency is depreciating against another currency or appreciating against
another currency.
So, the positive percentage change if you see the delta if you for example, percentage the
positive percentage change represent appreciation of the foreign currency while a
negative change represents the depreciation of the foreign currency. So, that is the way
the appreciation and depreciation for example, the rupee versus dollar was 72 rupees
yesterday then it has become 74 today.
Then if you are calculating this change today then it is (74 – 72) / 72 then; obviously, it
is positive the delta value is positive. So, if it is positive that means the foreign currency
is appreciating; it is not home currency it is appreciating the foreign currency is
appreciating because the value of the home currency is declining. The foreign home
currency is depreciating and foreign currency is appreciating, but for example, it was 72,
then it become 70, then it will be (70 -72) / 72.
Then by default it will be negative; that means, the home currency is appreciating, but
the foreign currency is depreciating. So, in that context if your reference point is foreign
currency then you can use this, but if your reference point is the home currency then your
interpretation should be reversed should be opposite. So, that is the way the exchange
rate movements are represented in the market or in the system.
917
So, let us see that how this particular what are those factors which are responsible for this
movement. The particular factors whenever we talk about there are many factors which
are basically affect this exchange rate. So, already as other factors always we think we
discuss or we determine in the context of the different markets, here also the exchange
rate is again determined by the demand and supply forces of the foreign currency.
Here let the home currency is the rupees and foreign currency is the dollar and then
already I told you that the exchange rate is the price of a currency or the rate at which
918
one currency can be exchanged with another currency right. So, the equilibrium
exchange rate in a particular time period is determined by the demand and supply of the
foreign currency in that particular economy in that particular system.
So, when it increases when it decreases. So, if the demand for the currency increases
when the value of the currency decreases then there is basically will lead to a downwards
sloping demand curve. And, supply of currency increases and this value of the currency
increases which basically going towards the upward slope in the supply curve. If you see
here for example, demand it was 65 the demand was this, whenever it was let 48 the
demand was this demand has gone down. What demand for what? The demand for the
dollar because, the dollar value is depreciating.
So, then go on if you go by the 70 then again further the quantity of dollar available in
the system further go down. So, because of that there is a downward sloping demand
curve and the supply; obviously, that is again you can say that the price and demand
relationship you can observe. So, the supply basically will increase whenever the value
of the particular currency is increasing, in that particular context the value is increasing
they are ready to provide more supply.
Because, the particular values they can convert or they can get more money by
conversion of that particular currency with respect other currency. So, that is the way the
demand and supply is determined and the equilibrium can be established wherever the
demand and supply is intersecting to each other. So, that is the equilibrium exchange rate
which basically we can determine in the economic system.
So, that is the way the exchange rate is determined in the financial market, but the
question here is; that means, there are what factor determine this exchange rate?
Obviously, the factors which are affecting the demand and supply of the foreign currency
or demand and supply of the home currency whatever it may be; the demand and supply
factors which are affecting the currency in that particular system that is the responsible
factors which are affecting the exchange rate determination in that particular context.
So, let us see: what are those factors which are affecting this demand and supply of the
currency. The first one is the relative inflation rate you remember it is relative inflation
rate we do not consider the inflation rate of a particular country, we consider the inflation
rate for both the countries. That is why we are using this word relative inflation rate that
919
you can keep in the mind. We are telling that inflation rate in India is 5 percent, inflation
rate in India has increased to 7 percent.
That has no implication no meaning whenever you are interpreting the determination of
exchange rate, but if you are saying that this inflation rate in India has gone up against
another particular with respect to or in comparison to the another countries inflation rate
then there is a possibility that this will have the impact on the high impact on the
exchange rate. We will start the example the inflation rate, let there are 2 countries here
we have taken one is India and another one is USA.
There are 2 currency, we have the Indian rupee and you have the dollar US dollar. So,
we have the 2 currencies for example, the inflation rate in India has gone up, if inflation
rate in India has gone up then what is happening in India. Indian demand for US goods
will increase because, Indian commodities will become costlier. If Indian commodities
will become costlier in comparison to US Indian commodities if US commodities are
cheaper then the demand for US commodities will increase in India.
If the demand for US commodities will increase in India then the demand for dollar will
increase right. At the same time, what will happen in US? The US desire for Indian
goods will go down because, Indian goods become costlier. If India goods become
costlier then the supply of the dollar will go down. Because, America will not buy this
products from India because of the high price they will not buy. If they will not buy the
Indian commodities then what is happening? Obviously, there will be no flow from US
to India and that flow is basically nothing, but the supply side of the dollar.
So, therefore, high inflation rate in the Indian system will increase the demand for the
dollar and it will decline the supply of the dollar. So, because of that let this is your
original demand curve this is your original supply curve now what is happening because
of change in the inflation rate the demand has gone up and the supply has gone down.
So, then this was the original equilibrium where it was e 0. Now, this has become here
basically it has become e 1. So, the exchange rate has gone up, it was e 0 then it has
become e 1 this is the way for dollar basically the demand is more, but supply is not
there. So, if the demand is there supply is not there then foreign currency will appreciate,
but the home currency will deprecate.
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So, here the exchange rate if you talk about we are talking about from the foreign
countries or foreign currencies prospective. So, here you can observe that there is an
increase in the exchange rate of that particular foreign currency with respect to the home
currency. Then we can see that what are those other factors, one is you can say that is
basically your inflation rate.
Then another major factor we have that is interest rate. Then how the interest rate is
affecting? The exchange rate, let the Indian interest rate hypothetically you have 2
countries already we have taken, then India’s interest rate has gone up. If India’s interest
rate will go up then what will happen? The Indian demand for US bank deposits will go
down. Why? Because, India is giving more interest if Indian banks are giving more
interest, then the demand for US bank who are the people who wants to deposit the
money in the US bank they may not be deposited the money in the US bank they want to
deposit the money in the Indian bank.
So, that is why the Indian demand for US bank deposits will go down. So, therefore, the
demand for dollar will go down. If the demand for dollar will go down, but at the same
time what is happening the US desire for Indian bank deposits will go up, because in
India they are getting more interest. You see we are taking very simplistic example
simplistic cases. The cases may be complex, but you can keep in the mind these are the
fundamentals which are basically affecting the exchange rate determination.
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You can put lot of conditions you can put lot of hypothetical situations through which
that particular relationship may not hold good we are not basically discussing those
things here. What we are discussing? That, how the change in interest rate in one country
is going to affect the demand and supply of the foreign currency and by that the
exchange rate basically will be changed, or will be fluctuating over the time.
So, if the US desire in that particular point of time if US desire for Indian bank deposits
will go up then the supply of the dollar will go up because dollar will come into India.
Then finally, the availability of the US dollar in the Indian system will go up then what is
happening that what will happen then the demand for dollar will go down, but at the
same time the supply is going up.
So, then what is going to happen by general intuition supply is more demand is less then
the price will go down. So, now, the exchange rate which was there is zero this has come
down to E 1. So, then this is the way this interest rate changes in the economic system
can affect the demand and supply of the foreign currency. And, once the demand and
supply of the foreign currency gets changed then the exchange rate also gets changed or
gets affected by that.
Then we have other factors. So, another question here if you keep in the mind then which
interest rate whether we should consider real interest rate or nominal interest rate?
922
Already, all of you know that the real interest rate is nothing, but the nominal interest
rate minus the inflation which we call it Fisher effect.
So, relatively high interest rate may actually reflect expectations of relatively high
inflation. Generally, if you see what is the relationship between interest rate and
inflation, the interest rate if interest rate is very high that means what we are assuming
the expected inflation also is going to be high that means, the inflation rate is high
because of that their increasing in the interest rate to decrease the money supply in the
economic system to make this price become more stable. So, that is why if there is an
inflation in the system then it will discourage the foreign investment.
So obviously, the demand for dollar and supply of the dollar will get affected and here
we are telling that the demand for US citizens towards the Indian bank deposits will go
up because of the supply of dollar will go up. But, if there is high inflation in the
economic system then what is going to happen the real rate of return what they are going
to generate from the market that may not be realized.
If the real rates are not realized then what will happen this will basically discourage the
foreign investors. If it will discourage the foreign investors then what basically will
happen, that; that may change this dynamics of the demand and supply of the particular
foreign currency. So, whenever we are going to incorporate or we are going to analyze
the concept of interest rate as the determinants of exchange rate we generally consider
the real exchange rate we do not consider the nominal exchange rate.
Therefore, always consider the real interest rates which adjusts the nominal interest rate
for inflation that already you know that the real interest rate is nothing, but a nominal
interest rate - the inflation rate; that actually always you keep in the mind unless it may
have some different kind of dynamics while they will play while determining the interest
rate in the system.
923
Then another factor we have that is relative income level, if you assume the level of
income in Indian system has gone up. If the level of income will go up then what will
happen? Now, Indian people have more money right. So, if Indian people have more
money they want branded products, more luxury products, more comfort products, better
technological products in that context we feel that US technology is better, US products
are better because it is imported from US.
So, in that context what is happening? That the Indian demand for US goods will
increase because people can afford there are taste and preferences will change if the taste
and preference will change then what is happening the US demand for Indian demand for
US goods will increase. Then what is happening, the demand for dollar will increase.
But, that will have no impact on the supply because any way this supply side factor
because Indian income they can demand more US products thats why the demand for
dollar will go up, but there is no such theoretical logic we can establish between the
income with the supply of the dollar income of increase in the income of the home
country will have not much impact or will have no impact on the supply of the dollar in
that particular home country.
So, this supply curve will remain same as usual now the demand curve have shifted
towards the right because the Indian demand for US goods have increased because the
peoples taste and preference, they want the foreign flavor from that because of that what
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is going to happen that the demand for dollar will go up. So, if the demand for dollar will
go up then if you observe here it was the original equilibrium point now it has move in to
this. So, the exchange rate has gone up. That means what? The Indian rupee has been
depreciating or has depreciated and the foreign currency has been appreciated. So, that is
the logic what basically you can get whenever you are saying that there is a relative
income level of Indian economy has gone up.
So, that is another factor, then we have some more factors also that already you know
that one most important factor is trade barriers. We have different kind of tariffs, you
have the quotas, you have import duties. Those factors also contributes significantly the
current account balance of the economic system.
If the current account balance which talks about the export and import, that gets highly
affected whenever the trade barriers will increase, if the trade barriers will be more or let
we have lot of import duties. If government of India will put lot of import duties on other
countries products then what is going to happen the demand for those commodities will
go down because that will become costlier. Then obviously, the demand for those
commodities will go down then the demand for foreign currency in the home country
will go down.
So, that will have the impact on the trade and as well as the exchange rate. So, that is
why the trade barriers is one of the important factors, we have another factor, we have
925
different exchange rate market intervention by the regulator. Sometimes what happens
because of some reason if there is some kind of fluctuations high fluctuations are
observed in terms of the exchange rate fluctuations in the foreign exchange market. Then
the Central Bank or Reserve Bank of India can intervene in to that.
To control that they can take or the basis of the requirement they take whatever possible
measures they can take depending upon whether they want to increase the foreign
currency or they want to decrease the foreign currency. Depending upon that policy
basically they change and that will have the impact on the demand and supply and once
the demand and supply gets affected, then automatically the exchange rate gets affected.
Then we have another factor the expectations of the market participants and here you see
major factor the news impact any news which comes to the market which is related to the
foreign exchange that will have lot of implication on the fluctuations of the exchange
rate. Because, the news are basically coming to the market randomly and already you
know that the news can be positive news can also be negative news. And all of you now
that there is an asymmetry always happens in the market because, negative news have
more impact than the positive news.
But, whether it is negative or positive that is going to affect the demand and supply of
the foreign currency and accordingly what is going to happen or any policy measure
government has announced something which may be conducive for the exporters or may
not be conducive for the exporters. So, then what is happening their expectations may
change if the expectations level may change then automatically what is going to happen
that will have the impact on the demand and supply of the foreign currency.
Finally, the exchange rate and institutional investors often take currency positions based
on the anticipated interest rate moments in the various countries from the beginning
depending upon certain other fundamentals they look at that how this interest rates in
that particular economy is going to be changed. Accordingly, they take their positions
and that will also have impact on the demand and supply that already we have discussed.
926
Then there are 3 types of exchange rate system that what we have just now discussed we
have discussed mostly the floating exchange rate system which is market determined
system. We have a fixed exchange rate where the exchange rates are basically always
fixed by the government by the regulator and they follow a particular range and the
interest rate only or the exchange rate can move only into that. And basically the country
like China and other countries they follow this fixed exchange rate system where, the
exchange rate is not market determined the exchange rate is determined or fixed by the
government.
Then we have another kind of exchange rate that is called the floating exchange rate,
pure floating exchange rate there all those factors whatever we have discussed or any
factor which affect the exchange rate or demand and supply of the currency that basically
will decide that how much exchange rate will be there with respect to that foreign
currency that is purely market driven, but another one is managed exchange rate or
sometimes it is called the dirty float exchange rate. What is that? Here, the market
basically is responsible for determination of the exchange rate, but if there is any
requirement then government can intervene into that to control that.
So, Indian context we have a managed exchange rate system because generally our
exchange rates are market determined, but if there is any kind of situation arises then the
Reserve Bank of India or the government can intervene into that to make this particular
927
market stable or to control this high fluctuations of the foreign exchange in that
particular system. So, this is the way the exchange rate systems are defined in this
particular foreign exchange market.
So, this is about the determination of the foreign exchange and the factors which are
affecting the foreign exchange and the foreign exchange rate system. Further we will be
discussing about the foreign exchange market how the Central Banks intervene into that
and some issues related to the foreign exchange reserves and the FDI and FII kind of
issues which are playing a significant role on the development of the foreign exchange
market across the countries
So, for this you can go through these references.
Thank you.
928
Lecture – 58
Foreign Exchange Market – III
So, in the previous class we discussed about the exchange rate and the quotations for the
exchange rate and as well as the different factors which determine the exchange rate and
the exchange rate system. There we have seen there are 3 types of exchange rate system:
one is your fixed exchange rate system, then you have the floating rate, then you have
the managed exchange rate system. And, if the exchange rate is determined by the
market determined factors every time, then we can assume that the floating exchange
rate system is prevailing in that particular country or particular market.
So, now today we will be discussing about the foreign exchange market particularly with
reference to India. So, whenever you talk about the foreign exchange market already we
discussed that, what is the exchange rate, the exchange rate is nothing but whenever you
are converting one particular currency into another currency. Here one currency is the
home currency or domestic currency another one is the foreign currency or you are
converting either from domestic to foreign or foreign to domestic then that basically we
call it the exchange rate.
929
So, the market where these particular transactions are taking place that market is
basically defined as the foreign exchange market. So, here if you see the formal
definition of the foreign exchange market is this is the market in which the national
monetary units or the claims are exchanged for the foreign monitoring units. Why we are
talking about the claims? The monetary units can be only.
There are different ways the transactions take place either transactions in terms of the
international trade, the transactions can also take in terms of the investments like your
foreign direct investment or foreign portfolio investments. And as well as the
transactions also can be in the form of foreign aid or the borrowings from the external
market or from the external agencies international agencies like IMF and all these things.
These are all comes under the foreign exchange market. So, after all wherever the
national monetary units are claims or exchanged for the foreign monitor units that
particular market is defined as the foreign exchange market. So, the transaction can be
from any angle; it can be from the trade angle, it can be from the investment angle, it can
be from the foreign aid angle. So, that is not the issue; the issue is basically here, we are
dealing with the two different currencies or different type of currencies with respect to
the domestic currency. That is what basically always we can define the foreign exchange
market.
So, like other market foreign exchange market is also not a physical place. This is again
informal, it can be informal to some extent because there is an OTC market for foreign
exchange market also. But, mostly it is basically an electronically linked network of the
big banks, or the foreign exchange brokers and the dealers whose function is to basically
bring buyers and seller together.
So, the basic job of the dealer is basically to bring buyers and sellers together. So,
directly the transaction can takes place between the banks or the transaction can take
place through the foreign exchange dealers. And, the dealer basically just work like stock
exchange who try to bring the buyers and sellers together. So, your buyers requirement
and sellers requirements can be shown or can be informed to the dealer and dealer is
trying to make them together, in one particular on the basis of the requirements of the
buyers and sellers in that particular market.
930
So, that is the way the foreign market is always working. Here if you see that the foreign
exchange market transactions usually done 24 hours in a day by telephones. Because,
one market may be open in the night the time differences are always there across the
globe because it deals with the foreign exchange transactions or the different countries
that involved in this particular process. So, because of that the market always work for
the 24 hours basis and may be if you are dealing with US market other market and you
are in India. So, then there is always a time differences between these two.
So, therefore, any time where ever the US there is night we have the day or we have the
day and they have the night. So, in those context we can say that it is 24 hours this is
open, and how they are basically linked? They are linked basically, through a different
kind of electronics system. It can be through fax machines, it can be through telex, it can
be through satellite communications.
So, here in the satellite communication we have a system called the Society for
Worldwide International Financial Telecommunications in short we call it SWIFT. You
might have heard this word for example, whenever you are going to a spend or going to
send some money to some international agency; let you want to attend a conference
somewhere and you have to pay your registration fee.
And there what basically you can see always in that portal you can find out there is a
SWIFT code. Let you want to transfer your money through the bank so, if you want to
transfer instead of transferring through the online, let you want to transfer it through the
bank directly. Then you can go to the bank and the bank always need the SWIFT code of
the particular bank to which bank the money will be credited.
So, the particular agencies would provide the SWIFT code of that particular whether it is
unique number or unique kind of code what this particular bank will have; and this
particular person who is organizing function or particular organization who is organizing
this conference.
So, this would have the account in that particular bank and if the SWIFT code will be
available then with that SWIFT code all the other details and everything if you go to the
bank then the bank will try to transfer that money from rupee to dollar or rupee to euro,
whatever conversion you want and finally, the money will be sent to that particular
beneficiaries account.
931
So, that is basically called the SWIFT, but that particular system is a satellite system
where all banks and the foreign exchange participants are linked through that particular
satellite system. So, this is what basically this in overall the foreign exchange market is
defined this is the way the foreign exchange market can be always we want to study.
So, whenever we talk about the foreign exchange market the foreign exchange market
are either pure dealers market what basically just now we have discussed, or it is a
combination of the dealer and the auction markets. So, whenever we are talking about
how the market is in the actual sense defined we said the dealers job is basically to make
the buyers and sellers bring them together. And, on the basis of the requirements they
can trade in this particular market, but whenever you talk about there is another segment
of the foreign exchange market that is called the auction market.
So, in the dealers market if you see some dealers are market makers and play a central
role in the determination of the exchange rate in the flexible exchange rate regions or
flexible exchange rate system. What do we mean by the market makers? The market
maker mean they basically are the bigger stake holder in this particular system who
contributes or plays the significant role on the determination of the pricing in that
particular market. So, here whenever we are talking about the foreign exchange market;
so, in the foreign exchange market what is the price? The price is nothing, but the
932
exchange rate; as they are the market makers and their bid and ask prices are highly
honored in the market for determination of the equilibrium price.
So, then those kind of market makers play a significantly role for the determination of
the exchange rate in that particular system provided this particular country or particular
economy should always follow the flexible exchange rate system in that particular point
of time. So, the market makers basically set the two way exchange rates, at which they
are willing to deal with the other dealers or two way exchange rate means both buying
and selling; let you can say you want to convert from rupee to dollar. Let somebody
wants to convert from rupee to dollar that means let we say that 70 rupees is equal to 1
dollar.
So, the 70 rupees is 1 dollar let that can be a buying price or that can be a selling price.
For example, you have you want to convert your rupee into dollar you go to the bank.
What the bank will do? The bank basically is going to sell the dollar to you and
whenever you have the dollar and you are converting into rupee there bank is buying the
dollar from you and against that they are giving the rupee.
So, in that context the market makers always set the exchange rate and willing to both
the ways and as well as they are willing to deal with the other dealers. But, in the auction
market on auctioneer or auction mechanism allocates the foreign exchange by matching
the supply and demand orders what basically exactly happens whenever we deal with the
stock exchange rates and other things or the stock market. There we provide our
requirements and accordingly the matching takes place between the different stake
holder and buyers and sellers and finally, the price will be determined.
Here what is happening whenever buying and selling takes place in the foreign exchange
market mostly it is done by the dealers market or by a direct market between the
different banks. But, there is also the trading platform through which the auction can take
place of the different currency and accordingly the price can be determined or the
exchange rate can be determined.
So, in the pure auction markets or order imbalances are cleared only by exchange rate
adjustments. So, why basically we say that exchange rate adjustment where let
somebody wants to buy the dollar at particular price, but there is no seller for that. So,
accordingly what will happen depending upon this demand and supply of the dollar in
933
that particular point of time, there is an adjustment in terms of the exchange rate. And,
finally what will happen that they can find out the equilibrium point which will be
matching with the requirement of both buyers and sellers. And, accordingly the market
mechanism of the foreign exchange market can work if this is an auction market.
So, this is about the different types of how the foreign exchange market is defined or
different classifications and different types of the foreign exchange market exits across
the globe.
Then if you see there are two levels of the foreign exchange market always prevail in the
system. One is different interbank level another one is we have an indirect level via the
exchange brokers. One is foreign exchange broker through the foreign exchange broker
another one is between the two banks directly.
So, one bank wants to buy dollar, one bank wants sell the dollar they can always deal
with each other directly mostly this particular interbank transactions always done
through the telephone. So, one bank wants to buy the dollar he can request another bank
that I want to buy the dollar, please tell the price of the dollar or if you want to sell the
dollar then you can tell that what price you want to buy the dollar from me. But, one
thing remember whenever any kind of bank tries to buy or the sell the dollar or buy or to
sell any kind of currency they do not tell their intension that, whether they want to buy
the dollar or they want to buy the rupee or they want to sell the rupee.
934
So, thats why the price is mostly quoted both the ways both bid price and ask price are
always revealed by the bank for example, you pick up the phone bank x there is a bank X
and there is a bank Y. So, there is a bank X and bank Y and bank X wants to deal some
foreign exchange transactions with bank Y then what they can do the bank X can pick up
the phone and tell the bank Y what is the price of dollar; that means, his intension is not
clear whether he wants to buy the dollar or he wants to sell the dollar.
So, the bank Y can quote both the prices. Let, if they want to buy dollar from bank X
what price they want to pay or if they want to sell the dollar to bank X then what price
specifically they want to charge. So, this intension is not clear, whenever the call goes
from one bank to another bank and you see this price is always change in every seconds,
every second the price is changed.
So, because of that the banks are always look for the opportunity where the prices are
good for them in terms of generating the profit or creating the arbitrage opportunity. So,
because of that what happens immediately they lock that particular transactions and on
that price the transaction can happen between these two particular banks.
So, that is why because the intension is not clear both buying price and selling price can
be quite quoted by the two different banks. Whenever they want to do some transactions
in terms of the foreign exchange then that particular point of time it is defined as
decentralized continuous open bid double auction market. Open bid means we are talking
about both buying and selling there is no such restrictions that whether you want to go
for you want to buy this or you want to sell this and double auction in the sense both the
banks tell their quotations to rest to each other.
So, that is what you can tell your buying price and your selling price, they can tell their
buying price and selling price and there is no restrictions in terms of the bidding any
price basically you can quote and your intension is not clear. That is why it is a
continuous of one bit double auction market always we define it whenever we talk about
the direct bank in this or direct transactions direct interbank level of transactions in the
foreign exchange market.
Then another thing is through broker if you want to trade then you put the orders with the
broker and broker put them on the books and try to match the purchase and sales order
for the different currencies. And finally, the charge and commission for that because they
935
want to always try to fix the matching between the buyers and sellers, and always as well
as they can put both of them on the board.
So, here your intension is clear to the broker, you can tell your broker you want to buy
this dollar or you want to sell the dollar and broker again will look for the particular
bank, where whatever price basically you want whether in the same price any other bank
is ready to basically take that one and provide you the dollar.
So, the because of that this market is defined as quasi centralized not full centralized
quasi centralized continuous limit book single auction market. Single auction market
means the intension is very much clear, that whether you are going for buying the share
or selling the share. And that is the limit book means the prices are basically limited in
this there is no such kind because already you provided that what price you want to buy
this dollar or at what price you want to sell this dollar to the foreign exchange broker.
So, because of that this is the way the two different levels the foreign exchange market
works. Then we can move in to the other issues related to the foreign exchange market.
So, other ways the foreign exchange market in general always have 2 segments one is
retail segment another one is the whole sale segment. So, if you talk about the foreign
exchange market, in terms of the retail segment these are in the retail segment there is an
exchange of bank notes, bank drafts, currency, ordinary and travelers cheques between
936
the private customers, tourists, banks, tourist and banks. These are a part of the retail
market the reason is any small transactions which are always happening in the foreign
exchange market either somebody wants to visit abroad they need foreign exchanges
already I have given the example somebody wants to pay the registration fee for
attending the conferences, he needs foreign exchange.
So, again somebody wants to study foreign exchange he want to pay the fees then that is
again they need foreign exchange. So, because of that those kind of small transactions
always take place in the retail market. So, that may be includes the ordinary and travelers
cheques or the bank drafts or notes or anything. There are different ways basically this
retail segment works or different instruments are available in the retail segment.
But whenever we are talking about the whole sale market in the whole sale market it is
primarily interbank market two banks basically involve in this particular process. And
major banks basically trade in currencies, held in different currency dominated bank
accounts and they transfer their bank deposits from sellers to buyers’ accounts export and
import business and all these things that also is a part of the whole sale market, whenever
you talk about the foreign exchange business in the system. So, that is the way also the
foreign exchange market can be categorized or can be divided.
If you see that whenever you talk about the rates what basically determined in this
particular foreign exchange market the exchange rate between the banks is determined
937
by the interbank market, but whenever the exchange rates what the banks and this is
some way depending upon the demand and supply of that particular currency or that
particular point of time. But whenever, we talk about the exchange rate what the bank
charge on the clients this is little bit different.
So, the banks always have the price which is more than the market price banks never
charges for example, if you want to convert your 10000 rupees in to pound let one pound
in the market let it is 90 rupees. So, the bank may not convert that pound into 90 rupees
the banks price is little bit basically always higher than this. So, let the bank is charging
92 rupees for 92 rupees 1 pound, and if you go with the pound and you want to convert
into the dollar then that time the bank will not be ready to give 92 rupees bank will ready
to give you let, 80; 88 rupees.
So, the question here is there is a differences of the exchange rate what basically we find
it in the market and there is some kind of exchange rate what we observe whenever the
bank charges that particular money on the different clients which are existing in the
system. So, therefore, bank charges their customers more than the inter banks selling or
ask rate and pay their customers less than the interbank buying or the bid rate.
So, bank charge their customers more than the interbank selling and pay their customers
less than the interbank buying. So, if you have the dollar available to you want to convert
it into the rupee what example I have taken then they will charge a different price as a
lower price, but whenever you are converting from rupee to dollar then their price is
different than the price what they charge whenever you are converting the different
alternative currencies or the reverse currencies.
So, that is why banks charge their customers more than the interbank selling or ask rate
and pay their customers less than the interbank buying or the bid rate. So, that is the
general observations always we find whenever we deal with the foreign exchange
market.
938
Then the major sources of foreign exchange in Indian context if you see there the
receipts of accounts of exports and invisibles in the current account then for and inflows
which includes the foreign direct investment and portfolio investment, then you have the
external commercial borrowings then you have the NRI deposits.
These are that is why it includes both the all kinds of accounts we have a current account
which deals with the trade we have the capital account. The capital account deals with
the investments then we have some official resolves and all these things always we have.
Then also we have some kind of part related to commercial borrowings and the
nonresident deposits or NRI deposits which is also a kind of major sources of foreign
exchange rates or foreign exchange in the Indian context.
So, therefore, the demand for foreign exchange always comes from the imports and the
services which is invisible payments in the current account then amortization of the
external commercial borrowings including the short term trade credits external aid
redemption of NRI deposits outflows of the account in terms of direct and as well as the
portfolio investments. So, this is the major sources what always we get it in terms of the
foreign exchange market transactions.
939
So, then let us see that whenever we talk about this then what are those who are those
players who are participating who are the major players in the foreign exchange market
in India. Already, we have discussed again and again the foreign exchange market is
directly regulated by reserve bank of India known transactions in the Indian market is
possible without the permission of the reserve bank of India. No foreign exchange
transactions can be carried out without the consent what you have to take from the RBI
or the Reserve Bank of India which is the Central Bank.
So, that is why Central Bank is the major stake holder and who are basically the
authorized dealers, foreign exchange brokers, who are basically the intermediaries and
the customers basically the individuals and the corporates. They are basically the user
they are the end user and the transactions takes place between the intermediaries and the
customers intermediaries and the foreign exchange brokers and they are basically the
customers individuals and the corporates.
So, the intermediaries means mostly the intermediaries are authorized dealers or the
banks and there are some foreign exchange brokers who have got the license from RBI to
do the foreign exchange business in Indian market. So, we have all the schedule
commercial banks like public sector, private sector and foreign banks are the category
one authorized dealer in India they are considered as the category one and all full fledged
940
money changers; Western Union Money Transfer and other are some kind of full fledged
money changers are available in Indian market.
So, they are basically called and some Regional Rural Banks and Co-Operative Banks
they are basically considered as the category two of authorized dealers. Then there are
some selected financial institution such as EXIM Bank who deals with export and import
business in India they are considered as the category three authorized dealers in the
Indian market.
So, we have three types of authorized dealers on the basis of the nature of the business
what they can do. And, the first category is always commercial bank then second
category is the authorized money changers and the RRB’s then some Co-Operative
Banks whose balance it does reasonably good enough to do the foreign exchange
transactions. Then you have the EXIM Bank specialized financial intuitions which are
we have that is the EXIM Bank. That is considered as the category three. So, these are
the major players who basically always participate in the foreign exchange market in
India.
Who are those customers then the customers are mostly already I have told you these are
the either individuals or the corporates, and whenever you talk about the individuals the
transactions you just already we have discussed their use is not very high. But, for
941
specific temporary reasons they need some foreign exchange thats why they go to the
foreign exchange market for their with some demand to get this foreign currency.
But mostly if you talk about the bigger transaction in the foreign exchange market that
comes from the corporate sector, but here in India if you see mostly they are dominated
by the public sector units and mostly the large public sector units like all the oil
companies like Indian oil corporation ONGC and all. Then you have BHEL Bharat
Heavy Electrical Limited who deals with these heavy materials and all these things then
you have SAIL then you have the Maruti Udyog and also the government of India for the
defense and civil debts service.
So, because any kind of foreign deals and transactions if anything any kind of
instruments, or any kind object, or any kind of other war weapons, or anything can be
bought. Then always you can deal with the foreign countries and because of that the
transactions are made through the foreign currency.
Then the civil debt service also that has to be done through the foreign currency. So,
thats why government is a major user then you have the major companies what some of
the example I have given like IOL, ONGC, BHEL, SAIL then we have Maruti Udyog
and all these things because they have a foreign Maruti Udyog has a collaboration with
Suzuki, because of that all kinds of transactions where they take place and most of the
vehicles what Maruti makes in India that also goes abroad and there is a demand for that.
So, because of that what happens that the foreign exchange transactions by those
company are more in the Indian context. And if you see the recent data the FIIs also have
emerged as a major player in the foreign exchange market because they are driving the
stock market. But, because they are coming to India for their investment then the money
has to be always converted into the foreign currency and foreign currency again has to be
converted in to Indian currency, depending upon the nature of the positions what are
taking in the Indian stock exchange or the stock market.
Foreign exchange dealers association there is a self regulatory body that is called
Association of India they play a special role in the foreign exchange market which
ensures a smooth and speedy growth of the foreign exchange market from the various
prospective. Various prospective in the sense it can be size it can be depth or whatever
942
all kinds of issues always taken by the FEDAI or Foreign Exchange Dealer Association
in the Indian context.
The trading or foreign exchange market in India generally takes place on four platforms
one is a FX CLEAR of the CCIL which was started in august 2003 we have FX direct
that is a foreign exchange trading platform launched by IBS FOREX private limited in
2002 in collaboration with financial technology India limited. And two other platforms
are there by Reuters D2 platform and Reuters market data system RMDS they have a
minimum trading amount you remember this is very important, the minimum transaction
this market is basically 1 million US dollar.
The 1 million US dollar is the minimum transactions that is why very high network the
individuals or companies only can participate in this trading platform other people are
not that much financially sound or not eligible to participate in the system. And what are
those trading platform, what kind of currencies or exchange rates are available?
Obviously dollar versus rupee, dollar Indian rupee.
Transactions are the major transactions which happens in this and other currencies are
EUR USD then USD Japanese yen then you have the your pound versus rupee and
though USDINR constitute the most of the foreign exchange transactions in terms of the
value and FX CLEAR of the CCIL that basically is the most widely used trading
platform in the Indian context.
943
So, here there are different type of risk the foreign exchange market faces settlement
risk, market risk, credit risk, operational risk that already you know what kind of risk it is
the settlement risk arises because, the delivery of the two currencies generally involved
in the trade in the two different countries and they are in the different zones. So, because
of that that happens and VaR model is used to measure the risk in the market mostly
whenever we deal with the foreign exchange market that is the value at risk model
always we use.
944
In Indian exchange rate policy if you see what is the objective, the objective is to ensure
that economic fundamentals are reflected in the external value of the rupee, to reduce the
excess volatility in the foreign exchange rate and to ensure that the market corrections of
overvalued or undervalued exchange rate is orderly and calibrated.
And also it objective is to help the and maintain adequate level of foreign exchange
reserves that we will discuss further more about this and to help the elimination of
market constant in the way of development of the healthy foreign exchange market.
These are the major objectives of the operations of the foreign exchange policy in the
Indian context that we will see how the policy works in this particular directions.
This is the reference what basically you can go through for this session.
Thank you.
945
Lecture – 59
Foreign Exchange Market – IV
So, in the previous class, we discussed about the exchange rate determination and as well
as the foreign exchange market in India, who are those participants, and how the foreign
exchange market functions, how the trading takes place, what are the different platform
which are available for the investment in the foreign exchange market. So, today we will
be discussing about certain issues related to how the central bank intervenes into the
foreign exchange market, and why this interbank intervenes, and what is the basic
objective behind that and all those issues.
See, if you see already what we have discussed that we have three types of systems. We
have a fixed exchange rate system, we have fixed exchange rate, you have a floating
exchange rate system, then you have a managed exchange rate system. So, already what
we have discussed that fixed exchange rate system, the government basically fixes the
range of exchange rates, that how the exchange rate basically moves from one particular
range with respect to a particular currency. And in the floating exchange rate, it is purely
946
market driven or market determined factors. But whenever it is managed, here basically
it is a mixture of the floating and as well as plus the government intervention.
So, why basically government intervention to the system whenever there is any kind of
fluctuations happens in the market, and one particular currency is highly depreciated or a
particular currency a value is going to decline, then in that particular point of time, the
central bank of that particular economy tries to intervene into that particular system. And
they try to see that whether really this particular concept or particular price fluctuations,
which is happening that is that can be any way can be controllable or can be controlled.
So, in that context the central bank intervention comes into the picture. So, that basically
is always a phenomena we discussed with respect to the managed exchange rate system
in the economy. So, therefore, the basic objective of central bank intervention is to make
this particular price table or to control any kind of uneven fluctuations of the prices in a
particular direction.
So that is why in the central bank interventions objective are to influence the trend
movements in the exchange rate, because the central bankers perceive that the long-run
equilibrium values to be different from the actual values. So, which is exchange rate
which is prevailed in the market at that particular point of time; that basically is not
driven by the actual fundamentals. There must be some external forces which makes this
particular price away from the equilibrium level. So, in that particular point of time, the
central bank tries to intervene in to that to make this particular price level the equilibrium
level or to make this particular level stable.
Another objective of central bank intervention is to make this kind of exchange rate in a
particular level by that the export can be competitive. The export market can be
competitive, so that means, they can increase or decrease the export in that particular
market with respect to the requirement of that particular economy. Because in a
particular if the exchange rate of a home currency is highly depreciated, then obviously,
there is an increase in the performance of the export, but that export performance may
not be on that particular point of time be good for the economy in a larger extent or in a
longer period of time.
So, because the price is highly fluctuating, the commodities price became very cheaper
with respect to the other currency, but the question is that here the economy also to some
947
extent gets affected because the prices we are basically whenever we are going for
importing or something, then we have to pay large amount of money. So, because of that,
that particular discrepancy makes this particular system unstable. So, to maintain this
export competitiveness, we always or there is a requirement of the central bank
intervention into the system.
You see if the home currencies depreciating, so let per dollar rupee if you convert, then
70 rupees. So, we are it has gone to 75, then what is happening that the export basically
become very cheaper in that particular context, but in the import become costlier. So, if
the import become costlier, then it is difficult to maintain that current account balance in
that particular system. So, because of that what is happening this interbank tries to
intervene into that, so that is basically another objective or another requirement of the
central bank intervention.
Then another objective is central bank or an intervention is also required to manage the
volatility in the financial market more particularly with respect to the foreign exchange
market. Because sometimes the exchange rate fluctuations are so large, and because of
certain external bank factors may be the market is not able to control that particular
fluctuations, then central bank takes certain steps to make this particular exchange rate
fluctuations stable in a particular range. By that it will not have much adverse impact on
the export and import. And another objective is to protect the currency from speculative
attack and the crisis.
So, these are the different objectives of the central bank intervention and that is why the
central bank tries to intervene into the market to make this particular market more stable.
So, then we will see that how the central bank intervenes in the foreign exchange market.
948
So, there are two types of intervention foreign exchange market does. One is we call it
the sterilised intervention, and another one is we call it the non-sterilised intervention.
We have a sterilised intervention, then we have a non-sterilised intervention. So,
whenever you talk about the sterilised intervention, what exactly it means, it means that
or sterilised intervention occurs when the purchase or the sale of the foreign currency is
offset by a corresponding sale or purchase of the domestic government debt to eliminate
the effect of the domestic money supply.
What it exactly means it means that whenever the central bank tries is to buy a particular
foreign currency or tries to sell a particular foreign currency, then it will have the impact
on the money supply. Because if you are buying, if the foreign currency is bought by the
central bank, then what will happen, it will increase the money supply in the economic
system. So, increase the money supply will lead to the price rise or we can say that
inflation.
If inflation will increase, then what will happen it will have the adverse impact and other
real economic factors within the economic system. So, because of that we have to make
certain kind of step by that whatever increase is there in terms of the foreign assets, so
that foreign assets increase can be offset by any kind of decisions, which is taken by the
central government to reduce the domestic money supply in the economy in that
particular point of time.
949
So, therefore, in that particular point of time, what they do they try to use this open
market operation which is a major instrument of the monetary policy. So, what they do
they buy or sell depending upon the positions whatever they have taken in the foreign
exchange market.
By that whatever increase will be there in terms of the foreign currency and or in terms
of any kind of other currencies to create that particular gap so to minimize that gap in
that particular point of time simultaneously, they take certain steps in terms of the buying
and selling of the foreign the government dated securities to control the money supply
within the system, by that the net effect will be 0. That means the amount of money
supply in the economy will be same as usual
That means, for example, they are buying if they are buying then what is happening the
foreign assets will increase in the economic system that means, the money supply should
increase. But in that particular point of time, what they will do they will basically try to
extract certain money in the domestic market what already it is there. So, in that time
whatever they will do, they will sell the bond. If they will sell the bond, then the people
or public will take the bond and against that they will pay the money to the central bank.
So, in the economy they can extract they can absorb certain money supply within the
domestic market.
So, whatever money basically has increased in terms of the foreign assets, the same
amount of the money can be reduced by taking this kind of steps. So, then the total effect
will be nullified in the system. So, here what is happening, whenever we are we know
that in the open market operation, we can buy or the sell depending upon the requirement
in the economic system. So, that means, they are sterilised this, the money supply has
been sterilised, so the net effect will be 0.
So, another one is the non-sterilised intervention, non-sterilised intervention basically

what there the authorities purchase or the sell foreign exchange, normally against their
own currency, without any offsetting actions. So, they only go and try to buy or sell the
foreign exchange from the foreign exchange market, but they do not take any positions in
the domestic market to control the money supply.
So, here what we are doing we are basically taking that buying or selling of the
securities, if you remember in the money market or in the monetary policy instrument we
950
have discussed, in the open market operation what we do either you buy or you sell the
domestic dated securities or government dated securities.
So, when you buy, what you do, you buy the security buy the bonds from the public,
whenever you buy it, you have takeaway the bonds and inject the money supply in the
system, give the money to the public. And whenever you are selling the bonds, basically
what you are giving the bonds, and against that you are taking away the money from
them.
So, whatever money you are taking away from the system that will basically reduce the
money supply in the economic system. So, that positions if they will take simultaneously
with this buying and selling of the foreign assets, then we call it, that is the sterilised
intervention. But if this kind of steps they do not take, they simply buy or sell foreign
exchange to fulfill that particular gap in terms of that particular currency, then we can
call it the non-sterilised intervention. So, this is what basically this, what we can say that
the types of intervention in the system always we look at.
Then if you see what is the impact we have already discussed that the non-sterilised
foreign exchange intervention whenever they make, they purchase it. So, the effect on
net foreign assets will be positive will increase, effect on net domestic asset will be 0. So,
the effect will be positive; the money supply will increase if it is non-sterilised.
951
But if it is a sterilised foreign intervention, and they are going for purchasing, this one
will increase, this thing will decline, net effect will be 0. So, if both go for selling, then it
will have a negative impact, it will be 0, then obviously money supply will go down.
Then whenever you go for sterilised intervention in terms of the selling, then effect is
negative; here it is positive. They have to take the reverse, position, then finally the
effect will be 0.
So, this is the way the intervention works in the foreign exchange market by the central
bank. So, here what basically here we are trying to see that the exchange rate
intervention in the foreign exchange market is an inevitable thing in terms of central
bankers point of view, because sometimes the fluctuations also happens not because of
any economic fundamentals that may also happen because of certain other external
forces which is not in that way in control of the monetary authority.
So, another issue with respect to the foreign exchange market is the currency
convertibility which is the very popular issue always we discuss about. What do you
mean by this currency convertibility? Here also the central bank plays a significant role
in terms of the policies, in terms of norms, in terms of regulations. So, if you define the
currency convertibility, then it is nothing but it is the freedom, it is freedom to convert
the local financial assets into the foreign financial assets and vice versa at market-
determined rates of exchange.
952
So, here what is happening we are trying to convert our local currency or local assets into
the foreign assets or we are converting the foreign assets into the local assets, how
practically or how easily we are able to convert this things at a market-determined rate of
exchange, then accordingly we can measure the degree of currency convertibility.
So, currency convertibility is basically associated with the degree of ownership in

foreign domestic financial assets, foreign or domestic financial assets and the liabilities,
and basically always it is embodies the creation and liquidation of the claims, by the rest
of the world. How fast the particular assets can be liquidated, how fast the particular
assets can come into the market for the trading and how far the particular assets valuation
can be possible, so that is the way the currency convertibility is defined in the economic
sense.
So, whenever we talk about the currency convertibility, we have two types of currency
convertibility; we have partial and we have the full. Whenever we have a complete
freedom to convert the local financial assets into the foreign financial assets, then we can
call it is the full convertibility, the complete freedom as a market-determined rate of
exchange we are completely free to convert our assets into the foreign assets or foreign
assets can be converted into the domestic assets, then we can call it the full
convertibility.
953
The partial convertibility means that it is again the freedom to buy or sell the currency,
but up to a limited amount. And it is only for the foreigners foreign assets point of view
that means, here the 100 percent you are allowed to convert your asset into the foreign
asset, and foreign assets can be converted into the local or the domestic assets. But
whenever it is partial convertibility, we have certain kind of restrictions in terms of the
conversion. So, whenever the restrictions are put on this we define that particular term as
a partial convertibility or partial capital convertibility or partial currency convertibility in
that particular market.
There are some researchers, they basically according to them, the full convertibility
means removing the trade and exchange controls completely, and shifting away from the
fixed, managed, pegged exchange rate system towards the flexible or the floating
exchange rate system in the economy. Completely you can remove all those restrictions
into the market, at any point of time any foreign assets can be converted into the
domestic asset or the value of the domestic assets can be converted into also the local
assets. So, this is the way the convertibility in an economic sense is defined or this is the
way there are two types of convertibility we can come across whenever we deal with the
foreign exchange market.
Then if you see the different characteristics, the capital convertibility or the currency
convertibility, already one thing we have discussed that is basically we want to make
954
exchange rate completely free or it should be completely market-determined, this is
number one. It is the elimination of the import licensing, custom duties, import taxes,
tariffs, advance import deposits, export incentives, multiple exchange rates, all kinds of
things basically we can eliminate that means, completely the exchange rate is floating,
exchange rate is completely free. All kind of restrictions are not available in the foreign
exchange market. For trading or any other thing or any other operations which is related
to the foreign exchange market investments.
It is also deals with the restrictions removal of the restrictions on international services
transactions, use, availability, retention, and holding of the foreign exchange at home and
abroad, and on international capital movements as well as buying and selling of the
foreign exchange. You see capital convertibility is also dealing with the international
capital mobility, capital movements, there should be free capital mobility.
There should not be any restrictions with respect to sectors or with respect to any kind of
other kind of characteristics like an industry or particular product and all these things. No
restrictions, the 100 percent is allowed, any time, anybody can convert their asset in to
the foreign asset; and foreign assets can be converted into the local or the domestic
assets, then we can say that is a full convertibility which is happening in this
So, it also gives the freedom to remit the abroad profit, dividends, and other legitimate
income in the foreign currencies. If any multinational which is working abroad, and they
have the parent operation in a hosting country, so they are also free to distribute their
dividends or any kind of income whatever they are generating in that country to their
parent country and free of cost. And there is no such kind of restrictions in terms of that
kind of payments to the stake holders or the investors who are available in this particular
parent country.
So, in that context, we can see that there should not be any kind of restrictions in terms
of exchange rate point of view and as well also the other financial cash flows which are
happening in the economic system. So, that is the way the convertibility or currency
convertibility is defined in the financial system.
955
Then what are those prerequisites, what we need to make this particular system
convertible. With the exchange rate must be realistic, in the sense that should not be
driven by any kind of factors which are not economical driven; this is number one. The
country should enjoy the low inflation rate and there should be stability in terms of
internal financial market. Within the market the economy should not be highly volatile,
and should not be that kind of instability in terms of the price fluctuations, the other or
other economic parameters which are affecting this particular pricing or exchange rate in
that particular system.
Foreign exchange reserve should be large in practice. The amount of foreign exchange
reserves whatever the company or the country has that should be very large amount. The
trading partner should open up the trade and payment systems. All the trading partner
should be open in the sense the openness of that particular economy should be quite
high, because this particular country is trying to do unlimited trade or unlimited
transactions with respect to that country with respect to the different sectors. So, if there
is any restrictions of that foreign country, then here the kind of facilities or this kind of
relaxation is not going to help in terms of the capital mobility and as well as the other
factors mobility.
The debt level particularly external debt of the country should be low, unless they have
always a fixed obligations, and the balanced of payment of the country will becoming
956
worse and worse, if the interest payments and all these things over the year will increase
or we can say that the debt level is quite high for that particular country. The fiscal and
monetary austerity, prudence, consolidation, and drastic reduction of fiscal deficits
should be achieved. The fiscal deficit should be less. If the fiscal deficit is high, then we
have the different kind of deficit where the largest deficit all the broader deficit
definition is the fiscal deficit.
If the fiscal deficit is already high, then there is a high pressure on the other kind of items
which are a part of the fiscal definition which includes the current account deficit or the
capital account deficit. If those deficits are getting affected because of the aggregate
deficit in the system is quite large, then also it is very difficult to make this particular
convertibility in the easier way. So, that is why we have to look at that what kind of
deficit we have. If deficit is more, then convertibility will be again be a burden or
challenge for the regulator or the policy makers.
The labor market should be reformed, the unemployment insurance basically should be
always there for the economic system, jobs should be retained and the wage discipline
should be achieved. So, whenever we are paying the wage to the different customers that
discipline of per payment of the wage also should be there.
There should not be much disparity in terms of the same type of job or in terms of the
particular operation that individual or that entity is doing in that particular point of time.
So, if all those prerequisites are maintained, then only what we can say the country is
suitable, country is eligible to go for capital convertibility in that particular point of time.
957
But there are certain problems with respect to this capital convertibility or the currency
convertibility. What are those problems? First of all it increases the risk of the capital
flights in both ways. If there is increase in the risk, then it increase the volatility in
exchange rate and the financial market. And this risk are very real in practice due to the
fact that 90 percent of the transactions in the foreign exchange market are not related to
trade.
Here already I told you there are two things we have a current account, and we have a
capital account. But if mostly transactions are done through export and import business,
then there may be some kind of control, but mostly the foreign exchange transactions are
related to NRIs, NRI deposits, the FDIs, FFIs and all these things.
So, if there is a full capital convertibility, then the fluctuations and amount of flow to the
economy will be very uneven. In one day, it will be very high other day it will be large
may be it is because of certain kind of stocks, certain kind of rumors or there is no such
specific reason behind that, but that possibility is there which make certain kind of
problem in the economic system as a whole.
It may increase the inflationary pressure because of foreign goods become available at a
higher prices. It can result in the flooding of domestic markets with imports particularly
non essential ones. So, if there is no restrictions in terms of the import may be the
tendency towards the import may increase, so they people will not try to produce that
958
particular product in that home country, they try to always go for trading. And because of
that all those price and as well as the demand for domestic products will be getting
negatively or adversely affected by that.
It can also misuse the foreign exchange not only for the luxury and the leisure industry,
but also the smuggling of the goods, drugs, arms and other nefarious activities can
increase in the economic system. So, the controlling those things also relatively will be
more difficult for the concerned persons and concerned authorities in that particular point
of time.
Unlimited access to the short-term external borrowings, and giving unrestricted freedom
to domestic residence to convert that domestic bank deposits and idle assets in response
to market developments and exchange rate expectations should cause extreme domestic
financial volatility as the experience of the Asian crisis has already thought us. Because
the Asian crisis what has happened this was the same reason why that South East Asian
crisis has happened in 96-97 because of the full capital convertibility. There was no
restrictions in terms of the buying and selling of any kind of domestic product and
conversion of any asset into one different kind of currencies.
So, what has happened in that particular point of time, although in the short-term the
countries; where getting very high amount of growth, but that particular model was not
sustainable. So, within a short span of time the particular model get collapsed, and
finally, there is a big crisis we have witnessed, we have experienced in that particular
point of time. So, these are the different problems or dangers with respect to CC or the
capital convertibility or currency convertibility.
959
So, there are some recommendations, different committees have given with respect to
capital convertibility. We can go through these things. There is a spot and forward
markets for both. Then bank margin on foreign exchange transactions for smaller
customers need to be reduced. Then the interest rate parity in forward market should be
there. Currency futures may be introduced the existing guaranteed settlement platform of
CCIL needs to be extended for the forward markets. Banking sectors should be allowed
to his currency swaps.
A monitoring exchange rate band of plus or minus 5 percent around the neutral real
effective exchange rate may be considered. Then as an operative role if the current
account deficit possessed beyond the 3 percent of GDP the exchange rate policy should
be reviewed. So, these are the committee’s recommendation in term of the adaptation of
the full capital account convertibility in India.
960
Then another important thing is foreign exchange reserve. So, here what is happening,
why we need a foreign exchange reserve in the system, it is because we have the main
objective is to managing a stock of reserves for any developing country or reserving their
long-term value in terms of the purchasing power over goods and services, and the
minimizing the risk and volatility in returns.
So, there are four factors or five factors which mostly effect the foreign exchange
reserve. One is your size of the economy; second one is your vulnerability of the current
and capital accounts; the exchange rate flexibility; opportunity cost and the financial
market integration, these are the major factors which affect the foreign exchange
reserves.
And if you talk about India then the major sources of the foreign exchange reserves are
the NRI deposits foreign investments, external assistant what we get it from other
countries, and external commercial borrowings, these are the major components of the
foreign exchange reserve in India.
961
So, if you see the India there are high level of foreign exchange reserve, there are reasons
for that. It shows the India’s ability to meet the financial obligations and maintain the
countries mental stability. It is shows also the India’s ability to import more goods or to
absorb the shocks and uncertainty in the world economy. Ability to cope up with crisis
and capital flight; greater availability of liquidity and confidence and they can get higher
sovereign rating better rating and greater backing of domestic currency and finer terms of
the debt. So, these are the different advantages of the high foreign exchange reserve.
962
There are some negative impact also. Maintaining high exchange high foreign exchange
reserve is costly because the cost of holding foreign exchange reserves is the opportunity
cost of investing them in the productive activities. It augments the domestic money
supply that is why this we have to take some sterilised intervention step. It also increase
the interest rate burden of the economy, because the larger part of them are from NRI
deposits. Increase the volatility or the vulnerability in the market.
The reserves have not been built of due to favorable balance of trade or the surplus in the
current account. So, these are the adverse implications of the high foreign exchange
reserves in the economic system.
How to know that whether the foreign exchange reserves in the system is adequate or
not, we have the different measures, we have import cover of reserves. Foreign exchange
reserve to reserve money, foreign exchange reserve to broad money, foreign exchange
reserve to external debt, foreign exchange reserve to short-term debt, then foreign
exchange reserve to GDP.
For example, it is measured that if your foreign exchange reserve is able to cover up the
3 to 4, 5 months import demand or import requirements then we can say that it is
adequate, but India is now having around 9 months import coverage of the foreign
exchange reserves. So, in that context, we are adequately or may be more than that
reserve we have in the economic system.
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So, in that case we have a high amount of foreign exchange reserve. These are the limits
and the advantages just now we have seen or we have discussed. Then we can say that
whether this really foreign exchange reserve is good or bad in the economic system as a
whole or the financial system in particular.
These are the references what you can go through for this.
Thank you.
964
Lecture – 60
Foreign Exchange Market – V
So, in the last class we discussed about the how the central bank intervention to the
Foreign Exchange Market and certain issues related to the capital convertibility and the
foreign exchange reserve management. So, today we will be discussing about certain
issues related to the foreign capital.
So, whenever we talk about the foreign capital, why we need the foreign capital? There
are many advantages, there are many disadvantages we have always whenever we
discuss about foreign capital. But if you see in a larger point of view, foreign capitals are
very important from the domestic growth point of view or economic growth point of
view. Why? Because it relaxes the domestic savings constant, we may not have enough
money for investment in the economic system because we need savings for the
investment always we cannot say that investment crates the savings. But if you believe
that the saving is a factor which is affecting investment, then there are sometimes we
have enough investment opportunity. But savings are not enough to fulfill that particular
gap, then we need some foreign capital in the domestic market for the investment.
965
It also helps to overcome the foreign exchange barriers. So, there are certain kind of
always we observe that, in the current account part there are some kind of deficit always
we observe. So, the current account deficit can be fulfilled through the capital account
surplus. So, how many inflow how much outflow in terms of capital account we will
have that particular deficit whenever we observe in a particular account. The other
account can be used for compensation or to make this particular thing balanced.
Through this foreign capital, we can access to the better technology for the foreign
country. We can also attract the superior managerial skills, then also we can also occupy
the bigger markets. We can create the demand for our commodities in the bigger
markets. So, that is why the foreign capital is very important because through that we can
also access to the better technology which is again helpful for the domestic market for
the productions.
It also provides the risk sharing capital financing it is one of the sources through which
the companies can use it for financing their investments. Foreign capital is another
sources of financing for the investment of the domestic country. So, any kind of foreign
capital which is used in the Indian market that also can be used for the foreign capital or
as a source of financing for the companies. Basically it also fulfills the requirement
because you see every time the fund may not be adequate enough to utilize the full
capacity of the particular companies.
So, the funds which are required for the full capacity utilization, that requirement always
we can fulfill by taking the money from the foreign in the form of the foreign capital. So,
that is why it is also needed for the full utilization of the existing production capacity of
the home country. And it increases the competition in the market and also increases the
efficiency.
Because we are getting better technology, if you are getting better technology then the
productivity and the efficiency may increase for the domestic countries production
process number 1. And because the other companies can enter in to the market further
investments with a better technology or better facilities, then it will also always increase
the competition.
And that competition sometimes also helps this Indian companies or other domestic
companies to perform better in the economic system. So, this is the way the foreign
966
capitals are quite important for any country, if you think from the domestic companies
point of view.
What motivates, what are the determinants of the foreign capital in aggregate?
Obviously, the first one is interest rate, if the interest rate is higher in a domestic country
the companies will be ready to borrow the money from their home country at a lower
rate and invest that particular money in the domestic market or for them it is a foreign
market at a higher rate.
So; obviously, it will be profitable for although the relatively the risk level is higher, but
still sometimes the real rate of return what they are going to extract from this because
there is always enough of investment opportunity or growth opportunity exist in the
emerging economies or any kind of economies which are not that way matured enough
in terms of the economic growth.
So, any if the interest rate is higher, this attracts the foreign investors to come to that
country because that can take the advantage of the return of that particular market
because they want to borrow these things at a lower rate and can invest it in a higher rate
in the domestic economy in that particular point of time.
Degree of openness: degree of openness in the sense if the market is more open, then
more company will be coming to India or coming to any domestic market. The reason is
967
it will be hassle free, the cost of the investment in that particular market will be less and
it attracts basically more foreign investors to come to the domestic market for their
investment.
Second thing is a next thing is you have the legal and institutional structure. The
institutional structure or the infrastructure facilities should be adequate enough to create
that kind of ambience for the investment in that particular economy. And that the legal
structure should not be so stringent to get their license and all these things to start their
business in the home country or to make their investment in that home country.
So, the legal and institutional structures both are conducive for the foreign investors to
make their investment, to make their business in the home country. So, because of that it
will attract more people or more companies to come to a domestic market around another
market for their investment. And another one is the relative rates of inflation. If inflation
rate purchasing power of that particular company or particular country people is less, in a
particular foreign country so, then what is happening that the value of the commodities in
that particular market will be less, but the value of the commodities in another market
may be more. The purchasing power of the money can be better utilized by investing that
particular product in a particular country where there is a price stability or the companies
can take the advantage in terms of the larger production at a lower cost.
Then stability of the exchange rate, if one country is if you see the currency with respect
to another currency the conversion; if it is highly volatile, then it is not good for the
country or good for the other companies come and invest in another country, but more or
less if it is stable then they prefer to come to another country because they know that
how much assets and liabilities they will have in the futures.
But even if there is some kind of fluctuations, some of the investors are there who are
relatively risky in nature or they always are not that much risk averse. They can get that
particular benefit out of this because if the fluctuations is always in their way which is
favoring to their particular value of the trade. Then they always prefer to invest in that
particular market to get that particular advantage.
Then with the business cyclic conditions because cyclic conditions in the economy may
not be same across the countries, in one country may be in the recession another country
is in the boom. So, if there is a boom in one country, then may be that particular point of
968
time they can take the advantage by investing in that particular market because the
market is doing well people have lot of purchasing power, then they can put their money
in that particular products. So, because of that they can invest in that particular market at
that particular point of time.
Then another one thing is in today’s world always we look at the consumer prospective.
The consumers preferences are changing over the years, people are going for the
multiple brands. They want the products produced by the multinationals, their behavioral
perception towards that particular products are different.
So, to take the advantage or to cater that demand, we also need the foreign capital or the
investments by the foreign entities are very much required for that because the
preferences of the investors is going towards that directions. A preferences of consumers
also going towards that directions.
So, the investor wants to always extract the return where ever there is a opportunity and
consumer also wants the product from where they want to buy that or particular product
or they want to maximize their utility by using that particular product. So, these are
major factors which are affecting the flow of the foreign capital to a particular country.
If you talk about India, we have the different components of the foreign capital. What are
those components? We have a debt component, we have ECBs External Commercial
969
Borrowings, we have a major component always we take the loans from IMF, we have a
position in the IMF we can take the loan from IMF, we have NRI deposits, we have then
we have foreign direct investments and foreign institutional investments.
So, NRIs have the different ways, different routes are there they can send their money to
India and they can deposit their money India because they want to get the return out of
this or some kind of interest out of this. We need money from IMF because of some kind
of infrastructural development within the country. External commercial borrowings is
related to the companies because already we discuss that it is also a part of the sources of
finances of the company.
Because if the company needs any kind of funds excess funds may be the availability of
the domestic funds which are there that may not be sufficient enough to cater the demand
for investments of that particular country. They can take the help of the external
commercial borrowings and the country can also take the loans or kind of debt from
other countries for some specific purpose.
So, those are the different components of the foreign capital. But whenever you refer the
foreign capital with respect to another country, we mostly focus on more on FDI and FII.
FDI means the Foreign Direct Investment and FII means the Foreign Institutional
Investment. The other name of that thing is foreign portfolio investments, either it is FII
or FDI what we coin the words interchangeably in the concept of India.
970
So, we will see that what exactly this FDI is and how it is basically available and how it
is used in the market and what are the benefits and what are those disadvantages and as
well as also we discuss something with respect to the FII. So, the foreign direct
investment basically what it exactly means? The foreign direct investment basically
happens when firm invest directly in the facilities in a foreign country.
They can have a different ways it is not confined to a particular area or particular
domain; this can be for various reasons. What are those reasons? It can be in terms of the
production, they can participate in terms of the production process. They can also
participate in terms of the marketing or services prospective.
They can also invest certain money in terms of R and D Resources and Development.
They can also participate in terms of the raw materials providing the raw materials or
other resources whichever are required for the that particular production of the
commodities or the output for that particular country a particular company.
So, this is what different ways they can participate. It is not confined to that in one
particular purpose the FDI is available. FDI is available in various reasons in the
production process, in terms of the production, in terms of the marketing, in terms of the
R and D Resources and Development. It can be in terms of the raw materials whatever.
So, there are some kind of way they want to directly invest in another country.
So, the degree of managerial control depends on the extent of ownership in the foreign
entity and on other contractual terms of the FDI. You see you can have a collaboration
with another company you can take the example of Maruti Suzuki. So, if you see those
kind of examples, what kind of ownership we have? Further Suzuki has majority
ownership or the Maruti has the majority ownership depending upon that the managerial
control always works.
Though who ever whose ownership is more always the control of the manager for that
particular company is always with that particular kind of country. So, a country which
basically doing the foreign investments in another country, then they go by the rules and
regulations of that particular country and accordingly the ownership will be decided in
India we can have 49 percent, 51 percent, we have 71 percent, 29 percent. So, all the
combinations are available, so any combination can work out. So, depending on that the
managerial control with respect to that particular country will be there.
971
So, one firm may have the foreign direct investments in many countries, the ones they
have involved in the foreign direct investment process that company becomes a
multinational MNCs, that company becomes a multinational company. Because they
have the operations, they have the business across the globe or at least some of the
countries are at least they are going beyond their national boundary. So, because of that
those particular companies are defined as the multinational companies from our
prospective.
So, this is what basically FDI but if you see there are different types of FDI, different
ways the FDI investments basically are made what are those ? For example, the foreign
direct investment can be made through accusations, one particular foreign company or
one particular company can acquire another company in another country. They can
purchase cross border acquisitions always they can make.
So, if they will purchase an existing company in the foreign countries we call it
acquisitions through that they have invested in the foreign capital through that also we
can say that, the capital has been flown in to that particular country this is one way.
Second way we have the green field investments, what do you mean by the green field
investments?
Here one foreign company, one company comes to another company and set up
completely a new company, set up a new company from the ground in the foreign
972
country. Let India has gone to establish a new company in USA, so then we can call it is
a green field investments because the company was not existing before, but they have
started this company in that particular country from the zero ground level.
So, example if you see the Motorola who was started some investments they have made
in China and they have built a plant to produce the cell phones. The Motorola is a
American company who has started a plant in China to produce the cell phone; that
means, we can say they have set up a new business there at all which was not there
before.
So, all those production and everything assembling and everything are taking place in
China, then we can say that this is a green field investments whatever they have made in
that particular foreign country. So, that way also the foreign capital can come to a
particular country.
It can also come in the form of the wholly owned subsidiary when it happens? It happens
when a company in the foreign country is entirely controlled by one single company, you
can take the example of like Coca Cola; Coca Colas parent company let in US and they
have the hundred percent subsidiary which is available in India which is called the Coca
Cola India.
So, they have a parent company, but again we have a company which is established in
India which is called the coca cola India, that is the separate company which is operating
in India, but their profit and everything is accumulated and finally, one consolidated
balance it may be prepared from the Coca Cola world point of view or aggregate point of
view, but still it is full subsidiary to the Coca Cola USA which is the parent company.
So, that is why that is another way of having the foreign direct investment in another
country. Then we have another option is joint venture that already I have told you we
have taken the example of Maruti Suzuki, it occurs when 2 or more companies together
form a new company in the host country. Here our host country is India let Suzuki is in
Japanese, then Maruti is in the India company they have established a new company
formed a new company which is called the Maruti Suzuki.
So, in that context they are producing the cars, they are selling the cars and everything
and that comes under the banner of the Maruti Suzuki which is the new company which
973
is formed in the hosting country like indie. So, this is another way of making the foreign
direct investments in a particular country.
In the theoretical sense we have 2 types of FDI one is horizontal and another one is
vertical. If you talk about horizontal; horizontal means investment in the same industry,
as a firm operates at home. Whatever business they are doing in US, the same business
they are doing in India, same business they are doing in China, same business they are
doing in Australia.
So, then what we can say there is a horizontal FDI horizontal investment they are
making, you can take the example of Macdonald, Starbucks and all, who are basically
have same type product they are selling across this globe. We have another kind of FDI
which may happen that is called vertical FDI. Here the investment in a downstream
supplier or an off stream purchaser as compared to the business that the firm operates in
home country.
I can take an example for example, somebody is producing a product let a car and to run
the car they need the battery. But they find that producing the battery in that particular
country is expensive for them, then what they can do? They can have kind of another
company establish another company. They can have a joint venture to another company.
In other country who is expertise in producing the battery and the battery will be
produced in that particular country only for these cars.
974
So, one input which is required for that particular final product, they can produce it
another country for that a separate company will be there. They produce that product and
sell it to that particular company which is exclusive made for that particular product for
the, whatever final product the company is producing, so therefore, that is called the
backward.
Forward means what here forward vertical FDI what we call it, here basically what is
happening you do not have to have any product, you can acquire the dealers to sell your
product in other country. Let if Audi wants to sell the car in US what they can do? The
Audi is let Germany car then what they if they say they want to sell that product in USA
or India.
They can totally acquire the dealer setup or marketing setup in India, by that through that
they want to market or they want to sell their product in Indian context or Indian market.
So, in that context we call it a forwarded vertical FDI which may happen with respect to
that type of product. So, that is the way the forward vertical FDI are defined.
If you talk about the impact of FDI on hosting country, let India is the hosting country
then some other countries are investing in India like US, Japan whoever the countries are
investing in India. Then what kind of benefits the hosting country can have or what kind
of impact it will have on the hosting country? First of all we have discussed it will have a
975
resource transfer, they transfer it in terms of capital in terms of technology, in terms of
management or managerial skill all kinds of things can happen.
It will increase the employment in the hosting country because new plants will be there
new investments will be there, so because of that so more people in the hosting country
can be employed. It will have a better balance of payment impact because already I told
you; it will strengthen the capital account of the balance of payment.
The deficit whatever we have in the current account that can be compensated by the
surplus in the capital account and it will also increase the competition. So, if the
competition will increase then price will be competitive and if the price will be
competitive then; obviously, it will have a positive impact on the overall price on that
overall pricing of that particular product.
So, in India there are 2 roots through which the FDI can come, one is automatic root
another one is the prior permission from the Foreign Investment Promotion Board FIPB,
in short we call it. So, anybody wants to come to India for investments they can directly
come no prior permission is required, but all those information to the reserve bank of
India should be given with in this 30 days of inflow.
Whatever inflow they have made they have to give the information to reserve bank of
India within these 30 days. And another thing is it is not through automatic root, there
976
are some kind of regulations, some kind of constants, some kind of norms are there. So,
they have to apply to FIPB for a Foreign Investment Promotion Board.
And foreign investment promotion board gives 4 to 6 weeks, to go through that

documents whatever requirements we should have in terms of investments in India. Once
they will by approve those kind of things and all those companies fulfill that
requirements, they can come and invest in the Indian market. So, this is the way two
routes, entry routes to Indian market.
Then we have the foreign institutional investments, we have the foreign institutional
investments basically what it is the made by the foreign investor in the shares of a
company that is listed in the hosting country or in bonds offered by the hosting country;
that means, it’s confined to the financial market mostly the FII investments are confined
to the financial markets for FDI we have not confined to any kind of sector.
For example if a foreign investor buys the shares of Infosys, that qualifies as a FII
investments for us for India. So, where the FIIs can invest, the FIIs can invest in
securities in primary and secondary equity markets.
They can invest in mutual funds domestic mutual funds, they can invest in government
securities, they can invest in the derivatives in the stock exchange and they can also
invest in the commercial papers like that these are major investments which are allowed
977
to FIIs or they can put their positions in the financial markets in terms of investments in
these kind of assets. So, this is the way the instruments are chosen for FII investments in
India.
So, who can be the FII, to whom we can call FII or Foreign Institutional Investor? They
can be this particular organization or institutions which is established or incorporated
outside India. It can be a pension fund, it can be mutual fund, it can be investment trust,
it can be insurance company, it can be reinsurance company anything any financial
institutions who are doing the business outside India or established their setup outside
India. Or it can be also a multi lateral organization, a foreign government agency, a
sovereign wealth fund foreign central bank all everybody can be considered as the
foreign investors.
It can be an asset management company, investment manager, bank, portfolio manager

that is established or incorporated outside India and they want to make investments in
India on behalf of the broad based fund and its proprietary fund if it is any.
The trustee or the trust which are established outside India, who wants to make
investments in India on behalf of the broad based funds or its proprietary fund like the
university fund, endowments, foundations, charitable trust, charitable societies. So, they
all can be considered as the foreign investors if anybody wants to invest in the Indian
978
markets, so they are basically categorized as the FII. This can be also any kind of bank or
any kind of other companies who want to invest in the Indian market.
Another way of investment also there that is called the sub accounts. So, what do you
mean by the subaccounts? Let any person who is a foreigner who is a resident outside
India, but they want to invest in India. So how they do it because that is he or she is not
an institutions he is an investor, he or she lives outside India or he or she is the citizen of
other country, but they want to invest in India. So, how they do it? There is a provision
called sub accounts.
So, here on whose behalf investments are proposed to be made in India by FII investor or
foreign institutional investor who is registered as a sub account under the SEBI
regulation 1995. So, they can invest through FII in the Indian market and through FII
who is already registered as a FII as per the SEBI regulation 1995.
Who can hold the sub account? It is the proprietary fund of a registered foreign
institutional investor foreign individual who has a net worth not less than 50 million US
dollar, holds a valid passport of a foreign country for a period of at least five years, holds
a certificate of good standing from bank. He should not be bankrupt or there should not
be any kind of legal problems with respect to the financing has happened to that
particular person.
979
And is the client of that particular FII for a period of at least three years on behalf of
whom FII is investing in India that person should be the client of that FII for at least
three years. Foreign corporate it is for individuals foreign corporate, but they are not
considered as FII, but that has its securities listed in the stock exchange outside India,
having an asset base not less than 2 billion US dollar.
And having an average net profit of not less than 50 million US dollar during the three
financial year preceding the date of the application. They are not FII considered as FII,
but they can invest through another FII, but they should fulfill these conditions. They can
invest through this sub accounts.
The limits how much they can invest, the total holding of each account holder under this
scheme should not extend 10 percent of the total paid up capital each; each foreign
institutional investor cannot hold the 10 percent of the total paid up capital for that
particular company, either it is equity or the debenture whatever it may be they cannot go
beyond the 10 percent. And the total holding of all FIIs or sub accounts put together
should not exceed 24 percent of the paid up capital and the paid up value of each series
of convertible debentures.
The limit of 24 percent can be increased to the sectoral gap, it can increase to some
extent with the special resolution by the general body. It can be first passed through the
980
board of directors followed by the special resolution to that effect by its general body 24
percent in aggregate and each it should not exceed 10 percent.
But whenever we talk for example, any company anybody wants or any kind of foreign
FIIs wants to invest in a company, if one individual FII can go maximum up to 10
percent of the total paid up capital, but in aggregate in that particular company the
percentage of the FII should be 24 percent, but it can increase by the resolution of the
general body or the board of directors.
If say the differences FDI is applicable to many sectors, FII is confined to financial
sector, FDI is for long term investment, FIIs for the short term investment, FDIs
investment in fixed assets, FII is the only financial capital, investments are stable here it
is highly volatile because the money invested in FII through FII is called the hot money.
It targets the specific company, but here it targets the whole financial market.
Transfer of resources in many forms like technology, strategy and everything, here only
money is transferred. Entry and exit is difficult if somebody or any company wanted as
invested through FDI and entry and exit is easy in terms of FII any time they can go out
of this investment or the market.
981
So, these are the major differences what we can observe and hosting country has control
over FDI and in terms of FII we have not much control any time they can go out of the
market.
So, these are the references you can go through for the session and now you can have the
broad idea about the financial system as a whole and as well as how the market
functions, how the regulatory bodies functions, how the banks work and all these things
and I hope you must have enjoyed all those topics whatever we have discussed in
throughout this particular subject.
Thank you.
982
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NOT FOR SALE
NOR COMMERCIAL USE
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INDEX

2 Equilibrium in Financial Markets 17

3 Efficiency of Financial Markets 32

4 Measures of Financial Development 47

5 Financial Development and Economic Growth 61

7 Unsystematic risks in financial system 93

8 Return concepts in financial system 108

9 Fundamental analysis of financial assets 122

10 Technical analysis of financial assets 137

12 Theories of interest rate determination-II 170

13 Term structure theories of interest rate-I 187

14 Term structure theories of interest rate-II 200

15 Term structure theories of interest rate-III 215

17 RBI- structure and objective functions 247

18 Monetary policy instruments 263

20 SEBI, IROA and PFRDA structure and function 295

23 Commercial bank performance 342

24 Basel Accords 357

25 Measure of risk in commercial banks 373

27 Insurance companies 410

28 Mutual funds-I 428

29 Mutual funds-II 444

32 Venture capital 490

33 Merchant banks 508

34 Credit Rating Agencies 525

35 Non-banking statutory financial organization 542

37 Call Money Market-II 578

38 Treasury Bills Market 593

39 Miscellaneous short-term money market-I 609

40 Miscellaneous short-term money market-II 624

42 Bond Analysis-II 658

43 Bond Analysis-III 675

44 Bond Analysis-IV 693

45 Bond market in India 711

47 Stock market-II 744

48 Stock market-III 764

49 Stock market-IV 782

50 Stock market-V 799

52 Derivatives Market-II 832

53 Derivatives Market-III 851

54 Derivatives Market-IV 866

55 Derivatives Market-V 884

57 Foreign Exchange Market-II 915

58 Foreign Exchange Market-III 929

59 Foreign Exchange Market-IV 946

60 Foreign Exchange Market-V 965

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Please go through these particular references for this particular session.

Thank you very much.

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Please go through these particular references for this particular session.

Thank you very much.

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