Financial Institutions and Markets

June 2024 Examination

Q1. Ms. Suraksha, after completing her graduation, has recently joined a bank. With a
steady income and good growth prospects for her career, she intends to save regularly
and increase the amount of savings gradually over the years. Her colleagues in the bank
have advised her investing in Mutual Funds (MFs), as a suitable option for her.
However, Ms. Suraksha is not at aware with MFs. Help Suraksha to understand about
mutual funds, types of MF and why she should invest through mutual fund? (10
marks)

Ans 1.

Introduction

Mutual funds represent a cornerstone of the modern investment landscape, offering

individuals a way to participate in the financial markets with relative ease and diversification.
For Ms. Suraksha, a newcomer to the world of investing, mutual funds could serve as an
invaluable tool to grow her savings while mitigating risks. At their core, mutual funds pool
money from many investors to purchase a broad portfolio of stocks, bonds, or other
securities. This collective investment scheme democratizes access to sophisticated investment
strategies and asset classes that might be out of reach for individual investors. Additionally,
mutual funds are managed by professional fund managers, who apply their expertise to select
investments that align with the fund’s objectives. For someone like Suraksha, who is starting
her journey into saving and investing with an aim to gradually increase her savings, mutual
funds offer a blend of growth potential, risk management, and simplicity.

Concept and application

Mutual funds have emerged as one of the most popular investment vehicles for both novice
and experienced investors alike. This popularity is due in large part to the unique
characteristics and benefits that mutual funds offer, including diversification, professional
management, liquidity, and the ability to participate in markets that may be difficult for
individual investors to access directly. For Ms. Suraksha, and indeed for anyone looking to
start or enhance their investment journey, understanding the concept of mutual funds, the
types available, and the rationale for investing in them is crucial.

Understanding Mutual Funds

At its most basic, a mutual fund is an investment vehicle that pools money from multiple
investors to buy a diversified portfolio of stocks, bonds, or other securities. Each investor
owns shares in the fund and can buy or sell these shares at the fund's current net asset value
(NAV), which is the total value of all the securities the fund owns divided by the number of
the fund's shares. One of the key benefits of mutual funds is the diversification they offer. By
investing in a wide range of securities, mutual funds can help reduce the risk of loss from
poor performance of any single investment.

Professional Management

Mutual funds are managed by professional fund managers, who research and select securities
to meet the specific investment objectives of the fund. This professional management can be
particularly appealing for new investors like Ms. Suraksha, who may not have the time,
resources, or expertise to manage their investments. Fund managers make the buying and
selling decisions, saving investors the complexity of picking individual stocks or bonds. This
expertise comes at a cost, however, in the form of fees and expenses, which can vary widely
among funds.

Types of Mutual Funds

Mutual funds come in various forms, catering to different investment objectives, risk
tolerance levels, and time horizons. Broadly, they can be classified into the following
categories:

1. Equity Funds: These funds invest primarily in stocks and aim for growth by capital
appreciation. Equity funds are suited for investors with a higher risk tolerance,
seeking substantial returns over the long term.

2. Debt Funds: Also known as fixed income funds, they invest in bonds and other debt
instruments. They aim to provide steady income to investors and are generally
considered lower risk than equity funds.
 3. Balanced or Hybrid Funds: These funds invest in a mix of equities and fixed-
income securities in varying proportions, offering a balance between risk and returns.
They are suitable for investors looking for a mix of income and growth.

4. Index Funds: These funds aim to replicate the performance of a specific index, such
as the S&P 500, by investing in the index's constituent stocks. Index funds are known
for their low expense ratios and are a popular choice for passive investors.

5. Sector or Thematic Funds: These funds invest in a particular sector (e.g.,

technology, healthcare) or theme (e.g., environmental sustainability), and are suitable
for investors who wish to capitalize on the growth of specific market segments.

6. Money Market Funds: These funds invest in short-term debt instruments and are
considered safe, offering liquidity and stable returns. They are suitable for investors
looking for a temporary place to park their funds.

Why Invest in Mutual Funds?

For someone like Ms. Suraksha, mutual funds offer several advantages as an investment
option:

 Diversification: Mutual funds spread their holdings across a wide range of securities,
reducing the impact of any single security's poor performance on the overall portfolio.

 Accessibility: With mutual funds, investors can start with relatively small amounts of
money and gain exposure to a portfolio of investments that would be difficult to
replicate on their own.

 Liquidity: Mutual fund shares can be bought or sold at the NAV with ease, providing
investors with the flexibility to access their funds when needed.

 Transparency: Mutual funds provide regular information on their holdings,

performance, and fees, allowing investors to make informed decisions.

 Potential for Higher Returns: While all investments carry risk, mutual funds offer
the potential for higher returns compared to traditional savings accounts or fixed
deposits, especially over the long term.

Conclusion
In conclusion, mutual funds present a compelling option for Ms. Suraksha as she embarks on
her investment journey. They offer a blend of professional management, diversification, and
the flexibility to choose from a variety of fund types to match her financial goals and risk
tolerance. Whether she seeks growth, income, or stability, there is likely a mutual fund that
aligns with her needs. By investing in mutual funds, Suraksha can take advantage of the
collective knowledge and resources of professional fund managers, while also benefiting
from the pooled resources of many investors. This approach not only spreads out her
investment risk but also provides her with the opportunity to grow her savings effectively
over time. Mutual funds can be a cornerstone in building a resilient and diversified
investment portfolio, making them a wise choice for anyone looking to navigate the
complexities of the financial markets with confidence.

Q2. You are appointed as a Senior financial research analyst in a reputed firm. Your
manager asks you to advise him on the different ways to test market efficiency. Discuss
the various test for market efficiency which will help the Firm’s investment to earn
excess returns. (10 Marks)

Ans 2.

Introduction

Market efficiency is a fundamental concept in financial economics that posits prices of

securities in the stock market fully reflect all available information at any given time. As a
senior financial research analyst, understanding and testing for market efficiency is crucial,
not just for academic purposes but also for practical investment strategies. The Efficient
Market Hypothesis (EMH) suggests that it's impossible to consistently achieve higher than
average returns by using any information that the market already knows. However, testing for
market efficiency involves examining whether there are anomalies that contradict the EMH,
thereby potentially allowing investors to earn excess returns. These tests are categorized into
three forms based on the information set involved: weak-form, semi-strong form, and strong-
form efficiency tests. By meticulously analyzing these tests, investors and analysts can gauge
the level of efficiency in a market and refine their investment strategies accordingly,
navigating through the complexities of financial markets with a more informed perspective.

Concept and application

In the realm of finance, the concept of market efficiency is a cornerstone, dictating the extent
to which market prices reflect all available information. The Efficient Market Hypothesis
(EMH), formulated by Eugene Fama in the 1970s, argues that securities prices in financial
markets are always a perfect reflection of available information. This hypothesis implies that
it is impossible to consistently achieve higher than average returns on a risk-adjusted basis,
given that any new information affecting a security's value is quickly incorporated into its
price. However, the real-world financial markets present various degrees of efficiency,
prompting analysts to devise tests to evaluate this efficiency. These tests are crucial for a
senior financial research analyst aiming to identify potential opportunities for earning excess
returns for their firm’s investments.

Tests for Market Efficiency

Market efficiency is typically analyzed through three forms of tests: weak-form, semi-strong
form, and strong-form tests, each corresponding to different levels of available information.

Weak-Form Efficiency Tests

Weak-form tests assess whether past trading information, such as stock prices and volume,
can predict future prices. If a market is weak-form efficient, it implies that historical data
cannot be used to achieve excess returns. Technical analysis, which involves the study of past
stock prices and volumes to forecast future price movements, is rendered ineffective in weak-
form efficient markets.

1. Serial Correlation Tests: These tests check for correlations between successive price
changes to detect any patterns or trends. A lack of serial correlation suggests market
efficiency.

2. Runs Tests: A runs test analyzes the randomness of price movements by examining
sequences of price increases or decreases. Non-random patterns indicate potential
predictability, challenging weak-form efficiency.

Semi-Strong Form Efficiency Tests

Semi-strong form tests evaluate if all publicly available information, including but not limited
to historical prices, is reflected in stock prices. This form assumes that stock prices adjust to
new public information rapidly and accurately, making it impossible to earn excess returns by
trading on this information.
 1. Event Studies: These studies examine stock price reactions to specific significant
events, such as earnings announcements, mergers, or regulatory changes. If prices
adjust quickly and fully to the new information, the market is considered semi-strong
form efficient.

2. Regression and Anomaly Tests: Analysts use regression analysis to identify

relationships between stock returns and public information variables. The
identification of anomalies, such as the January effect or the size effect, can suggest
inefficiencies.

Strong-Form Efficiency Tests

Strong-form tests are the most stringent, positing that stock prices fully reflect all
information, public and private. If a market is strong-form efficient, no investor, not even
company insiders with privileged information, could consistently achieve abnormal returns.

1. Insider Trading Studies: These tests investigate whether insiders are able to earn
excess returns from trading on non-public information. Persistent insider trading
profits would contravene strong-form efficiency.

2. Private Information Studies: These involve analyzing the performance of

investment managers and analysts to determine if they can consistently outperform
the market using undisclosed information.

Application and Implications

Testing for market efficiency is more than an academic exercise; it has profound implications
for investment strategy and portfolio management. Weak-form tests challenge the utility of
technical analysis, suggesting that investors cannot rely on past price patterns to make trading
decisions. Semi-strong form tests question the efficacy of strategies based on publicly
available information, such as fundamental analysis or news-based trading. Finally, strong-
form tests scrutinize the advantage that insider information might confer, underscoring the
challenges of achieving sustained outperformance.

The Reality of Market Anomalies

Despite the EMH's broad acceptance, numerous studies have identified market anomalies that
seem to contradict it. These anomalies, such as momentum, value, and size effects, suggest
that markets may not be perfectly efficient and that skilled analysts might exploit these
inefficiencies for excess returns. However, exploiting these anomalies is not straightforward;
it requires sophisticated analysis, a deep understanding of market dynamics, and a
consideration of transaction costs.

Conclusion

The testing of market efficiency is a critical endeavor for financial analysts, offering insights
into the nature of information processing in financial markets and the potential for earning
excess returns. While the EMH provides a foundational framework for understanding market
behavior, anomalies and empirical tests reveal a more nuanced picture. Markets may not
always operate with perfect efficiency, offering opportunities for excess returns under certain
conditions. However, the pursuit of these opportunities demands rigorous analysis, a nuanced
understanding of market dynamics, and an ongoing evaluation of efficiency tests. As such,
financial research analysts play a pivotal role in navigating these complexities, guiding
investment strategies that are informed by an evolving understanding of market efficiency.

Q3. “PNB unearthed the scam on January 25, 2018, and submitted a fraud report to the
Reserve Bank of India (RBI) on January 29. On that day, a criminal complaint for
registration of FIR was also made with the CBI. This was followed by another fraud
report being submitted to the RBI on February 7, the day when one more complaint
was filed with the CBI”

a. With reference to the PNB Fraud case, analyse the event in details. (5 Marks)

Ans 3a.

Introduction

The Punjab National Bank (PNB) fraud case, detected in early 2018, stands as one of the
largest financial frauds in Indian banking history. It involved the issuance of fraudulent
Letters of Undertaking (LoUs) in favor of companies associated with billionaire jeweler
Nirav Modi and his uncle, Mehul Choksi. These LoUs were used to obtain short-term loans
from overseas branches of Indian banks, without proper authorization and collateral, leading
to a massive financial embezzlement that shook the foundations of the banking sector in
India.
Concept and application

The PNB fraud case came to light on January 25, 2018, when the bank discovered fraudulent
transactions at one of its Mumbai branches. The scam was engineered by exploiting a
loophole in the banking software, allowing the issuance of LoUs without recording them in
the bank’s main system. These LoUs served as guarantees to overseas banks, enabling Nirav
Modi's companies to secure loans under false pretenses.

The modus operandi involved rogue employees of PNB who issued unauthorized LoUs on
behalf of the accused companies. These documents were then transmitted to overseas
branches of Indian banks, relying on the implicit trust in PNB's guarantees. The funds raised
were not used for the stated purposes but were diverted to pay off previous loans, creating a
cycle of fraud that lasted for several years.

Upon discovery, PNB acted swiftly by informing the Reserve Bank of India (RBI) and filing
criminal complaints with the Central Bureau of Investigation (CBI). The bank submitted
detailed fraud reports to the RBI on January 29 and February 7, alongside filing complaints
with the CBI, highlighting the magnitude and seriousness of the scam.

The fallout from the scam was widespread, affecting not only PNB but also other banks that
had extended loans based on the fraudulent LoUs. The incident raised questions about the
regulatory oversight and the internal control systems within Indian banks, leading to a call for
stricter compliance measures and reforms in the banking sector.

Conclusion

The PNB fraud case underscores the critical need for robust internal controls and vigilance in
the banking sector. It serves as a stark reminder of the potential vulnerabilities within banking
operations and the importance of maintaining stringent oversight mechanisms to prevent such
frauds. The event not only led to significant financial losses but also eroded public trust in the
banking system, emphasizing the necessity for transparency, accountability, and stronger
regulatory frameworks to safeguard against future instances of financial fraud.

b. Enumerate the various risk that is highlighted in this event and bring out the
difference between Systemic Risk and Unsystematic Risk. (5 Marks)

Ans 3b.

Introduction
The Punjab National Bank (PNB) fraud case not only unveiled a significant financial scam
but also exposed various risks within the banking sector. This event serves as a prime
example to differentiate between systemic and unsystematic risk, highlighting the
vulnerabilities in the financial system. Systemic risk affects the entire banking system and
financial markets, potentially leading to a collapse, while unsystematic risk is specific to a
single entity or group, without broader market implications.

Concept and application

Risks Highlighted by the PNB Fraud Event:

1. Operational Risk: This includes the risk of loss resulting from inadequate or failed
internal processes, people, and systems. The PNB fraud was primarily an operational
risk, where employees issued unauthorized LoUs.

2. Credit Risk: The risk that a borrower will default on any type of debt by failing to
make required payments. The fraudulent LoUs exposed PNB and other banks to high
credit risk, as funds were not used as intended.

3. Reputation Risk: Following the scam, PNB and the Indian banking sector faced
severe reputation damage, affecting customer trust and investor confidence.

4. Compliance Risk: This involves the risk of legal or regulatory sanctions, financial
forfeiture, or material loss an organization faces when it fails to comply with laws,
regulations, codes of conduct, and standards of good practice. PNB's failure to detect
the fraud early on pointed to significant compliance lapses.

Systemic Risk vs. Unsystematic Risk:

 Systemic Risk is inherent to the entire market or market segment, indicating how the
failure of a single entity or group of entities can trigger a loss in value across the
financial system. It's associated with the collapse of an entire financial system or
market, as seen during the 2008 financial crisis. This risk cannot be easily mitigated
through diversification.

 Unsystematic Risk, also known as specific or idiosyncratic risk, is unique to a

particular company or industry. In the context of the PNB fraud, the risk was initially
unsystematic, affecting primarily PNB and its direct stakeholders. Unsystematic risk
can be reduced through diversification of investments.
The PNB fraud case primarily showcases unsystematic risk, as the direct impact was confined
to specific entities rather than the entire banking system. However, it also raised concerns
about systemic risk by highlighting vulnerabilities in banking practices and oversight that
could have broader implications if not addressed.

Conclusion

The PNB fraud case illustrates the complex web of risks within the banking sector,
particularly emphasizing the difference between systemic and unsystematic risks. While the
immediate effects of the fraud were unsystematic, confined to PNB and related entities, the
event underscored potential systemic vulnerabilities across the banking industry. It serves as a
reminder of the importance of robust risk management and regulatory oversight to safeguard
against both specific and widespread financial threats. Understanding and mitigating these
risks are crucial for maintaining the stability and integrity of the financial system.