2006 ipu exam paper

7/29/2019 2006 ipu exam paper

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END TERM EXAMINATION

THIRD SEMESTER [MBA] DECEMBER 2006

PAPER CODE: - MS219 SUBJECT: Financial Markets and Institutions

Q1).Indian Financial system has under gone complete metamorphosis afterindependence in terms of institutions, markets and instruments. Discuss in the context of

first and second generation reforms in the financial sectors since 1991.

Financial institution - A financial system can be defined at the global, regional or firm

specific level. The firm's financial system is the set of implemented procedures that track

the financial activities of the company. On a regional scale, the financial system is the

system that enables lenders and borrowers to exchange funds. The global financial

system is basically a broader regional system that encompasses all financial institutions,

borrowers and lenders within the global economy.

The financial system conveys resources from lenders to borrowers, and transfers risks

from those who wish to avoid them to those who are willing to take them. It is a complex

interactive system, events in one component of which can have significant repercussions

elsewhere. There are also complex interactions between financial transactions and other

forms of economic activity, as consequence of which a malfunction of the financial

system can cause a malfunction of the economy, and vice-versa. The system has evolved

by adaptation and innovation, and the conduct of its participants has been modified from

time to time by regulations designed to preserve its stability

The financial system of any country consists of

(a) specialised and non-specialised financial institutions

(b) organised and unorganised financial markets

(c) financial instruments and services which facilitate transfer of funds.

Significance of Institutions are as follows:


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Financial institutions have tended to play down their potential role in moving towards

sustainable development, believing that such matters are primarily the role of

government. Financial markets normally supply financial capital with the intention that is

should ideally increase, and at least should be safeguarded. Financial institutions can

respond quickly to new opportunities, particularly when the potential is presented to them

in a clear and consistent manner,Banking system and the Financial Institutions play very

significant role in the economy. First and foremost is in the form of catering to the need

of credit for all the sections of society An efficient banking system must cater to the

needs of high end investors by making available high amounts of capital for big projects

in the industrial, infrastructure and service sectors. At the same time, the medium and

small ventures must also have credit available to them for new investment and expansion

of the existing units. Rural sector in a country like India can grow only if cheaper credit is

available to the farmers for their short and medium term needs.

Credit availability for infrastructure sector is also extremely important. The success of

any financial system can be fathomed by finding out the availability of reliable and

adequate credit for infrastructure projects. Fortunately, during the past about one decade

there has been increased participation of the private sector in infrastructure projects.

The banks and the financial institutions also cater to another important need of the

society i.e. mopping up small savings at reasonable rates with several options. The

common man has the option to park his savings under a few alternatives, including the

small savings schemes introduced by the government from time to time and in bank

deposits in the form of savings accounts, recurring deposits and time deposits. Another

option is to invest in the stocks or mutual funds. The economic development greatly

depends on the rate of capital formation. Now, the capital formation depends upon

whether finance is made available in time, in adequate quantity, and on favorable terms

all of which a good financial system could achieve .A efficient financial system helps inmobilizing the savings thus results in economic growth of a economy. A financial system

helps output to increase by moving the economic system towards the existing PPF or by

moving the PPF of the economy rightwards. This is done by transforming a given total

amount of wealth into more productive forms. It induces people to hold less of savings in

the form of precious metals, real estate land, consumer durables, currency and to replace


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these assets by bonds, shares, units etc. It also helps to increase the volume of investment.

Thus financial institutions play a quite significant role in the economic growth of a

economy

Q2).a . Distinguish between financial integration and financial intermediates? what is the

role of each in development of an efficient financial system?

b .Flow of funds accounts provide a virtual mine of information for the financialpolicy making on the part of authorities of a country explain

Ans. Difference between financial integration and financial intermediates

Financial integration Financial intermediates

Financial integration is defined asintegration between two or more

dimension of financial services within or

between financial services sector.

Financial intermediates is defined as

mediator between client and financial

sectors(i.e. institutes, agencies etc.)

Financial integration can be of

geographic and functional integration.

Financial intermediates can be internal

agent or external agent.

Financial integration cannot help in risk

diversification benefit.

Financial intermediates can help in risk

diversification benefit.

Example

Mutual funds, global banks.

Example

Brokers, factoring.

Financial integration promotes the adoption of modern technology and payment systems

to achieve cost effective financial intermediation services.

Role of each in development of an efficient financial system

The financial system is the system that allows the transfer of money between savers (andinvestors) and borrowers. A financial system can operate on a global, regional or firm

specific level.

Financial systems are crucial to the allocation of resources in a modern economy. They

channel household savings to the corporate sector and allocate investment funds among


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firms; they allow inter temporal smoothing of consumption by households and

expenditures by firms; and they enable households and firms to share risks. These

functions are common to the financial systems of most developed economies

Financial system now become more integrated. Financial integration involves a blending

of relational contracts (or activities) with market-based contracts (or activities).As such,

financial integration may represent the transitional phase of the financial system from

relational to more arms-length form. It may represent that threshold point where market

based structure is about to supplant the relatively bank-dominated system of emerging

economies

Factors behind greater integration are The government entry in a very big way in the wholesale trading of a large no. of

commodities.

An unprecedented expansion of a network of rural branches of bank

A transformation in the perception of the role of financial institutions.

Financial markets and financial intermediaries perform the function of channeling funds

from agents who have saved funds and want to lend to agents who need funds andwant to borrow.

Financial intermediaries play a number of special roles, and help solve a number of

special problems, in the process of indirect finance.

Financial intermediaries can help solve this problem by gathering information about

potential borrowers and screening out bad credit risks. Financial intermediaries can help

solve this problem by monitoring borrowers activities

(b) Flow of funds accounts provide a virtual mine of information for the financial policymaking on the part of authorities of a country explain

Yes, fund flow statement provide virtual mine for financial policy making by theauthorities by providing:


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(1)The flow-of-funds system is a quadruple-entry system compared to the double-entry

system of the national income products accounts, that is, a given transaction is recorded

twice in the accounts of both economic units involvedon cease debit and on ceasecreditwhile only on entry for each participating unit is made in the national income and

product accounts.

(2)The flow-of-funds statement distinguishes considerably larger number of sectors thanthe national income and products accounts now do. Specifically consumers, corporatebusiness, nonfarm non corporate business, farm business, the banking system (with four

subsectors), life-insurance companies, pension plans, other insurance companies, saving

and loan associations, and non profit organizations constitute separate sectors in thepublished flow-of-funds statements. No separate figures for these sector saresh own in

the national income and product accounts, which distinguish, in so far as detail is

concerned, only between two private sectorsconsumers (including non- profitorganizations) and business.

(3)The flow-of-funds statement provides information chases and sales by each sector

(where applicable or where figures are available) on the following 12 types of financial

assets, none of which enter into the national income and profit accounts: gold andTreasury currency, currency an demand deposits, time deposits, savings and loan and

credit unions shares, bank loans, Federal obligations, State and local obligations,

corporate securities, mortgages, consumer credit, and trade credit.

(4)The flow-of-funds statement is published only on annual basis and so far only withconsiderable delay, while the main aggregates in the national income and product

accounts are estimated quarterlyandarereleasedlesthan2monthsafterthendofthe quarter.

(5)The flow-of-funds statement includes figures for the holdings of claims and liabilities,

though no to f equity securities and tangible assets, of each sector, information that doesnot figure in the national income and product accounts. This feature, however, is not

necessarily in the flow-of-funds statement

Q3 (a) Briefly examine the two segment of Indian securities market ?mention the

specific areas where the SEBI has succeded in toning them up?

The securities market is divided into two interdependent segments:

The primary market provides the channel for creation of funds through issuance

of new securities by companies, governments, or public institutions. In the case of

new stock issue, the sale is known as Initial Public Offering (IPO).

The secondary market is the financial market where previously issued securitiesand financial instruments such as stocks, bonds, options, and futures are traded.

The Securities and Exchange Board of India (SEBI), the regulatory authority for

Indian securities market, was established in 1992 to protect investors and improve

the microstructure of capital markets. In the same year, Controller of Capital

Issues (CCI) was abolished, removing its administrative controls over the pricing


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of new equity issues. In less than a decade later, the Indian financial markets

acknowledged the use of technology (National Stock Exchange started online

trading in 2000), increasing the trading volumes by many folds and leading to the

emergence of new financial instruments.

SEBIprotects the interests of investors in securities and promotes the development of thesecurities market. The board helps in regulating the business of stock exchanges and any

other securities market. SEBI is also responsible for registering and regulating the

working of stock brokers, sub-brokers, share transfer agents, bankers to an issue, trustees

of trust deeds, registrars to an issue, merchant bankers, underwriters, portfolio managers,

investment advisers, and such other intermediaries who may be associated with securities

markets in any manner.

The board registers the venture capitalists and collective investments like mutual funds.

SEBI helps in promoting and regulating self regulatory organizations.

(b) List the regulatory guidelines for issue of commercial paper in India?

Commercial Paper (CP) is an unsecured money market instrument issued in the form of a

promissory note. CP, as a privately placed instrument, was introduced in India in 1990

with a view to enabling highly rated corporate borrowers to diversify their sources ofshort-term borrowings and to provide an additional instrument to investors.

Subsequently, primary dealers, satellite dealers and all-India financial institutions were

also permitted to issue CP to enable them to meet their short-term funding requirementsfor their operations.

The guidelines for issue of CP incorporating all the amendments issued till date is givenbelow:

Corporates, primary dealers (PDs) and the all-India financial institutions (FIs) that havebeen permitted to raise short-term resources under the umbrella limit fixed by the

Reserve Bank of India are eligible to issue CP.

I. A corporate would be eligible to issue CP provided:(a) the tangible net worth of the company, as per the latest audited balance sheet, is not

less than Rs. 4 crore;

(b) company has been sanctioned working capital limit by bank/s or all-India financial

institution/s; and(c) the borrowal account of the company is classified as a Standard Asset by the

financing bank/s/ institution/s.

All eligible participants shall obtain the credit rating for issuance of Commercial Paperfrom either the Credit Rating Information Services of India Ltd. (CRISIL) or the

Investment Information and Credit Rating Agency of India Ltd. (ICRA) or the Credit


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Analysis and Research Ltd. (CARE) or the FITCH Ratings India Pvt. Ltd. or such other

credit rating agencies as may be specified by the Reserve Bank of India from time to

time, for the purpose.

CP can be issued in denominations of Rs.5 lakh or multiples thereof. Amount invested by

a single investor should not be less than Rs. 5 lakh (face value).

The aggregate amount of CP from an issuer shall be within the limit as approved by its

Board of Directors or the quantum indicated by the Credit Rating Agency for thespecified rating, whichever is lower.

An Foreign Investor can issue CP within the overall umbrella limit fixed by the RBI, i.e.,

issue of CP together with other instruments, viz., term money borrowings, term deposits,certificates of deposit and inter-corporate deposits should not exceed 100 per cent of its

net owned funds, as per the latest audited balance sheet.

CP can be issued either in the form of a promissory note or in a dematerialised formthrough any of the depositories approved by and registered with SEBI.

CP will be issued at a discount to face value as may be determined by the issuer.

No issuer shall have the issue of CP underwritten or co-accepted.

* Every issuer must appoint an Issuing and Paying Agent (IPA) for issuance of CP.

*Investors shall be given a copy of IPA certificate to the effect that the issuer has a validagreement with the IPA and documents are in order.

Q4). Write Short Notes on:

a) Credit rating

b) Consortium Finance

c) Bill discounting

d) Venture Capital Maximum Permissible Bank Finance

A. CREDIT RATING


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Credit ratings assess the credit worthiness of an individual cooperation or even country.

It is an evaluation made by a credit rating agencyof the debtor's ability to pay back the

debt and the likelihood ofdefault.

Credit rating are calculated from financial history and current assets and liabilities. Credit

ratings are not based on mathematical formulas. Instead, credit rating agencies use their

judgment and experience in determining what public and private information should be

considered in giving a rating to a particular company or government. A credit rating tells

a lender or investor the probability of the subject being able to pay back loan. A poor

credit rating indicates a high risk of defaulting on a loan and thus lends to higher interest

rate. A credit does not create fiduciary relationship between the agencies and the user.

Credit rating essentially establishes a link between risk and return.

Objective of Credit Rating: The main objective is to provide superior and low cost

information to investors for taking a decision regarding risk-return trade off, but it also

helps to market participants in the following ways;

Improves a healthy discipline on borrowers.

Lends greater credence to financial and other representations,

Facilitates formulation of public guidelines on institutional investment,

Helps merchant bankers, brokers, regulatory authorities, etc. in discharging their

functions related to debt issues,

Encourages greater information disclosure, better accounting standards, and

improved financial information(helps in investors protection),

May reduce interest costs for highly rated companies,

Acts as a marketing tool

Functions of a Credit Rating Agency

A credit rating agency serves following functions:
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1. Provides quality and dependable information:. A credit rating agency is in a

position to provide quality information on credit risk which is more authenticate and

reliable.

2. Provides information at low cost: Most of the investors rely on the ratings assigned

by the ratings agencies while taking investment decisions. These ratings are published

in the form of reports and are available easily on the payment of negligible price. It is

not possible for the investors to assess the creditworthiness of the companies on their

own.

3. Provide easy to understand information: Rating agencies first of all gather

information, then analyze the same. At last these interpret and summaries complex

information in a simple and readily understood formal manner. Thus in other words,

information supplied by rating agencies can be easily understood by the investors.

They need not go into details of the financial statements.

4. Provide basis for investment: An investment rated by a credit rating enjoys higher

confidence from investors. Investors can make an estimate of the risk and return

associated with a particular rated issue while investing money in them.

5. Healthy discipline on corporate borrowers: Higher credit rating to any credit

investment enhances corporate image and builds up goodwill and hence it induces a

healthy/ discipline on corporate

6. Formation of public policy: Once the debt securities are rated professionally, it

would be easier to formulate public policy guidelines as to the eligibility of securities

to be included in different kinds of institutional port-folio.

B. CONSORTIUM FINANCE

Consortium is a Latin word, meaning 'partnership, association or society.

A consortium is an association of two or

more individuals, companies,organizationsorgovernments(or any combination of these
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entities) with the objective of participating in a common activity or pooling their

resources for achieving a common goal.

Under consortium financing, several banks (or financial institutions) finance a single

borrower with common appraisal, common documentation, joint supervision and

follow-up exercises, these banks have a common agreement between them, the

process is somewhat similar to loan syndication.

The Consortium approach to project delivery is chosen because of the desire to share

as evenly as possible the risk inherent in that project. It is like a establishing a

temporary business without the formal structure or tax liabilities, a business that is

governed by the rules laid down in a consortium agreement.

Advantages

1. Ease of Formation- No formal procedure must be followed. Also no capital is

required to create the consortium.

2. Flexibility- Members of consortium can change their contractual agreement at any

time to suit changed circumstances.

3. Ease of termination- Consortia can be set to expire on a given date or on the

occurrence of certain events without the formal requirements needed in the case ofdissolution of the corporation

4. Tax transparency-The consortium is not directly subject to taxation however the

individuals are.

5. Confidentiality- Some of the members may choose to be undisclosed parties in

dealings with third parties.

6. Costs-The cost of running a contractual joint venture is generally lower thanrunning Joint Venture Company.

Disadvantages

1. Liability- It is difficult for a consortium member to restrict or limit its liability.

Members may even become liable to third parties for the nonperformance of other


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members of the consortium or debts of such members incurred in undertaking the

common project.

2. External Relationships and Funding-Third parties often find it difficult to enter

into a contract with a non legal entity like consortium. Because it is non legal

entity the funding is also normally available to the individual members and not the

consortium itself.

3. Lack of permanent structure- The lack ofpermanent structure makes it difficult

for a consortium to establish a long termbusiness relationship with third parties

C. BILL DISCOUNTINGThe act of handling over an endorsed Bill of Exchange for ready money is called

discounting the bill of exchange.

According to the Indian Negotiable Instrument Act, 1881:

The bill of exchange is an instrument in writing containing an unconditional order,

signed by the maker, directing acertain person to pay a certain sum of money only to, or

tothe order of, a certain person, or to the bearer of that instrument.

Bill discounting is a major activity with some of the smaller Banks. Under this type of

lending, Bank takes the bill drawn by borrower on his (borrower's) customer and pays

him immediately deducting some amount as discount/commission. The Bank then

presents the Bill to the borrower's customer on the due date of the Bill and collects the

total amount. If the bill is delayed, the borrower or his customer pays the Bank a pre-

determined interest depending upon the terms of transaction

Business activities across borders are done through letter of credit. Letter of credit is an

instrument issued in the favor of the seller by the buyer bank assuring that payment will

be made after certain timer frame depending upon the terms and conditions agreed, it

could be either sight, 30 days from the Bill of Lading or 120 days from the date of bill of

lading. Now when the seller receives the letter of credit through bank, seller prepares the

documents and presents the same to the bank. The most important element in the same is


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the bill of exchange which is used to negotiate a letter of credit. Seller discounts that bill

of exchange with the bank and gets money. Discounting bill terminology is used for this

purpose. Now it is seller's bank responsibility to send documents and bill of exchange to

buyer's bank for onward forwarding to the buyer for the acceptance and the buyer finally,

accepts bill of exchange drawn by the seller on buyer's bank because he has opened that

LC. Buyers bank than get that signed bill of exchange from the buyer as guarantee and

release payment to the sellers bank and waits for the time span.

There are two types of bill discounting:

Import bill discounting.

Export bill discounting.

Import bill discount is a kind of short-term finance offered by the bank to the importer

according to his demand upon receiving the bills under the letter of credit and the import

collection items. They have the following virtues:

1. Reduce the funding occupied

2. Grasp the market opportunity.

While export bill discounting is financing of money in transit supplied by the bank. The

virtues for export bill discounting are:

1. Accelerate the funding circulation.

2. Improve the cash flow.

3. Save the financial expenses.

Processing of Bill Discounting

Credit assessment banks and NBFCs undertake a detailed appraisal of a customer

and thoroughly assess his creditworthiness before providing the bill discounting

facility.

Quantum of business undertaken by the party that is turnover of inventory.

Credit worthiness of drawer (client).

Credit worthiness of drawee and details of dishonor, if any.

Nature of customers industry.


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Precautions

1. The bills are drawn on the place where the finance company is operating.

2. The goods covered by the documents are those in which the party deals.

3. The amount of the bill commensurate with the volume of business turnover of the

party.

4. The description of goods mentioned in the invoice and railway receipt are same.

5. The goods are properly insured.

6. The bill is properly stamped.

7. Bill offered for discount do not cover goods whose prices fluctuate too much.

8. The bills are drawn in favor of the finance company and have been accepted by

the drawee.

D. VENTURE CAPITAL MAXIMUM PERMISSIBLE BANK FINANCE

Venture capital refers to risk capital supply to hi-tech growing companies particularly in

the form of equity participation it includes both startup capital and developmental capital.

Venture capital provides initial support to new companies using high technologies and

which have potential for high profits but suffers from capital inadequacy. Venture capital

is also known as risk capital. The origin of venture capital can be treated back to the USA

in 1946. The American research and development was formed as the first venture

organization which financed over 100 companies.

Q5)(a).. Role of RBI in Indian economy

Issuer of currency

Except for issuing one rupee notes and coins, RBI is the sole authority for the issue of

currency in India. The Indian government issues one rupee notes and coins. Major

currency is in the form of RBI notes, such as notes in the denominations of two, five, ten,

twenty, fifty, one hundred, five hundred, and one thousand. Earlier, notes of higher

denominations were also issued. But, these notes were demonetized to discourage users


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from indulging in black-marketoperations.

Banker to the Government

RBI acts as banker, both to the central government and state governments. It manages all the

banking transactions of the government involving the receipt and payment of money. In

addition, RBI remits exchange and performs other banking operations.

RBI provides short-term credit to the central government. Such credit helps the government

to meet any shortfalls in its receipts over its disbursements. RBI also provides short term

credit to state governments as advances.

RBI also manages all new issues of government loans, servicing the government debt

outstanding, and nurturing the market for governments securities. RBI advises the

government on banking and financial subjects, international finance, financing of five-year

plans, mobilizing resources, and banking legislation.

Managing Government Securities

Various financial institutions such as commercial banks are required by law to invest

specified minimum proportions of their total assets/liabilities in government securities. RBI

administers these investments of institutions.

The other responsibilities of RBI regarding these securities are to ensure -

Smooth functioning of the market

Readily available to potential buyers

Easily available in large numbers

Undisturbed maturity-structure of interest rates because of excess or deficit supply

Not subject to quick and huge fluctuations

Reasonable liquidity of investments

Good reception of the new issues of government loans

Banker to Other Banks


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The role of RBI as a banker to other banks is as follows:

Holds some of the cash reserves of banks

Lends funds for short period

Provides centralized clearing and quick remittance facilities

Exchange Manager and Controller

RBI manages exchange control, and represents India as a member of the international

Monetary Fund [IMF]. Exchange control was first imposed on India in September 1939 when

World War II started and continues till date.

Publisher of Monetary Data and Other Data

RBI maintains and provides all essential banking and other economic data, formulating and

critically evaluating the economic policies in India. In order to perform this function, RBI

collects, collates and publishes data regularly. Users can avail this data in the weekly

statements, the RBI monthly bulletin, annual report on currency and finance, and otherperiodic publications.

Credit control

Credit control is a very important function of RBI as the Central Bank of India. For smooth

functioning of the economy RBI control credit throughquantitative and qualitative methods.

Thus, the RBI exercise control over thecredit granted by the commercial bank.

5 (b) RBI guidelines on classification and valuation of investment of banks :

Non performing Assets

An asset, including a leased asset, becomes non performing when it ceases

to generate income for the bank. A non performing asset (NPA) is a loan or an advance

where:


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i. interest and/ or instalment of principal remain overdue for a period of more than 90

days in respect of a term loan,

ii. the account remains out of order respect of an Overdraft/Cash Credit (OD/CC),

iii. the bill remains overdue for a period of more than 90 days in the case of bills

purchased and discounted,

iv. the instalment of principal or interest thereon remains overdue for two crop seasons

for short duration crops,

v. the instalment of principal or interest thereon remains overdue for one crop season for

long duration crops,

vi. the amount of liquidity facility remains outstanding for more than 90 days, in respect

of a securitisation transaction undertaken in terms of guidelines on securitisation dated

February 1, 2006.

vii. in respect of derivative transactions, the overdue receivables representing positive

mark-to-market value of a derivative contract, if these remain unpaid for a period of 90

days from the specified due date for payment. Banks should, classify an account as NPA

only if the interest due and charged during any quarter is not serviced fully within 90

days from the end of the quarter.

ASSET CLASSIFICATION

Categories of NPAs

Banks are required to classify nonperforming assets further into the following three

categories based on the period for which the asset has remained nonperforming and the

realisability of the dues:

i. Substandard Assets

ii. Doubtful Assets

iii. Loss Assets

Substandard Assets

With effect from 31 March 2005, a substandard asset would be one, which has remained

NPA for a period less than or equal to 12 months. In such cases, the current net worth of


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the borrower/ guarantor or the current market value of the security charged is not enough

to ensure recovery of the dues to the banks in full. In other words, such an asset will have

well defined credit weaknesses that jeopardize the liquidation of the debt and are

characterised by the distinct possibility that the banks will sustain some loss, if

deficiencies are not corrected.

Doubtful Assets

With effect from March 31, 2005, an asset would be classified as doubtful if it has

remained in the substandard category for a period of 12 months. A loan classified

as doubtful has all the weaknesses inherent in assets that were classified as

substandard,with the added characteristic that the weaknesses make collection or

liquidation in full, on the basis of currently known facts, conditions and values

highly questionable and improbable.

Loss Assets

A loss asset is one where loss has been identified by the bank or internal or external

auditors or the RBI inspection but the amount has not been written off wholly. In other

words, such an asset is considered uncollectible and of such little value that its

continuance as a bankable asset is not warranted although there may be some salvage or

recovery value.

Guidelines for classification of assets

Broadly speaking, classification of assets into above categories should be

done taking into account the degree of well-defined credit weaknesses and the extent of

dependence on collateral security for realisation of dues. Banks should establish

appropriate internal systems to eliminate the tendency to delay or postpone the

identification of NPAs, especially in respect of high value accounts. The banks may fix a

minimum cut off point to decide what would constitute a high value account depending

upon their respective business levels. The cutoff point should be valid for the entire

accounting year. Responsibility and validation levels for ensuring proper asset

classification may be fixed by the banks. The system should ensure that doubts in asset

classification due to any reason are settled through specified internal channels within one

month from the date on which the account would have been classified as NPA as per

extant guidelines.


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Availability of security / net worth of borrower/ guarantor.

The availability of security or net worth of borrower/ guarantor should not be taken into

account for the purpose of treating an advance as NPA or otherwise, except to the extent

provided as income recognition is based on record of

recovery.

Accounts with temporary deficiencies .

The classification of an asset as NPA should be based on the record of recovery.Bank

should not classify an advance account as NPA merely due to the existence of some

deficiencies which are temporary in nature such as non-availability of adequate drawing

power based on the latest available stock statement, balance outstanding exceeding the

limit temporarily, non-submission of stock statements and nonrenewal of the limits on the

due date, etc.

drawings are permitted in the account for a continuous period of 90 days even

though the unit may be working or the borrower's financial position

is satisfactory.

Q6). a) Briefly explain the use of Duration in management of Interest rate risk.

b) List the various theories concerning term structure of interest rates. Give

example from the various segments of the Indian financial market, which are

experiencing flat and downward sloping yield curves respectively.

A) Interest Rate Risk

The change in bond values as a result of change in market interest rate or required rate of

return of the investors is known as Interest rate risk. Investment is fixed interest securities

become risky because of existence of interest rate risk.

An investor needs a measure of average maturity on the basis of promised cash flows.

Effective maturity of a bond is known as duration of a bond. Duration is a measure of

time. Also it may be defined as the weighted average of the lengths of time until the

remaining cash flows are received. Hence duration is a measure of the length of time at

the end of which the investor would get his investment returned.

Duration is a measure of the interest rate risk of a bond. It shows the sensitivity of a

bonds price to interest rate changes and also takes into account the timing of the bonds


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cash flows. It is a measure of how responsive a bond price is to changing interest rates.

Duration is a relative change in prices with respect to changes in interest rates.

B) Theories of term structure of Interest rate risk

Several theories of interest rates have been structured to explain the shape, slope and

change of yield curve. Some of these are:

a) Market expectations (pure expectations) Theory

This theory assumes that the various maturities are perfect substitutes and suggests that

the shape of the yield curve depends on market participants' expectations of future

interest rates. Using this, future rates, along with the assumption that arbitrage

opportunities will be minimal in future markets, and that future rates are unbiasedestimates of forthcoming spot rates, is enough information to construct a complete

expected yield curve.

For example, if investors have an expectation of what 1-year interest rates will be next

year, the 2-year interest rate can be calculated as the compounding of this year's interest

rate by next year's interest rate.

More generally, rates on a long-term instrument are equal to the geometric mean of theyield on a series of short-term instruments. This theory perfectly explains the observation

that yields usually move together. However, it fails to explain the persistence in the shape

of the yield curve.

Shortcomings of expectations theory: Neglects the risks inherent in investing in bonds

(because forward rates are not perfect predictors of future rates).

1) Interest rate risk 2) Reinvestment rate risk

b) Liquidity premium theory

The Liquidity Premium Theory is an offshoot of the Pure Expectations Theory. The

Liquidity Premium Theory asserts that long-term interest rates not only reflect investors

assumptions about future interest rates but also include a premium for holding long-term


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bonds (investors prefer short term bonds to long term bonds), called the term premium or

the liquidity premium. This premium compensates investors for the added risk of having

their money tied up for a longer period, including the greater price uncertainty. Because

of the term premium, long-term bond yields tend to be higher than short-term yields, and

the yield curve slopes upward. Long term yields are also higher not just because of the

liquidity premium, but also because of the risk premium added by the risk of default from

holding a security over the long term.

c) Market segmentation theory

This theory is also called the segmented market hypothesis.

In this theory, financial instruments of different terms are not substitutable. As a result,

the supply and demand in the markets for short-term and long-term instruments is

determined largely independently. Prospective investors decide in advance whether they

need short-term or long-term instruments. If investors prefer their portfolio to be liquid,

they will prefer short-term instruments to long-term instruments. Therefore, the market

for short-term instruments will receive a higher demand. Higher demand for the

instrument implies higher prices and lower yield. This explains the stylized fact that

short-term yields are usually lower than long-term yields. This theory explains thepredominance of the normal yield curve shape. However, because the supply and demand

of the two markets are independent, this theory fails to explain the observed fact that

yields tend to move together (i.e., upward and downward shifts in the curve).

Q7). Distinguish between :

(a) NBFCs and SFCs

(b) Cedit Gap and Maturity Gap

(c) Mutual fund and Asset management Company(AMC)

NBFCs and SFCs

NBFCs - Non-banking financial companies, or NBFCs, are financial institutions thatprovide banking services, but do not hold a banking license. These institutions are not

allowed to take deposits from the public. Nonetheless, all operations of these institutions

are still covered under banking regulations.


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NBFCs do offer all sorts of banking services, such as loans and credit facilities,

retirement planning, money markets, underwriting, and merger activites. The number of

non-banking financial companies has expanded greatly in the last several years as venturecapital companies, retail and industrial companies have entered the lending business.

SFCs - In order to provide medium and long term credit to industrial undertaking, which

fall outside the normal activities of commercial banks, a central industrial financecorporation was set up under the industrial Finance Corporations act, 1948.The state

governments wished that similar corporations should be set up in their states to

supplement the work of industrial financial corporation. The intention is that the Statecorporations will confine to financing medium and small scale industrial and will , as far

as possible consider only such access which are outside the preview of industrial fianc

corporation .

Credit Gap and Maturity Gap

Credit Gap- It refers to a situation where supply of credit does not match with that of

supply of the credit.Maturity Gap- A measurement of interest rate risk for risk-sensitive assets and

liabilities. The market values at each point of maturity for both assets and liabilities areassessed, then multiplied by the change in interest rate and summed to calculate the

net interest income or expense

This method, while useful, is not as popular as it once was due to the rise of newtechniques in recent years. Newer techniques involving asset/liability duration and value

at risk have largely replaced maturity gap analysis.

Mutual fund and Asset management Company(AMC)

Asset management Company

A company that invests its clients' pooled fund into securities that match its declaredfinancial objectives. Asset management companies provide investors with more

diversification and investing options than they would have by themselves.

Mutual funds, hedge funds and pension plans are all run by asset managementcompanies. These companies earn income by charging service fees to their clients

AMCs offer their clients more diversification because they have a larger pool of

resources than the individual investor. Pooling assets together and paying out

proportional returns allows investors to avoid minimum investment requirements oftenrequired when purchasing securities on their own, as well as the ability to invest in a

larger set of securities with a smaller investment.

Mutual Fund Company a regulated investment company with a pool of assets thatregularly sells and redeems its shares. A mutual fund is a collection of a wide number of

stock and bond combinations held by individuals that are entrusted to a mutual fund

companyThe manager of the mutual fund will develop the mutual fund with the purposeof making a certain investment objective A mutual fund is a collection of a wide number

of stock and bond combinations held by individuals that are entrusted to a mutual fund

company.


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Submitted To Submitted By:

Ms.Meenakshi Kaushik Ms. Nidhi Sharma

HoD, MBA Assistant Professor

RDIAS RDIAS


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Documents

2006 ipu exam paper