Full Marks: 80
Time: 3 hours
The figures in the margin indicate full marks for the questions
1. (a) “Financial Management is an integral part of General Management process in most companies”. Examine the statement. (16)
-> Financial management plays a critical role in the financial success of a business. Therefore, an organization should consider financial management as a key component of the general management of the organization. The goal of Financial management includes the tactical and strategic goals related to the financial resources of the business. Some of the specific roles included in banking administration systems include accounting, bookkeeping, accounts payable and receivable, investment opportunities, and risk.
The goal of financial management is one of the most important responsibilities of owners and business leaders . They must consider the potential consequences of their management decisions on profits, cash flow, and the financial condition of the company. The activities of every aspect of a business have an impact on the company’s financial performance and must be evaluated and controlled by the business owner.
MBA Finance or banking administration is an essential part of the economic and non-economic activities which leads to decide the efficient procurement and utilization of finance in a profitable manner. Earlier, Financial administration was a part of accountancy with the traditional approaches. Nowadays it has been enlarged with innovative and multi-dimensional functions in the field of business. With the effect of industrialization, banking administration has become a vital part of the business concern and they are concentrating more in the field of the banking industry. This Management also developed as corporate finance, business finance, financial economics, financial mathematics, and financial engineering.
Financial management is called upon to take three major decisions:
1. Investment decision; e.g., capital budgeting or financial plan.
2. Financing decision or formulation of the best financing mix or capital structure of the enterprise; and
3. Dividend decision or dividend policy.
Financial management involves the implementation of these three major decisions. The decisions are interrelated and should be implemented jointly. Together, these vital decisions determine the value of the enterprise to its shareholders and investors. It makes use of analytical tools in the analysis, planning, and control of the enterprise involving funds.
Importance of Financial Management
It is an integral part of overall management rather than merely a staff activity concerned with money managing operations.
1. Financial Management Helps Setting Clear Goal
The clarity of the goal is important for any firm. Financial management defines the goal of the firm in clear terms (maximization of the shareholder’s wealth). The setting goal helps to judge whether the decisions taken are in the best interest of the shareholders or not. It also directs the efforts of all functional areas of business towards achieving the goal and facilitates among the functional areas of the firm.
2. Financial Management Helps Efficient Utilization Of Resources
Firms use fixed as well as current assets which involve a huge investment. Acquiring and holding assets that do not earn a minimum return do not add value to the shareholders. Moreover, the wrong decision regarding the purchase and disposal of fixed assets can cause a threat to the survival of the firm. The application of financial management techniques (such as capital budgeting techniques) helps to answer the questions like which asset to buy when to buy and whether to replace the existing asset with a new one or not.
The firm also requires current assets for its operation. They absorb a significant amount of a firm’s resources. Excess holdings of these assets mean inefficient use and inadequate holding exposes the firm to higher risk. Therefore, maintaining the proper balance of these assets and financing them from proper sources is a challenge to a firm. It helps to decide what level of current assets is to be maintained in a firm and how to finance them so that these assets are utilized efficiently.
3. Financial Management Helps Deciding Sources Of Financing
Firms collect long-term funds mainly for purchasing permanent assets. The sources of long-term finance may be equity shares, preference shares, bonds, term loans, etc. The firm needs to decide the appropriate mix of these sources and the number of long-term funds; otherwise, the firm will have to bear the higher cost and expose to higher risk. Financial management (capital structure theories) guides in selecting these sources of financing.
4. Financial Management Helps Making Dividend Decision
The dividend is the return to the shareholders. The firm is not legally obliged to pay a dividend to the shareholders. However, how much to pay out of the earning is a vital issue. Financial management (dividend policies and theories) helps a firm to decide how much to pay a dividend and how much to retain in the firm. It also suggests answering questions such as when and in what form (cash dividend or stock dividend) should the dividend be paid?
The goal of financial management is not limited to the managers who make decisions in the firm. Proper finance management will help firms to supply better products to their customers at lower prices, pay a higher salary to its employees, and still provide a greater return to investors.
A business enterprise as a system has a dynamic flow of funds represented by the funds- flow cycle. Financial management is in charge of efficient planning and control of the cycle of the flow of funds inflow and outflow of funds.
The scope of Financial Management
The scope of financial management includes the following:
Economic concepts (such as macro and microeconomics, economic order quantity, money value discounting factor, and more) are directly applied with the banking administration approaches.
· Accounting plays a critical role in management decision making and in ‘financial management’.
· It applies a large number of mathematical and statistical tools and concepts (also known as econometrics).
· Production management is the operational aspect of decision making requiring the support of financial management.
· The Finance department allocates resources for marketing and related activities that play a crucial role in a firm’s marketing budget.
· It is related to the human resource department, which provides manpower to all the functional areas of management.
The traditional approach to the scope of financial management refers to its subject matter, in academic literature in the initial stages of its evolution, as a separate branch of academic study. The term ‘corporation finance’ was used to describe what is now known in the academic world as ‘financial management’. As the name suggests, the concern of corporation finance was with the financing of corporate enterprises. In other words, the scope of the finance function was treated by the traditional approach in the narrow sense of procurement of funds by the corporate enterprise to meet their financing needs.
The modern approach views the term financial management in a broad sense and provides a conceptual and analytical framework for financial making. According to it, the finance function covers both acquisitions of funds as well as their allocations. Thus, apart from the issues involved in acquiring-external funds, the main concern of banking and finance management is the efficient and wise allocation of funds to various uses. Defined in a broad sense, it is viewed as an integral part of overall management. The new approach is an analytical way of viewing the financial problems of a firm. The main contents of this approach are what is the total volume of funds an enterprise should commit? What specific assets should an enterprise acquire? How should the funds require to be financed? Alternatively, the principal contents of the modern approach to financial management can be said to be: (i) How large should an enterprise be, and how fast should it grow? (ii) In what form should it hold assets? and (iii) What should be the composition of its liabilities? The three questions posed above cover between them the major financial problems of a firm. In other words, financial administration, according to the new approach, is concerned with the solution of three major problems relating to the financial operations of a firm, corresponding to the three questions of investment, financing, and dividend decisions. Thus, financial management, in the modem sense of the term, can be broken down into three major decisions as functions of finance: (i) The investment decision, (ii) The financing decision, and (iii) The dividend policy decision.
(b) What is the traditional concept of finance and how do you see the transition to the new approach? (16)
-> The following points highlight the three main approaches to financial management. The approaches are: 1. Traditional View 2. Modern View 3. Liquidity and Profitability.
Approach 1- Traditional View:
Financial management is primarily concerned with acquisition, financing and management of assets of business concern in order to maximize the wealth of the firm for its owners. The basic responsibility of the Finance manager is to acquire funds needed by the firm and investing those funds in profitable ventures that will maximize firm’s wealth, as well as, yielding returns to the business concern.
The success or failure of any firm is mainly linked with the quality of financial decisions. The focus of Financial management is on efficient and judicious use of resources to attain the desired objective of the firm.
The basic objectives of Financial management centres around (a) the procurement funds from various sources like equity share capital, preference share capital, debentures, term loans, working capital finance, and (b) effective utilization of funds to maximize the profitability of the firm and the wealth of its owners.
The responsibilities of the Finance managers are linked to the goals of ensuring liquidity, profitability or both and are also related to the management of assets and funds of any business enterprise.
The traditional view of financial management looks into the following functions, that a Finance manager of a business firm will perform:
(a) Arrangement of short term and long-term funds from financial institutions.
(b) Mobilization of funds through financial instruments like equity shares, preference shares, debentures, bonds etc.
(c) Orientation of finance function with the accounting function and compliance of legal provisions relating to funds procurement, use and distribution.
With the increase in complexity of modern business situation, the role of a Finance manager is not just confined to procurement of funds, but his area of functioning is extended to judicious and efficient use of funds available to the firm, keeping in view the objectives of the firm and expectations of the providers of funds.
Approach 2- Modern View:
The globalization and liberalization of world economy has caused to bring a tremendous reforms in financial sector which aims at promoting diversified, efficient and competitive financial system in the country. The financial reforms coupled with diffusion of information technology has caused to increase competition, mergers, takeovers, cost management, quality improvement, financial discipline etc.
Globalization has caused to integrate the national economy with the world economy and it has created a new financial environment which brings new opportunities and challenges to the individual business concern. This has led to total reformation of the finance function and its responsibilities in the organization.
Financial management in India has changed substantially in scope and complexity in view of recent Government policy. Today’s Finance managers are seized with problems of financial distress and are trying to overcome it by innovative means. In the current economic scenario, financial management has assumed much greater significance.
It is now a question of survival of entities in the total spectrum of economic activity, with pragmatic readjustment of financial management. The information age has given a fresh perspective on the role of financial management and Finance managers. With the shift in paradigm it is imperative that the role of Chief Finance Officer (CFO) changes from Controller to a Facilitator.
In view of modern approach, the Finance manager is expected to analyse the firm and to determine the following:
(i) The total funds requirement of the firm,
(ii) The assets to be acquired, and
(iii) The pattern of financing the assets.
The Finance manager of a modern business firm will generally involve in the following three types of decisions:
(1) Investment decisions,
(2) Finance decisions, and
(3) Dividend decisions.
(1) Investment Decisions:
Investment decisions are those which determine how scarce resources in terms of funds available are committed to projects. The project may be as small as purchase of equipment or as big as acquisition of an entity.
Investment in fixed assets requires supporting investment in working capital in the form of inventory, receivables, cash etc. Investment which enhance internal growth is termed as ‘internal investment’ and acquisition of entities represents ‘external investment’.
The investment decisions should aim at investment in assets only when they are expected to earn a return greater than a minimum acceptable return, which is also called as ‘hurdle rate’. The minimum return should reflect whether the money raised from debt or equity meets the returns on investments made elsewhere on similar investments.
The hurdle rate has to be set at higher for riskier projects and has to reflect the financing mix used i.e., the proportion of debt and equity. The Finance function involves not only in investment decisions, but also in disinvestment decisions, for example withdrawing from unsuccessful projects or restructuring with a strategic motive.
Investment decisions relate to the careful selection of viable and profitable investment proposals, allocation of funds to the investment proposals with a view to obtain net present value of the future earnings of the company and to maximize its value.
It is the function of a Finance manager to carefully analyze the different alternatives of investment, determination of investment levels in different assets i.e., fixed assets and current assets.
The investment decisions of a Finance manager cover the following areas:
(a) Ascertainment of total volume of funds, a firm can commit.
(b) Appraisal and selection of capital investment proposals.
(c) Measurement of risk and uncertainty in the investment proposals.
(d) Prioritizing of investment decisions.
(e) Funds allocation and its rationing.
(f) Determination of fixed assets to be acquired.
(g) Determination of levels of investments in current assets viz., inventory, receivables, cash, marketable securities etc., and its management.
(h) Buy or lease decisions.
(i) Asset replacement decisions.
(j) Restructuring, reorganization, mergers and acquisitions.
(k) Securities analysis and portfolio management etc.
(2) Finance Decisions:
The financing objective asserts that the mix of debt and equity chosen to finance investments should maximize the value of investments made. The debt equity mix should minimize the hurdle rate allows the firm to take more new investments and increase the value of existing investments.
Financing decisions relate to acquiring the optimum finance to meet financial objectives and seeing that working capital is effectively managed. Financing decisions call for good knowledge of costs of raising finance, procedures in hedging risk, different financial instruments and obligations attached to them etc. Important principle to consider in financing is that long-term assets should be financed with long-term debt and short-term assets should be financed with short-term debt.
Firms that violate this basic rule do so at their own risk. It is one of the important functions of a Finance manager is procurement of funds for the firm’s investment proposals and its working capital requirements.
In fund raising decisions, he should keep in view the cost of funds from various sources, determination of debt-equity mix, the advantages and disadvantages of debt component in the capital mix, impact of taxation and depreciation in maximization of earnings per share to the equity holders, consideration of control and financial strain on the firm in determining level of gearing, impact of interest and inflation rates on the firm etc.
The Finance manager involved in the following finance decisions:
(a) Determination of degree or level of gearing.
(b) Determination of financing pattern of long-term funds requirement.
(c) Determination of financing pattern of medium and short-term funds requirement.
(d) Raising of funds through issue of financial instruments viz., equity shares, preference shares, debentures, bonds etc.
(e) Arrangement of funds from banks and financial institutions for long-term, medium-term and short-term needs.
(f) Arrangement of finance for working capital requirement.
(g) Consideration of interest burden on the firm.
(h) Consideration of debt level changes and its impact on firm’s bankruptcy.
(i) Taking advantage of interest and depreciation in reducing the tax liability of the firm.
(j) Consideration of various modes of improving the earnings per share and the market value of the share.
(k) Consideration of cost of capital of individual components and weighted average cost of capital to the firm.
(l) Analysis of impact of different levels of gearing on the firm and individual shareholder.
(m) Optimization of financing mix to improve return to the equity shareholders and maximization of wealth of the firm and value of the shareholders’ wealth.
(n) Portfolio management.
(o) Consideration of impact of over capitalization and under capitalization on the firm’s profitability.
(p) Consideration of foreign exchange risk exposure of the firm and decisions to hedge the risk.
(q) Study of impact of stock market and economic conditions of the country on modes of financing.
(r) Maintenance of balance between owners’ capital to outside capital.
(s) Maintenance of balance between long-term funds and short-term funds.
(t) Evaluation of alternative use of funds.
(u) Setting of budgets and review of performance for control action.
(v) Preparation of cash-flow and funds flow statements and analysis of performance through ratios to identify the problem areas and its correction, etc.
For financing decisions, the capital structure is broadly divided into:
(a) Equity, and
The raising funds through issue of shares attract flotation costs. The shareholder expects the return in the form of dividends and capital appreciation of their investment reflected in the increase in stock market price.
The dividend payments are made only if the distributable profits are available with the company, after payment of interest charges and tax payments. Any further issue of shares by the existing companies may dilute the controlling interest.
The equity is considered as low risk but most expensive way of funding the company’s projects. The equity funds are not returnable except in the case of liquidation. However, the buy-back of shares is allowed under the provisions of the Companies Act, 1956.
The equity holders will participate in the policy decisions of the company. In company form of business, only legal personality exists, hence all decisions are carried through the agents who work for remuneration. Therefore, agency problems arise with the managers.
The debt funds are raised in the form of debentures, bonds, term loans etc. The expectation of the providers of debt is obtain return in the form of interest payments which should commensurate with the risk attached to their investment. The debt is repaid as per the agreement. The interest should be paid irrespective of the profitability of the firm.
The portion of debt component in capital structure will facilitate the trading on equity Le. the interest on debt is payable at a fixed rate and if the firm’s return on capital employed is more than the interest payable, the excess return over fixed interest will be added to the profits available to equity providers.
But the high proportion of gearing i.e., excess reliance on debt funds will increase the financial risk of the firm. The cost of debt is always lower than cost of equity, since any interest payable will reduce the tax liability of the firm. The non-repayment of interest and principal amounts in time may sometimes call for liquidation of the company.
(3) Dividend Decisions:
Dividend decisions concerned with the determination of quantum of profits to be distributed to the owners and the frequency of such payments. The dividend decisions will effect in two ways (a) the amount to be paid out and its influence on share price, and (b) the amount of profit to be retained for internal investment which maximizes the value of firm and ultimately improves the share value of the firm.
The level and regular growth of dividends represent a significant factor in determining a profit-making company’s market value and the value of its shares in the stock market. The dividend decisions of a Finance manager is mainly concerned with the decisions relating to the distribution of earnings of the firm among its equity holders and the amounts to be retained by the firm.
The Finance manager will involve in taking the following dividend decisions:
(a) Determination of dividend and retention policies of the firm.
(b) Consideration of impact of levels of dividend and retention of earnings on the market value of the share and the future earnings of the company.
(c) Consideration of possible requirement of funds by the firm for expansion and diversification proposals for financing existing business requirements.
(d) Reconsideration of distribution and retentions policies in boom and recession periods.
(e) Considering the impact of legal and cash-flow constraints on dividend decisions.
The investment, finance and dividend decisions are interrelated to each other and, therefore, the Finance manager while taking any decision, should consider the impact from all the three angles simultaneously.
In the words of Ezra Solomon “the function of Financial management is to review and control decision to commit and recommit funds to new and on going uses. Thus in addition to raising funds, Financial management is directly concerned with production, marketing and other, functions within an enterprise whatever decisions are made about the acquisition or distribution of assets”.
This statement will reflect the modern view of financial management. From the point of view of modern corporate firm, financial management is related not only to fund raising but encompasses the wider perspective of managing the finances for the company efficiently. Hence, Financial management is nothing but managerial decision making on asset mix, capital mix and profit allocation.
The corporate finance theory centres around three important objectives of a finance function:
(a) Allocation of funds i.e. investment decisions,
(b) Generation of funds i.e. financing decisions, and
(c) Distribution of funds i.e., dividend decisions.
The guiding factors for the above said finance decisions are as follows:
(i) The wealth maximization objective of firm, and
(ii) The existence of efficient capital markets.
The whole subject of financial management is based on following tenets:
(a) The owners will have primary interest in the firm’s success and growth.
(b) The shareholder’s wealth is the determinant of current share price.
(c) The firm will go on spending on capital investment proposals so long as it generates positive net present values.
(d) The firm’s capital structure and dividend decisions are irrelevant, since they are guided by the management control over firm and also depends on the efficiency of capital market.
Interrelationship of Investment, Financing and Dividend Decisions:
The corporate finance theory has broadly categorized the financial decisions into investment, financing and dividend decisions. All these financial decisions aims at the maximization of shareholders’ wealth through maximization of firm’s wealth.
i. Investment Decisions:
The firm should select only those capital investment proposals whose net present value is positive and the rate of return on the projects should exceed the marginal cost of capital. In situations of capital rationing, the investment proposals are selected based on maximization of net present value. The profitability of each individual project will contribute to the overall profitability of the firm and leads to creation of wealth.
ii. Financing Decisions:
The financing of capital investment proposals are done in two forms of finances in general i.e., equity and debt. The finance decisions should consider the cost of finance available in different forms and the risks attached to it. The reduction in cost of capital of each component would lead to reduction in overall weighted average cost of capital.
The principle of trading on equity should be kept in view while selecting the debt-equity mix or capital structure decisions. The relative advantages and risk attached to debt financing and equity financing should also be considered. The lower cost of capital and minimization of risks in financing will lead to the profitability of the organization and create wealth to the owners.
iii. Dividend Decisions:
The dividend distribution policies and retention of profits will have ultimate effect on the firms wealth. The company should retain its profits in the form of reserves for financing its future growth and expansion schemes. The conservative dividend payments will adversely affect the firms’ share prices in the market. Therefore, an optimal dividend distribution policy will lead to the maximization of shareholders’ wealth.
In conclusion, it is viewed that the basic aim of the investment, financing and dividend decisions is maximize the firm’s wealth. If the firm enjoys the stability and growth, its share prices in the market will improve and will lead to capital appreciation of shareholders’ investment; and ultimately maximizes the shareholders wealth.
Approach 3- Liquidity and Profitability:
Ezra Solomon states that “liquidity measures a company’s ability to meet expected as well as unexpected requirements of cash to expand its assets, reduce its liabilities and cover up any operating losses.”
The balancing of liquidity and profitability is one of the prime objectives of a Finance manager. One of the important problems faced by Finance manager is the dilemma of liquidity vs. profitability. Liquidity ensures the ability of the firm to honour its short-term commitments.
The liquidity means the firm’s ability to pay trade creditors as and when due, ability to honour its bills payable on due-dates, ability to pay salaries and wages on time when it is due, ability to meet unexpected expenses etc. It also reflects the firm’s ability to convert its assets into cash, cash equivalents and other most liquid assets.
The liquidity of the firm indicates the ability of the organization to realize value in money, and its ability to pay in cash the obligations that are due for payment. To maintain concern’s liquidity, the Finance manager is expected to manage all its current assets and liquid assets in such a way as to ensure its affectivity with a view to minimize its costs. Under profitability objective, the Finance manager has to utilize the funds in such a manner as to ensure the highest return.
Profitability concept signifies the operational efficiency of an organization by value addition through the utilization of resources i.e., men, materials, money and machines. It refers to a situation in terms of efficiency in utilization of resources to achieve profit maximization for the owners.
There is an inverse relationship between profitability and liquidity. The higher the liquidity the lower will be the profitability and vice versa. Liquidity and profitability are competing goals for the Finance manager. Under liquidity management, the Finance manager is expected to manage all its current assets including near cash assets in such a way as to ensure its affectivity with a view to minimize costs.
Sometimes, even if the profit from operations is higher, the firm may face liquidity problems due to the fact that the amount representing the profit may be in the form of either in fixed assets like plant, buildings etc. or in the form of current assets like inventory, debtors – other than in the form of cash and bank balances. In situations where the firm faces the liquidity problems, will hamper the working of the company which result in lower profitability of the firm.
If, more assets of the firm are held in the form of highly liquid assets it will reduce the profitability of the firm. Lack of liquidity may lead to lower rate of return, loss of business opportunities etc.
Therefore, a firm should maintain a trade-off situation where the firm maintains its optimum liquidity for greater profitability and the Finance manager has to strike a balance between these two conflicting objectives. If, more assets of the firm are held in the form of highly liquid assets, it will reduce the profitability of the firm.
2. (a) Who needs financial information for analysis? What information is needed and for what purposes? (8+8=16)
(b) The following figures apply to a small manufacturing company.
Annual sales for the previous year
Profit after tax for the previous year
Budget annual sales for the next year
Budgeted profit after tax for the next year
In the first of the two years, the average total assets amounted to Rs. 2,00,000, and are estimated to be Rs. 2,20,000 for the next year. Assuming full budget realization and taking turnover into account, what alteration will take place in the ratio representing return on capital employed and what are the reasons?
3. (a) Explain Public issue of Equity and Rights issue of Equity shares. (8+8=16)
-> A company relies on various methods to raise funds like public issues, debentures, financial assistance from banks, etc. to meet its day-to-day business needs and working capital requirements. The fund requirement of a company can either be short term or long term, and depends upon the type of project it is working on. The sources of funds available to a business in India can be classified as:
· Public Issue
1. Initial Public Offer (IPO)
2. Further Public Offer (FPO)
3. Offer for Sale
· Right Issue
· Bonus Issue
· Private Placement
1. Preferential Issue
2. Qualified Institutional Placement
In India, Public Issues is one of the most prevalent forms of raising funds from a large group of investors. In this process, a company offers prospectus to invite the general public to purchase its shares by paying the share application money. It is a way of offering convertible shares or securities in the primary market to attract new investors for the subscription.
The advantages of Public Issues can be summarised as follows:
- Repayment of Capital
If a company raises capital through Public Issues, there is no need to repay the amount to the investors except when the company goes into the winding-up process.
- Rate of Interest
Unlike debentures, public issues do not provide any fixed rate of interest.
- Transfer of Securities
In comparison to debentures, the ownership of a shareholder is easily transferable in the case of public issues.
As compared to any other form of securities, shares are more liquid as they can be converted into cash easily.
- Enhancing value
The goodwill of a company increases when it trades shares on a recognised stock exchange. It also increases the level of transparency and trust among the investors and the public.
Types of Public Issues
The entry norms of public issue are governed by the SEBI (Securities Exchange Board of India) through its provisions under the SEBI (Disclosure for Investor & Protection) Guidelines, 2000. In India, the types of public issues are:
· Initial Public Offer (IPO) for Unlisted Companies;
· Further Public Offer (FPO) for Listed Companies;
· Offer for Sale.
Right issue of equity shares:-
A rights issue is a primary market offer to the existing shareholders to buy additional shares of the company on a pro-rata basis within a specified date at a discounted price than the current market price.
It is important to note that the rights issue offer is an invitation that provides an opportunity for existing shareholders to increase their shareholding. It is a right that a shareholder may or may not choose to exercise and not an obligation to buy the shares.
Advantages and Disadvantages of Right Issue of Shares
The rights issue refers to buying the existing shares of a company at a discounted price on a particular ratio. Equity capital can be fulfilled using a rights issue. The rights issue gives the option to the existing shareholders to purchase shares at a lower price on or before a specified date, to remain their existing shareholding percentage. The following are the advantages and disadvantages of the right issue.
Advantages of Right Issue of Shares
1. The right issue is a fast source of raising funds
Issuing rights is the fastest method and the cheapest source of raising capital for a firm. Our shareholders can buy new shares at a discount for a certain period on the right issue. The right issue involves less rigorous rules and regulations as it is more of an internal matter in the company.
2. The right issue incurs low cost
A company can initiate the rights issue process to its existing shareholders at indigent times without incurring underwriting fees. The company also saves money that is spent on advertising, underwriting fee, etc. The company does not have to incur such expenses compared with raising fresh equity from an IPO.
3. The right issue provides an option for the shareholders to maintain the same ownership
The number of additional share purchases allowed to an existing shareholder is always in proportion to his existing shareholding. Shareholders have the option to maintain their original proportion of share ownership.
Existing shareholders will have more certainty of getting shares, when a fresh issue is made to the existing shareholders, instead of the general public. The share price of the right issue will be less than the current share price which attracts the existing shareholders.
4. Raise funds without a form of debt
The right issue is a process to raise capital wherein the company can raise capital without any increase in debt. The company can raise the capital from its existing shareholders without altering the shareholder’s holding percentage. The scope of the right issue is purely in the form of equity and it eliminates any scope for debt.
5. The board of directors cannot misuse share issuing option
The board cannot misuse the opportunity of issuing new shares at a lower price. The right issue shares offered proportionately to the existing shareholders according to their existing holdings. Directors do not have much control over the right issue.
Disadvantages of Right Issue of Shares
1. The existing shareholding percentage may get diluted
Existing shareholders have the option either to ‘subscribe’ to the right issue or ‘ignore’ to the right issue. If a shareholder ‘ignore’ the right issue then their shareholding percentage will get diluted. This is due to the extra shares issued by the company if it is ‘ignore’ by existing shareholders. If more shareholders ‘ignore’ the right issue then there are chances of stake dilution of the existing shareholders. As the existing shareholder percentage gets reduced with the initiation of new shareholders, it could be a troublesome situation for the existing shareholders.
2. After the right issue share price gets decrease
After the right issue, a certain percentage of shares will be newly introduced at a discounted price. This results in a dilution of the previous share price. Dilution occurs because a new large number share spreads the company’s net profit.
3. Limitation of fund raise
Most of the stock exchanges have put certain limits or restrictions on the amount of a company could rise through a rights issue. This limit is usually decided based on the existing equity value of the firm. The company cannot raise an amount compared to an IPO (Initial Public Offering). Raising funds through the right issue might create pressure on the company if a company has undervalued stocks.
4. The negative effect of the company’s public image
The right issue is an indication of liquidity crises that a company suffers. Generally, companies will practice the right issue option in the case of a financial crisis. The brand name of the company could negatively be affected when the right issue is announced. In another way, the shareholders also could assume that the company is struggling to run its business and could tend to sell their shares, which could then reduce the share price further.
(b) Explain how would go for reporting of ordinary shares. (16)
-> Ordinary shares, also known as common shares, is defined as shares of a company that give shareholders the right to vote in the company’s meeting and also an income in the form of dividends from the corporation’s profits.
Common shares are one of the most common types of shares. The number of ordinary shares an investor owns is proportional to the percentage of ownership he/she has in a company. For instance, if a company issues all of its 50 shares in the stock market and you own 30 out of them. You would have a 60% ownership of the company.
Ordinary shares come with a wide array of benefits. Not only do you have the right to vote in the company’s meetings on various matters concerned with the shareholders, but you can also claim a proportional income in the form of dividends depending on the company’s performance.
Also, common shares do not carry a maturity date. Meaning your ownership in the company remains unaffected until the company decides to delist itself or when another company takes over.
Ordinary or common shares are generally issued in the stock market to raise capital for the company. Even if the company wishes to issue more shares in the future, shareholders are first given the option to purchase the issued shares in proportion to your prevailing ownership through the rights issue. This ensures that the holders’ shares in the company remain undiluted.
Ordinary shareholders are often referred to as unsecured creditors as shareholders are the last in line to receive dividends if any. The company first distributes the dividends among its preferred shareholders and bondholders. Only then are the dividends, if any, are made available to the ordinary shareholders.
Despite the high financial risk, ordinary shareholders are rewarded greater when compared to preferred shareholders. Unlike the latter whose dividends are fixed or limited, ordinary shareholders are entitled to a greater chunk of the profits if the company performs well.
Ordinary Shares Capital Formula
The formula for ordinary shares capital as per below:
Ordinary Share Capital = Issue Price of Share – Number of Outstanding Shares
· The issue price of the share is the face value of the share at which it is available to the public.
- The number of outstanding shares is the number of shares available to raise the required amount of capital.
4. (a) What is trade credit? How would you stretch Account payable? (8+8=16)
Trade Credit is the credit extended by one trader to another for the purchase of goods and services. It facilitates the purchase of supplies without immediate payment and is commonly used by business organizations as a source of short-term financing. Trade credit appears in the records of the buyer of goods as ‘sundry creditors’ or ‘accounts payable’. It is granted prudently to those customers who have reasonable amount of financial standing and goodwill. The volume and period of credit extended depends on factors such as reputation of the purchasing firm, financial position of the seller, volume of purchases, past record of payment and degree of competition in the market. Terms of trade credit may vary from industry to industry and from person to person. As we know, trade is the purchase and sale of goods on profit motive. So, trade credit strictly refers to the routine business activity.
1. Increased Sales
A customer will buy more of a supplier’s products if they don’t have to pay cash immediately for their purchases. The most common credit term offered by sellers is payment within 30 days. Rarely do you see credit terms extended beyond this time.
2. Customer Loyalty
The extension of credit terms tells the buyer that the seller considers them trustworthy and has confidence that they will pay their bills when they’re due. The buyer rewards the seller’s vote of confidence by continuing to make purchases.
3. Competitive Advantage
A seller who is able to offer trade credit to buyers has an advantage over his competitors, if they are not able to offer credit terms. This makes sense. Naturally, a buyer would prefer to purchase on credit terms than to pay cash for all of his purchases.
4. Incentives for Customers to Pay
Even when they offer 30 days credit, sellers often encourage their customers to pay sooner by offering them a 2 percent discount if they pay with 10 days. The existence of this potential discount is a huge incentive for buyers to pay earlier. If a buyer does not take advantage of the 2 percent discount, this means that he’s paying a very high interest rate to delay payment for the additional 20 days.
1. Negative Effect on Cash Flow
The most immediate effect of trade credit is that sellers do not receive cash immediately for sales. Sellers have their own bills to pay and extending credit terms to buyers creates a hole in their companies’ cash flow.
2. Must Investigate Creditworthiness of Customers
Just like a bank, a vendor who extends credit to customers needs to analyze their credit ratings. This takes money and time. Obtaining business credit reports, such as Dun & Bradstreet, cost money, and making calls to check on references takes time. A vendor may need to hire an additional person who has credit analysis skills to help make the decisions about extending terms of payment.
3. Monitoring Accounts Receivable
Extending credit creates more outstanding accounts receivable, and someone needs to monitor these customers to make sure that they are paying on time. A company that is making its sales in cash does not have this problem.
4. Financing Accounts Receivable
The extension of credit terms to buyers means that the seller has to finance these receivables. A seller may have to lean on his own suppliers to receive trade credit, borrow on his bank line of credit or use the company’s accumulated retained earnings. All of these methods have an inherent cost of capital.
5. Possibility of Bad Debts
Inevitably, the extension of trade credit will lead to some buyers not paying their debts. When this happens, an employee needs to spend time making collection calls to the late payers, and, eventually, the seller may need to write off the unpaid receivables and take a loss.
Extending credit terms to buyers is common in most industries. Businesses must offer some level of extended payments to be competitive in their markets. However, offering credit terms requires taking risks and spending additional time monitoring and collecting accounts receivable.
(b) Write a note on Commercial and Captive Finance Companies. (16)
-> Commercial Finance Companies:-
The definition of a commercial finances company refers to a company that makes loans to commercial businesses or helps finance the sale of a company’s products to its customers.
Not all finance companies lend to commercial businesses, some lend to consumers. As finance companies do not take deposits from the public, they are not considered banks and thus are free from the strict regulations associated with banks. Instead, finance companies earn money from their own lending or from parent companies, which is then used to provide loans. Many finance companies base their loans on the value of the assets promised by their customers as security.
Finance companies provide loans for their customers and typically have higher interest rates than those of banks. This loan interest is how finance companies generate revenue. Many people have poor credit history and will turn to finance companies to offer them loans. These clients offer collateral to secure their loans, typically by promising to give the finance company valuable person assets, if the loan is not repaid.
For example, if Stefano borrows $8,000 from a finance company to fund the launch of his cleaning business, the company may ask that he offer his personal vehicle as collateral. If Stefano fails to make his loan payments (as in, if he defaults on the loan), the company would take possession of his vehicle.
Types of Finance Companies
There are three primary types of finance companies:
· Consumer finance companies.
· Sales finance companies.
· Commercial finance companies.
The first category, consumer finance companies , makes small loans to consumers (individuals), typically with terms that benefit the company and are unfavorable for the consumer. Direct-loan and payday loan companies fall within this category and have a poor reputation for taking advantage of people who are struggling and in need of quick cash.
Consumer finance companies offer loans with higher interest rates than the market average, which are called subprime loans. Many states in the US have small-loan laws that prohibit consumer finance companies from charging interest rates of more than 25 percent.
The second category is sales finance companies, which are also called acceptance companies. These finance companies offer services for businesses in a similar way that direct-loan companies offer services for individuals, with some key differences. The businesses that borrow money from sales finance companies are typically large corporations with impressive credit ratings. A large corporation does not need to secure its loan with collateral. In addition, these businesses often receive better interest rates than they would receive from a bank.
The third category is commercial finance companies, also known as commercial credit companies. These finance companies offer loans to both small and large businesses, usually to help them pay for new equipment or other significant upgrades.
As small businesses pose greater risks to commercial finance companies, they often have to pay higher interest rates than larger businesses. These subprime loans’ interest rates are usually between 0.1 percent and 0.6 percent higher than the loans given by banks to more qualified customers (prime rate loans). This may appear to be a small difference, but for finance companies, this translates into thousands of additional dollars in revenue. However, finance companies are more likely to have delinquent clients than a bank, so this extra money from paying customers helps mitigate these losses.
Commercial Finance Companies
Banks usually offer lower interest rates, more flexible terms, and higher loan amounts than commercial finance companies. The primary reason is that banks are extremely tight with their credit. Only 20 percent of business owners who apply for loans through a bank receive the loan.
On the other hand, alternative lenders, such as finance companies, have much more flexible financing options that allow many small business owners to use their services. Not only do these lenders offer lines of credit and term loans, but they also offer merchant cash advances, invoice financing, short term loans, working capital loans, and much more. In addition, commercial finance companies work much faster than banks. Some might even approve a loan the same day you apply.
Captive Finance Companies:-
A captive finance company is a wholly-owned subsidiary that finances retail purchases from the parent firm. They range from mid-sized entities to giant firms depending on the size of the parent company .
The basic services of a captive finance company include basic card services like a store credit card and full-scale banking. This can offer the parent company a significant source of profit and limit the amount of risk exposure .
A captive finance company is usually wholly owned by the parent organization. The best-known examples of captive finance companies are found in the automobile industry and the retail sector. When it comes to the auto sector, captive finance companies offer car loans to buyers in of need financing. Some examples include General Motors Acceptance Corporation, Toyota Financial Services, Ford Motor Credit Company, and American Honda Finance.
Notably, after the bankruptcy of General Motors in 2009, GMAC underwent a name change to Ally Bank and rebranded as Ally Financial in 2010. Each company represents the financing and credit divisions of the larger brand name automobile manufacturer.
In contrast, retailers use captive finance companies to support store card operations. Store credit cards offer customers various benefits for shopping at specific stores, including free shipping, additional discounts, and amplified rewards with every purchase.
It also helps the parent company reduce risk exposure. The captive company ends up incurring losses rather than the larger corporation when a customer defaults on a store card or fails to make a payment. This enables the parent company to increase sales and avoid the struggle of outsourcing funds from outside lenders. Furthermore, the larger corporation also receives interest from store cards issued by captive companies.
Advantages of a Captive Finance Company
A captive finance company can be a significant driver of sales and profit growth for larger corporations. Customers with store credit cards often have an incentive to spend more at the specific store and benefit from the convenience of owning the card. As for the bottom line, the larger company receives interest payments from past due accounts. This helps fuel earnings growth and profitability.
Loans from a captive finance company can be mutually beneficial for customers as well. Obtaining loans from a captive finance company involves minimal guesswork as rates and payment schedules are often predetermined. Sometimes captive finance companies offer lower loan rates than other types of loan companies. In the auto industry, they can also extend loans to buyers with below-average credit, as they control both the loan and purchase in one sitting.
5. (a) Give an overview of Global Derivatives Markets with special reference to Global derivatives recent trends exchange trade Vs OTC Market. (16)
-> Trading in exchange-trade financial derivatives contracts continued to grow rapidly in 2003, with turnover expanding by 26% to $874 trillion. The compares with increases of 17% in 2002 and 55% in 2001. Business in 2003 was brisk all of the broad market risk categories. Money market contracts accounted for most of the increase in trading in dollar terms but activity in the small market for currency contracts grew at the most rapid pace.
European fixed income business benefits from deepening liquidity
Worldwide trading in fixed income contracts, the largest segment of exchange-trade markets, rose by 27% to $794 trillion. Money market contracts, including futures and options on Eurodollar, Euribor and euryen rates, accounted for the biggest increase in activity in dollar terms, rising by $137 billion, or 25%, to $683 trillion. However, longer-term contracts, largely on government bonds, expanded at a faster pace, up by 41% to 5111 trillion.
One of the most notable developments in the area of money market products was the particularly strong expansion of activity on European exchanges European trading of such instruments, principally on Euribor, jumped by 64% to $278 trillion, compared with an increase of 7% in North America to $369 trillion. Trading in options on European money market rates was particularly buoyant, up by 111% to 583 trillion compared with an increase in futures of 50% to $195 trillion
One of the most notable developments in the area of money market products was the particularly strong expansion of activity on European exchanges. European trading of such instruments, principally on Euribor, jumped by 64% to $278 trillion, compared with an increase of 7% in North America to $369 trillion. Trading in options on European money market rates was particularly buoyant, up by 111% to $83 trillion compared with an increase in futures of 50% to $195 trillion. Trading in European money market instruments has been catching up rapidly with that in North America since 2002. Changing expectations about the stance of monetary policy in the euro zone played a role in the expansion of the short-term segment but activity also appears to have been boosted by a deepening of liquidity in over-the-counter (OTC) derivative instruments indexed to Euribor. In particular, the euro denominated interest rate swap market continued to grow vigorously in 2003, generating a flow of secondary hedging transactions in Euribor futures. The notably strong increase in exchange-traded options may have resulted from a shift of business away from the OTC derivatives market. Volatility in several types of option products traded in the OTC market, including interest, rate swaptions, reached unusually high levels in the second half of 2003. This may have prompted some market participants to switch to exchange- traded instruments.
Activity in longer-term fixed income instruments was also more buoyant on European exchanges than in other major geographical areas. European business in such contracts rose by 49% to 566 trillion, compared with an increase of 36% to 536 trillion in North America. As was the case for European trading in short-term rate contracts, European business in options on government bonds was especially active. Trading in such options rose by 86% to 55.6 trillion compared with an increase in futures of 46% to $60 trillion. Trading in government bond contracts in Europe and North America was fuelled by sharp swings in long-term interest rates in the first three quarters of 2003. The rally in fixed income markets in the first half of the year and its subsequent reversal from the end of June created a heavy volume of rebalancing transactions. Financial institutions, in particular, actively use fixed income futures and options to adjust the duration of their assets and liabilities as the level of interest rates changes. Such “immunization strategies create a positive link between transactions and market movements.
Stock index bustness driven by Astan activity
Global activity in stock index contracts rose by 20% to $75.5 trillion. Business expanded at widely differing rates across the major geographical areas. Turnover in the Asia Pacific region rose by 48% to $27.8 trillion and that in Europe by 19% to $14.7 trillion. The notable increase in activity in Asia was once again largely attributable to robust trading in options on the Korea Stock Exchange’s KOSPI 200 index, with a rise in turnover of such instruments of 49% to $21 trillion. Options trading in Korea was introduced in 1997 but has expanded i exponentially in recent years. Meanwhile, business in Japanese stock index contracts rose by 40% to 53 trillion, a tentative recovery following the stagnation observed in recent years. By contrast, activity in North America was much weaker, with transactions growing by 45 to $32.3 trillion. The upward movement of US equity markets from March onwards was accompanied by significantly lower volatility, realized and implied, which may have acted to weaken investor demand for protection.
Contracts on individual stocks, for which is measured only in terms of the number of contracts, also expanded by 20% in 2003 to 17 billion. Business on North American exchanges rose by 17% to $837 million contracts, while that on European exchanges grew by 8% to 592 million. Trading in the Asia-Pacific region jumped by 112% to 43 million contracts, largely because of the introduction of trading in options in India. Activity in the rest of the world received a boost from a 96% increase in futures and options in Brazil to 176 million.
Currency contracts recover on dollar weakness
Exchanges-traded currency contracts, which account for less than 1% of overall turnover in financial instruments, grew by 51% to $1.4 trillion in 2003. Such contracts appear to have been recovering in recent years from a long period of stagnation. This recovery stems largely from a significant increase in the turnover of dollar/euro futures on the Chicago Mercantile Exchange (CME), the largest marketplace in the world for exchange-traded currency contracts. Trading in such contracts was boosted by protection-seeking as the dollar depreciated sharply in the foreign exchange market. Trading in dollar/yen futures also rose notably, fuelled by the G7 countries’ call in September for more exchange rate flexibility. Market participants noted that the introduction by the CME of round-the-clock electronic trading for its currency contracts in April 2001 had helped enlarge the pool of traders in such instruments. Electronic trading may enable exchanges to complete more effectively with the much larger OTC market for currency instruments.
Commodity contracts grow with the rise of commodity prices
Business in commodity contracts, as measured by the number of contracts traded also expanded in 2003. Overall, turnover rose by 10% to 530 million contracts. Trading in contracts on precious and non-precious metals, which together account for one third of total turnover in commodity contracts, was particularly brisk, up by 26% and 30% respectively. Activity in contracts on non-precious metals appears to have been fuelled by stronger expectations of a pickup in global economic activity. Transactions in contracts on precious metals, especially gold, mirrored to some extent the movements of the dollar, playing the role of safe asset when the slide in the US currency accelerated. By comparison, business in agricultural commodities and energy products was lackluster, with turnover rising by 4% and 2% respectively.
The recent developments in information technology have contributed to the sharp growth in the OTC derivatives,
over the last few years, accompanied by the modernization of commercial and investment banking and the globalization of financial activities. While both exchange-traded and OTC derivative contracts offer many benefits, the former have rigid structures compared with the latter. The episodes of turbulence in financial markets in 1998 revealed the risks posed to market stability originating in features of OTC derivative instruments and markets.
The OTC derivatives markets have the following features, compared to exchange-traded derivatives:
1. The management of counter-party (credit) risk is. decentralized and located within individual institutions;
2 There are no formal centralized limits on individual position, leverage, or margining;
3. There are no formal rules for risk and burden sharing;
4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants, and
5. The OTC contracts are generally not regulated by both a regulatory authority and the exchange’s self regulatory organization, although they are affected. indirectly by national legal systems, banking, supervision and market surveillance.
Some of the features of OTC derivatives markets embody risks to financial market stability. The following features of OTC derivatives markets can give rise to instability in institutions, markets, and the international financial system: (1) the dynamic nature of gross credit exposures; (ii) information asymmetries; (ii) the effect of OTC derivative activities on available aggregate credit; (iv) the high concentration of OTC derivative activities in major institutions, and (v) the central role of OTC derivatives markets in the global financial system. Instability arises when shocks, such as counter-party credit events and sharp movements in asset prices that underlie derivative contracts, occur which significantly alter the perceptions of current and potential future credit exposures. When asset prices change rapidly, the size and configuration of counter-party exposures can become unsustainably large and provoke a rapid unwiding of positions.
There has been some progress in addressing these risks and perceptions. However, the progress has been limited in implementing reforms in risk management, including counter party, liquidity and operational risks, and OTC derivatives markets continue to pose a threat to international financial stability. The problem is more acute as heavy reliance on OTC derivatives creates the possibility of systematic financial incidents, which fall outside the more formal clearing house structures. Moreover, those who provide OTC derivative products, hedge their risks through the use of exchange traded derivatives. In view of the inherent risks associated with OTC derivatives, and their dependence on exchange traded derivatives, Indian laws consider them illegal.
The structure of OTC derivatives markets has also been importantly influenced by developments in the major financial systems. In Japany the withdrawal of Japanese financial institutions from international activity and weak credit ratings for the major financial institutions have also meant their withdrawal from global derivatives markets (though market participants suggest that some major Japanese institutions with relatively high credit ratings may have remained involved in trading with foreign counterparties). However, Japanese financial institutions (including lower-rated city banks, regional banks, and insurance companies) are active in a domestically oriented derivatives market, principally involving yen-denominated interest rate swaps in which Japanese institutions pay floating rates and received fixed rates (e.g., synthetic bond positions funded at floating rates). Given the importance of counterparty credit quality, major global financial institutions have largely stayed out of this market – which is said to account for about half of the yen interest rate swaps market (or some $5 trillion in notional principal). This market is evidently broadly this connected from international markets, with swaps generally indexed to domestic rather than international interbank floating rates (e.g., TIBOR rather than LIBOR).
(b) Give an overview of Derivatives Market structure In India with special reference to forward contracts. (16)
-> Apart from traditional financial markets, two markets are emerging, namely the derivatives market has come into recently and the banc assurance market, which is like to emerge in an important way once banks start undertaking insurance business derivatives in the Indian financial markets are of recent origin barring trade related forward contracts in the forex market. Futures markets in the commodity segment, however, have existed for a long time. Recently, over-the counter (OTC) as well as exchange traded derivatives have been introduced, marking an important development in the structure of financial markets in India. Forward contracts in the forex market have also been liberalized. Exchange traded derivatives tend is more standardized and offer greater liquidity than OTC contacts, which are negotiated between counterparties and tailored to meet the needs of the parties to the contract. Exchange traded derivatives also offer centralized limits on individual positions and have formal rules for risk and burden sharing.
In India, OTC derivatives, viz. Interest Rate Swaps (IRS) and Forward Rate Agreements (FRAS) were introduced in July 1999, while one exchange trade derivative. Viz, Stock Index. Futures were introduced by the two largest stock exchanges in June 2000. The FRA is an off-balance sheet contract between. two parties under which one party agrees on the start date (or trade date) that on a specified future date (the settlement date) that party, rt, the party that agrees, would lodge a notional deposit with the other for a specified sum of money for a specified period of time (the FRA period) at a specified rate interest (the contract rate) The party that has agreed to make the notional deposit has, thus, sold the FRA to the other party who has bought it. The IRS is a contract between two counterparties for exchanging interest payment for a specified period based on a notional principal amount. The notional principal is used to calculate interest payments but is not exchanged. Only interest payments are exchanged. The IRS and FRA were introduced with a view to deepening the money market as also to enable banks, Primary Dealers and financial institutions to hedge interest rate risks. The IRS has emerged as the more popular of the two instruments in the Indian market, accounting for nearly all of the 928 outstanding deals, amounting to Rs. 12,620 crore of notional principal as on November 17, 2000. The overnight call money rates and the forex forward have emerged as the most popular benchmark rates.
A resident of India who had borrowed foreign exchange in accordance with the FEMA, may enter into an interest rate swap or currency swap o coupon swap or foreign currency option or interest rate cap/collar or Forward Rate Agreement (FRA) contract with an authorized dealer (AD) in India or with a branch outside India of an authorized dealer fro hedging his loan exposure and unwinding from such hedges provided that (1) the contract does not involve rupee, (u) foreign currency borrowing has been duly approved, (ii) the notional principal amount of the hedge does not exceed the outstanding amount of the loan, and (iv) the maturity of the hedge does not exceed the un-expired maturity of the underlying loan. As resident in India can enter legally into a foreign exchange derivative contract without the prior permission of the Reserve Bank. Among the non-residents, while FIls may enter into a forward contract with rupees as one of the currencies with an AD in India, non-resident Indians and Overseas Corporate Bodies could take forward cover with an AD to hedge (1) dividend due on shares held in India, (ii) balances in FCNR (B) and NR (E) A, and (iii) the amount of investment made under portfolio scheme. The Reserve Bank may also consider allowing residents to hedge their commodity price risk (including gold but excluding oil and petroleum products (subject to certain conditions.
This market has emerged as an important segment of the forex market in India in the recent years. It comprises customers, such as, corporates, exporters, importers, and individuals. Authorised Dealers (Ads) and the Reserve Bank. Of late, FIls have emerged as major participants in this segment. The marker operates from major centres with Mumbai accounting for bulk of the transactions. Till February 1992, forward contract were permitted only against trade related exposures and these contract could not be cancelled except where the underlying transactions failed to materialize. In March 1992, in order to provide operational freedom to corporate entitles, unrestricted booking and cancellation of forward contracts for all genutne exposures, whether trade related or not, were permitted. At present, the forward contracts market is active up to six months where two-way quotes are available. The maturity profile has recently elongate with quotes available up 10 one year. With the gradual opening up of the capital account, forward premium is now increasingly getting aligned with the interest rate differential. Importers and exporters also influence the forward market in many ways. Besides, banks are allowed to grant foreign Though the Futures & Options segment provides a nation-wide market, Mumb leads the city-wise distribution of contracts traded at 49.08 per cent followed by Delhi (including Ghaziabad) at 24.38 per cent Kolkata (including Howrah) at 12 per cent, and others accounted for balance share of trading. The others include cities such as Kochi, Erukulam, Parur, Kalamasserry, Always at 2.44 per cent each, Ahmedabad (2.25 per cent), Chennai (2.01 per cent), Hyderabad, Secunderabad and Kukatpally at 1.54 per cent and others at 5.80 per cent.
If there is a winner of the current bull run on the bourses, it is undoubtedly the infantile derivatives segment. In the battle for turnover, the derivatives segment has overshadowed the long-established cash market.
Today, in less than three years, the derivatives segment has only overtaken the traditional cash market, but has also emerged as an ideal hedging mechanism in the equities market. The derivatives market was able to beat the cash market in terms of monthly turnover for the first time in February 2003. Then the derivatives segment of the equity market clocked a total monthly turnover of Rs. 49,395 crore compared with the total cash market’s Rs 48,289 crore. By July 2003 the derivatives segment has recorded a turnover of Rs. 109,850 crore, while the cash market segment has been pushed behind with a turnover of Rs. 78,878 crore. The average daily turnover in the derivatives market has touched Rs. 4,776 crore against the cash market turnover of Rs. 3,429 crore. For the past six months (except in the month of May 2003), the monthly volume in the derivatives segment has been higher than in the cash market.
The growing volume turnover indicates a healthy sign. The derivatives segments has brought in a lot of liquidity and depth to the market, and the mind-boggling turnover statistics of the derivatives segment speak for themselves. But why are derivatives such a big hit in Indian market? Generally, the reasons cited are: (i) The derivatives products-index futures, index options, stock futures and stock options provide a carry forward facility for investors to take a position (bullish or bearish) on an index or a particular stock for period ranging from one to three months; (ii) They provide a substitute for the infamous badla system; (ul) The current daily settlement in the cash market has left no room for speculation. The cash market has turned into a day market, leading to increasing attention to derivatives; (iv) Unlike the cash of full payment or delivery, investors don’t need much funds to buy derivatives products. By paying a small margin, one can take a position in stocks or market index: (v) The derivatives volume is also picking up in anticipation of reductions of contract size and finally everything works in a rising market. Unquestionably, there is also a lot of trading interest in the derivatives market.
Futures are more popular in the Indian market as compared to options. The popularity of stock futures can be traced to their similarity to the earlier badla system of carrying forward of trades. Stock futures encourage speculation in the capital market and with speculation being an integral part of the market; the popularity of the product is not a surprise. Also stock futures have the advantage of giving higher exposure by paying a small margin. Also stock futures product like index futures and stock futures are easy to understand as compared to options product. Options’ being more complicated product is nor very much popular in the market if the compare futures, stock futures are much more population as compared to index futures. Starting off with a measly turnover of Rs. 2,811 crore. in November 2001, the stock futures turnover jumped to Rs. 14,000 crore by March 2002, Rs. 32,752 crore in May 2003 and Rs. 70,515 crore in July 2003 Similarly, index futures started its turnover journey with Rs. 35 crore-figure way back in June 2000. The trading interest picked up steadily and jumped to Rs. 524 crore in March 2001, Rs. 1,309 crore in June 2001, Rs. 2747 crore in February 2002, Rs. 3,500 crore in November 2002 and Rs. 14,743 crore in July 2003. Infact, the stock futures were a hit right from their launch. It is important to note that the Securities & Exchange Board of India introduced stock futures in November 2001 after it launched all the other derivative products and now it accounts for nearly 65% of total volumes. In the month of July alone, stock futures considered to be the riskiest of the lot recorded a turnover of Rs. 70,515 crore followed by stock options, index futures and index options.
However, contrary to international experience, the volumes have been so far low in the Indian derivatives market. SEBI’s Technical Group on New Derivative Products has recently. examined this issue, and made the following recommendations: (i) In order to generate volume, the system of sub-brokers be used for trading in derivatives market; (ii) In order to facilitate free arbitrage between cash and derivatives market, financial institutions and mutual funds may be permitted to short sell in the cash market. Such short sale may, however, be restricted to the extent of corresponding exposure in the derivatives market. Moreover, such transactions can also be permitted through a separate dedicated fund; (iii) Arbitage between cash and futures market will also help in between price discovered in both the markets.
RBI has allowed FIls to trade in derivatives market, subject to the condition that the overall open position of the FII shall not exceed 100 per cent of market value of the concerned FII’s total investment. Managed future funds should be permitted to take position in the derivatives market without having any exposure in the cash market. Also, FIls intending to invest funds in the cash market should also be permitted to take long position in the futures market to hedge their transactions.
SEBI and RBI should jointly examine the issuesconcerning trading in derivatives by Fls and FIls.
In development countries, one important character of insurance business and of long-term life insurance, in particular, is that insurance policies is seen as a possible source of competition for the banking industry, as the insurance industry developes on a competitive basis. There are, however, other considerations, that point to the possible complement rites and synergies between the insurance and banking business.
The most important source of complementarily arises due to the critical role that banks could play in distributing and marketing of insurance products. So, far, direct branch network LIC, GIC and its subsidiaries together with their agents have been instrumental in marketing of insurance products in India. With further simplification of insurance products, however, the vast branch network and the depositor base of commercial banks are expected to play an important role in marketing insurance products over the counter. The eagerness on the part of several banks and NBFCs to enter into insurance business following the opening up of the industry to private participation reflects this emerging process.
The present interest of banks to enter into insurance business also mirrors the global trend. In Europe the synergy between banking and insurance has given rise to the concept of ‘bancasssurance a package of financial services that can fulfill both banking and insurance needs. In France, for example, over half of the insurance products are sold through banks. In the US, banks lease space to insurers and retail products of multiple insurers, in the way the shops sell products. The institutional framework within which this functional overalaps are taking place has been varied floatating of separate insurance companies by banks, banks’ buying stakes in existing insurance companies, and swap of shares and mergers. Insurance companies have also sought to acquire stakes in some banks.
In India, the Reserve Bank, in recognition of the symbiotic relationship between banking and the insurance industries, has identified three routes of banks’ participation in the insurance business, riz, (i) providing fee-based insurance services without risk participation, (ii) investigating in an insurance company for providing infrastructures and services support and (iii) setting up of a separate joint-venture Insurance company with risk participation. The third route, due to its risk aspects, involves compliance to stringent entry norms. Further, the bank has to maintain an ‘arms length’ relationship between its banking business and its insurance outfit. For banks entering into insurance business with risk participation, the prescribed entity (viz. separate joint-venture company) also enables to avoid possible regulatory overlaps between the Reserve Bank and the Government/IRDA. The joint-venture insurance company would be subjected entirely to the IRDA/Government regulations.
Besides commercial banks, rural cooperative credit institutions are also envisaged as an important vehicle for distributing insurance products in under-served rural areas. The Task Force to Study the Co-operative Credit System and Suggest. Measures for its, Strengthening noted that this could have the attendant benefit of portfolio diversification for these institutions.