(Indian Financial System)
Full Marks: 80
The figures in the margin indicate full marks for the questions.
1. (a) Discuss the importance of Financial Market and Financial Instruments to the Financial System of a country. (8+8=16)
-> The financial market is a very broad term that primarily refers to a marketplace where buyers and sellers participate in the trade, i.e., buying and selling of assets . Simply saying, it is a platform that facilitates traders to buy and sell financial instruments and securities. These instruments and securities can be shares, stocks, bonds , commercial papers, bills, debentures , cheques and more.
Financial markets are known for transparent pricing, strict regulations, costs and fees and clear guidelines. One big characteristic of such markets is that the market forces determine the price of the assets. Also, a financial market may or may not have a physical location, meaning investors can buy and sell assets over the Internet or phone.
(1) Mobilization of Savings and their Channelization into more Productive Uses:
Financial market gives impetus to the savings of the people. This market takes the uselessly lying finance in the form of cash to places where it is really needed. Many financial instruments are made available for transferring finance from one side to the other side. The investors can invest in any of these instruments according to their wish.
(2) Facilitates Price Discovery:
The price of any goods or services is determined by the forces of demand and supply. Like goods and services, the investors also try to discover the price of their securities. The financial market is helpful to the investors in giving them proper price.
(3) Provides Liquidity to Financial Assets:
This is a market where the buyers and the sellers of all the securities are available all the times. This is the reason that it provides liquidity to securities. It means that the investors can invest their money, whenever they desire, in securities through the medium of financial market. They can also convert their investment into money whenever they so desire.
(4) Reduces the Cost of Transactions:
Various types of information are needed while buying and selling securities. Much time and money is spent in obtaining the same. The financial market makes available every type of information without spending any money. In this way, the financial market reduces the cost of transactions.
(b) Discuss the powers and functions of the Securities Exchange Board of India (SEBI). (16)
-> SEBI is essentially a statutory body of the Indian Government that was established on the 12th of April in 1992. It was introduced to promote transparency in the Indian investment market. Besides its headquarters in Mumbai, the establishment has several regional offices across the country including, New Delhi, Ahmedabad, Kolkata and Chennai.
It is entrusted with the task to regulate the functioning of the Indian capital market. The regulatory body lays focus on monitoring and regulating the securities market in India to safeguard the interest of investors and aims to inculcate a safe investment environment by implementing several rules and regulations as well as by formulating investment-related guidelines.
The Structural Set Up of SEBI India
SEBI India follows a corporate structure. It has a Board of Directors, senior management, department heads and several crucial departments.
To be precise, it comprises of over 20 departments, all of which are supervised by their respective department heads, who in turn are administered by a hierarchy in general.
The SEBI’s hierarchical structure comprises of the following 9 designated officers –
- The Chairman – Nominated by the Indian Union Government.
- Two members belonging to the Union Finance Ministry of India.
- One member belonging to the Reserve Bank of India or RBI.
- Other five members – Nominated by the Union Government of India.
The below-mentioned list highlights some of the most important departments of SEBI –
- The Information Technology Department.
- The Foreign Portfolio Investors and Custodians.
- Office of International Affairs.
- National Institute of Securities Market.
- Investment Management Department.
- Commodity and Derivative Market Regulation Department.
- Human Resource Department.
Besides these, other crucial departments take care of legal, financial and enforcement-related affairs.
Powers and Functions of SEBI
Being a regulatory body, SEBI India has several powers to perform vital functions. The SEBI Act of 1992 carries a list of such powers vested in the regulatory body. The functions of SEBI make it an issuer of securities, protector of investors and traders and a financial mediator.
The following pointers offer a brief idea about the same.
· To protect the interests of Indian investors in the securities market.
· To promote the development and hassle-free functioning of the securities market.
- To regulate the business operations of the securities market.
· To serve as a platform for portfolio managers, bankers, stockbrokers, investment advisers, merchant bankers, registrars, share transfer agents and other people.
· To regulate the tasks entrusted on depositors, credit rating agencies, custodians of securities, foreign portfolio investors and other participants.
· To educate investors about securities markets and their intermediaries.
· To prohibit fraudulent and unfair trade practices within the securities market and related to it.
- To monitor company take-overs and acquisition of shares.
· To keep the securities market efficient and up to date all the time through proper research and developmental tactics.
- Quasi-judicial powers: In cases of frauds and unethical practices pertaining to the securities market, SEBI India has the power to pass judgments.
The said power facilitates to maintain transparency, accountability and fairness in the securities market.
- Quasi-executive powers: SEBI has the power to examine the Book of Accounts and other vital documents to identify or gather evidence against violations. If it finds one violating the regulations, the regulatory body has the power to impose rules, pass judgments and take legal actions against violators.
- Quasi-Legislative powers: To protect the interest of investors, the authoritative body has been entrusted with the power to formulate suitable rules and regulations. Such rules tend to encompass the listing obligations, insider trading regulations and essential disclosure requirements. The body formulates such rules and regulation to get rid of malpractices that are prevalent in the securities market.
The Supreme Court of India and the Securities Appellate Tribunal tend to have an upper hand when it comes to the powers and functions of SEBI. All its functions and related decisions have to go through the two apex bodies first.
2. (a) What do you mean by Money Market? Discuss role of RBI as a regulator of Money and credit. (16)
-> The money market is an organized exchange market where participants can lend and borrow short-term, high-quality debt securities with average maturities of one year or less. It enables governments, banks, and other large institutions to sell short-term securities to fund their short-term cash flow needs. Money markets also allow individual investors to invest small amounts of money in a low-risk setting.
Some of the instruments traded in the money market include Treasury bills, certificates of deposit, commercial paper, federal funds, bills of exchange, and short-term mortgage-backed securities and asset-backed securities.
Large corporations with short-term cash flow needs can borrow from the market directly through their dealer, while small companies with excess cash can borrow through money market mutual funds.
Individual investors who want to profit from the money market can invest through their money market bank account or a money market mutual fund. A money market mutual fund is a professionally managed fund that buys money market securities on behalf of individual investors.
Functions of the Money Market
The money market contributes to the economic stability and development of a country by providing short-term liquidity to governments, commercial banks, and other large organizations. Investors with excess money that they do not need can invest it in the money market and earn interest.
Here are the main functions of the money market:
1. Financing Trade
The money market provides financing to local and international traders who are in urgent need of short-term funds. It provides a facility to discount bills of exchange, and this provides immediate financing to pay for goods and services.
International traders benefit from the acceptance houses and discount markets. The money market also makes funds available for other units of the economy, such as agriculture and small-scale industries.
2. Central Bank Policies
The central bank is responsible for guiding the monetary policy of a country and taking measures to ensure a healthy financial system. Through the money market, the central bank can perform its policy-making function efficiently.
For example, the short-term interest rates in the money market represent the prevailing conditions in the banking industry and can guide the central bank in developing an appropriate interest rate policy. Also, the integrated money markets help the central bank to influence the sub-markets and implement its monetary policy objectives.
3. Growth of Industries
The money market provides an easy avenue where businesses can obtain short-term loans to finance their working capital needs. Due to the large volume of transactions, businesses may experience cash shortages related to buying raw materials, paying employees, or meeting other short-term expenses.
Through commercial paper and finance bills, they can easily borrow money on a short-term basis. Although money markets do not provide long-term loans, it influences the capital market and can also help businesses obtain long-term financing. The capital market benchmarks its interest rates based on the prevailing interest rate in the money market.
4. Commercial Banks Self-Sufficiency
The money market provides commercial banks with a ready market where they can invest their excess reserves and earn interest while maintaining liquidity. Short-term investments, such as bills of exchange, can easily be converted to cash to support customer withdrawals.
Also, when faced with liquidity problems, they can borrow from the money market on a short-term basis as an alternative to borrowing from the central bank. The advantage of this is that the money market may charge lower interest rates on short-term loans than the central bank typically does.
Types of Instruments Traded in the Money Market
Several financial instruments are created for short-term lending and borrowing in the money market. They include:
1. Treasury Bills
Treasury bills are considered the safest instruments since they are issued with a full guarantee by the United States government. They are issued by the U.S. Treasury regularly to refinance Treasury bills reaching maturity and to finance the federal government’s deficits. They come with a maturity of one, three, six, or twelve months.
Treasury bills are sold at a discount to their face value, and the difference between the discounted purchase price and face value represents the interest rate. They are purchased by banks, broker-dealers, individual investors, pension funds, insurance companies, and other large institutions.
2. Certificate of Deposit (CD)
A certificate of deposit (CD) is issued directly by a commercial bank, but it can be purchased through brokerage firms. It comes with a maturity date ranging from three months to five years and can be issued in any denomination.
Most CDs offer a fixed maturity date and interest rate, and they attract a penalty for withdrawing prior to the time of maturity. Just like a bank’s checking account, a certificate of deposit is insured by the Federal Deposit Insurance Corporation (FDIC) .
3. Commercial Paper
Commercial paper is an unsecured loan issued by large institutions or corporations to finance short-term cash flow needs, such as inventory and accounts payables. It is issued at a discount, with the difference between the price and face value of the commercial paper being the profit to the investor.
Only institutions with a high credit rating can issue commercial paper, and it is therefore considered a safe investment. Commercial paper is issued in denominations of $100,000 and above. Individual investors can invest in the commercial paper market indirectly through money market funds. Commercial paper comes with a maturity date between one month and nine months.
4. Banker’s Acceptance
A banker’s acceptance is a form of short-term debt that is issued by a firm but guaranteed by a bank. It is created by a drawer, providing the bearer the rights to the money indicated on its face at a specified date. It is often used in international trade because of the benefits to both the drawer and the bearer.
The holder of the acceptance may decide to sell it on a secondary market, and investors can profit from the short-term investment. The maturity date usually lies between one month and six months from the issuing date.
5. Repurchase Agreements
A repurchase agreement (repo) is a short-term form of borrowing that involves selling a security with an agreement to repurchase it at a higher price at a later date. It is commonly used by dealers in government securities who sell Treasury bills to a lender and agree to repurchase them at an agreed price at a later date.
The Federal Reserve buys repurchase agreements as a way of regulating the money supply and bank reserves. The agreements’ date of maturity ranges from overnight to 30 days or more.
Key functions of RBI
The preamble of the Reserve Bank of India describes its main functions as ‘to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage’.
Reserve bank of India is the only authority who is authorized to issue currency in India. While coins are minted by Government of India (GoI), the RBI works as an agent of GoI for distributing and handling of coins. Upto Re.1 coins are minted by GoI although RBI ensures their distribution in the country.
RBI also works to prevent counterfeiting of currency by regularly upgrading security features of currency. RBI prints currency at its 4 currency printing facilities at Dewas, Nasik, Mysore and Hyderabad. The RBI is authorized to issue notes up to the value of Rupees 10,000 (Ten thousand).
Banker to Government
Like individuals, firms and companies who need a bank to carry out their financial transactions effectively & efficiently, Governments also need a bank to carry out their financial transactions. RBI serves this purpose for the Government of India (GoI). As a banker to the GoI, RBI maintains its accounts, receive in and make payments out of these accounts. RBI also helps GoI to raise money from public via issuing bonds and government approved securities.
Supervisor of Banks: Bankers’ Bank
RBI also works as banker to all the scheduled commercial banks. All the banks in India maintain accounts with RBI which help them in clearing & settling inter-bank transactions and customer transactions smoothly & swiftly. Maintaining accounts with RBI help banks to maintain statutory reserve requirements. RBI also acts as lender of last resort for all the banks.
RBI has the responsibility of regulating the nation’s financial system. As a regulator and supervisor of the Indian banking system it ensures financial stability & public confidence in the banking system. RBI uses methods like On-site inspections, off-site surveillance, scrutiny & periodic meetings to supervise new bank licenses, setting capital requirements and regulating interest rates in specific areas. RBI is currently focused on implementing Basel-III norms to regulate the hidden Non Performing Assets (NPAs) in Banking system.
RBI as Country’s Foreign Exchange Manager
RBI has an important role to play in regulating & managing Foreign Exchange of the country. It manages forex and gold reserves of the nation.
On a given day, the foreign exchange rate reflects the demand for and supply of foreign exchange arising from trade and capital transactions. The RBI’s Financial Markets Department (FMD) participates in the foreign exchange market by undertaking sales / purchases of foreign currency to ease volatility in periods of excess demand for/supply of foreign currency.
RBI as Controller of Credit: Regulator of Money supply
RBI formulates and implements the Monetary Policy of India to keep the economy on growth path. Monetary Policy refers to the process employed by RBI to control availability & cost of currency and thus keeping Inflationary & deflationary trends low and stable. RBI adopts various measures to regulate the flow of credit in the country. The measures adopted by RBI can broadly be categorized as Quantitative & Qualitative tools.
1. Quantitative Tools
Quantitative measures of credit control are applicable to entire money and banking system without discriminations. They broadly refer to reserve ratios, bank rate policy etc. Reserve ratios are the share of net demand & time liabilities (NDTL) which banks have to keep aside to ensure that they have sufficient cash to cover customer withdrawals.
A. Cash Reserve Ratio
CRR is one of the most commonly used by RBI as quantitative tool of credit control. The ratio specifies minimum fraction of the total deposits of customers, which commercial banks have to hold as reserves either in cash or as deposits with the central bank. CRR is set according to the guidelines of the central bank of a country. RBI is empowered to vary CRR between 3 percent and 15 percent.
Current CRR is 4% in India. Cash Reserve Ratio was quoted at 4 percent in its recently announced Sixth bi-monthly Monetary Policy Statement 2019-20. Earlier, the Cash Reserve Ratio in India averaged 5.67 percent from 1999 until 2016, reaching an all time high of 10.50 percent in March of 1999 and a record low of 4 percent in February of 2013.
CRR: Impact of Increase & decrease
CRR is the share of Net Demand and Time Liabilities (NDTL) that banks must maintain as cash with RBI. The RBI has set CRR at 4%. So if a bank has 200 Crore of NDTL then it has to keep Rs. 8 Crore in cash with RBI. RBI pays no interest on CRR.
B. Statutory Liquidity Ratio (SLR)
The current SLR announced by RBI is 19% of NDTL as announced by RBI in May 2019. The share of net demand and time liabilities that banks must maintain in safe and liquid assets, such as government securities, cash and gold is SLR.
C. Bank Rate
Current Bank rate is 6.25% . When banks want to borrow long term funds from RBI, it is the interest rate which RBI charges from them. The bank rate is not used to control money supply these days although it provides the basis of arriving at lending and deposit rates. However, if a bank fails to keep SLR or CRR, RBI will then impose penalty & it will be 300 basis points above bank rate.
D. Repo Rate
Present Repo rate is 5.75% with effect from June 6, 2019. If banks want to borrow money (for short term, usually overnight) from RBI, the banks have to pay this interest rate. Banks have to pledge government securities as collateral. This kind of deal happens through a repurchase agreement. If a bank wants to borrow Rs. 100 crores, it has to provide government securities at least worth Rs. 100 crore (could be more because of margin requirement which is 5%-10% of loan amount) and agree to repurchase them at Rs. 106.50 crore at the end of borrowing period. So the bank has paid Rs. 6.50 crore as interest. This is the reason it is called repo rate. The government securities which are provided by banks as collateral cannot come from SLR quota (otherwise the SLR will go below 21.5% of NDTL and attract penalty). Banks have to provide these securities additionally.
To curb inflation, RBI increases Repo rate which will make borrowing costly for banks. Banks will pass this increased cost to their customers which make borrowing costly in whole economy. Fewer people will apply for loan and aggregate demand will get reduced. This will result in inflation coming down. RBI does the opposite to fight deflation. Although when RBI reduces Repo rate, banks are not legally required to reduce their base rate.
The Reserve Bank of India on Thursday June 6, 2019, cut its benchmark repo rate by 25 basis points to 5.75%. This is the third rate cut in 2019. The change in repo rate is likely to lower interest rates on new bank loans.
E. Reverse Repo Rate
At present,reverse repo rate is 5.75% with effect from May 2019. Reverse repo rate is just the opposite of repo rate. If a bank has surplus money, they can park this excess liquidity with RBI and central bank will pay interest on this. This interest rate is called reverse repo rate.
F. Open Market Operation (OMO)
Open market operation is the activity of buying and selling of government securities in open market to control the supply of money in banking system. When there is excess supply of money, RBI sells government securities thereby taking away excess liquidity. Similarly, when economy needs more liquidity, RBI buys government securities and infuses more money supply into the economy.
G. Marginal Standing Facility (MSF)
This scheme was introduced in May, 2011 and all the scheduled commercial banks can participate in this scheme. Banks can borrow up to 2.5% of their respective Net Demand and Time Liabilities. RBI receives application under this facility for a minimum amount of Rs. 1 crore and in multiples of Rs. 1 crore thereafter. The important difference with repo rate is that bank can pledge government securities from SLR quota (up to 1%). Current MSF rate is 6.25%.
Qualitative Tools of Money Control
Qualitative measures of credit control are discriminatory in nature and are applied for specific purpose or to specific financial organization, bank or others which RBI thinks are violating the monetary policy norms.
A. Loan to Value LTV or Margin Requirements
Loan to Value is the ratio of loan amount to the actual value of asset purchased. RBI regulates this ratio so as to control the amount bank can lend to its customers. For example, if an individual wants to buy a car from borrowed money and the car value is Rs. 10 Lac, he can only avail a loan amount of Rs. 7 Lac if the LTV is set to 70%. RBI can decrease or increase to curb inflation or deflation respectively.
B. Selective credit control
RBI can specifically instruct banks not to give loans to traders of certain commodities. This prevents speculations/ hoarding of commodities using money borrowed from banks.
C. Moral Suasion
RBI persuades bank through meetings, conferences, media statements to do specific things under certain economic trends. An example of this measure is to ask banks to reduce their Non-performing assets (NPAs).
Regulates and Supervises the Payment and Settlement Systems
The Payment and Settlement Systems Act of 2007 (PSS Act) gives the Reserve Bank oversight authority, including regulation and supervision, for the payment and settlement systems in the country. In this role, the RBI focuses on the development and functioning of safe, secure and efficient payment and settlement mechanisms. Two payment systems National Electronic Fund Transfer (NEFT) and Real Time Gross Settlement (RTGS) allow individuals, companies and firms to transfer funds from one bank to another. These facilities can only be used for transferring money within the country.
(b) Write brief notes on the following: (16)
1) National Stock Exchange (NSE).
-> The National Stock Exchange of India Limited (NSE) is the largest financial exchange in the Indian market. It was established in 1992 on the recommendation of the High-Powered Study Group, which was founded by the Indian government to provide solutions to simplify participation in the stock market and make it more accessible to all interested parties. In 1994, the NSE introduced electronic trading in the Indian stock exchange market.
The National Stock Exchange of India Limited offers a platform to companies for raising capital. Investors can access equities, currencies, debt, and mutual fund units on thE platform. In India, foreign companies can raise capital using the NSE platform through initial public offerings (IPOs) , Indian Depository Receipts (IDRs), and debt issuances. The NSE also offers clearing and settlement services.
· To establish a trading facility for debt, equity, and other asset classes accessible to investors across the nation.
· To act as a communication network providing investors an equal opportunity to participate in the trading system.
- To meet the global standards set for financial exchange markets.
· To provide a shorter trade settlement period and enable the book-entry settlement system.
NSE Listing Benefits
· Investors can get trade and post-trade information through the NSE trading system. They can see the top sell orders and buy orders, as well as the number of securities available for transactions.
· The trading expenses of investors are reduced as the impact cost on the trading activity decreases owing to the volume of the trading activity.
· The trading system of the NSE processes the transaction at a pace that allows the investors to get the best prices.
· The NSE provides monthly trade statistics to the listed companies. The companies can utilize the data to track their performance.
· The electronic system of trading provides investors with a transparent and effective exchange market.
2) Depository System in Indian Capital Market.
-> It is a system whereby the transfer and settlement of scrips take place not through the traditional method of transfer deeds and physical delivery of scrips but through the modern system of effecting transfer of ownership of securities by means of book entry on the ledgers or the depository without the physical movement of scrips.
The new system, thus, eliminates paper work, facilitates automatic and transparent trading in scrips, shortens the settlement period and ultimately contributes to the liquidity of investment in securities. This system is also known as ‘scripless trading system’.
There are essentially four players in the depository system:
(i) The Depository
(ii) The Participant
(iii) The Beneficial Owner, and
(iv) The Issuer.
(i) The Depository:
A depository is a firm wherein the securities of an investor are held in electronic form and who carries out the transactions of securities by means of book entry. The depository acts as a defector owner of the securities lodged with it for the limited purpose of transfer of ownership. It functions as a custodian of securities of its clients.
The name of the depository appears in the records the issuer as the registered owner of securities.
At present there are two depositories in India:
(a) National Securities Depository Ltd. (NSDL), and
(b) Central Depository Services (India) Ltd. (CDSL).
National Securities Depository Limited which commenced operations during November 1996 was promoted by IDBI, UTI and National Stock Exchange (NSE). Central Depository Services (India) Limited commenced operations during February 1999. It was promoted by Mumbai Stock Exchange in association with Bank of Baroda, Bank of India, and State Bank of India and HDFC Bank.
(ii) The Participant:
A participant is an agent of the depository. He functions as a bridge between the depository and the beneficial owners. He maintains the ownership records of every beneficial owner in book entry form. Both the depository and the participant have to be registered with the Securities and Exchange Board of India.
SEBI grants necessary approval for the same only on the satisfaction of the condition that adequate systems and safeguards are available in such companies in order to ensure against manipulation of records and transactions.
(iii) The Beneficial Owner:
Beneficial owner means a person whose name is recorded as such with a depository. A beneficial owner is the real owner of the securities who has lodged his securities with the depository in the form of book entry. He has all the rights and liabilities associated with the securities.
(iv) The Issuer:
The issuer is the company which issues the security. It maintains a register for recording the names of the registered owners of securities, the depositories. These issuers send a list of shareholders, who opt for the depository system, to the depositories.
2. (a) What do you mean by Merchant Bankers? Discuss the role of Merchant Bankers to the Indian Primary Capital Market. (4+12=16)
-> Merchant banking can be defined as a skill-oriented professional service provided by merchant banks to their clients, concerning their financial needs, for adequate consideration, in the form of fee.
Merchant banks are a specialist in international trade and thus, excel in transacting with large enterprises.
Services offered by Merchant Banks
Merchant Banks offers a range of financial and consultancy services, to the customers, which are related to:
- Marketing and underwriting of the new issue.
- Merger and acquisition related services.
- Advisory services, for raising funds.
- Management of customer security.
- Project promotion and project finance.
- Investment banking
- Portfolio Services
- Insurance Services.
Merchant banking helps in reinforcing the economic development of the country, by acting as a source of funds and information to the business entities.
Any person, indulged in issue management business by making arrangements with respect to trade and subscription of securities or by playing the role of manager/consultant or by providing advisory services, is known as a merchant banker. The activities carried out by merchant bankers are:
· Private placement of securities.
· Managing public issue of securities
· Satellite dealership of government securities
· Management of international offerings like Depository Receipts, bonds, etc.
· Syndication of rupee term loans
· Stock broking
· International financial advisory services.
In India, the functions of the merchant bankers are governed by the Securities and Exchange Board of India (SEBI) Regulations, 1992.
Role of Merchant Bankers:-
Merchant Bankers help their clients in raising finance by way of issue of a debenture, shares, bank loans, etc. They tap both the domestic as well as the international markets. Finance raised by this method may be used for commencing a new project or business or it may even be used for expansion and modernization of an existing business.
In India, merchant bankers play the role of promoter of industrial enterprises. They help entrepreneurs in conceiving ideas, identifying projects, preparation of feasibility reports, getting Government approvals as well as incentives, etc. Merchant bankers may, at times, also provide assistance in financial and technical collaborations and i joint ventures.
Brokers in stock exchanges
Merchant bankers buy and sell shares in the stock exchange on behalf of the clients. They additionally conduct researches on equity shares, advise the clients on the share to be purchased, the time of purchase, quantity of such purchase and the time for selling these shares. Mutual funds offer merchant banking services, large brokers, investment banks, and venture capitals.
Merchant bankers offer help to clients in several ways in the process of project management. They offer advice regarding the location of the project, preparation of project report, in carrying out feasibility studies, planning out the financing of the project, tapping sources of such finance, information regarding incentives and concessions from the government.
Advise on modernisation and expansion
Merchant bankers advise on amalgamations, mergers, acquisitions, takeovers, foreign collaborations, diversification of business, technology up-gradation, joint-ventures, etc.
Managing public issue
They provide the following services in the above-mentioned process:
- the timing of the public issue
- the size of the issue
- the price of the issue
- acting in the capacity of manager to the issue
· assisting in receiving applications as well as allotment of securities
- appointment of brokers as well as underwriters of the issue
- listing of the shares on the relevant stock exchange.
Initially, merchant bankers mostly performed the function of managing new public issues of corporate securities of either newly formed companies or existing companies and foreign companies in the process of dilution of equity provided under the FERA  . Here, they acted as sponsors of issues. They get the permission of the Controller of Capital Issues (which is now the SEBI). They also provide several other services to guarantee success in the process of marketing of securities. These services include, preparation of the prospectus, making underwriting arrangements, appointing registrars, bankers, brokers to the issue, arranging for advertising and publicity as well as compliance with the listing requirements of the relevant stock exchanges, etc. A merchant banker acts as experts on the terms, type and timing of the issues of the corporate securities and makes them suitable for investors and provides freedom and flexibility to issuing companies.
A merchant banker provides specialized services in the stages of preparation of a project, the loan applications required for the raising of short-term and long- term credit from various banks and financials institutions, etc. They help in managing Euro-issues and raising funds abroad.
Handling government consent for industrial projects
A merchant banker completes all formalities for his or her client, about government permission to expand and modernize business (necessary for companies) and commencing new businesses (necessary for business people).
Special assistance to entrepreneurs and small companies
Merchant banker advises entrepreneurs and small companies on availability and existence of business opportunities, concessions, incentives and government policies and helps them to take advantage of this option available to them, to the best of their capabilities.
Services to PSU’s
Merchant banker offers numerous services to public sector undertakings and units and their public utilities. They assist in raising capital (long-term), in the marketing of securities, in foreign collaborations as well as in arranging for long-term finances from lending institutions.
Revival of sick units
A merchant bank helps in reviving sick industrial units. They negotiate with various agencies such as banks, long-term lending institutions, and the Board for Industrial and Financial Reconstruction (BIFR). They also plan and execute full revival packages.
Portfolio management of sick units
Merchant bankers offer revival services to companies that issue the securities as well as investors. These bankers advise clients, which are usually institutional investors, on investment decisions. They undertake purchase and sale of securities to provide them with portfolio management services. Some of these bankers are operating mutual funds as well as offshore funds.
These services of merchant bankers include mergers, acquisitions (about existing units), the sale of units and disinvestment. These procedures demand proper negotiations, thorough preparation of numerous documents and completion of lengthy legal formalities. Merchant bankers fulfill all these formalities on behalf of the clients.
Money market operations
A merchant bank deals with as well as underwrites short-term instruments like:
- government bonds
- certificate of deposit issued by banks and financial institutions
- commercial paper issued by large corporate firms
· treasury bills issued by the government (in India by the Reserve Bank of India)
Leasing and finance services
Merchant banks also assist leasing and financing services. A lease refers to a contract that exists between a lessor and a lessee, by which the lessor permits the use of a specific asset that belongs to him or her(like equipment, land) by the lessee for a specified period. There is a fee charged by the lessor charges which is referred to asthe rentals. Several merchant bankers offer leasing and financing facilities to the customers. Some banks also keep venture capital funds to assist entrepreneurs. These banks also help the companies to raise finance through public deposits.
Merchant bankers now also act as the paying agents for service of the debt- securities and act as the registrars as well as the transfer agents. In this way, they maintain the registers of the shareholders and the debenture holders and also arrange the payment of dividend and or the interest that is due to them.
Management of dividend and interest
Merchant banks help the clients in the management of the interest on the debentures or loans, as well as the dividend on the shares. In addition to this, they advise the client with respect to the timings (whether interim or annual) of the dividend as well as the rate of the dividend.
Along with all the services mentioned above, the merchant bankers also offer certain other specialized services such as advisory services on matters such as mergers, amalgamations, tax related matters, on the matter of recruitment of executives, the cost of audit as well as its management among several others. The scope of functions, activities and the services provided by the merchant bankers are ever increasing and growing with the constant development in the money market.
(b) What do you mean by Mutual Fund Scheme? Discuss the advantages and disadvantages of Mutual Fund Investment. (6+10=16)
-> Mutual fund is a mechanism for pooling the resources by issuing units to the investors and investing funds in securities in accordance with objectives as disclosed in offer document.
Investments in securities are spread across a wide cross-section of
industries and sectors and thus the risk is reduced. Diversification
reduces the risk because all stocks may not move in the same direction in
the same proportion at the same time. Mutual fund issues units to the
investors in accordance with quantum of money invested by them. Investors
of mutual funds are known as unit holders.
The profits or losses are shared by the investors in proportion to their investments. The mutual funds normally come out with a number of schemes with different investment objectives which are launched from time to time. A mutual fund is required to be registered with Securities and Exchange Board of India (SEBI) which regulates securities markets before it can collect funds from the public.
A mutual fund scheme can be classified into open-ended scheme or close-ended scheme depending on its maturity period.
1. Open-ended Fund/ Scheme
An open-ended fund or scheme is one that is available for subscription and repurchase on a continuous basis. These schemes do not have a fixed maturity period. Investors can conveniently buy and sell units at Net Asset Value (NAV) related prices which are declared on a daily basis. The key feature of open-end schemes is liquidity.
2. Close-ended Fund/ Scheme
A close-ended fund or scheme has a stipulated maturity period e.g. 5-7 years. The fund is open for subscription only during a specified period at the time of launch of the scheme. Investors can invest in the scheme at the time of the initial public issue and thereafter they can buy or sell the units of the scheme on the stock exchanges where the units are listed. In order to provide an exit route to the investors, some close-ended funds give an option of selling back the units to the mutual fund through periodic repurchase at NAV related prices. SEBI Regulations stipulate that at least one of the two exit routes is provided to the investor i.e. either repurchase facility or through listing on stock exchanges. These mutual funds schemes disclose NAV generally on weekly basis.
Schemes according to Investment Objective
A scheme can also be classified as growth scheme, income scheme, or balanced scheme considering its investment objective. Such schemes may be open-ended or close-ended schemes as described earlier. Such schemes may be classified mainly as follows:
1. Growth / Equity Oriented Scheme
The aim of growth funds is to provide capital appreciation over the medium to long- term. Such schemes normally invest a major part of their corpus in equities. Such funds have comparatively high risks. These schemes provide different options to the investors like dividend option, capital appreciation, etc. and the investors may choose an option depending on their preferences. The investors must indicate the option in the application form. The mutual funds also allow the investors to change the options at a later date. Growth schemes are good for investors having a long-term outlook seeking appreciation over a period of time.
2. Income / Debt Oriented Scheme
The aim of income funds is to provide regular and steady income to investors. Such schemes generally invest in fixed income securities such as bonds, corporate debentures, Government securities and money market instruments. Such funds are less risky compared to equity schemes. These funds are not affected because of fluctuations in equity markets. However, opportunities of capital appreciation are also limited in such funds. The NAVs of such funds are affected because of change in interest rates in the country. If the interest rates fall, NAVs of such funds are likely to increase in the short run and vice versa. However, long term investors may not bother about these fluctuations.
3. Balanced Fund
The aim of balanced funds is to provide both growth and regular income as such schemes invest both in equities and fixed income securities in the proportion indicated in their offer documents. These are appropriate for investors looking for moderate growth. They generally invest 40-60% in equity and debt instruments. These funds are also affected because of fluctuations in share prices in the stock markets. However, NAVs of such funds are likely to be less volatile compared to pure equity funds.
4. Money Market or Liquid Fund
These funds are also income funds and their aim is to provide easy liquidity, preservation of capital and moderate income. These schemes invest exclusively in safer short-term instruments such as treasury bills, certificates of deposit, commercial paper and inter-bank call money, government securities, etc. Returns on these schemes fluctuate much less compared to other funds. These funds are appropriate for corporate and individual investors as a means to park their surplus funds for short periods.
5. Gilt Fund
These funds invest exclusively in government securities. Government securities have no default risk. NAVs of these schemes also fluctuate due to change in interest rates and other economic factors as is the case with income or debt oriented schemes.
6. Index Funds
Index Funds replicate the portfolio of a particular index such as the BSE Sensitive index, S&P NSE 50 index (Nifty), etc these schemes invest in the securities in the same weightage comprising of an index. NAVs of such schemes would rise or fall in accordance with the rise or fall in the index, though not exactly by the same percentage due to some factors known as “tracking error” in technical terms. Necessary disclosures in this regard are made in the offer document of the mutual fund scheme.
There are also exchange traded index funds launched by the mutual funds which are traded on the stock exchanges.
Advantages of Mutual Funds
Unless you opt for close-ended mutual funds , it is relatively easier to buy and exit a mutual fund scheme. You can sell your open-ended equity mutual fund units when the stock market is high and make a profit. Do keep an eye on the exit load and expense ratio of the mutual fund.
Equity mutual funds have their share of risks as their performance is based on the stock market movements. Hence, the fund manager spreads your investment across stocks of companies across various industries and different sectors called diversification . In this way, when one asset class doesn’t perform, the other sectors can compensate to avoid loss for investors.
A mutual fund is good for investors who don’t have the time or skills to do the research and asset allocation. A fund manager takes care of it all and makes decisions on what to do with your investment.
The fund manager and the team of researchers decide on the appropriate securities such as equity, debt or a mix of both depending on the investment objectives of the fund. Moreover, the fund manager also decides on how long to hold the securities.
Your fund manager’s reputation and track record in fund management should be an essential criterion for you to choose a mutual fund. The expense ratio (which cannot be more than 2.25% annualised of the daily net assets as per SEBI) includes the fees of the fund manager.
Less cost for bulk transactions
You must have noticed how price drops with the purchase of increased volumes. For instance, if a 100g toothpaste costs Rs 10, you might get a 500g pack for say, Rs 40.
The same logic applies to mutual fund units as well. If you buy multiple mutual fund units at a time, the processing fees and other commission charges will be lesser as compared to buying one mutual fund unit.
Invest in smaller denominations
By investing in smaller denominations of as low as Rs 500 per SIP instalment, you can stagger your investments in mutual funds over some time. This reduces the average cost of investment – you spread your investment across stock market lows and highs. Regular (monthly or quarterly) investments, as opposed to lumpsum investments, give you the benefit of rupee cost averaging.
Suits your financial goals
There are several types of mutual funds available in India catering to investors across all walks of life. No matter what your income is, you must make it a habit to set aside some amount (however small) towards investments. It is easy to find a mutual fund that matches your income, time horizon, investment goals and risk appetite.
You can check the expense ratio of different mutual funds and choose the one with the lowest expense ratio. The expense ratio is the fee for managing your mutual fund.
Quick and hassle-free process
We can start with one mutual fund and slowly diversify across funds to build your portfolio. It is easier to choose from handpicked funds that match our investment objectives and risk tolerance.
Tracking mutual funds will be a hassle-free process. The fund manager , with the help of his team, will decide when, where and how to invest in securities according to the investment objectives. In short, their job is to beat the benchmark index and deliver maximum returns to investors, consistently.
You can invest in tax-saving mutual funds called ELSS which qualifies for tax deduction up to Rs 1.5 lakh per annum under Section 80C of the Income Tax Act, 1961. Though a 10% tax on Long-Term Capital Gains (LTCG) above Rs 1 lakh is applicable, they have consistently delivered higher returns than other tax-saving instruments in recent years.
It is common to delay SIPs or postpone investments due to some reason. You can opt for paperless automation with your fund house or agent by submitting a SIP mandate, where you instruct your bank account to automatically deduct SIP amounts when it’s due. Timely email and SMS notifications make sure you stay on track with mutual fund investments.
There is a general notion that mutual funds are not as safe as bank products. This is a myth as fund houses are strictly under the purview of statutory government bodies like SEBI and AMFI . One can easily verify the credentials of the fund house and the asset manager from SEBI. They also have an impartial grievance redressal platform that works in the interest of investors.
Systematic or one-time investment
You can plan your mutual fund investment as per your budget and convenience. For instance, starting a SIP (Systematic Investment Plan) on a monthly or quarterly basis in an equity fund suits investors with less money. On the other hand, if you have a surplus amount, go for a one-time lumpsum investment in debt funds.
Disadvantages of Mutual Funds
Costs of managing the mutual fund
The salary of the market analysts and fund manager comes from the investors along with the operational costs of the fund. Total fund management charges are one of the first parameters to consider when choosing a mutual fund. Higher management fees do not guarantee better fund performance.
You have exit load as fees charged by AMCs when exiting a mutual fund. It discourages investors from redeeming investments for some time. It also helps the fund manager garner the required funds to purchase the appropriate securities at the right price and time.
While diversification averages your risks of loss, it can also dilute your profits. Hence, you should not invest in many mutual funds at a time.
As you have just read above, the benefits of mutual funds can undoubtedly override the disadvantages, if you make informed choices.
However, investors may not have the time, knowledge or patience to research and analyze different mutual funds. Investing with Clear Tax could solve this problem as we have already done the homework for you by handpicking the top-rated funds from the best fund houses in the country.
4. Briefly explain any two of the following: (8+8=16)
1) Credit Derivatives.
-> Credit derivative refers to any one of various instruments and techniques designed to separate and then transfer the credit risk or the risk of an event of default of a corporate or sovereign borrower, transferring it to an entity other than the lender or debt holder. Simply explained it is the transfer of the credit risk from one party to another without transferring the underlying.
They are the negotiable bilateral contracts (reciprocal arrangement between two parties to perform an act in exchange of the other parties act) that help the users to manage their exposure to credit risks. The buyer pays a fee to the party taking on the risk.
Types of credit derivatives
1. Unfunded credit derivatives.
2. Funded credit derivatives.
Unfunded credit derivatives: It is a contract between two parties where each is responsible of making the payments under the contract. These are termed as unfunded as the seller makes no upfront payment to cover any future liabilities. The seller makes any payment only when the settlement is met. Ultimately the buyer takes the credit risk on whether the seller will be able to pay any cash / physical settlement amount. Credit Default Swap (CDS) is the most common and popular type of unfunded credit derivatives.
Funded Credit derivatives: In this type, the party that is assuming the credit risk makes an initial payment that is used to settle any credit events that may happen going forward. Thereby, the buyer is not exposed to the credit risk of the seller. Credit Linked Note (CLN) and Collateralized Debt Obligation (CDO) are the charmers of the funded credit derivative products. These kinds of transactions generally involve SPVs for issuing / raising a debt obligation which is done through the seller. The proceeds are collateralized by investing in highly rated securities and these note proceeds can be used for any cash or physical settlement.
Products under each type
Unfunded Credit Derivatives
Funded Credit Derivatives
1. Credit default Swap (CDS)
1. Credit linked note (CLN)
2. Credit default swaption
2. Constant Proportion Debt Obligation (CPDO)
3. Credit spread option
3. Collateralized debt obligation (CDO)
4. Total return swap
5. CDS index products
6. CDS on Asset backed securities
UNFUNDED CREDIT DERIVATIVES
A. Credit default Swap (CDS):
The most popular form of unfunded credit derivative is Credit Default Swap (CDS).
In a credit default swap, the seller negotiates an upfront or continuous fee, in order to compensate the buyer when a specified event, such as default or failure to make a payment occurs.
The benefit to the buyer and the seller in CDS is that the buyers can remove risky entities from their balance sheets without having to selling them while the sellers can gain higher returns from investments by entering markets which are otherwise difficult for them to get into.
CDS are mainly of four types:
Credit default swaps on single entities: In this form, the swap is on a single entity
Credit default swaps on a basket of entities: In this the swap is on a bunch of entities combined
Credit default index swaps: this includes a portfolio of single entity swaps
First-loss and tranche-loss credit default swaps: In this type, the buyer is compensated for any losses from the credit events unlike that in the first loss credit default swap which only compensates the loss from the first credit event
Finally, the value of a default swap depends on the probability of entity or the counterparty or the correlation between them.
B. Credit default swaption:
Credit default swaption or credit default option is an option to buy protection (payer option) or sell protection (receiver option) as a credit default swap on a specific reference credit with a specific maturity. (Wikipedia).
Simply put it is an option on a CDS. It gives the holder a right and not obligation to buy / sell protection for an entity for specified future time period.
C. Credit spread option:
A credit spread, or net credit spread, involves a purchase of one option and a sale of another option in the same class and expiration but different strike prices. Investors receive a net credit for entering the position, and want the spreads to narrow or expire for profit. (Wikipedia)
D. Total return swap:
It is defined as the total transfer of both the credit risk and market risk of the underlying asset. The assets commonly are bonds, loans and equities.
E. CDS index (CDSI) products
It is a credit derivative used to hedge credit risk or to take a position on a basket of credit entities. CDSI is a standardized credit security unlike a CDS which is an OTC derivative.
F. Asset backed CDS (ABCDS):
The reference asset in this case is an asset backed security rather than any corporate credit instrument.
FUNDED CREDIT DERIVATIVES
A.CREDIT LINKED NOTE (CLN):
It is structured as a security with an embedded CDS allowing the issuer to transfer a specific credit risk to credit investors. In this case the issuer is not obligated to repay the debt if a specified event occurs. The ultimate purpose of the CLN is to pass on the risk of specific default to the investors who are willing to bear the risk in return for higher yield.
B. Constant Proportion Debt Obligation (CPDO):
CPDO is a complex financial instrument, invented in 2006 by ABN Amro and designed to pay the same high interest rate as a risky junk bond while offering the highest possible credit rating. It is defined as a type of synthetic collateralized debt instrument that is backed by a debt security index. These are credit derivatives for the investors who are willing to take exposure to credit risk.
C. Collateralized debt obligation (CDO):
It is a type of structured asset backed security (ABS). The CDO is divided into tranches through which the flow of payments is controlled. The payments and interest rates vary with the tranches with the most senior one paying the lowest rates and the lowest tranche paying the highest rates to compensate for the default risk. Synthetic CDOS are credit derivatives that are synthesized through basic CDs like CDSs and CLNs. These are divided into credit tranches based on the level of credit risk.
Benefits & Risks of Credit Derivatives
Benefits of Credit derivatives
Risks of Credit Derivatives
1. Enable the lenders / investors to take the credit risk as per capacity
1. It could lead to increased leverage and risk taking by investors
2. Help in enhancing the market efficiency and liquidity
2. markets need to be liquid to manage risk through CDs
3. They act as financial shock absorbers for the economy
3. It may not always channel risk to those who best understand / handle it
4. Creates macroeconomic and financial stability
4. New instruments keep appearing constantly and are not always tested
2) Treasury Bills.
-> Treasury bills, also known as T-bills, are short term money market instruments. The RBI on behalf of the government to curb liquidity shortfalls. It is a promissory note with a guarantee of payment at a later date. The funds collected are usually used for short term requirements of the government. It is also used to reduce the overall fiscal deficit of the country.
Treasury bills or T-bills have zero-coupon rates, i.e. no interest is earned on them. Individuals can purchase T-bills at a discount to the face/value. Later, they are redeemed at a nominal value, thereby allowing the investors to earn the difference. For example, an individual purchase a 91-day T-bill which has a face value of Rs.100, which is discounted at Rs.95. At the time of maturity, the T-bill holder gets Rs.100, thus resulting in a profit of Rs.5 for the individual.
Therefore, it is an essential monetary instrument that the Reserve Bank of India uses. It helps RBI to regulate the total money supply in the economy as well as raising funds.
Types of Treasury Bills
Four types of treasury bills are auctioned. The primary distinction for these treasury bills tbills is their holding period.
14-day Treasury bill
These bills complete their maturity on 14 days from the date of issue. They are auctioned on Wednesday, and the payment is made on the following Friday. The auction occurs every week. These bills are sold in the multiples of Rs.1lakh and the minimum amount to invest is also Rs.1 lakh.
91-day Treasury bill
These bills complete their maturity on 91 days from the date of issue. They are auctioned on Wednesday, and the payment is made on the following Friday. They are auctioned every week. These bills are sold in the multiples of Rs.25000 and the minimum amount to invest is also Rs.25000.
182-day Treasury bill
These bills complete their maturity on 182 days from the date of issue. They are auctioned on Wednesday, and the payment is made on the following Friday when the term expires. They are auctioned every alternate week. These bills are sold in the multiples of Rs.25000 and the minimum amount to invest is also Rs.25000.
364-day Treasury bill
These bills complete their maturity 364 days from the date of issue. They are auctioned on Wednesday, and the payment is made on the following Friday when the term expires. They are auctioned every alternate week. These bills are sold in the multiples of Rs.25000 and the minimum amount to invest is also Rs.25000.
As mentioned above, the holding period for each bill remains constant. However, the face value and the discount rates of treasury bills can change periodically. This depends on the funding requirements and monetary policy of RBI along with total bids received.
Also, The Reserve Bank of India issues treasury bills calendar for auction. It announces the exact date of the auction, the amount to be auctioned and the maturity dates before every auction.
Features of Treasury Bills
Treasury bills can be issued in a physical form as a promissory note or dematerialized form by crediting to SGL account (Subsidiary General Ledger Account).
Minimum Bid Amount
Treasury bills are issued at a minimum price of Rs.25000 and in the same multiples thereof.
Treasury bills are issued at a discounted price. However, they are redeemed at par value at the time of maturity.
Individuals, companies, firms, banks, trust, insurance companies, provident fund, state government and financial institutions are eligible to purchase T-bills.
Treasury bills are highly liquid negotiable instruments. They are available in both financial markets, i.e. primary and secondary market.
The 91 day T-bill follows a uniform auction method, whereas, 364 day T-bill follows a multiple auction method.
The yields are assured. Hence, they have zero risks of default.
For treasury bills, the day count is 364 days in a year.
Besides this, it also have other characteristics like market-driven discount rate, selling through auction, issued to meet short term cash flow mismatch, assured yield, low transaction cost, etc.
Advantages and limitations of treasury bills
Treasury bills investments come with many advantages as it provides safety and security to its investors.
Treasury bills is a popular short term government security. The Central government backs them. They act as a liability to the Indian government as they need to be paid within a stipulated time.
Therefore, investors have total security on their funds invested as they are backed by the government of India, I.e. the highest authority in the country. The amount has to be paid to the investors even during the crisis.
Treasury bill has a highest maturity period of 364 days. They help in raising money for short term requirements for the economy. Individuals who are looking for short term investments can park their funds here. Also, T-bills can be sold in the secondary market. This allows investors to convert their holding into cash during any emergency.
Treasury bills are usually auctioned by RBI every week. This allows the retail investors to place their noncompetitive bids. This increases the exposure of investors to the government bond market, which creates higher cash flows to the capital market.
Limitations of Treasury Bills
Compared to other stock market investment tools, treasury bills yield lower returns as they are government-backed debt securities. Treasury bills are zero-coupon bonds, i.e. no interest is paid on them to investors. They are issued at a discount and redeemed at face value. Therefore, the returns earned by investors in T-bills remains fixed throughout the bond tenure irrespective of the economic condition of the country.
Stock market variations influence the returns generated by equity, equity fund, and debt fund and debt instruments. Subsequently, when the stock market moves upwards, the yield generated by equity, equity fund, and debt fund or debt instruments is also higher. However, the returns generated by T-bills remain fixed irrespective of the financial market movements.
3) Certificate of Deposits.
-> Certificate of deposit (CD) is an agreement between the depositors and the authorized bank or financial institution. This agreement is for a specific period of time with a certain amount of money to invest where the financial institution pays interest. You can redeem at the time of maturity of the instrument. Hence, you cannot withdraw before the completion of the tenure.
CDs are issued in a dematerialized form. It is a promissory note that a bank or financial institution issues. Federal Deposit Insurance Corporation (FDIC) insures it. And Reserve Bank of India (RBI) regulates it. The RBI lays the guidelines regarding the investments in CDs.
At the time of maturity of a CD, the depositor gets a grace period of 7 days to decide about the matured amount. In case the depositor does not withdraw within the seven days grace period, the maturity amount is reinvested. Furthermore, one can also withdraw the matured amount after the grace period by paying the penalty. Otherwise, the actual investment cannot be redeemed on demand or penalty payment.
CDs were introduced in the year 1989 to increase the range of money market instruments . This enables investors to manage short term funds more effectively.
Features of Certificate of Deposit
One should understand the salient features of Certificate of deposit before investing.
RBI authorizes only a few selective banks and financial institutions to issue CDs. There are specific guidelines that RBI issues for the purchase of CDs. Banks can issue CDs to individuals, mutual funds, trusts, insurers and pension funds.
Commercial Banks issue CDs which have a tenure ranging from 7 days to one year. However, financial institutions issue Certificate of deposits with different maturity dates. They can be 1year CD upto 3year CD.
The Certificate of deposits CDs are issued in the multiples of Rs.1lakh, and the minimum size of investment is also Rs. 1lakh.
An electronic certificate of deposit is transferable through endorsement or delivery. However, certificates in the demat account are transferable as per the guidelines of the demat securities.
Loan against Certificate of Deposit
Banks do not grant loans against CDs since these certificates do not have a lock-in period. Banks cannot buy back CDs before maturity.
Discount on Certificate of Deposit
Certificate of deposit is issued at a discount on face value. Also, financial institutions, banks and credit unions can issue Certificate of deposits on a floating rate basis. The method of calculating the floating rate is market-based
Eligibility for issuance of a certificate of deposit
Reserve Bank of India has laid down the following specifications for both investors and lenders for Certificate of deposit –
· Only selected financial institutions and scheduled commercial banks issue Certificate of deposits CDs in India within a specific limit. The Federal Deposit Insurance Corporation (FDIC) insures it.
· Certificate of deposit is issued to depositors. With this, depositors are individuals, companies, corporations and mutual fund houses.
· Certificate of deposits CDs can also be issued to Non-Resident Indians (NRIs) on a non-repatriable basis. However, one cannot endorse CDs to another NRI in the secondary market.
· Banks and financial institutions cannot provide loans against Certificate of deposits. Also, banks cannot buy their CDs before the latter’s maturity.
· However, cooperative banks and regional rural banks cannot issue the Certificate of deposits.
· As per RBI guidelines, banks have to maintain their statutory liquidity ratio (SLR) and cash reserve ratio (CRR) on the price of Certificate of deposit.
Advantages and limitations of investing
Though Certificate of deposits are one among many useful investment options , they have their benefits and limitations of investing
Investment in the stock market or debt funds is very volatile. However, one considers investment in Certificate of deposits as safe because banks or financial institutions issue them. Further, they invest in safe instruments that generate growth.
The Certificate of deposits CD rate is pre-determined throughout the investment tenure. Hence, they offer better returns when compared to the savings account. Also, staying invested for a longer duration in a certificate of deposit generates higher returns. Hence, financial institutions issue Certificate of deposits with different maturity periods like 1year CD up to 3year CD.
One can choose the duration and issue price of CDs they want to invest. However, the bank sets the parameters. One can also opt for monthly, annual or a lump sum payout at the time of maturity of the CD. Therefore, investors can select based on their investment planning and financial plan objectives.
On maturity of CDs, investor’s get a grace period of 7 days which help them decide about their maturity amount. One can continue to reinvest or withdraw the same.
Compared to other stock market or debt fund investment options, Certificate of deposits yield lower returns. The government backs them. Usually, CDs are issued at a discount value and redeemed at face value. Therefore, irrespective of the economic condition of the country, the returns earned by investors though Certificate of deposits remains fixed.
One can only redeem the matured amount after the grace period by paying a withdrawal penalty. Otherwise, one cannot redeem the actual investment amount on demand or penalty payment. Hence, Certificate of deposits has limited liquidity.
4) Short-term sources of finance.
-> Short-term financing may be defined as the credit or loan facility extended to an enterprise for a period of less than one year.
It is a credit arrangement provided to an enterprise to bridge the gap between income and expenses in the short run. It helps the enterprise to manage its current liabilities, such as payment of salaries and wages to labors and procurement of raw materials and inventory.
The availability of short-term funds ensures the sufficient liquidity in the enterprise. It facilitates the smooth functioning of the enterprise’s day-to-day activities.
The various short-term sources of finance are as follows:
Source 1- Trade Credit:
Trade credit refers to the credit extended by the supplier of goods or services to his/her customer in the normal course of business. It occupies a very important position in short-term financing due to the competition. Almost all the traders and manufacturers are required to extend credit facility (a portion), without which there is no business. Trade credit is a spontaneous source of finance that arises in the normal business transactions without specific negotiation, (automatic source of finance).
In order to get this source of finance, the buyer should have acceptable and dependable creditworthiness and reputation in the market. Trade credit is generally extended in the form of open account or bills of exchange. Open account is the form of trade credit, where supplier sends goods to the buyer and the payment to be received in future as per terms of the sales invoice.
As such trade credit constitutes a very important source of finance, represents 25 per cent to 50 per cent of the total short-term sources for financing working capital requirements.
Getting trade credit may be easy to the well-established, but for a new or a firm with financial problems, will generally face problems in getting trade credit. Generally, suppliers look for earnings record, liquidity position and payment record while extending credit. Building confidence in suppliers is possible only when the buyer discusses his/her financial condition, future plans and payment record. Trade credit involves some benefits and costs.
The main advantages are:
(i) Easy availability when compared to other sources of finance (except financially weak companies)
(ii) Flexibility is another benefit, as the credit increases with the growth of the firm’s sales.
(iii) Informality as stated in the above that it is an automatic finance.
Costs of Trade Credit:
The above discussion on trade credit reveals two things:
(i) Cost of trade credit is very high beyond the cash discount period, company should not have cash discount for prompt payment.
(ii) If the company is not able to avail cash discount it should pay only at the end of the last day of credit period, even it can delay one or two days if it does not affect the credit standing.
Source 2- Accruals:
Accrued expenses are those expenses which the company owes to the other, but not yet due and not yet paid the amount. Accruals represent a liability that a firm has to pay for the services or goods, it has received. It is spontaneous and interest-free source of financing. Salaries and wages, interest and taxes are the major constituents of accruals. Salaries and wages are usually paid on monthly and weekly base, respectively.
The amounts of salaries and wages are owed but not yet paid and shown them as accrued salaries and wages on the balance sheet at the end of the financial year. The longer the time lag in–payment of these expenses, the greater is the amount of funds provided by the employees. Similarly, interest and tax are accruals, as source of short-term finance. Tax will be paid on earnings.
Income-tax is paid to the government, on quarterly basis and some other taxes may be payable half- yearly or annually. Amount of taxes due as on the date of the balance sheet but not paid till then are shown as accrued taxes on the balance sheet. Like taxes, interest is paid periodically in the year but the funds are used continuously by a firm. All other such items of expenses can be used as a source of short-term finance but shown on the balance sheet.
The amount of accrual varies with the level of activities of a firm. When the level of activity expands, accruals increase and automatically they act a source of finance. Accruals are treated as “cost free” source or finance, since it does not involve any payment of interest.
But in actual terms it may not be true, since payment of salaries and wages is determined by provisions of law and industry practice. Similarly, tax payment is governed by laws and delay in payment of tax leads to penalty. Hence, a firm must note that use of accruals as a source of working capital paying may not be possible.
Source 3- Deferred Income:
Deferred income is income received in advance by the firm for supply of goods or services in future period. This income increases the firm’s liquidity and constitutes an important source of short-term finance. These payments are not showed as revenue till the supply of goods or services, but showed in the balance sheet as income received in advance.
Advance payment can be demanded by firms which are having monopoly power, great demand for its products and services and if the firm is manufacturing a special product on a special order.
Source 4- Commercial Papers (CPs):
Commercial paper represents a short-term unsecured promissory note issued by firms that have a fairly high credit (standing) rating. It was first introduced in the USA and it is an important money market instrument. In India, Reserve Bank of India introduced CP on the recommendations of the Vaghul Working Group on Money Market. CP is a source of short-term finance to only large firms with sound financial position.
1. The maturity period of CP ranges from 15 to 365 days (but in India it ranges between 91 to 180 days).
2. It is sold at a discount from its face value and redeemed at its face value.
3. Return on CP is the difference between par value and redeemable value.
4. It may be sold directly to investors or indirectly through dealers.
5. There is no developed secondary market for CP.
Source 5- Public Deposits:
Public deposits or term deposits are in the nature of unsecured deposits, are solicited by the firms (both large and small) from general public primarily for the purpose of financing their working capital requirements.
Fixed deposits accepted by companies are governed by the Companies (Acceptance of Deposits) Amendment Rules, 1978.
The main features of this regulation are:
1. A firm cannot issue public deposits for more than 25 per cent of its share capital and free reserves.
2. The public deposits can be issued for a period ranging from a minimum 6 months to maximum 3 years, only for an amount up to 10% of the company’s share capital and free reserves. Maximum period of 5 years allowed for non-banking financial corporation (NBFC’s).
3. The company that has raised funds by way of issue of public deposits is required to set aside, a deposit and/or investment, by the 30th April each year an amount equal to 10 per cent of the maturity deposits by the 31st March of the next year. The amount, so set aside can be used only for repaying the amount of deposits.
4. Finally, and importantly, a company soliciting and accepting the public deposits from the public is required to disclose true, fair, vital and relevant facts in regard to its financial position and performance.
Source 6- Inter-Corporate Deposits (ICDs):
A deposit made by one firm with another firm is known as Inter-Corporate Deposit (ICD). Generally, these deposits are made for a period up to six months.
Such deposits may be of three types:
(a) Call Deposits:
These deposits are those expected to be payable on call/on just one day notice. But, in actual practice, the lender has to wait for at least 2 or 3 days to get back the amount. Inter-corporate deposits generally have 12 per cent interest per annum.
(b) Three Months Deposits:
These deposits are more popular among companies for investing the surplus funds. The borrower takes this type of deposits for meeting short-term cash inadequacy. The interest rate on these types of deposits is around 14 per cent per annum.
(c) Six months Deposits:
Inter-corporate deposits are made for a maximum period of six months. These types of deposits are usually given to ‘A’ category borrowers only and they carry an interest rate of around 16 per cent per annum.
i. There are no legal regulations, which make an ICD transaction very convenient.
ii. Inter-corporate deposits are given and taken in secrecy.
iii. Inter-corporate deposits are given based on if the borrower is financial sound, but in practice lender lends money based on personal contacts.
Source 7- Commercial Banks:
Commercial banks are the major source of working capital finance to industries and commerce. Granting loan to business is one of their primary functions. Getting bank loan is not an easy task since the lending bank may ask a number of questions about the prospective borrower’s financial position and its plans for the future.
At the same time the bank will want to monitor borrower’s business progress. But there is a good side to this that is borrower’s share price tends to rise, because investor knows that convincing banks is very difficult.
Forms of Bank Finance:
Banks provide different types of tailor- made loans that are suitable for specific needs of a firm.
The different types or forms of loans are:
(iii) Cash credits,
(iv) Purchase or discounting of bills and
(v) Letter of Credit.
Loan is an advance lump sum given to the borrower against some security. Loan is given to the applicant in the form of cash or by credit to his/her account. In practice the loan amount is paid to the customer by crediting his/her account. Interest will be charged on the entire loan amount from the date the loan is sanctioned.
Borrower can repay the loan either in lump sum or in installments depending on conditions. If the loan is repayable in installment basis interest will be calculated on quarterly and on reduced balances. Generally, working capital loans will be granted for one-year period.
Overdraft facility is an agreement between the borrower and the banker, where the borrower is allowed to withdraw funds in excess of the balance in the firm’s current account up to a certain limit during a specified period. It is flexible from the borrower point of view because the borrower can withdraw and repay the cash whenever he/she wants within the given stipulations. Interest is charged on daily over drawn balances and not on the overdraft limit given by the bank. But bank charges some minimum charges.
(iii) Cash Credit:
It is the most popular source of working capital finance in India. A cash credit facility is an arrangement where a bank permits a borrower to withdraw money up to a sanctioned credit limit against tangible security or guarantees.
Borrower does not require to withdraw the total sanctioned credit at a time, rather, he/she can withdraw according to his/ her requirements and he/she can also repay the surplus cash in his/her cash credit account. Interest is chargeable oil actually used amount and there is no commitment charge. Cash credit is a flexible source of working capital from borrower’s point of view.
(iv) Purchasing or Discounting of Bills:
Bills receivable arise out of credit sales transaction, where the seller of goods draws the bill on the buyer. The bill may be documentary or clean bill. Once the bill is accepted by the buyer, then the drawer (seller) of the bill can go to the bank for bill discounting or sale.
The creditworthiness of the drawer (seller) is satisfactory, and then bank purchases or discounts the bill and provides funds by way of crediting to the customer’s account. The credited amount will be less than the bill amount. At the end of the maturity period of the bill bank presents the bill to the drawer (acceptor) for payment.
If the bill is discounted and it is dishonored by the drawer, then the customer (seller) is liable to pay the bill amount and any other expenses incurred by the bank. If the bill is purchased then bank takes the risk of non-payment.
(v) Letter of Credit [L/C]:
There are two non-fund based sources of working capital, viz., letter of credit (L/Cs) and Bank Guarantees (B/Gs). These are also known as quasi-document issued by the Buyer’s Banker (BB) at the request of the Buyer’s, in favour of the seller, where the Buyer’s Banker gives an undertaking to the seller, that the bank pay the obligations of its customer up to a specified amount, if the customer fails to pay the value of goods purchased.
It helps the bank’s customer to obtain credit from the seller (supplier), which is possible by assurance of the payment. Put it simply, it allows the supplier to extend credit, since the risk of non-payment is transferred to the buyer’s bank. Letter of credit facility is available from banks only for the companies that are financially sound and bank charges the customer for providing this facility.
Source 8- Factoring:
Factoring is one of the sources of working capital. Banks have been given more freedom of borrowing and lending both internally and externally and facilitated the free functioning in lending and investment operations. From 1994, banks are allowed to enter directly leasing, hire purchasing and factoring services, instead through their subsidiaries. In other words, banks are free to enter or exit in any field depending on their profitability, but subject to some RBI guidelines.
Banks provide working capital finance through financing receivables, which is known as “factoring”. A “Factor” is a financial institution, which renders services relating to the management and financing of sundry debtors that arises from credit sales.
Features of Factoring:
The following are the salient features of the factoring arrangement:
(i) Factor selects the accounts of the receivables of his client and set up a credit limit, for each account of receivables depending on safety, financial stability and creditworthiness.
(ii) The factor takes the responsibility for collecting the accounts receivables selected by it.
Factor advances to the client against selected accounts that may be not-yet, collected and not-yet- due debts. Generally, the amount of money as advance will be between 70 per cent to 80 per cent of the amount of the bills (debt). But factor charges interest on advances, that usually is equal to or slightly higher than the landing rate of commercial banks.
5. (a) Discuss the importance of Foreign Capital to Indian economy. What initiatives have been taken by the Government of India to encourage foreign capital inflow to India? (8+8=16)
(b) Briefly explain the following: (8+8=16)
1) NRI Investment in India.
-> As an NRI investing in India, your investments need to comply with regulations prescribed by the Foreign Exchange Management Act (FEMA). Your residential status as per FEMA will determine whether you can make your investments as a Resident or NRI.
You will be considered an NRI or a Non-Resident Indian if you are an Indian citizen who has resided in India for less than 182 days  during the preceding financial year or if you have gone or stayed out of India for employment, for carrying out a business or vocation. You are also considered to be an NRI if you have gone or remained outside India for any other purpose for an unspecified amount of time. Investments made by such an individual are considered to be NRI investments.
Investment options for NRIs
When it comes to investing in India, NRIs have several lucrative options. Fixed deposits, stocks and bonds, mutual funds and real estate are all excellent investment opportunities for NRIs. Fixed deposits and bonds are relatively less risky, while mutual funds and stocks tend to carry higher risk. If you are looking to buy a home in India, real estate is a great investment option as well. You will need to know the tax benefits of each investment option before you consider it. Moreover, you will need an NRE or NRO account to begin investing in India.
Steps for NRI investments
Each investment option has its procedures and requirements. However, you need to open an NRE (Non-Resident External) or NRO (Non-Resident Ordinary) savings bank account for any investment. An NRE account can be used for parking foreign earnings in India. NRE accounts are exempt from tax, and the principal amount and the interest earned on it, are freely repatriable.
An NRO account is used to park income earned in India through rent, pension, etc. Interest earned on this account is taxable and there is a cap on the principal amount that can be repatriated.
Through these accounts, you can start FDs or buy, sell or manage your real estate investments. However, if you want to invest in mutual funds or the stock market, you need to follow additional steps.
To invest in mutual funds, once your NRE/NRO account is functional, you will have to:
· Submit KYC papers and a copy of your PAN card. In the KYC form, you must mention whether this investment is on a repatriable or non-repatriable basis.
· An NRI can invest in mutual funds through another person by giving that person Power of Attorney (POA). In this case, KYC documents must contain the signature of both the NRI investor and the POA.
To invest in the stock market, NRIs will have to perform a few more steps after opening an NRE/NRO account, which are:
· Open a Portfolio Investment Scheme (PIS) bank account for buying and selling stocks. Transactions made through this account are reported to the RBI.
· Open a Demat and trading account with a SEBI-registered brokerage firm as all transactions can only be done through an Indian stockbroker.
Documents required for NRI investments
This section tells you all about the important NRI investment documents. The KYC form needs to be accompanied by documents like a recent photograph, attested copies of PAN card, passport, overseas residence proof and bank statements. Public notaries can do attestation of documents, a court magistrate or judge as well as authorised officials of overseas branches of commercial banks registered in India. It can also be done by the Indian embassy/consulate general in the country of residence.
Documents needed to open PIS/Demat/trading account include all of the above plus a copy of your Visa and PIS permission letter.
Taxes on NRI investments in India
If your country of residence has signed the Double Taxation Avoidance Treaty (DTAA) with India, you will have to pay tax in only one country. NRO FDs attract taxes in India. Interest earned is charged at a Tax Deducted at Source (TDS) rate of around 30% as per the Income Tax Act 1961. Similarly, rent earned from a real estate property too is taxable. When it comes to equity mutual funds, short-term capital gains are taxed at 15% and per the finance bill of 2018, long-term capital gains exceeding Rs. 1 lakh per annum are taxed at 10%.
Concerning debt funds, short-term capital gains (STCG) is taxable at the rate of 30% for a period, not more than 36 months. If you hold the fund for more than 36 months, you will have to pay 20% tax on the long-term capital gains with indexation benefit. LTCG on non-listed funds will be taxed at the rate of 10% without indexation.