banking foundation course v1.8

8/9/2019 Banking Foundation Course v1.8

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Foundation Course in Banking


Version : 1.8

Date : 16-July-2004

Cognizant Technology Solutions

500 Glenpointe Centre WestTeaneck, NJ 07666

Ph: 201-801-0233www.cognizant.com


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TABLE OF CONTENTS

1. THE CONCEPT OF MONEY............................................................................................................3

2. FINANCIAL INSTRUMENTS......................................................................................................... 11

3. FINANCIAL MARKETS..................................................................................................................22

4. RISK MANAGEMENT.....................................................................................................................31

5. INTRODUCTION TO BANKING................................................................................................... 39

6. RETAIL BANKING ..........................................................................................................................47

7. ELECTRONIC BANKING...............................................................................................................62

8. PRIVATE BANKING/WEALTH MANAGEMENT...................................................................... 69

9. ASSET MANAGEMENT.................................................................................................................. 77

10. CORPORATE LENDING ............................................................................................................86

11. TRADE FINANCE........................................................................................................................94

12. TREASURY SERVICES & CASH MANAGEMENT .............................................................106

13. INVESTMENT BANKING ........................................................................................................ 120

14. INVESTOR SERVICES.............................................................................................................. 135

15. RECENT DEVELOPMENTS .................................................................................................... 143

GLOSSARY .............................................................................................................................................. 153

REFERENCES.......................................................................................................................................... 161


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Cognizant Confidential Page 3 of 162

1. THE CONCEPT OF MONEY


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THE CONCEPT OF MONEY

DEFINING MONEY

“Money is a standardized unit of exchange”. The practical form of money is currency. It variesacross countries whereas money remains the same. For example, in India, the currency is theIndian Rupee (INR) and in the US, it is the US Dollar (USD).

Due to various economic factors, the value of each country’s currency is not equal. For example,if the exchange rate between US Dollars (USD) and Indian Rupees (INR) is USD 1 = INR 46.70,it implies that one U.S dollar is equivalent to 46.70 Indian Rupees. The USD is normally taken asa benchmark against which to compare the value of each currency.

THE CONCEPT OF INTEREST: SIMPLE INTEREST AND COMPOUND INTEREST

Interest is the amount earned on money; there is such an earning because present consumptionof the lender is being sacrificed for the future; you are letting somebody else use the money forpresent consumption. Using an analogy, interest is the ‘rent’ charged for delaying presentconsumption of money. Interest rates are not constant and will vary depending on different

economic factors

Simple interest

Simple interest is calculated only on the beginning principal. Simple Interest = P*r*t/100 where: Pis the Principal or the initial amount you are initially borrowing or depositing, to earn or chargeinterest on, r is the interest rate and t is the time period.

Example

If someone were to receive 5% interest on a beginning value of $100, the first year they would

get:

0.05*$100 = $5

If they continued to receive 5% interest on the original $100 amount, over five years the growth in

their investment would look like this:

Year 1: (5% of $100 = $5) + $100 = $105

Year 2: (5% of $100 = $5) + $105 = $110

Year 3: (5% of $100 = $5) + $110 = $115

Year 4: (5% of $100 = $5) + $115 = $120

Year 5: (5% of $100 = $5) + $120 = $125


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Compound interest

With compound interest, interest is calculated not only on the beginning interest, but on anyinterest accumulated with the initial principal in the meantime. Compound interest =

[P*(1+r/100)^t – P], where: P is the Principal or the initial amount you are initially borrowing ordepositing, to earn or charge interest on, r is the interest rate and t is the time period.

Example

If someone were to receive 5% compound interest on a beginning value of $100, the first year

they would get the same thing as if they were receiving simple interest on the $100, or $5. The

second year, though, their interest would be calculated on the beginning amount in year 2, which

would be $105. So their interest would be:.05 x $105 = $5.25

If this were to continue for 5 years, the growth in the investment would look like this:

Year 1: (5% of $100.00 = $5.00) + $100.00 = $105.00

Year 2: (5% of $105.00 = $5.25) + $105.00 = $110.25

Year 3: (5% of $110.25 = $5.51) + $110.25 = $115.76

Year 4: (5% of $115.76 = $5.79) + $115.76 = $121.55

Year 5: (5% of $121.55 = $6.08) + $121.55 = $127.63

Note that in comparing growth graphs of simple and compound interest, investments with simpleinterest grow in a linear fashion and compound interest results in geometric growth. So withcompound interest, the further in time an investment is held the more dramatic the growthbecomes.

INFLATION

Inflation captures the rise in the cost of goods and services over a period of time. For example, ifRs.100 today can buy 5 kg of groceries, the same amount of money can only buy 5/(1+I) kgs. ofgroceries next year, where I refers to the rate of inflation beyond today.

Thus, if the inflation rate is 5%, then everything else being equal (that is, same demand & supplyand other market conditions hold), next year, you can only buy 5/(1.05) worth of groceries.


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A quantitative estimate of inflation in a particular economy can be calculated by measuring theratio of Consumer Price Indices or CPI of two consecutive years. That’s right, the CPI that youhear of, is the weighted average price, of a predefined basket of basic goods. The % increase ofthe CPI this year vs. the CPI of last year, gives the inflation, or rise in price of consumer goods,over last year.

Inflation results in a decrease in the value of money over time. The link between the interestrates, nominal and real, and inflation enables you to identify this impact.

Nominal Interest

Nominal rate of interest (N) refers to the stated interest rate in the economy. For example, ifcounter-party demands 110 rupees after a year in return for 100 rupees lent today, the nominalrate of interest is 10%. This, as you see, includes the inflation rate.

Example

You’ve lent out 100 rupees, at 10%, for one year. On maturity, you get a profit, so you think, of 10

rupees. But this sum of 110 rupees buys less than 110 rupees did a year ago, due to inflation!

Thus, the value of 110 rupees today is actually, or really, less than the value of 110 rupees a year

ago, and it is less by the inflation rate. Thus the real interest you earned is less than 10%.

Real rate of Interest

Real rate of interest (R) refers to the inflation-adjusted rate of interest. It is less than the nominalrate of interest for economies having positive rate of inflation.

The relationship between the R (real rate of interest), N (nominal rate of interest) and I (rate of

inflation) is as:R= N-I

(This is a widely used approximation; the exact formula takes into account time value of inflationetc.)

Why is it important to know the real rate of return? Take an example where a business is earninga net profit of 7% per annum. But, inflation is also standing at 7%. So, real profit is actually atzero.

Example

Nominal rate (N) = 10%, Inflation (I) = 5%

Therefore, real interest is:

R = N – I = 5%

Therefore, the real rate of return is not 10% but 5%.


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TIME VALUE CONCEPT OF MONEY

Time value of money, which serves as the foundation for many concepts in finance, arises fromthe concept of interest. Because of interest, money on hand now is worth more than the same

money available at a later point of time. To understand time value of money and related conceptslike Present value and future value, we need to understand the basic concepts of simple andcompound interest described above.

Future Value

Future Value is the value that a sum of money invested at compound interest will have after aspecified period.

The formula for Future Value is:

FV = PV*(1 + i)n

where:

FV : Future Value at the end of n time periods

PV : Beginning value OR Present Value

i : Interest rate per unit time period

n : Number of time periods

Example

If one were to receive 5% per annum compounded interest on $100 for five years,

FV = $100*(1.05)5 = $127.63

Intra-year compounding

If a cash flow is compounded more frequently than annually, then intra-year compounding isbeing used. To adjust for intra-year compounding, an interest rate per compounding period mustbe found as well as the total number of compounding periods.

The interest rate per compounding period is found by taking the annual rate and dividing it by thenumber of times per year the cash flows are compounded. The total number of compoundingperiods is found by multiplying the number of years by the number of times per year cash flows

are compounded.


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Example

Suppose someone were to invest $10,000 at 8% interest, compounded semiannually, and hold itfor five years.,

Interest rate for compounding period = 8%/2 = 4%

Number of compounding periods = 5*2 = 10

Thus, the future value FV = 10,000*(1+0.04)^10 = $14,802.44

Present value

Present Value is the current value of a future cash flow or of a series of future cash flows. It is

computed by the process of discounting the future cash flows at a predetermined rate of interest.

If $10,000 were to be received in a year, the present value of the amount would not be $10,000because we do not have it in our hand now, in the present. To find the present value of the future$10,000, we need to find out how much we would have to invest today in order to receive that$10,000 in the future. To calculate present value, or the amount that we would have to investtoday, we must subtract the (hypothetical) accumulated interest from the $10,000. To achievethis, we can discount the future amount ($10,000) by the interest rate for the period. The futurevalue equation given above can be rearranged to give the Present Value equation:

PV = FV / (1+I)^n

In the above example, if interest rate is 5%, the present value of the $10,000 which we will

receive after one year, would be:

PV = 10,000/(1+0.05) = $ 9,523.81

Net Present Value (NPV)

Net Present Value (NPV) is a concept often used to evaluate projects/investments using theDiscounted Cash Flow (DCF) method. The DCF method simply uses the time value concept anddiscounts future cash flows by the applicable interest rate factor to arrive at the present value ofthe cash flows. NPV for a project is calculated by estimating net future cash flows from theproject, discounting these cash flows at an appropriate discount rate to arrive at the present valueof future cash flows, and then subtracting the initial outlay on the project.

NPV of a project/investment = Discounted value of net cash inflows – Initial cost/investment. The

project/investment is viable if NPV is positive while it is not viable if NPV is negative.


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Example

An investor has an opportunity to purchase a piece of property for $50,000 at the beginning of theyear. The after-tax net cash flows at the end of each year are forecast as follows:

Year Cash Flow

1 $9,000

2 8,500

3 8,000

4 8,000

5 8,0006 8,000

7 8,000

8 7,000

9 4,500

10 51,000 (property sold at the end of the 10th year)

Assume that the required rate of return for similar investments is 15.00%.

NPV = - 50000 + 9000/(1+0.15)^1 + 8500/(1+0.15)^2 + ….. +51000/(1+0.15)^10 = $612.96

However, if we assume that the required rate of return is 16.00%,

NPV = - 50000 + 9000/(1+0.16)^1 + 8500/(1+0.16)^2 + ….. +51000/(1+0.16)^10 = ($1360.77)

Thus, it can be seen that the NPV is highly sensitive to required rate of return. NPV of a project:

• Increases with increase in future cash inflows for a given initial outlay

• Decreases with increase in initial outlay for a given set of future cash inflows

• Decreases with increase in required rate of return

Internal Rate of Return (IRR)

Internal Rate of Return (IRR), also referred to as ‘Yield’ is often used in capital budgeting. It is theimplied interest rate that makes net present value of all cash flows equal zero.


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In the previous example, the IRR is that value of required rate of return that makes the NPV

equals zero.

IRR = r, whereNPV = - 50000 + 9000/(1+r)^1 + 8500/(1+r)^2 + ….. +51000/(1+r)^10 = $0.00

IRR can be calculated using trial and error methods by using various values for r or using the IRR

formula directly in MS Excel. Here, IRR = 15.30%. In other terms, IRR is the rate of return at

which the project/investment becomes viable.


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2. FINANCIAL INSTRUMENTS


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FINANCIAL INSTRUMENTS

RAISING CAPITAL

Corporations need capital to finance business operations. They raise money by issuing Securitiesin the form of Equity and Debt . Equity represents ownership of the company and takes the form ofstock. Debt is funded by issuing Bonds, Debentures and various certificates. The use of debt isalso referred to as Leverage Financing. The ratio of debt/equity shows a potential investor theextent of a company’s leverage.

Investors choose between debt and equity securities based on their investment objectives.Income is the main objective for a debt investor. This income is paid in the form of Interest ,usually as semi-annual payments. Capital Appreciation (the increase in the value of a securityover time) is only a secondary consideration for debt investors. Conversely, equity investors areprimarily seeking Growth, or capital appreciation. Income is usually of lesser importance, and isreceived in the form of Dividends.

Debt is considered senior to equity (i.e.) the interest on debt is paid before dividends on stock. Italso means that if the company ceases to do business and liquidate its assets, that the debtholders have a senior claim to those assets.

SECURITY

Security is a financial instrument that signifies ownership in a company (a stock), a creditorrelationship with a corporation or government agency (a bond), or rights to ownership (an option).Financial instruments can be classified into:

• Debt

• Equity

• Hybrids

• Derivatives

DEBT

Debt is money owed by one person or firm to another. Bonds, loans, and commercial paper areall examples of debt.

Bond

An investor loans money to an entity (company or government) that needs funds for a specifiedperiod of time at a specified interest rate. In exchange for the money, the entity will issue acertificate, or bond, that states the interest rate (coupon rate) to be paid and repayment date(maturity date). Interest on bonds is usually paid every six months (semiannually).

Bonds are issued in three basic physical forms: Bearer Bonds, Registered As to Principal Onlyand Fully Registered Bonds.

Bearer bonds are like cash since the bearer of the bond is presumed to be the owner. Thesebonds are Unregistered because the owner’s name does not appear on the bond, and there is norecord of who is entitled to receive the interest payments. Attached to the bond are Coupons. Thebearer clips the coupons every six months and presents these coupons to the paying agent toreceive their interest. Then, at the bond’s Maturity , the bearer presents the bond with the lastcoupon attached to the paying agent, and receives their principal and last interest payment.


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Bonds that are registered as to principal only have the owner’s name on the bond certificate, butsince the interest is not registered these bonds still have coupons attached.

Bonds that are issued today are most likely to be issued fully registered as to both interest andprincipal. The transfer agent now sends interest payments to owners of record on the interestPayable Date. Book Entry bonds are still fully registered, but there is no physical certificate andthe transfer agent keeps track of ownership. U.S. Government Negotiable securities (i.e.,Treasury Bills, Notes and Bonds) are issued book entry, with no certificate. The customer’sConfirmation serves as proof of ownership.

Principal and Interest

Bondholders are primarily seeking income in the form of a semi-annual coupon payment. Theannual rate of return (also called Coupon, Fixed, Stated or Nominal Yield ) is noted on the bondcertificate and is fixed. The factors that influence the bond's initial coupon rate are prevailingeconomic conditions (e.g., market interest rates) and the issuer's credit rating (the higher thecredit rating, the lower the coupon). Bonds that are In Default are not paying interest.

The principal or par or Face amount of the bond is what the investor has loaned to the issuer. Therelative "safety" of the principal depends on the issuer’s credit rating and the type of bond thatwas issued.

Corporate bond

A bond issued by a corporation. Corporations generally issue three types of bonds: SecuredBonds, Unsecured Bond s (Debentures), and Subordinated Debentures.

All corporate bonds are backed by the full faith and credit of the issuer, but a secured bond isfurther backed by specific assets that act as collateral for the bond.

In contrast, unsecured bonds are backed by the general assets of the corporation only. There arethree basic types of Secured Bonds:

Mortgage Bonds are secured by real estate owned by the issuer

Equipment Trust Certificates are secured by equipment owned and used in the issuers business

Collateral Trust Bonds are secured by a portfolio of non-issuer securities. (usually U.S. Governmentsecurities)

Secured Bonds are considered to be Senior Debt Securities, and have a senior creditor status; theyare the first to be paid principal or interest and are thus the safest of an issuer’s securities.

Unsecured Bonds include debentures and subordinated debentures. Debentures have a generalcreditor status and will be paid only after all secured creditors have been satisfied. Subordinateddebentures have a subordinate creditor status and will be paid after all senior and generalcreditors have first been satisfied.

Example• IBM can issue 10 year bonds with a coupon of 5.5%.

• Priceline can issue similar 10 year bonds at 8%

• The difference in coupon is due to their credit rating!


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Municipal bond (Munis)

A bond issued by a municipality. These are generally tax free, but the interest rate is usuallylower than a taxable bond.

Treasury Securities

Treasury bills, notes, and bonds are marketable securities the U.S. government sells in order topay off maturing debt and raise the cash needed to run the federal government. When an investorbuys one of these securities, he/she is lending money to the U.S. government.

Treasury bills are short-term obligations issued for one year or less. They are sold at a discountfrom face value and don't pay interest before maturity. The interest is the difference between the

purchase price of the bill and the amount that is paid to the investor at maturity (face value) or atthe time of sale prior to maturity.

Treasury notes and bonds bear a stated interest rate, and the owner receives semi-annualinterest payments. Treasury notes have a term of more than one year, but not more than 10years.

Treasury bonds are issued by the U.S. Government. These are considered safe investmentsbecause they are backed by the taxing authority of the U.S. government, and the interest onTreasury bonds is not subject to state income tax. T-bonds have maturities greater than tenyears, while notes and bills have lower maturities. Individually, they sometimes are called "T-bills," "T-notes," and "T-bonds." They can be bought and sold in the secondary market atprevailing market prices.

Savings Bonds are bonds issued by the Department of the Treasury, but they aren't are not

marketable and the owner of a Savings Bond cannot transfer his security to someone else.

Zero coupon bonds

Zeros generate no periodic interest payments but they are issued at a discount from face value.The return is realized at maturity. Zeros sell at deep discounts from face value. The differencebetween the purchase price of the zero and its face value when redeemed is the investor's return.

Case Study

• Enron set up power plant at Dabhol, India

• The cost of the project (Phase 1) was USD 920 Million

• Fundingo Equity USD 285 mio

o Bank of America/ABN Amro USD 150 mio

o IDBI & Indian Banks USD 95 mio

o US Govt – OPIC USD 100 mio

o US Exim Bank USD 290 mio

• Enron US declared bankruptcy in 2002

• Enron India’s assets are mortgaged to various banks as above.

• Due to interest payments and depreciation, assets are worth considerably less than

USD 920 mio.

• Who will get their money back? And how much?


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Zeros can be purchased from private brokers and dealers, but not from the Federal Reserve orany government agency.

The higher rate of return the bond offers, the more risky the investment. There have beeninstances of companies failing to pay back the bond (default), so, to entice investors, mostcorporate bonds will offer a higher return than a government bond. It is important for investors toresearch a bond just as they would a stock or mutual fund. The bond rating will help indeciphering the default risk.

Commercial paper

An unsecured, short-term loan issued by a corporation, typically for financing accounts receivableand inventories. It is usually issued at a discount to face value, reflecting prevailing marketinterest rates. It is issued in the form of promissory notes, and sold by financial organizations asan alternative to borrowing from banks or other institutions. The paper is usually sold to othercompanies which invest in short-term money market instruments.

Since commercial paper maturities don't exceed nine months and proceeds typically are usedonly for current transactions, the notes are exempt from registration as securities with the United

States Securities and Exchange Commission. Financial companies account for nearly 75 percentof the commercial paper outstanding in the market.

There are two methods of marketing commercial paper. The issuer can sell the paper directly tothe buyer or sell the paper to a dealer firm, which re-sells the paper in the market. The dealermarket for commercial paper involves large securities firms and subsidiaries of bank holdingcompanies. Direct issuers of commercial paper usually are financial companies which havefrequent and sizable borrowing needs, and find it more economical to place paper without the useof an intermediary. On average, direct issuers save a dealer fee of 1/8 of a percentage point. Thissavings compensates for the cost of maintaining a permanent sales staff to market the paper.

Interest rates on commercial paper often are lower than bank lending rates, and the differential,when large enough, provides an advantage which makes issuing commercial paper an attractivealternative to bank credit.

Commercial paper maturities range from 1 day to 270 days, but most commonly is issued for lessthan 30 days. Paper usually is issued in denominations of $100,000 or more, although somecompanies issue smaller denominations. Credit rating agencies like Standard & Poor rate theCPs. Ratings are reviewed frequently and are determined by the issuer's financial condition, banklines of credit and timeliness of repayment. Unrated or lower rated paper also is sold in themarket.

Investors in the commercial paper market include private pension funds, money market mutualfunds, governmental units, bank trust departments, foreign banks and investment companies.There is limited secondary market activity in commercial paper, since issuers can closely matchthe maturity of the paper to the investors' needs. If the investor needs ready cash, the dealer orissuer usually will buy back the paper prior to maturity.

EQUITY

Equity (Stock) is a security, representing an ownership interest. Equity refers to the value of thefunds contributed by the owners (the stockholders) plus the retained earnings (or losses).


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Stock Terminology

Public Offering Price (POP ) – The price at which shares are offered to the public in a PrimaryOffering . This price is fixed and must be maintained when Underwriters sell to customers.

Current Market Price – The price determined by Supply and Demand in the Secondary Markets.

Book Value – The theoretical liquidation value of a stock based on the company's Balance Sheet.

Par Value – An arbitrary price used to account for the shares in the firm’s balance sheet. Thisvalue is meaningless for common shareholders, but is important to owners of Preferred Stock .

Preferred Stock

Preference shares carry a stated dividend and they do not usually have voting rights. Preferredshareholders have priority over common stockholders on earnings and assets in the event ofliquidation. Preferred stock is issued with a fixed rate of return that is either a percent of par

(always assumed to be $100) or a dollar amount. Although preferred stock is equity and represents ownership, preferred stock investors areprimarily seeking income. The market price of income seeking securities (such as preferred stockand debt securities) fluctuates as market interest rates change. Price and yield are inverselyrelated.

There are several different types of preferred stock including Straight, Cumulative, Convertible,Callable, Participating and Variable. With straight preferred, the preference is for the currentyear’s dividend only. Cumulative preferred is senior to straight preferred and has a firstpreference for any dividends missed in previous periods.

Convertible preferred stock can be converted into shares of common stock either at a fixedprice or a fixed number of shares. It is essentially a mix of debt and equity, and most often usedas a means for a risky company to obtain capital when neither debt nor equity works. It offers

considerable opportunity for capital appreciation.

Non-convertible preferred stock remains outstanding in perpetuity and trades like stocks.Utilities represent the best example of nonconvertible preferred stock issuers.

Example

When Cognizant Technology Solutions came out with its Initial Public Offering on NASDAQ inJune 1998, the Public Offering Price (POP) was set at $10 per share. The stock was split

twice, 2-for-1 in March-2000 and 3-for-1 again in April 2003. As of Dec 6, 2003, the Current

Market Price stood at $46.26. However, if the stock-splits are taken into consideration the

actual market price would stand at 6 times the Current Market Price at whopping $253.56!!


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American Depository Receipts (ADR)

The purpose of an ADR is to facilitate the domestic trading of a foreign stock. An ADR is a receiptfor a specified number of foreign shares owned by an American bank. ADRs trade like shares,

either on a U.S. Exchange or Over the Counter. The owner of an ADR has voting rights and alsohas the right to receive any declared dividends. An example would be Infosys ADRs that aretraded in NASDAQ.

HYBRIDS

Hybrids are securities, which combine the characteristics of equity and debt.

Convertible bonds

Convertible Bonds are instruments that can be converted into a specified number of shares ofstock after a specified number of days. However, till the time of conversion the bonds continue topay coupons.

Warrants

Warrants are call options – variants of equity. They are usually offered as bonus or sweetener,attached to another security and sold as a Unit . For example, a company is planning to issuebonds, but the market dictates a 9% interest payment. The issuer does not want to pay 9%, sothey “sweeten” the bonds by adding warrants that give the holder the right to buy the issuersstock at a given price over a given period of time. Warrants can be traded, exercised, or expireworthless.

DERIVATIVES

A derivative is a product whose value is derived from the value of an underlying asset, index orreference rate. The underlying asset can be equity, foreign exchange, commodity or any otheritem. For example, if the settlement price of a derivative is based on the stock price, whichchanges on a daily basis, then the derivative risks are also changing on a daily basis. Hencederivative risks and positions must be monitored constantly.

Case Study

Tata Motors Ltd. (previously know as TELCO) recently issued convertible bond aggregating to

$100 million in the Luxemburg Stock Exchange. The effective interest rate paid on the issue

was just 4% which was much lower than what it would have to pay if it raised the money in

India, where it is based out of. The company would use this money to pay-back existing loans

borrowed at much higher interest rates.

• Why doesn’t every company raise money abroad if it has to pay lower interest rates? Will

there is

• Will there be any effect on existing Tata Motors share-holders due to the convertibleissue? If ‘Yes’, when will this be?


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Forward contract

A forward contract is an agreement to buy or sell an asset (of a specified quantity) at a certainfuture time for a certain price. No cash is exchanged when the contract is entered into.

Futures contract

A futures contract is an agreement between two parties to buy or sell an asset at a certain time inthe future at a certain price. Index futures are all futures contracts where the underlying is thestock index and helps a trader to take a view on the market as a whole.

Hedging involves protecting an existing asset position from future adverse price movements. Inorder to hedge a position, a market player needs to take an equal and opposite position in thefutures market to the one held in the cash market.

Arbitrage: An arbitrageur is basically risk averse. He enters into those contracts were he canearn risk less profits. When markets are imperfect, buying in one market and simultaneouslyselling in other market gives risk less profit. Arbitrageurs are always in the look out for such

imperfections.

Options

An option is a contract, which gives the buyer the right, but not the obligation to buy or sell sharesof the underlying security at a specific price on or before a specific date. There are two kinds ofoptions: Call Options and Put Options.

Call Options are options to buy a stock at a specific price on or before a certain date. Calloptions usually increase in value as the value of the underlying instrument rises. The price paid,called the option premium, secures the investor the right to buy that certain stock at a specifiedprice. (Strike price) If he/she decides not to use the option to buy the stock, the only cost is theoption premium. For call options, the option is said to be in-the-money if the share price is above

the strike price.

Put Options are options to sell a stock at a specific price on or before a certain date. With a PutOption, the investor can "insure" a stock by fixing a selling price. If stock prices fall, the investorcan exercise the option and sell it at its "insured" price level. If stock prices go up, there is no

need to use the insurance, and the only cost is the premium. A put option is in-the-money whenthe share price is below the strike price. The amount by which an option is in-the-money isreferred to as intrinsic value.

The primary function of listed options is to allow investors ways to manage risk. Their price isdetermined by factors like the underlying stock price, strike price, time remaining until expiration(time value), and volatility. Because of all these factors, determining the premium of an option iscomplicated.

Example

The Infosys stock price as of Dec 6 th, 2003 stood at Rs.5062. The cost of the Dec 24th, 2003

expiring Call option with Strike Price of Rs.5200 on the Infosys Stock was Rs.90. This would

mean that to break-even the person buying the Call Option on the Infosys stock, the stock

price would have to cross Rs.5290 as of Dec 24th, 2003!!


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Types of Options

There are two main types of options:

• American options can be exercised at any time between the date of purchase and theexpiration date. Most exchange-traded options are of this type.

• European options can only be exercised at the end of their life.

Long-Term Options are options with holding period of one or more years, and they are calledLEAPS (Long-Term Equity Anticipation Securities). By providing opportunities to control andmanage risk or even speculate, they are virtually identical to regular options. LEAPS, however,provide these opportunities for much longer periods of time. LEAPS are available on most widely-held issues.

Exotic Options: The simple calls and puts are referred to as "plain vanilla" options. Non-standard options are called exotic options, which either are variations on the payoff profiles of theplain vanilla options or are wholly different products with "optionality" embedded in them.

Open Interest is the number of options contracts that are open; these are contracts that have not

expired nor been exercised.

Swaps

Swaps are the exchange of cash flows or one security for another to change the maturity (bonds)or quality of issues (stocks or bonds), or because investment objectives have changed. Forexample, one firm may have a lower fixed interest rate, while another has access to a lowerfloating interest rate. These firms could swap to take advantage of the lower rates.

Currency Swap involves the exchange of principal and interest in one currency for the same inanother currency.


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Forward Swap agreements are created through the synthesis of two different swaps, differing induration, for the purpose of fulfilling the specific timeframe needs of an investor. Sometimesswaps don't perfectly match the needs of investors wishing to hedge certain risks. For example, ifan investor wants to hedge for a five-year duration beginning one year from today, they can enterinto both a one-year and six-year swap, creating the forward swap that meets the requirementsfor their portfolio.

Swaptions - An option to enter into an interest rate swap. The contract gives the buyer the optionto execute an interest rate swap on a future date, thereby locking in financing costs at a specifiedfixed rate of interest. The seller of the swaption, usually a commercial or investment bank,assumes the risk of interest rate changes, in exchange for payment of a swap premium.

Case Study

• The World Bank borrows funds internationally and loans those funds to developing

countries. It charges its borrowers a cost plus rate and hence needs to borrow at the

lowest cost.• In 1981 the US interest rate was at 17 percent, an extremely high rate due to the anti-

inflation tight monetary policy of the Fed. In West Germany the corresponding rate was 12

percent and Switzerland 8 percent.

• IBM enjoyed a very good reputation in Switzerland, perceived as one of the best managed

US companies. In contrast, the World Bank suffered from bad image since it had used

several times the Swiss market to finance risky third world countries. Hence, World Bank

had to pay an extra 20 basis points (0.2%) compared to IBM

• In addition, the problem for the World Bank was that the Swiss government imposed a

limit on the amount World Bank could borrow in Switzerland. The World Bank had

borrowed its allowed limit in Switzerland and West Germany

• At the same time, the World Bank, with an AAA rating, was a well established name in the

US and could get a lower financing rate (compared to IBM) in the US Dollar bond marketbecause of the backing of the US, German, Japanese and other governments. It would

have to pay the Treasury rate + 40 basis points.

• IBM had large amounts of Swiss franc and German deutsche mark debt and thus had

debt payments to pay in Swiss francs and deutsche marks.

• World Bank borrowed dollars in the U.S. market and swapped the dollar repayment

obligation with IBM in exchange for taking over IBM's SFR and DEM loans.

• It became very advantageous for IBM and the World Bank to borrow in the market in

which their comparative advantage was the greatest and swap their respective fixed-rate

funding.


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3. FINANCIAL MARKETS


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FINANCIAL MARKETS

WHAT ARE FINANCIAL MARKETS?

A financial transaction is one where a financial asset or instrument, such as cash, check, stock,bond, etc are bought and sold. Financial Market is a place where the buyers and sellers for thefinancial instruments come together and financial transactions take place.

TYPES OF FINANCIAL MARKETS

Primary Markets

Primary market is one where new financial instruments are issued for the first time. They providea standard institutionalized process to raise money. The public offerings are done through aprospectus. A prospectus is a document that gives detailed information about the company, theirprospective plans, potential risks associated with the business plans and the financial instrument.

Secondary marketsSecondary Market is a place where primary market instruments, once issued, are bought andsold. An investor may wish to sell the financial asset and encash the investment after some timeor the investor may wish to invest more, buy more of the same asset instead, the decisioninfluenced by a variety of possible reasons. They provide the investor with an easy way to buy orsell.

The Different Financial Markets

A financial market is known by the type of financial asset or instrument traded in it. So there areas many types of financial markets as there are of instruments. Typical examples of financialmarkets are:

• Stock market• Bond (or fixed income) market

• Money market

• Foreign exchange (Forex or FX for short) market (also called the currency market).

Stock and bond markets constitute the capital markets. Another big financial market is thederivatives market.

CAPITAL MARKETS

Why businesses need capital?

All businesses need capital, to invest money upfront to produce and deliver the goods andservices. Office space, plant and machinery, network, servers and PCs, people, marketing,licenses etc. are just some of the common items in which a company needs to invest before thebusiness can take off. Even after the business takes off, the cash or money generated from salesmay not be sufficient to finance expansion of capacity, infrastructure, and products / servicesrange or to diversify or expand geographically. Some financial services companies need to raiseadditional capital periodically in order to satisfy capital adequacy norms.


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What is the role of Capital Markets?

For businesses to thrive and grow, presence of vibrant and efficient capital markets is extremelyimportant. Capital markets have following functions:

1. Channeling funds from “savings pool” to “investment pool” - channeling funds from “thosewho have money” to “those who need funds for business purpose”.

2. Providing liquidity to investors - i.e. making it easy for investors, to buy and sell financialassets or instruments. Capital markets achieve this in a number of ways and it is particularlyimportant for institutional investors who trade in large quantities. Illiquid markets do not allowthem to trade large quantities because the orders may simply not get executed completely ormay cause drastic fluctuations in price.

3. Providing multitude of investment options to investors – this is important because the riskprofile, investment criteria and preferences may differ for each investor. Unless there aremany investment options, the capital markets may fail to attract them, thus affecting thesupply of capital.

4. Providing efficient price discovery mechanism – efficient because the price is determined bythe market forces, i.e. it is a result of transparent negotiations among all buyers and sellers inthe market at any point. So the market price can be considered as a fair price for thatinstrument.

STOCK MARKETS

Stock markets are the best known among all financial markets because of large participation ofthe “retail investors”. The important stock exchanges are as follows:

• New York Stock Exchange (NYSE)

• National Association of Securities Dealers Automated Quotations (NASDAQ)

• London Stock Exchange (LSE)

• Bombay Stock Exchange (BSE),

• National Stock Exchange of India (NSE)

Stock Exchanges provide a system that accepts orders from both buyers and sellers in all sharesthat are traded on that particular exchange. Exchanges then follow a mechanism to automaticallymatch these trades based on the quoted price, time, quantity, and the order type, thus resulting intrades. The market information is transparent and available real-time to all, making the tradingefficient and reliable.

Earlier, before the proliferation of computers and networks, the trading usually took place in anarea called a “Trading Ring” or a “Pit” where all brokers would shout their quotes and find the“counter-party”. The trading ring is now replaced in most exchanges by advanced computerizedand networked systems that allow online trading, so the members can log in from anywhere tocarry out trading. For example, BOLT of BSE and SuperDOT of NYSE.

What determines the share price and how does it change?

The share price is determined by the market forces, i.e. the demand and supply of shares at eachprice. The demand and supply vary primarily as the perceived value of the stock for differentinvestors varies. Investor will consider buying the stock if the market price is less than the


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perceived value of the stock according to that investor and will consider selling if it is higher. Alarge number of factors have a bearing on the perceived value. Some of them are:

• Performance of the company

• Performance of the industry to which it belongs

• State of the country’s economy where it operates as well as the global economy

• Market sentiment or mood relating to the stock and on the market as a whole

Apart from these, many other factors, including performance of other financial markets, affect thedemand and supply.

BOND MARKETS

As the name suggests, bonds are issued and traded in these markets. Government bondsconstitute the bulk of the bonds issued and traded in these markets. Bond markets are alsosometimes called Fixed Income markets. While some of the bonds are traded in exchanges, mostof the bond trading is conducted over-the-counter (OTC), i.e. by direct negotiations betweendealers. Lately there have been efforts to create computer-based market place for certain type of

bonds.

Participants in the Bond Market

Since Government is the biggest issuer of bonds, the central bank of the country such as FederalReserve in US and Reserve Bank of India in India, is the biggest player in the bond market. Likestock markets, one needs to be an authorized dealer of Govt. securities, to subscribe to the bondissues. Typically, the Govt. bond issues are made by way of auctions, where the dealers bid forthe bonds and the price is fixed based on the bids received. The dealers then sell these bonds inthe secondary market or directly to third parties, typically institutions and companies.

If the interest rate is fixed for each bond, why do the bond prices fluctuate?

Bond prices fluctuate because the interest rates as well as the perceptions of investors on thedirection of interest rates change. Remember, bond pays interest at a fixed coupon ratedetermined at the time of issue, irrespective of the prevailing market interest rate. Market interestrates are benchmark interest rates, such as treasury bill rates, which are subject to changebecause of various factors such as inflation, monetary policy change, etc. So when the prevailingmarket interest rates change, price of the bond (and not the coupon) adjusts, so that the effectiveyield for a buyer at the time (if the bond is held to maturity) matches the market interest rate onother bonds of equal tenure and credit rating (risk).

So when the market interest rates go up, prices of bonds fall and vice-versa. Thus, since price ofbonds changes when market interest rate changes, all bonds have an interest rate risk. If themarket interest rates shoot up, then the bond price is affected negatively and an investor whobought the bond at a high price (when interest rates were low) stands to lose money or at least

makes lesser returns than expected, unless the bond is held to maturity.


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FOREIGN EXCHANGE MARKET

Foreign exchange markets are where the foreign currencies are bought and sold. For example,importers need foreign currency to pay for their imports. Government needs foreign currency topay for its imports such as defense equipment and to repay loans taken in foreign currency.

Foreign exchange rates express the value of one currency in terms of another. They involve afixed currency, which is the currency being priced and a variable currency, the currency used toexpress the price of the fixed currency. For example, the price of a US Dollar can be expressed indifferent currencies as: USD (US Dollar) 1 = Indian Rupee (INR) 46, USD 1 = Great Britain Pound(GBP) 0.6125, USD 1 = Euro 0.8780 etc. In this example, USD is the fixed currency and INR,

GBP, Euro are the variable currencies.US Dollar, British Sterling (Pound), Euro and Japanese Yen are the most traded currenciesworldwide, since maximum business transactions are carried out in these currencies.

The exchange rate at any time depends upon the demand – supply equation for the differentcurrencies, which in turn depends upon the relative strength of the economies with respect to theother major economies and trading partners.

Participants

Only authorized foreign exchange dealers can participate in the foreign exchange market. Anyindividual or company, who needs to sell or buy foreign currency, does so through an authorizeddealer. Currency trading is conducted in the over-the-counter (OTC) market.

The role of the Central Bank in the foreign exchange market

The central bank regulates the markets to ensure its smooth functioning. The degree of regulationdepends on the economic policies of the country. The central bank may also buy or sell theircurrency to meet unusual demand – supply mismatches in the markets.

Example

Bond Price calculation can be summed by an easy formula:

where B represents the price of the bond and CF k represents the k th cash flow which is made

up of coupon payments. The Cash Flow (CF) for the last year includes both the coupon

payment and the Principal.

• What would be the bond price for a 3-Year, Rs.100 principal, bond when the interest rate

(i ) is 10% and the Coupon payments are Rs.5 annually?

• Would the bond price increase/decrease if the coupon is reduced? What would be happen

to bond rice if the interest rates came down?


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The foreign exchange rate and transactions are closely monitored because the fluctuations inforex markets affects the profitability of imports and exports of domestic companies as well asprofitability of investments made by foreign companies in that country. Regulators try to ensurethat the fluctuations are not caused by any factor other than the market forces.

MONEY MARKET

Money market is for short term financial instruments, usually a day to less than a year. The mostcommon instrument is a “repo”, short for repurchase agreement. A repo is a contract in which theseller of securities, such as Treasury Bills, agrees to buy them back at a specified time and price.Treasury bills of very short tenure, commercial paper, certificates of deposits etc. are alsoconsidered as money market instruments.

Since the tenure of the money market instruments is very short, they are generally consideredsafe. In fact they are also called cash instruments. Repos especially, since they are backed by aGovt. security, are considered virtually the safest instrument. Therefore the interest rates onrepos are the lowest among all financial instruments.

Money market instruments are typically used by banks, institutions and companies to park extracash for a short period or to meet the regulatory reserve requirements. For short-term cashrequirements, money market instruments are the best way to borrow.

Participants

Whereas in stock market the typical minimum investment is equivalent of the price of 1 share, theminimum investment in bond and money markets runs into hundreds of thousands of Rupees orDollars. Hence the money market participants are mostly banks, institutions, companies and thecentral bank. There are no formal exchanges for money market instruments and most of thetrading takes place using proprietary systems or shared trading platforms connecting theparticipants.

REGULATION OF CAPITAL MARKETS

There are many reasons why the financial markets are regulated by governments:

• Since the capital markets are central to a thriving economy, Governments need to ensuretheir smooth functioning.

• Governments also need to protect small or retail investors’ interests to ensure there isparticipation by a large number of investors, leading to more efficient capital markets.

• Governments need to ensure that the companies or issuers declare all necessary informationthat may affect the security prices and that the information is readily and easily available to allparticipants at the same time.

Example

The Bank of Japan plays the role of central bank in Japan. It strictly monitors the exchange

rates to ensure that the importers/exporters are not hurt due to any exchange rate

fluctuations. Still, the USD/JPY, which is the second most traded currency pair in the world,

maintains a long-standing reputation of sharp increases in short-term volatilities.


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Typically the government designates one or more agencies as regulator(s) and supervisor(s) forthe financial markets. Thus India has Securities and Exchange Board of India (SEBI) and the UShas Securities and Exchange Commission (SEC). These regulatory bodies formulate rules and

norms for each activity and each category of participant. For example,• Eligibility norms for a company to be allowed to issue stock or bonds,

• Rules regarding the amount of information that must be made available to prospectiveinvestors,

• Rules regarding the issue process,

• Rules regarding periodic declaration of financial statements, etc.

Regulators also monitor the capital market activity continuously to ensure that any breach of lawsor rules does not go unnoticed. To help this function, all members and issuers have to submitcertain periodic reports to the regulator disclosing all relevant details on the transactionsundertaken.

FINANCIAL MARKET SYSTEMS

The demands of the capital market transactions, the need for tracking and managing risks, thepressure to reduce total transaction costs and the obligation to meet compliance requirementsmake it imperative that the functions be automated using advanced computer systems. Some ofthe major types of systems in capital market firms are briefly described below.

Trading Systems

The volume of transactions in capital markets demands advanced systems to ensure speed andreliability. Due to proliferation of Internet technology, the trading systems are also now accessibleonline allowing even more participants from any part of the world to transact, helping to increaseefficiency and liquidity. The trading systems can be divided into front-end order entry and back-

end order processing systems.

Order entry systems also offer functions such as order tracking, calculation of profit and lossbased on real-time price movements and various tools to calculate and display risk to the value ofinvestments due to price movement and other factors.

Back-office systems validate orders, route them to the exchange(s), receive messages andnotifications from the exchanges, interface with external agencies such as clearing firm, generatemanagement, investor and compliance reports, keep track of member account balances etc.

Exchange systems

The core exchange system is the trading platform that accepts orders from members, displaysthe price quotes and trades, matches buy and sell orders dynamically to fill as many orders as

possible and sends status messages and trade notifications to the parties involved in each trade.In addition, exchanges need systems to monitor the transactions, generate reports ontransactions, keep track of member accounts, etc.

Portfolio Management Systems

These systems allow the investment managers to choose the instruments to invest in, based onthe requirements or inputs such as amount to be invested, expected returns, duration (or tenure)


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of investment, risk tolerance etc. and analysis of price and other data on the instruments andissuers. The term “portfolio” refers to the basket of investments owned by an investor. A portfolioof investments allows one to diversify risks over a limited number of instruments and issuers.

Accounting SystemsThe accounting systems take care of present value calculations, profit & loss etc.- of investmentsand funds and not the financial accounts of the firms.


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SUMMARY

• Financial markets facilitate financial transactions, i.e. exchange of financial assets suchstocks, bonds, etc.

• Financial markets bring buyers and sellers in a financial instrument together, thus reducing

transaction costs, channeling funds, improving liquidity and provide a transparent pricediscovery mechanism.

• Each financial market is segmented into a Primary market, where new instruments are issuedand a Secondary market, where the previously issued instruments are bought and sold byinvestors.

• Stock markets, bond markets, money markets, foreign exchange markets and derivativesmarkets are prominent examples of financial markets.

• Shares (stock) of a company are issued and traded in the stock markets.

• Bond markets are where bonds such as treasury bonds, treasury notes, corporate bonds, etc.are traded.

• Money markets, like bonds markets, are also fixed income markets. Instruments traded inmoney markets have very short tenure.

• Foreign exchange markets trade in currencies.

• Derivatives markets trade derivatives, which are complex financial instruments, whosereturns are based upon the returns from some other financial asset called as the underlyingasset.

• Price of any financial instrument depends basically on demand and supply, which in turndepend upon multiple different factors for different markets.

• Each financial instrument has a differing level of inherent risk associated with it. Moneymarket instruments are considered the safest due to their very short tenure.

• Regulators play a very important role in the development and viability of financial markets.Regulators try to ensure that the markets function in a smooth, transparent manner, thatthere is sufficient and timely disclosure of information, that the interest of small investors isnot compromised by the large investors, and so on, which is critical for overall vibrancy,

efficiency and growth of the market and the economy.


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4. RISK MANAGEMENT


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RISK MANAGEMENT

Risk is any element of the operating environment that can cause loss or failure. Risks are difficultto define and they keep changing constantly. For example, if we ask two derivative traders toidentify the biggest risks faced by them, we may get different answers.

Let us look at an example of an Export Oriented Unit. Most or all of their revenue is earned inforeign exchange where as costs are in domestic currency. Expenses like cost of raw material,salaries, are paid out in Indian Rupees. If rupee appreciates significantly, the exporter’s profitsmay be significantly affected. This is summarized with a numerical example in the following table:

Scenario 1 Scenario 2

INR/USD 50 45Revenues in USD 100 million 100 million

Revenues in INR 5000 million 4500 million

Costs 4000 million 4000 million

Net Profit 1000 million 500 million

A 10% appreciation in rupee resulted in a 50% drop in profits. This is a case of exchange raterisk. Of course, in times of dollar appreciation, the firm will end up making pots of money!

THE RISK REWARD PRINCIPLE

The higher the risk you take, the higher is the potential reward and the lower the risk, thelower is the potential reward. The lower the credit rating of the borrower, the higher is the risk

of lending money but higher also is the interest rate that can be charged! Note that the word usedhere is “potential reward”. There is no set formula to say how much reward will justify a certainamount of risk. Also, sometimes the reward may depend upon the person’s or the organization’sability to take advantage. However, the risk-reward principle should be the guiding principle whiledeciding on a risk management strategy.

A ship is safe in the harbor…But that is not what ships are built for!


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THREE PILLARS OF RISK MANAGEMENT

DEFINING RISKS

The following are some of the possible risk types.

Define

What are the risks?

Measure

How to estimate the risk?

Manage

Set tolerance limits and act


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Credit risk is the possibility of loss as a result of default, such as when a customer defaults on aloan, or more generally, any type of financial contract.

Liquidity risk is the possibility that a firm will be unable to generate funds to meet contractualobligations as they fall due.

Operational risk is the possibility of loss resulting from errors in instructing payments or settlingtransactions.

Legal risk is the possibility of loss when a contract cannot be enforced -- for example, becausethe customer had no authority to enter into the contract or the contract turns out to beunenforceable in a bankruptcy.

Market risk is the possibility of loss over a given period of time related to uncertain movements inmarket factors, such as interest rates, currencies, equities, and commodities.

MEASURING RISKS

Once the risks have been identified, the next step is to choose the quantitative and qualitativemeasures of those risks. Risk is essentially measured in terms of the following factors:

a. The probability of an unfavorable event occurring (expressed as a number between 0 and 1)

b. The estimated monetary impact on organization because of the event

The unfavorable events differ for different types of risk. For example, in case of market risk, futureevents refer to market scenarios. These scenarios impact each portfolio prices differentlydepending on its composition.

Risk measurement is a combination of management, quantitative analysis and informationtechnology. Serious technology investment is required for accurate measurement and reporting.

One of the commonly used methodologies for market risk is “Value At Risk”

Value at Risk (VaR)Value at Risk is an estimate of the worst expected loss on a portfolio under normal marketconditions over a specific time interval at a given confidence level. It is also a forecast of a givenpercentile, usually in the lower tail, of the distribution of returns on a portfolio over some period.VaR answers the question: how much one can lose.

Another way of expressing this is that VaR is the lowest quantile of the potential losses that canoccur within a given portfolio during a specified time period. For an internal risk managementmodel, the typical number is around 5%. Suppose that a portfolio manager has a daily VaR equalto $1 million at 1%. This means that there is only one chance in 100 that a daily loss bigger than$1 million occurs under normal market conditions.

Suppose portfolio manager manages a portfolio which consists of a single asset. The return ofthe asset is normally distributed with annual mean return 10% and annual standard deviation

30%. The value of the portfolio today is $100 million. We want to answer various simple questionsabout the end-of-year distribution of portfolio value:

1. What is the distribution of the end-of-year portfolio value?

2. What is the probability of a loss of more than $20 million dollars by year end?

3. With 1% probability what is the maximum loss at the end of the year? This is the VaR at 1%.


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Value-at-Risk (VaR) is an integrated way to deal with different markets and different risks and tocombine all of the factors into a single number which is a good indicator of the overall risk level.

VaR Calculation

A generic step-wise approach to calculate would be:

• Get price data for you portfolio holdings.

• Convert price data in to log return data. (Log Return: ui = ln (Si / Si-1) where Si is the price ofthe asset on day i)

• Calculate standard deviations of each instrument or each proxy.

• Calculate preferred confidence level. 99% = 2.33 * standard deviation.

• Multiply position holdings by their respective Standard Deviation at a 99% confidence level.This results in a position VaR at a 99% confidence level.

A. Monte-Carlo Simulation

It is a simulation technique. First, some assumptions about the distribution of changes in marketprices and rates (for example, by assuming they are normally distributed) are made, followed bydata collection to estimate the parameters of the distribution. The Monte Carlo then uses thoseassumptions to give successive sets of possible future realizations of changes in those rates. Foreach set, the portfolio is revalued. When done, you've got a set of portfolio revaluationscorresponding to the set of possible realizations of rates. From that distribution you take the 99thpercentile loss as the VaR.

Example VaR Calculation

Assume that you have a holding in IBM Stock worth $10 million. You have calculated the

standard deviation (SD) of change over one day in IBM is $ 0.20.

Therefore for the entire position, SD of change over 1 day = $200,000

The SD of change over 10 days = $200,000 * √(10) = $632,456

The 99% VaR over 10 days = 2.33 * 632,456 = $1,473,621


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Example Monte-Carlo Simulation

Monte-Carlo simulation is a computation process that utilizes random numbers to derive an

outcome. So instead of having fixed inputs, probability distributions are assigned to some or

all of the inputs. This will generate a probability distribution for the output after the simulationis ran. Here is an example.

A firm that sells product X under a pure/perfect competition market* wants to know the

probability distribution for the profit of this product and the probability that the firm will loss

money when marketing it.

The equation for the profit is: TP = TR - TC = (Q*P) - (Q*VC+FC)

Assumptions:• The Quantity Demanded (Q) fluctuates between 8,000 and 12,000 units• All other similar Output factors are also simulated to reflect the change.

A simple simulation worksheet is prepared to with 50000 iterations for Q. It shows the profit

number (with frequency) under various scenarios of quantity sold. This translates into a near

Normal Curve with a Mean and Standard Deviation.

Using the required confidence interval from the normal curve and the standard deviation, a

VaR limit is generated from this distribution.


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B. Historical Simulation

Like Monte Carlo, it is a simulation technique, but it skips the step of making assumptions aboutthe distribution of changes in market prices and rates. Instead, it assumes that whatever therealizations of those changes in prices and rates were in the past is the best indicator for thefuture.

It takes those actual changes, applies them to the current set of rates and then uses those torevalue the portfolio. When done, you've got a set of portfolio revaluations corresponding to theset of possible realizations of rates. From that distribution, we can calculate the standarddeviation and take the 99th percentile loss as the VaR.

C. Variance-Covariance method

This is a very simplified and speedy approach to VaR computation. It is so, because it assumes aparticular distribution for both the changes in market prices and rates and the changes in portfoliovalue. It incorporates the covariance matrix (correlation effects between each asset classes)primarily developed by JP Morgan Risk Management Advisory Group in 1996. It is often calledRisk Metrics Methodology. It is reasonably good method for portfolio with no option type products.Thus far, it is the computationally fastest method known today. But this method is not suited for

portfolio with major option type financial products.

MANAGING RISKS

There are multiple strategies to manage risks. Some of the commonly followed ones are:

1. Diversification

2. Hedging or Insurance

3. Setting Risk Limits

4. Ignore the risk!

All the above strategies will reduce the risk – but may not eliminate them. The top management

will determine its risk policy (i.e.) its appetite for risk. The Risk Manager in a bank will beresponsible for identifying the risks, setting up tolerance limits, measuring the risk on a day to daybasis and take action whenever the limits are breached.


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SUMMARY

• Risk, defined as the deviation from expectation, is an extremely important concept forfinancial services industry.

• The nature of banking business gives rise to many different risks in this business. Credit risk,

Liquidity risk, Operational risk, Legal risk, Market risk are some examples.• Risk management is a 3-step process: Defining, Measuring and Managing risks. Risk is

measured in terms of the probability and the potential monetary impact should the adverseevent occur.

• Risk measurement is a combination of management, quantitative analysis and informationtechnology. Serious technology investment is required for accurate measurement andreporting. One of the commonly used methodologies for market risk is “Value at Risk”

• There are multiple ways of managing risks. Rejecting credit if the credit rating is bad is oneoperational measure to avoid high risk. Diversification spreads the total risk to the businessover multiple markets, thus reducing the impact of risk from any one market on the overallbusiness. Another way to reduce risk is to transfer or trade the risk, for example by buyinginsurance.

• However, any risk reduction measure has its own cost. Therefore, one has to achieve abalance between the cost of risk management and the benefit of those risk reductionmeasures.

• Risk managers aim to reduce the risk to a manageable and known level through various riskreduction measures. They use risk management systems to track and analyze the risks.

• A good risk management system not only calculates the risk based on a set of parameters,but also allows the risk managers to drill down the risk to lowest components, carry outsensitivity, what-if analyses, generates customizable reports and sends alerts automaticallywhen the risk crosses a defined tolerance limit.

• The Risk Manager in a bank will be responsible for identifying the risks, setting up tolerancelimits, measuring the risk on a day to day basis and take action whenever the limits arebreached.


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5. INTRODUCTION TO BANKING


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INTRODUCTION TO BANKING

WHAT IS A BANK?

The term ‘Bank’ is used generically to refer to any financial institution that is licensed to acceptdeposits and issue credit through loans.

Banks are the backbone of any economy, as all monetary transactions end up touching banks.The main functions of banks are to:

• Channelize Savings

• Provide credit facilities to borrower

• Provide investment avenues to investors

• Facilitate the trade and commerce dealings

• Provide financial backbone to support economic growth of the country

• Minimize Cash Transactions

• Provide Services

WHY DO WE NEED A BANK?

• They provide a return (pay interest) on our saving

• Safety of principal and interest

• Convenience of being able to write checks and use debit cards

• Raising funds when we need

From the business or economic point of view, however, banks are the primary source of finance.Since the deposits of the small investors are protected, bank deposits are considered a low riskinvestment avenue. Due to their access to a large source of funds at very low cost, owing largelyto the low interest rate on savings and term deposits, banks are in the best position to lend tobusinesses and individuals at competitive interest rates.

WHAT IS THE CENTRAL BANK AND WHAT ARE ITS ROLES?

The Central bank of any country can be called the banker’s bank. It acts as a regulator for otherbanks, while providing various facilities to facilitate their functioning. It also acts as theGovernment’s bank. The Federal Reserve is the central bank of the United States, while ReserveBank of India is the central bank in India.

The main objective of a central bank is to provide the nation with a safer, more flexible, and morestable monetary and financial system. They have the following responsibilities:

• Conducting the nation's monetary policy. Central banks define the monetary policy and thentake necessary actions to create an environment to make those policies feasible. E.g. if the

central bank wants to maintain soft interest rate, they can reduce the CRR to pump in moremoney in the economy.

• Supervising and regulating banking institutions and protecting the rights of consumers

• Maintaining the stability of the financial system, i.e. stability of interest rates and foreignexchange rate.

• Ensuring that the interest rates remain at such a level as to make business viable


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• Ensuring that sufficient funds are available for long term investment to businesses as well asgovernment, without causing inflation to rise

• Providing certain financial services to the government, the public, financial institutions, andforeign official institutions

•

Monitoring the foreign currency assets and liabilities and monitoring the inflow and outflow offoreign currency

BANKS, ECONOMY AND AMOUNT OF MONEY

Banks facilitate the creation of money in the economy. The primary function of banks is to putaccount holders' money to use by lending it out to others who can then use it to buy homes,businesses etc.

Let’s look at an example as how banks do this. The amount of money that banks can lend isdirectly affected by the reserve requirement set by the Central Bank. That is, every bank needs tomaintain a certain percentage of its total deposits as cash, to ensure liquidity. This reserverequirement is also known as the CRR (Cash Reserve Ratio). When a bank gets a deposit of$100, assuming a reserve requirement of 10%, the bank can then lend out $90. That $90 goes

back into the economy, purchasing goods or services, and usually ends up deposited in anotherbank. That bank can then lend out $81 of that $90 deposit, and that $81 goes into the economy topurchase goods or services and ultimately is deposited into another bank that proceeds to lendout a percentage of it. In this way, money grows and flows throughout the community in a muchgreater amount than physically exists. This is also called multiplier effect. In the picture below, aninitial deposit of $100 has created a reserve of $27, and loan of $244. Thus, banks facilitate theinvesting/spending of money that multiply funds through circulation and this is known as “MoneyMultiplier” effect.


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HOW DO BANKS MAKE MONEY?

Banks are like any other regulated business; the product they deal with is “Money”. So theyborrow money from individual or businesses “who have money”, and lend it to those “who needmoney”, by adding a mark up, to pay for expenses and profit. The difference between the rates,

which banks offer to depositors and lenders, is generally referred to as “Spread”. Understandably,the spread in this business is low; hence increasing the turnover (volume) is the key to makingprofit. Hence, in practice, banks offer a number of options – often termed as “products” - to bothinvestors and borrowers to meet their different requirements and preferences and thus increasebusiness. They also provide fee-based services such as managing cash for corporate clients, toincrease business and improve profit margin.

SERVICE OFFERINGS OF BANKS

Service offerings of banks are organized along following divisions:

• Corporate Banking

o Trade Finance

o Cash Management

• Retail Banking

o Electronic Banking

o Credit Card services

o Retail Lending – Personal Loans, Home Mortgages, Consumer Loans, Vehicle Loans

o Private Banking

o Asset Management

• Investment Banking

o Private Equity

o Corporate Advisory

o Capital Raising

o Proprietary Trading


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o Emerging Markets

o Sales, Trading & Research

Equity Fixed Income

Derivatives

TOP 50 BANKS IN THE US BY ASSET SIZE

As of March 2004 ($ Million)

Si no. Company Name Total Assets Total Deposits1 Citigroup, Inc. 1,317,877 499,1892 J.P. Morgan Chase & Co. 1,120,668 502,8263 Bank of America Corporation 1,016,247 573,3564 Wachovia Corporation 410,991 232,3385 Wells Fargo & Company 397,354 248,3696 U.S. Bancorp 192,093 118,9647 SunTrust Banks, Inc. 148,283 96,6618 National City Corporation 128,400 77,1229 ABN AMRO North America

Holding Company* 127,154 53,28910 HSBC North America Inc.* 125,950 86,24811 Citizens Financial Group, Inc.* 118,986 84,76412 BB&T Corporation 94,282 64,12513 Fifth Third Bancorp 93,732 55,25014 State Street Corporation 92,896 53,51215 Bank of New York Company, Inc. 92,693 55,96116 KeyCorp 84,448 49,931

17 Regions Financial Corporation 80,275 54,17018 PNC Financial Services Group,

Inc. 74,115 48,12519 Merrill Lynch Bank USA* 66,643 53,20820 MBNA Corporation* 59,126 31,86121 Comerica Incorporated 54,468 43,52322 SouthTrust Corporation 52,673 35,51523 M&T Bank Corporation 50,832 33,34124 AmSouth Bancorporation 47,415 31,54525 UnionBanCal Corporation 46,102 39,00626 BancWest Corporation* 43,814 30,79427 Northern Trust Corporation 40,179 28,44828 Bankmont Financial Corp.* 38,767 21,90829 Popular, Inc. 38,102 18,60330 Marshall & Ilsley Corporation 35,476 23,15131 Mellon Financial Corporation 33,898 20,30632 Huntington Bancshares

Incorporated 33,875 20,93533 Zions Bancorporation 29,790 21,486


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Si no. Company Name Total Assets Total Deposits34 Compass Bancshares, Inc. 27,481 16,52435 First Horizon National Corporation 27,084 17,71236 Banknorth Group, Inc. 26,880 17,958

37 North Fork Bancorporation, Inc. 26,178 19,16438 Commerce Bancorp, Inc. 24,955 22,88339 Capital One Bank 24,515 12,21340 Synovus Financial Corp. 22,286 16,21441 American Express Centurion

Bank 20,413 8,85842 Associated Banc-Corp 19,254 12,37543 RBC Centura Banks, Inc. 19,232 9,34744 Discover Bank 19,107 13,49045 Hibernia Corporation 18,717 14,88246 TD Waterhouse Group, Inc. 17,007 9,63047 Colonial BancGroup, Inc. 16,499 10,050

48 Webster Financial Corporation 15,090 8,63849 Commerce Bancshares, Inc. 14,485 10,25350 Merrill Lynch Bank & Trust

Company 14,377 12,252


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UNIVERSAL BANKING

The universal banking concept permits banks to provide commercial bank services, as well asinvestment bank services at the same time.

Glass-Steagall Act of 1933, created a Chinese wall between commercial banking and securities

businesses in US. That act was intended to address the perceived causes of bank failures duringthe Great Depression of 1929.

Today, Glass-Steagall restrictions have become outdated and unnecessary. It has become clearthat promoting stability and best practices cannot be done through artificially separating thesebusiness areas. Over the years, banks and securities firms have been forced to find variousloopholes in the Glass-Steagall barriers. The restrictions undermined the ability of Americanbanks to compete with the other global banks which were not covered by such legislation.

Most of Glass-Steagall provisions have been repealed in the US in 1990s enabling the banks tooffer a full range of commercial and investment banking services to their customers.

ExampleIn the late 1990s, before legislation officially eradicated the Glass-Steagall Act’s restrictions,the investment and commercial banking industries witnessed an abundance of commercialbanking firms making forays into the I-banking world. The mania reached a height in thespring of 1998. In 1998, NationsBank bought Montgomery Securities, Société Géneralebought Cowen & Co., First Union bought Wheat First and Bowles Hollowell Connor, Bank of America bought Robertson Stephens (and then sold it to BankBoston), Deutsche Bank boughtBankers Trust (which had bought Alex. Brown months before), and Citigroup was created in amerger of Travelers Insurance and Citibank.

While some commercial banks have chosen to add I-banking capabilities through acquisitions,some have tried to build their own investment banking business. J.P. Morgan stands as thebest example of a commercial bank that has entered the I-banking world through internalgrowth. J.P. Morgan actually used to be both a securities firm and a commercial bank untilfederal regulators forced the company to separate the divisions. The split resulted in J.P.Morgan, the commercial bank, and Morgan Stanley, the investment bank. Today, J.P. Morganhas slowly and steadily clawed its way back into the securities business, and Morgan Stanleyhas merged with Dean Witter to create one of the biggest I-banks on the Street.


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SUMMARY

• Banks are an integral part of any economy channelizing savings from lenders to borrowers

• Bank deposits are low risk investments

• The Central bank is the “Bankers’ Bank” and it regulates other banks in an economy.

• Central banks define a nation’s monetary policy

• A bank makes a profit by investing or lending money that is earning a higher rate of interestthan it pays to its depositors.

• A bank is required to keep a certain amount of "cash reserves" by regulation to maintainliquidity, i.e. to ensure that the banking system does not face a cash crunch due to higherwithdrawals, which can lead to panic among investors and a run on a bank.

• Banks create a “Money Multiplier” effect

• Banks are generally organized as corporate banking, investment banking, retail banking, andprivate banking functions.

• Universal banks provide commercial banking as well as investment bank services under oneroof


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6. RETAIL BANKING

8/9/2019 Banking F

banking foundation course v1.8

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