Financial Services Management

Presented by Saurabh Shah

Introduction to Financial Services

Chapter 1

Introduction to Financial Services

Financial intermediaries provide key financial services such as merchant banking, leasing, hire purchase, credit-rating, and so on which indirectly deals with the management of money.

These financial services are vital for creation of firms, industrial expansion, and economic growth.

Fund Based v/s Non Fund based

Fund Based
CASH CREDIT

BILLS FINANCE

Loans & Advances

OVERDRAFT

TERM FINANCE

RETAIL FINANCE

Comparison
Fund Based Fee Based

Service provider invests or Service provider does not invest commits to invest his own funds. his own funds. Service provider is exposed to Service provider is exposed to high minimal risk. risk. This is assistance or more of advisory role.

This is participative role.

Non Fund Based

Co Acceptance of Bills

Letter of Credit

Bank Guarantee

Agencies Providing Financial services

Commercial Banks Merchant Bankers

Leasing and Hire Purchase Companies

Mutual Funds

Venture Capital Funds

Rating Agencies

Other NBFCs

The Stock Exchanges

Financial Innovation and Engineering

Financial Engineering involves the design, the development and the implementation of innovative financial instruments and processes and the formulation of creative solutions to problems in finance. One of the essential characteristics of financial engineering products is Financial Innovation. Factors that propagate need for financial engineering i.e. innovation are:
1. 2. 3. 4. 5.

Competition Liberalization Technology Financial Awareness Matured Legal Processes

Process of Financial Engineering

The process of Financial Engineering is same as the process for developing new value added product and services. Stages in Financial Engineering 1. Need Identification 2. Idea formation of the Product 3. Product development, Model Building 4. Product Testing 5. Product Improvement based on test feedback 6. Product Pricing 7. Restructuring the product to suit pricing idea 8. Test Marketing 9. Launching of the Product

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Types of Financially Engineered Products

Financial Return Risk Debt Equity Proportion Strategic Goals

High Moderate

Low Strategic

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Types of Financially Engineered Products

Preference Shares Convertible Debentures Call & Put Option Warrants Derivatives Non Voting Shares ESOPs Sweat Equity Shares

Read explanation from Text Book

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Securitization of Debt
Chapter 4

Securitization of Debt
Securitization is the process of conversion of existing assets or future cash

flows into marketable securities.

In other words, securitization deals with the conversion of assets which are not

marketable into marketable ones.

The segments that dominated the securitization market are: 1. Asset-backed securities (ABS) such as commercial vehicle, car, two-

wheeler and personal loans;

2. Mortgage-backed (home loan) securities (MBS) Securities issued by the SPV in a securitization transaction are referred to as

Asset Backed Securities (ABS) because investors rely on the performance of the assets that collateralize the securities.
They do not take an exposure either on the previous owner of the assets (the

Originator), or the entity issuing the securities (the SPV).

Clearly, classifying securities as asset-backed seeks to differentiate them from

regular securities, which are the liabilities of the entity issuing them.
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Securitization of Debt
In practice, a further category is identified securities backed by mortgage

loans (loans secured by specified real estate property, wherein the lender has the right to sell the property, if the borrower defaults). Such securities are called Mortgage Backed Securities (MBS).
All securitized instruments are either MBS or ABS.

Illustration
Suppose Mr. X wants to open a multiplex and is in need of funds for the same.

To raise funds, Mr. X can sell his future cash flows (cash flows arising from sale of movie tickets and food items in the future) in the form of securities to raise money.
This will benefit investors as they will have a claim over the future cash flows

generated from the multiplex. Mr. X will also benefit as loan obligations will be met from cash flows generated from the multiplex itself.
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INVESTORS

GIC LIC Barclays Banks

Principal + Interest 300 + 400

Payment of SRs 80

Arcil as a Trust 100

Purchase Consideration (100)

Borrower

NAV is declared Quarterly and crystallization( M to M) is done at the end of the year.

Cash Realization 20
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Parties Involved
Securitization programmes usually involve several participants, each carrying out a specialist function such as creating and analyzing the asset pool, administration, credit rating, accounting, legal negotiation, etc. These include: Primary Parties 1. The Originator also interchangeably referred to as the Seller is the entity on whose books the assets to be securitized exist. It is the prime mover of the deal i.e. it sets up the necessary structures to execute the deal. It sells the assets on its books and receives the funds generated from such sale. In a true sale, the Originator transfers both the legal and the beneficial interest in the assets to the SPV. 2. Special Purpose Vehicle (SPV) - the SPV is the entity, which would typically buy the assets (to be securitized) from the Originator against issue of securities. As one of the main objectives of securitization is to remove the assets from the balance sheet of the Originator, the SPV plays a very important role in as much as it holds the assets in its books and makes the upfront payment for them to the Originator.
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Parties Involved

The Investors The investors may be in the form of Individuals or institutional investors like FIs, Mutual funds etc. They buy a participating interest in the total pool of receivables and receive their payment in the form of interest and principal as per agreed pattern.

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Parties Involved
Other parties

The Obligor(s): The Obligor is the Originator's debtor (borrower of the original loan). The amount outstanding from the Obligor is the asset that is transferred to the SPV. The credit standing of the Obligor(s) is of paramount importance in a securitization transaction. The Rating Agency: Since the investors take on the risk of the asset pool rather than the Originator, an external credit rating plays an important role. The rating process would assess the strength of the cash flow and the mechanism designed to ensure full and timely payment by the process of selection of loans of appropriate credit quality, the extent of credit and liquidity support provided and the strength of the legal framework. Administrator or Servicer: It collects the payment due from the Obligor/s and passes it to the SPV, follows up with delinquent borrowers and pursues legal remedies available against the defaulting borrowers. Since it receives the installments and pays it to the SPV, it is also called the Receiving and Paying Agent.
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Parties Involved

Agent and Trustee: It accepts the responsibility for overseeing that all the parties to the securitization deal perform in accordance with the securitization trust agreement. Basically, it is appointed to look after the interest of the investors. Structurer: Normally, an investment banker is responsible as structurer for bringing together the Originator, credit enhancer/s, the investors and other partners to a securitization deal. It also works with the Originator and helps in structuring deals. The different parties to a securitization deal have very different roles to play. In fact, firms specialize in those areas in which they enjoy competitive advantage. The entire process is broken up into separate parts with different parties specializing in origination of loans, raising funds from the capital markets, servicing of loans etc. It is this kind of segmentation of market roles that introduces several efficiencies securitization is so often credited with.

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Pass Through & Pay Through Certificates

Pass through Certificates Pay through Certificates On the other hand, Pay through It enable the investors to take a direct Certificates gives investors only a exposure on the performance of the charge against the securitized assets, securitized assets. while the assets themselves are owned by the SPV. Payments as per obligors payments Payments are structured demanded by investors as per

Mostly Pass through are without any Pay through are mostly with recourse to recourse to the originator in the case of the originator, ratings are enhance due default to originators guarantee.

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What type of assets can be securitized ?

Existing assets in the form of Long Term Receivables ( E.g. Housing Loans) Existing assets in the form of Short Term Receivables ( E.g. Credit Card Receivables)

Existing physical assets in the nature of Current Assets (E.g. Stock)

Existing Fixed Assets (E.g. Aircraft Lease) Future Receivables (Infrastructure projects)

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The Procedure

Selection and pooling of assets

These assets are sold or pass through another orgn called Special Purpose Vehicle(SPV)

The SPV then splits the pool into units/securities sells them to the investors at large and reimburses it.

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Venture Capital
Chapter 3

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WHAT IS VC FUNDING?
IS IT JUST THE STORY OF THE MAN WITH THE IDEA AND THE MAN WITH THE MONEY?

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WHAT IS VENTURE CAPITAL ?

Venture Capital is the early financing of new and young enterprises seeking to grow rapidly.

It is the support by investors of entrepreneurial talents with finance and business skills to exploit market opportunities and to obtain capital gains

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Features of Venture Capital

It is usually in the form of Equity or mix of Equity + Debt. Commercial success of the funded venture is not tested hence very risky, if successful VC can earn extraordinary profits. Venture capitalist are interested in capital gains and cash gains. VCs generally exit business after achieving desired growth. It is not just a fund provider but also involved in managing the envisaged growth.

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Stages of VC
Stop Gap or Intermediate Stage

Expansion Stage

Implementation Stage Concept & Idea Development Stage

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Investment Process
Initial screening Presenting a detailed business plan Due diligence Valuation and structuring the deal Monitoring the project Exit
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Investment Process
Initial Screening Average rates of return on their investment. A majority of the proposal are screened out, after a very brief initial review.

Business Plan
Business plan is the main vehicle for getting potential investment. The business plan should mirror the clarity of thinking and the business.
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Investment Process

Due Diligence
Research conducted by the VC to verify the accuracy of the statements made by the entrepreneur.

Competence of management team.

Market potential.

Uniqueness of product.
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Investment Process

Valuation and structuring the deal Valuation of Proposal. The next step is to structure the funding agreement. The instrument could be equity shares, preference share, debenture or any other form.

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Investment Process
Monitoring the project Advise could be in areas of strategy, finance, technology, acquiring key executive personnel or negotiating contracts. Exit Buy back of shares by promoters or company. Sale of stock. Selling to a new investor.

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Duration of Venture Capital Investment normally ranges from 3-7 years

EXIT OPTIONS: IPO's Mergers & Acquisitions Management Buy-out Sale to Another Fund Buyback by Promoter/ Company Stock Market
In case of Buyback by Promoter/Company , the value at which VC Fund would exit is IRR or market-based and is pre decided at the time of investment on a certain valuation
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EXIT
OPTIONS AVAILABLE TO

VENTURE
CAPITALIST

Merchant Banking
Chapter 2

Merchant Banking In India

The Grindlays Bank initiated the merchant banking activity in Indian Capital Market in 1969. Its business forms was on the management of Public Issues and Financial Consultancy.

Citi Bank introduced its merchant banking division in 1970.

In the view of the widening industrial base of the country, the

Banking commission report in 1972, stressed the need for merchant banking in India.

Following the recommendations of the banking Commission (1972), the State Bank of India (SBI) established its Merchant Banking Division in 1973, in the name of SBI Capital Markets Ltd. (SBICAP).

Merchant Banking In India

ICICI started merchant banking services in 1974.

Mid seventies onwards, there was a mushroom growth of

merchant banking sector.

Bank of Baroda, Canara Bank, Merchantile Bank, United Bank

of India, IFCI and IDBI also started merchant banking services.

Merchant Banking

Only a body corporate other than a non-banking financial company shall be eligible to get registration as merchant banker.

Without holding a certificate of registration granted by the Securities and Exchange Board of India, no person can act as a merchant banker.

The validity period of certificate of registration is 3 years from the date of issue.

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Services of Merchant Bankers

Managing of public issue of capital such as determining the type of securities to be issued

Draft of prospectus and application forms Appointment of Registrar to deal with share application and transfers Listing of Securities Project Feasibility study Assistance in ADR/GDR Arrangement of underwriting Placing of issues

Selection of brokers and bankers to the issue

Publicity and advertising agent

Private Placement of Securities Management of Debenture issue and syndication of loan

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Categories of Merchant Bankers

CAT I Lead manager,adviser, consultant, underwriter, portfolio manager. Rs.5 cr

Adviser, consultant,underwriter, portfolio manager. CAT II Rs 50 lacs Underwriter, adviser or consultant to an issue. CAT III Rs 20 lacs Adviser or consultant to an issue. CAT IV NIL

As per the new amendment, only one category exists, that is Category 1

Qualities required of Merchant Bankers

Knowledge

Capital Market Familiarity

Liaisoning Ability Innovation

Integrity

Merchant Banking:
Fee based (non-fund based) . Public offers ( known as issue management ) + private placement of securities in the capital market. Narrow term.

Investment Banking:
Fund based and non-fund based. Merchant banking services as well as other capital market activities such as, specialized corporate advisory services in the area of mergers and acquisitions etc. Wider term.

Merchant Banks & Commercial Banks

Merchant Banks Commercial banks

Assist in raising capital in the Provide funds in the form of term form of equity, preference shares, loan and working capital. syndicated loan and working capital instruments. Advisory is the main business. Financing is the main business. Do not accept chequable deposits. Demand deposits is the key feature. Mainly fee based business. Mainly fund based business.

They are mainly into management They are mainly into term lending of equity, pricing of issue, book and bank deposits. running etc.

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Credit Rating Agencies(CRAs)

Chapter 5

Introduction

Credit ratings are judgments of borrowers (Standard & Poor) Credit rating is essentially the opinion of the rating agency of the relative ability and willingness of the issuer of a debt instrument to meet the debt service obligation as and when they arise (CARE)

It is mandatory for the issuance of Debt instruments, Debentures, Commercial Paper issued by Corporate and Public deposits of all NBFCs (Non Banking Financial Companies).

It is an independent assessment of the creditworthiness of a bond (note or any security of any indebtness) by a credit rating agency.

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Functions of Credit Rating Agency(CRA)

CRAs reduce the informative asymmetry between lenders and investors, on one side, and issuers on the other side, about the creditworthiness of companies or countries. Credit Ratings determine the eligibility of debt and other financial instruments for the portfolios of certain institutional investors due to national regulations that restrict investment in speculative grade bonds. CRAs assess creditworthiness of the issuer of bonds and financial instruments.

In a way, regulators have outsourced to CRAs for assessing debt risk.

CRAs role has expanded with financial globalization and has received an additional boost from Basel II.

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Supplementary Functions of CRAs

In addition to the main task of rating, CRAs carryout some supplementary functions to assist the corporate: The credit rating agencies in India offer varied services like mutual consulting services, companies up gradation, risk management etc.. CRAs carryout research and development work of the industries. They provide training to the employees and executives of the companies for better management. They examine the risk involved in a new project, chalk out plans to fight with the problem successfully and thus improve the percentage of risk largely. For this, they carry on thorough research into the respective industry. CRAs have started offering services to the mutual fund sector through the application of fund utilization services.

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Global Credit Rating Agencies

MOODYS STANDARD & POORS CORPORATION [S & P] DUFF AND PHELPS CREDIT RATING CO [CDR] JAPAN CREDIT RATING AGENCY [JCR] IBCA LTD

Domestic Credit Rating Agencies

CRISIL [Credit Rating and

Information Services Of India]

ICRA [Investment Information

Services Of India]
CARE [Credit Analysis and

Research]
FITCH SMERA [SME Rating Agency of

India Ltd.]

Working of Credit Rating Agency

Rating Request Surveillance & Annual Review Collection of Information

Publication

Management Meeting

Advice to Issuer

Rating Committee/ Assignment of Rating

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Benefits to Investors

Safeguards against bankruptcy

Benefits of Rating to Company

Lower cost of borrowing Wider audience for borrowing Rating as marketing tool Self discipline by companies

Recognition of risk
Credibility of issuer Easy understandability of the investment proposal

Saving of resources i.e. Energy and time

Independence decision

of

investment

Good bye to thumb rule

Disadvantage of Credit Rating

Biased Rating and Misrepresentations Static study Concealment of Material information Rating is no guarantee for soundness of the company

Human Bias
Reflection of temporary adverse conditions Down grade Validity of Rating Difference in Rating of two agencies

Mutual Funds
Chapter 10

Assessment of Investor Needs

Clarity of Purpose Purpose of investment has to be clear Liquidity Requirement Depending on purpose and cash position

Risk Appetite Depending upon the risk taking capacity of an investor

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Assessment of Investment Avenues

Stock Markets Debt Markets Mutual Funds Insurance Money Markets Real Estate Markets Bullion Commodities
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Mutual Fund

The value associated with each of these units is known as (NAV). Mutual fund issue securities known as units to the investors known as unit holders in accordance with quantum of money invested by them.
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Structure of Mutual Fund

Trustees are legal owners

Investors are beneficial owners

Mutual is a Trust
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Working of Mutual Fund

Passed back to

Investors
Pool their money

Returns

Fund Managers

Invest in Generates

Securities
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Organization of Mutual Fund

A mutual fund is set up in the form of a trust, which has sponsor, trustees, Asset Management Company (AMC) and a custodian. The trust is established by a sponsor or more than one sponsor who is like a promoter of The custodian, who is registered a company. with SEBI, holds the securities of The trustees of the mutual fund various schemes of the fund in its hold its property for the benefit of custody. the unit-holders. The AMC, approved by SEBI, The trustees are vested with the general power of superintendence manages the funds by making and direction over AMC. investments in various types of They monitor the performance and securities. compliance of SEBI Regulations by the mutual fund. 60

Types of Mutual Funds

Mutual Fund

Structure

Investment

Close Ended

Open Ended

Growth Fund

Income Fund

Balance Fund

Index Funds

Money Market

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Open Ended Schemes

Closed Ended Schemes

Schemes

Accepts funds from investors on continuous basis.

are opened specified time period. throughout the year.

for

Corpus normally does not change Such schemes are normally listed

Repurchase facility available. No listing on the stock exchange. Better liquidity due to continuous repurchase.

in the stock exchange. Otherwise repurchase facility provided.

Liquidity normally at the time of

Sale and Repurchase based on NAV

redemption.
Long term investment strategies

depending on the life of the scheme.

Market price may be below or

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above par.

Growth Funds

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 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.
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Income Funds

These funds provide regular and steady income to investors. Such schemes generally invest in fixed income securities such as bonds, corporate debentures and Government securities.

Income Funds are ideal for capital stability and regular income.

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Balance Funds

Balanced funds work particularly well during a downturn in equity markets.

These funds invest both in equity shares and fixed-incomebearing instruments (debt) in some proportion.

While selecting a balanced fund, choose the conventional type 60:40 (equity: debt) with a steady track record.

Make sure the fund manager sticks to the 60:40 mandates even during bullish times, when most balanced fund managers succumb to the temptation of over-allocation to equities for higher growth.

They are ideal for medium to long-term investors who are willing to take moderate risks.
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These mutual funds would invest exclusively in money market instruments.

RBI introduced to provide an additional short- term avenue for investment and bring money market within reach of individuals.

Money Market Mutual Funds

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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 weight age

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.

There are also exchange traded index funds launched by the

mutual funds which are traded on the stock exchanges.

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Diversification Mutual funds invest in a number of companies across a broad cross-section of industries and sectors.

This diversification reduces the risk because seldom do all stocks decline at the same time and in the same proportion One achieves this diversification through a mutual fund with far less money than you can do on your own.

Professional management Mutual funds provide the services of experienced and skilled professionals, backed by a dedicated investment research team that analyses the performance and prospects of companies and selects suitable investments to achieve the objectives of the scheme.
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Advantages of Mutual Funds

Return potential Over a medium to long-term, mutual funds have the potential funds to provide a higher return as they invest in a diversified basket of selected securities. Reduction in transaction cost Mutual funds are a relatively less expensive way to invest as compared to directly investing in the capital markets because the benefits of scale in brokerage, custodial and other fees translate into lower costs for investors. Flexibility Through features such as regular investment plans, regular withdrawal plans and dividend reinvestment plans we can systematically invest or withdraw funds according to our needs 69 and convenience.

Advantages of Mutual Funds

Choice of schemes Mutual funds offer a family of schemes to suit our varying needs over a life time. Liquidity In open-end schemes, the investor gets the money back promptly at net asset value related prices from the mutual fund.

In the closed-end schemes, the units can be sold on a stock exchange at the prevailing market price or the investor can avail of the facility of direct repurchased at NAV related prices by the mutual fund.

Well regulated All mutual funds are registered SEBI and they function within the provisions of strict regulations designed to protect the interests of 70 investors.

Portfolio Management Services

Portfolio management involves deciding what assets to include in the portfolio, given the goals of the portfolio owner and changing economic conditions. Selection involves deciding what assets to purchase, how many to purchase, when to purchase them, and what assets to divest. These decisions always involve some sort of performance measurement, most typically expected return on the portfolio, and the risk associated with this return. Typically the expected return from portfolios comprised of different asset bundles are compared Portfolio management makes use of analytical techniques of analysis and conceptual theories regarding rational allocation of funds. Portfolio management is a complex process which tries to make investment activity more rewarding and less risky.
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Mutual Fund v/s PMS

Many people get confused between Mutual Fund and Portfolio Management Service, they think both are the same, one has to just invest money in a particular fund and let the fund manager do investing on their behalf and give returns. But, in actual terms there is lot of difference between both the services.
Mutual Funds Mass product Common service to all Entry & Exit Loads FIXED NO YES MONTLY YES NO YES (under section 80C) YES PMS Product Service Cost Fee Structure Portfolio Profiling Sector/Stock limits Updates Cross Subsidiary Transparency Customized Product Personalized NO entry exit loads Either Fixes or on Performance basis As per risk appetite of the customer NO DAILY NO YES NO NO
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Tax Benefit
Lock in period

Load Funds and No Load Funds

Loads are sales fees. Most common are front-end loads and back-end loads. If you are in a fund with a back-end load, you'll be hit with a sales fee when you sell your shares. Some funds claim to be "no load" but charge reinvestment fees when distributions are reinvested in a fund.

If youre a do-it-yourself investor, avoid funds that charge loads.

No-load funds generally outperform load funds for the simple reason that the sales fee adds to the cost, and therefore lower returns.

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Illustration

Compare two mutual fund schemes, one with a low cost structure (say Fund A) and the other which isnt quite as charitable (say Fund B). Investments in Fund A attract an entry load of 1.0%, while the number is 2.5% for Fund B. Similarly, the recurring expenses are 1.5% and 2.5% for fund A and fund B respectively. Assume that Rs 100,000 (one-time investment) is invested in each fund for a 10-Yr period and that both the investments grow at 15.0% per annum.
Fund A Entry load Recurring expenses Amount invested (Rs) Growth rate (per annum) 1.00% 1.50% 100,000 15.00% Fund B 2.50% 2.50% 100,000 15.00%

Maturity amount (Rs)

344,331

306,217

On maturity (i.e. at the end of 10 years), the investment in fund A would be worth Rs 344, 331, while that in fund B would be worth Rs 306, 217. The differential can be traced to Fund As cost effectiveness.
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Association of Mutual Funds in India(AMFI)

With the increase in Mutual Fund players in India, a need for Mutual Fund Association in India was generated to function as a non-profit organization. Association of Mutual Funds in India (AMFI) was incorporated on 22nd August, 1995. AMFI is an apex body of all Asset Management Companies (AMC) which has been registered with SEBI. Till date all the AMCs are that have launched mutual fund schemes are its members. It functions under the supervision and guidelines of its Board of Directors. Association of Mutual Funds India has brought down the Indian Mutual Fund Industry to a professional and healthy market with ethical lines enhancing and maintaining standards. It follows the principle of both protecting and promoting the interests of mutual funds as well as their unit holders.
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The with 30 registered AMCs of the country. The objectives are as follows: This Mutual Fund Association of India maintains high professional and ethical standards in all areas of operation of the industry. It also recommends and promotes the top class business practices and code of conduct which is followed by members and related people engaged in the activities of mutual fund and asset management. The agencies who are by any means connected or involved in the field of capital markets and financial services also involved in this code of conduct of the association. AMFI interacts with SEBI and works according to SEBIs guidelines in the mutual fund industry.
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Association of Mutual Funds Association of Mutual Funds of India works in India

Association of Mutual Funds in India

Association of Mutual Fund of India does represent the Government of India, the Reserve Bank of India and other related bodies on matters relating to the Mutual Fund Industry. It develops a team of well qualified and trained Agent distributors. It implements a program of training and certification for all intermediaries and other engaged in the mutual fund industry. AMFI undertakes all India awareness program for investors in order to promote proper understanding of the concept and working of mutual funds. At last but not the least association of mutual fund of India also disseminate information on Mutual Fund Industry and undertakes studies and research either directly or in association with other bodies
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Derivatives
Chapter 7

Derivatives

In recent years, financial markets have developed many new products whose popularity has become phenomenal.

Derivative products initially emerged, as hedging devices against fluctuations in commodity prices.

A derivative is an instrument whose value depends on the values of one or more basic underlying variables called bases. The underlying variables are forex, equity,

commodity, bonds, debentures etc.

Illustration : Wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. The price of this derivative is driven by the spot price of wheat which is the underlying.
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Derivatives

In derivative market when enter into a contract to buy or sell particular underlying:

Long position means to have a buy position for particular stock

Short position means to have a sell position for particular stock

Bid price (buyers price) is the rate/price at which there is a ready buyer for the stock.

Ask price (sellers price) is the rate/ price at which there is seller ready to sell his stock.

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Terminologies related to Futures

Spot price: the price at which an asset trades in the spot market. Futures price: the price at which the futures contract trades in the futures market.

Initial margin: the amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin.

Maintenance margin: This is somewhat lower than the initial

margin. This is set to ensure that the balance in the margin account never becomes negative.

Marked-to-market (M to M): in the futures market, at the end of each trading day, the margin account is adjusted to reflect the investors gain or loss depending upon the futures closing price. This is called marked-to-market.
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Options terminology

Option price/premium: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium.

Strike price: The price specified in the options contract is known as the strike price or the exercise price.

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Options terminology
In-the-money option: Spot price > Strike Price in case of call option. Spot price < Strike Price in case of put option. If exercised immediately it would lead to positive cash flow. E.g.: Spot value of Nifty is 2157. An investor buys a one-month nifty 2140 call option for a premium of Rs.7. the option is?
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Out-of-the-money option: Spot price < Strike price in case of call option. Spot price > Strike price in case of put option. If exercised immediately it would lead to negative cash flow. E.g.: Spot value of Nifty is 2140. An investor buys a one-month nifty 2157 call option for a premium of Rs.7. the option is?

Kinds of Derivatives

Swaps

Forwards

Futures

Derivatives
Options

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Forward Contract

A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at todays pre-agreed price. No cash is exchanged when the contract is entered into.

Illustration

Shyam wants to buy a TV, which costs Rs 10,000 but he has no cash to buy it outright. He can only buy it 3 months hence. He, however, fears that prices of televisions will rise 3 months from now. So in order to protect himself from the rise in prices Shyam enters into a contract with the TV dealer that 3 months from now he will buy the TV for Rs 10,000. What Shyam is doing is that he is locking the current price of a TV for a forward contract. The forward contract is settled at maturity.

The dealer will deliver the asset to Shyam at the end of three months and Shyam in turn will pay cash equivalent to the TV price on delivery.
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Features of Forward Contract

They are bilateral contracts and hence exposed to counter party risk.

Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality.

The contract price is generally not available in public domain. On the expiration date, the contract has to be settled by delivery of the asset.

If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party, which often results in high prices being charged.

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Futures Contract

A future contract is similar to Forward account. A futures contract is an agreement between two parties to buy

or sell an asset at a certain time in the future at a certain price.

Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded

contracts.

Index futures are all futures contracts where the underlying is the stock index (Nifty or Sensex) and helps a trader to take a

view on the market as a whole.

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Features of Futures Contract

The standardized items in a futures contract are:

Quantity of the underlying Quality of the underlying The date and the month of delivery The units of price quotation and minimum price change

Location of settlement

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Futures payoffs

Payoff for buyer of futures: Long futures

Payoff for seller of futures: Short futures

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Figure 1. Payoff for a buyer of Nifty futures

Profit

2220

Loss

The figure shows the profits / losses for long futures position
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Figure 2. Payoff for a seller of Nifty futures

Profit

2220

Loss

The figure shows the profits / losses for short futures position
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Example 1

On 15th Jan Mr. Aakash Mehta bought a Jan Nifty futures contract which cost him Rs.2,40,000. Each Nifty Future Contract is for delivery of 100 Nifties. On 25th Jan, the Index closed at 2460. How much profit/loss did he make?

Ans: +6000 [(2460 2400) * 100]

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Example 2

Amitabh Bachpan sold a Jan Nifty Futures contract for Rs.2,40,000 on 15th Jan. Each Nifty Futures Contract is for delivery of 100 Nifties. On 25th Jan, the Index closed at 2450. How much profit/loss did he make?

Ans: -5000 [(2450 2400) * 100]

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Forwards v/s Futures

Forwards
OTC in nature Contract terms are customized Requires no margin payment Traded on exchange

Futures
organized stock

Contract terms are standardized Requires margin payment

Settlement happens at end of Follows daily settlement period One delivery specified Some credit risk Counterparties exposure
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date

which

is

Range of delivery dates No credit risk

have

to

take Clearing house takes the exposure on both the parties

Types of Futures
The different types of Futures are but different facets of the same Futures.

Currencies Commodities. Interest Rates

Stocks
Index

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Options

Option, as the word suggests, is a choice given to the investor to either honor the contract; or if he chooses not to walk away from the contract.

An option gives its owner the right but not the obligation to purchase or sell an asset on or before some date in future.

The date when option expires is known as the exercise date, the expiration date or the maturity date.

The price at which asset can be purchased or sold is known as strike price.

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Types of Options

Call Option is the right, but not the obligation, to buy the underlying asset by a certain date for a certain price.

Put Option is the right, but not the obligation, to sell the underlying asset by a certain date for a certain price.

American options: are options that can be exercised at any time up-to the expiration date. Most exchange-traded options are American.

European options: are options that can be exercised only on the expiration date itself.
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Swaps

SWAPS have been termed as private agreement between the two parties to exchange cash flows or payments which will take place in the future.

SWAPS is also called as financial swap in global financial market.

There are different types of swaps such as interest rate swaps, currency swaps, equity swaps etc.

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Features of Swap

A swap is nothing but the combination of Forwards, so it has all the properties of forward contract.

It requires 2 parties with equal and opposite needs. There is no exchange of principal on the other hand fixed interest is exchanged for floating rate of interest.

Swaps are in the nature of long term agreement and they are
just like long dated forward contracts.

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Leasing & Hire Purchasee

Chapter 6

Introduction

Cash Purchase outright purchase for cash i.e. buyer gets unconditional ownership and possession. Credit Purchase Ownership and possession is established immediately after transaction. Leasing Its like rented asset. Ownership is not with the user.

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Credit Cards
Chapter 9

Introduction

A credit card system is a type of retail transaction settlement and credit system using a small plastic card issued to users of the system.

With a credit card, a person can make purchases without using cash. The credit card company pays for the purchase, but the card user has to repay the money borrowed to the card company at a later time.

In addition to the amount of the purchase, the card user also has to pay interest on the loan.

When purchase is made the user would indicate his/her consent to pay, by signing a receipt with a record of the card details and
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Visual Features of Credit Cards

The shape and size of the credit card is specified by the ISO standard usually 3 -1/8 inches by 2-1/8 inches in size. Front side contains following information
a) Printed Name and logo of issuing Bank Name and logo of co branding Merchant establishment. Name and logo of member affiliate Photo of card holder / family (optional) Picture (any deity or scene of holders choice optional) b) Embossed Period of validity Name of Card holder Card Number

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Visual Features of Credit Cards

Back side

Magnetic stripe often called as magstripe Credit card number in print Contact number of issuing bank Space for holders signature Terms and disclaimer clause of the bank

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Working of Credit Card

106

Clearing and Settlement

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Financial Features of Credit Card

Annual Membership Fee Minimum Payment Rate of Interest EMI Conversion Balance Transfer Personal Loans Insurance ATM
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