Module 1: Financial System and Risk Management

• Structure of a Financial System

The financial system is a complex network of institutions, markets, and instruments that facilitates the
flow of money between lenders and borrowers. It plays a vital role in economic development by
channeling funds to productive investments and enabling individuals and businesses to manage their
finances.
Here's a breakdown of the key components of a financial system:

Financial Institutions: These are the intermediaries that connect lenders and borrowers. They include
banks, credit unions, insurance companies, investment banks, pension funds, and brokerage firms. Each
type of institution plays a specific role in the financial system. For example, banks accept deposits from
individuals and businesses and then lend that money out to borrowers. Insurance companies pool risk
from policyholders and use the premiums collected to pay out claims.

Financial Markets: These are platforms where financial instruments are bought and sold. There are
two main types of financial markets: money markets and capital markets. Money markets deal with
short-term debt instruments, such as Treasury bills and commercial paper. Capital markets deal with
long-term debt and equity instruments, such as stocks and bonds.

Financial Instruments: These are contracts that represent a claim to financial assets. They include
stocks, bonds, loans, derivatives, and options. Financial instruments allow investors to pool their funds
and invest in a variety of assets, which helps to spread risk and increase potential returns.

Payment and Settlement Systems: These are the mechanisms that facilitate the transfer of funds
between buyers and sellers. They include electronic payment systems, such as ACH and wire transfers,
as well as paper-based systems, such as checks.

Regulatory Bodies: These are government agencies that oversee the financial system and ensure that
it operates fairly and efficiently. They set rules and regulations for financial institutions, protect
consumers, and maintain financial stability.

Financial Services: These are the services provided by financial institutions to their clients. They
include deposit-taking, lending, investing, insurance, and wealth management.

These components work together to ensure that funds flow smoothly throughout the economy. A well-
functioning financial system is essential for economic growth and stability.

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 • Market Risk Measurement

Market risk is the ever-present threat of loss due to broad fluctuations in the financial markets. Unlike
specific risk, which is tied to the performance of a single company or industry, market risk affects
everyone and can't be eliminated entirely. Market risk is typically categorized into several types:

Interest Rate Risk: The risk of losses due to changes in interest rates, affecting the value of fixed-
income securities such as bonds and loans.

Currency Risk (Foreign Exchange Risk): The risk of losses due to fluctuations in exchange rates,
impacting investments denominated in foreign currencies.

Commodity Risk: The risk of losses due to changes in commodity prices, affecting commodities such
as oil, gas, agricultural products, and metals.

Equity Risk: The risk of losses due to changes in stock prices, impacting investments in equities and
equity-related securities.

Common Methods for Measuring Market Risk

Value at Risk (VaR): This is a widely used statistical technique that estimates the potential loss of a
portfolio over a specific time horizon at a given confidence level. For instance, VaR might tell you that
there's a 95% chance your portfolio won't lose more than X amount in the next day.

Beta Coefficient (β): This metric compares the volatility of an individual security or portfolio to the
overall market (often represented by an index like the S&P 500). A beta of 1 indicates the investment
moves exactly in line with the market, while a beta greater than 1 suggests it'll be more volatile than the
market.

Market Risk Premium: This reflects the additional return investors expect for taking on market risk
compared to a risk-free investment (like government bonds). If the market is expected to deliver 7%
return and risk-free bonds offer 2%, the market risk premium would be 5%.

• Liquidity Risk Management

Liquidity risk refers to the inability of an institution or individual to meet short-term cash obligations.
It arises when there's difficulty in turning assets into cash quickly and at a reasonable price. This can
happen due to various reasons, like sudden withdrawals, unexpected expenses, or market disruptions.

Effective liquidity risk management is crucial for financial stability. Here's a breakdown of the key
aspects:

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Understanding Liquidity Risk:

Types of Liquidity Risk: There are two main types –

Funding Liquidity Risk: This refers to the risk of not having enough cash to meet upcoming liabilities.
Market Liquidity Risk: This refers to the difficulty of selling assets quickly without facing significant
price discounts.

Sources of Liquidity Risk: Common causes include asset-liability mismatches (having too many long-
term assets to fund short-term debts), heavy reliance on short-term funding sources, and market crises
that reduce asset valuations.

Liquidity Risk Management Strategies:

Maintaining a Buffer of Highly Liquid Assets: Holding cash, government bonds, and other assets
that can be easily converted into cash provides a cushion during times of stress.

Cash Flow Forecasting: Regularly monitoring and forecasting future cash inflows and outflows helps
anticipate potential shortfalls and take necessary actions.

Diversifying Funding Sources: Relying on a variety of funding sources, such as a mix of deposits,
debt instruments, and credit lines, reduces dependence on any single source that might dry up.

Stress Testing: Simulating various scenarios, including economic downturns or market crashes, helps
assess an institution's ability to withstand liquidity pressures.

Contingency Planning: Having a clear plan in place for how to respond to liquidity shortfalls, such as
borrowing from credit lines or selling assets, minimizes disruptions.

Regulatory Framework:

Financial regulators play a role in ensuring financial institutions maintain adequate liquidity. They set
guidelines and standards for liquidity risk management practices.

By implementing these strategies, institutions can significantly reduce their exposure to liquidity risk
and operate with greater financial resilience.

• Credit Risk Assessment and Management

Credit risk assessment and management are fundamental processes for any institution lending money.
It's the practice of evaluating a borrower's creditworthiness and taking steps to minimize potential losses
if they fail to repay their debts. Here's a breakdown of the key aspects:

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Credit Risk Assessment:

The Goal: To determine the likelihood of a borrower defaulting on a loan.

Factors Considered: Lenders consider various factors to assess creditworthiness. These often follow a
framework called the "5 Cs of Credit":

Character: Borrower's reputation for meeting financial obligations.

Capacity: Ability to repay the loan based on income and employment stability.
Capital: Borrower's overall financial health, including assets and liabilities.
Conditions: Current economic conditions and their impact on the borrower's ability to repay.
Collateral: Assets pledged as security for the loan, which can be repossessed if the borrower defaults.
Credit Scoring Models: Many lenders use statistical models that assign a credit score based on a
borrower's credit history, financial information, and other data points. These scores help lenders make
quick and objective credit decisions.

Credit Risk Management:

Strategies to Mitigate Risk: Once credit risk is assessed, lenders take steps to minimize potential losses.
Here are some common strategies:
Setting Loan Terms: Interest rates, loan amounts, and repayment schedules are determined based on
the borrower's credit risk. Higher risk borrowers may face higher interest rates or stricter terms.
Loan Covenants: These are contractual clauses that restrict the borrower's activities to protect the
lender's interests. For example, a covenant might limit the borrower's ability to take on additional debt.
Collateral Requirements: Demanding collateral, such as property or investments, provides lenders
with a way to recoup losses if the borrower defaults.
Loan Monitoring: Lenders keep track of borrowers' financial performance and creditworthiness
throughout the loan term. This allows for early detection of potential problems.
Portfolio Diversification: Spreading loans across different borrowers with varying risk profiles
reduces the overall credit risk of the lender's portfolio.

• Operational Risk Management

Operational risk management (ORM) is all about safeguarding your business from the potential pitfalls
of everyday operations. It's a continuous process that encompasses identifying, assessing, and
mitigating risks that stem from internal processes, people, systems, and external events that can disrupt
your business activities.

Here's a breakdown of the key elements of operational risk management:

Why is it Important?
Operational risks are widespread and can cause significant financial losses, reputational damage, or
even business disruptions. These risks can arise from human error, inadequate procedures, technology

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failures, or external events like natural disasters. Proactive ORM helps you anticipate these issues,
minimize their impact, and ensure your business runs smoothly.
The ORM Framework:
A robust ORM framework typically involves a cyclical process with these steps:

Risk Identification: This involves pinpointing all the potential operational risks your business faces.
Consider areas like IT infrastructure, employee conduct, fraud, and business continuity.

Risk Assessment: Evaluate the likelihood and potential impact of each identified risk. This helps
prioritize which risks need the most attention.

Risk Mitigation: Develop strategies to address the identified risks. This could involve implementing
controls like internal audits, staff training, data backup procedures, or business continuity plans.

Risk Monitoring and Reporting: Regularly monitor the effectiveness of your risk controls and report
on the overall ORM program to identify areas for improvement.

• Interest rate risk management

Interest rate risk is the ever-present threat that fluctuations in interest rates will negatively impact the
value of your investments. This is particularly true for fixed-income assets like bonds, where prices
move inversely to interest rates. When rates go up, bond prices go down, and vice versa.

Here's a breakdown of how to manage interest rate risk:

Understanding the Risk:

Impact on Investments: Rising interest rates pose a greater risk to long-term bonds compared to short-
term ones. Longer maturities experience larger price swings due to interest rate changes.

Impact on Institutions: Banks and other financial institutions are also susceptible to interest rate risk.
A mismatch between the maturities of their assets (loans) and liabilities (deposits) can cause problems
if rates rise unexpectedly.

Strategies for Interest Rate Risk Management:

Portfolio Diversification: Spreading your investments across assets with varying maturities and risk
profiles helps mitigate the impact of interest rate movements. Holding a mix of short-term and long-
term bonds can provide some stability.

Matching Maturities: Aligning the maturities of your assets and liabilities can minimize interest rate
risk. This strategy ensures your cash flow remains predictable as your investments mature and your
debts come due.

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Interest Rate Derivatives: Financial instruments like interest rate swaps, options, and futures contracts
can be used to hedge against interest rate fluctuations. These require a more sophisticated understanding
of derivatives but can be powerful tools for managing risk.

Investing in Floating-Rate Instruments: Consider investments whose interest rates adjust to market
fluctuations, such as floating-rate notes or adjustable-rate mortgages (ARMs). These can provide some
protection against rising rates.

• Systemic Risk Analysis

Systemic risk analysis delves into the potential for widespread financial instability triggered by the
failure of a critical institution, industry, or event. It goes beyond individual company risk and focuses
on interconnectedness within the financial system.

Here's a breakdown of key aspects of systemic risk analysis:

Why is it Important?

Systemic risks pose a significant threat to the entire financial system and the broader economy. The
2008 financial crisis serves as a stark reminder of the domino effect that can occur when interconnected
institutions and markets falter.

Proactive analysis helps identify potential vulnerabilities and allows policymakers and financial
institutions to take preventive measures to safeguard the system.

What Does it Analyze?

Systemic Risk Sources: Analysts delve into potential triggers like:

Large interconnected financial institutions: The collapse of a major bank or investment firm can
have ripple effects throughout the financial system due to its extensive network of relationships.
Fragile financial sectors: Industries heavily reliant on short-term funding or with high exposure to
risky assets are more susceptible to systemic risk.
Market contagion: A crisis in one asset class (e.g., housing market) can spread to others (e.g., stock
market) through interconnectedness.
External events: Macroeconomic shocks, natural disasters, or cyberattacks can disrupt the financial
system and trigger systemic risk.

Tools and Techniques:

Stress Testing: This involves simulating various economic or financial shocks to assess the
vulnerability of financial institutions and the broader system.

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Network Analysis: Mapping the interconnectedness between financial institutions and markets helps
identify potential contagion risks.
Early Warning Indicators: Monitoring key economic and financial data points can provide early signs
of potential systemic risk buildup.

• Risk Governance and Compliance

Risk governance and compliance (RGC) is a framework that organizations use to manage risk
effectively while adhering to relevant regulations. It ensures your organization operates within set
guidelines and safeguards its financial health and reputation. Here's a breakdown of the key aspects of
RGC:

Components of RGC:

Risk Governance: This focuses on the leadership's role in overseeing risk management practices. It
includes:

Setting risk appetite: Defining the level of risk the organization is willing to take to achieve its
objectives.
Risk management culture: Fostering a culture where risk awareness and mitigation are embedded
throughout the organization.
Clear risk management policies and procedures: Establishing a framework for identifying, assessing,
and managing risks.

Risk Management: This involves the day-to-day practices of identifying, assessing, and mitigating
risks. It compasses activities like:

Risk identification: Proactively pinpointing potential threats to the organization's goals.

Risk assessment: Evaluating the likelihood and potential impact of each identified risk.
Risk mitigation: Developing and implementing strategies to address identified risks. This could involve
controls like internal audits, training programs, or contingency plans.
Risk monitoring and reporting: Regularly monitoring the effectiveness of risk controls and reporting on
the overall risk management program.

Compliance: This ensures the organization adheres to all applicable laws, regulations, and industry
standards. It involves:

Identifying relevant regulations: Understanding the legal and regulatory framework your organization
operates within.
Developing compliance programs: Creating procedures to ensure adherence to regulations.
Compliance monitoring and reporting: Regularly monitoring compliance and reporting on any
identified issues.

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 • Stress Testing in Financial Institutions
Stress testing in financial institutions is a critical risk management tool used to evaluate the resilience
of financial systems, institutions, and markets under adverse conditions. It involves subjecting a
financial institution's balance sheet, portfolio, or specific components to hypothetical scenarios that
simulate extreme market conditions, economic downturns, or other adverse events.

Here's a breakdown of how stress testing typically works in financial institutions:

Scenario Development: Financial institutions, regulators, or risk management teams develop various
scenarios representing adverse market conditions or events. These scenarios can include economic
recessions, market crashes, interest rate spikes, geopolitical crises, or combinations of these factors. The
severity and likelihood of each scenario are carefully considered.

Modeling and Analysis: Once scenarios are developed, models are constructed to simulate the impact
of these scenarios on the institution's balance sheet, financial performance, liquidity, and capital
adequacy. These models can range from simple spreadsheets to complex econometric and financial
models that take into account various interdependencies and correlations.

Data Collection: Comprehensive data on the institution's assets, liabilities, cash flows, risk exposures,
and other relevant factors are collected and aggregated for use in the stress testing process. This data
often comes from various sources within the institution's operations, as well as external market data
providers.

Scenario Application: The scenarios are applied to the institution's balance sheet and portfolio to assess
the potential impact on key risk metrics such as credit risk, market risk, liquidity risk, and operational
risk. This involves projecting financial performance, estimating potential losses, and evaluating the
adequacy of capital and liquidity buffers under each scenario.

Risk Mitigation Strategies: Based on the results of stress testing, financial institutions identify
vulnerabilities, weaknesses, and areas of potential risk concentration. They then develop and implement
risk mitigation strategies to strengthen their resilience to adverse events. These strategies may include
adjusting asset allocations, hedging exposures, diversifying portfolios, raising capital, or adjusting
liquidity management practices.

Reporting and Communication: Results of stress testing exercises are typically reported to senior
management, the board of directors, regulators, and other stakeholders. Transparent communication of
stress test results is essential for building confidence in the institution's risk management practices and
maintaining regulatory compliance.

Iterative Process: Stress testing is an ongoing and iterative process, with institutions regularly updating
scenarios, models, and data inputs to reflect evolving market conditions, regulatory requirements, and
emerging risks. Continuous monitoring and evaluation of risks are essential to ensure the effectiveness
of stress testing programs.

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Overall, stress testing plays a vital role in helping financial institutions identify and manage risks,
enhance their resilience to adverse events, and maintain stability in the financial system.

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D
iamond and Dybvig

The model was published in 1983 by Douglas W. Diamond of the University of

Chicago and Philip H. Dybvig, then of Yale University.

Introduction

The Diamond-Dybvig model uses game theory to provide an explanation of the

provision of liquidity by a bank, and of the circumstances under which the
demand for liquidity can lead to a bank run.
For the purpose of the model, a bank is treated as an intermediary between
borrowers who want long-term loans for the purpose of investment, and savers
who have unpredictable needs for immediate access to cash.
Since the unpredictable needs of different savers are unlikely to coincide, a small
proportion of its receipts is normally sufficient to meet those needs. However, if
enough depositors attempt to make simultaneous withdrawals, the bank may be
unable to pay them all.
Among the findings of the model is the conclusion that the provision of deposit
insurance is a more efficient way of preventing bank runs than the alternative of
suspending withdrawals until sufficient funds can be raised to pay them.

The Model

Banks make loans that cannot be sold quickly at a high price. Reason??
Business investments often require expenditures in the present to procure
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returns in the future (for example, spending on machines and buildings in the
present period for production in future years). Therefore, when businesses
need to borrow to finance their investments, they prefer loans with a long
maturity (that is, low liquidity).
Banks accept demand deposits that allow depositors to withdraw at any time.
Thus, there is a tension between the needs of individual savers - who want
ready access to their funds in case a sudden need arises - and the requirements
of productive investment, which requires sustained commitment of resources.
Banks have accepted demand deposits throughout their history. In this role,
banks can be viewed as providing insurance that allows agents to consume
when they need the most.
Individual savers may have sudden, unexpected, unpredictable needs for cash,
due to unforeseen expenditures. So they demand liquid accounts which permit
them immediate access to their deposits (high liquidity).
Banks act as intermediaries between savers who prefer to deposit in liquid
accounts and borrowers who prefer to take out long-maturity loans.
Since banks provide a valuable service to both sides (providing the long-
maturity loans businesses want and the liquid accounts depositors want), they
can charge a higher interest rate on loans than they pay on deposits and thus
profit from the difference.
Individual expenditure needs are largely uncorrelated; by the law of large
numbers, banks expect few withdrawals on any given day. As long as all
depositors do not withdraw their deposits at the same time, the bank expects
only a small fraction of withdrawals in the short term, even though all
depositors have the right to take their deposits back at any time. Thus, a bank
can make loans over a long horizon, while keeping only relatively small
amounts of cash on hand to pay any depositors that wish to make withdrawals.
The problem, of course, is the vulnerability of such a system to self-fulfilling
panics: if people believe that a bank will fail, everyone will in fact want to
withdraw funds at the same time — and because the bank’s assets are illiquid,
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trying to meet those demands through fire sales can in fact cause the bank to
fail.

Nash Equilibria of the Model

In a nutshell, the model depicts fractional-reserve banks as intermediaries
dealing in illiquid assets and liquid liabilities and depicts the relationship
among depositors as a coordination game with two Nash equilibria, one in
which nobody tries to withdraw his/her funds because he/she believes no one
else will try to withdraw his/her funds, and one in which everyone tries to
withdraw their funds because they believe everyone else will try to withdraw
their funds.
The mismatch of liquidity, in which a bank’s liabilities are more liquid than its
assets, may cause problems for banks when too many depositors attempt to
withdraw at once (a situation referred to as a bank run).
This means that even healthy banks are potentially vulnerable to panics,
usually called bank runs.

What Next?
Banks faced with bank runs often shut down and refuse to permit more than a few
withdrawals, which is called suspension of convertibility.
While this may prevent some depositors who have a real need for cash from having
access to their money, it also prevents immediate bankruptcy, thus allowing the
bank to wait for its loans to be repaid, so that it has enough resources to pay back
some or all of its deposits.

Deposit Insurance
Suspension of convertibility cannot be an optimal mechanism for preventing
bank runs.
Diamond and Dybvig argue that a better way of preventing bank runs is deposit
insurance backed by the government or central bank.
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Such insurance pays depositors all or part of their losses in the case of a bank
run.
However, if depositors know that they will get their money back even in case of
a bank run, they have no reason to participate in a bank run.
Thus, sufficient deposit insurance can eliminate the possibility of bank runs.
In principle, maintaining a deposit insurance program is unlikely to be very
costly for the government: as long as bank runs are prevented, deposit
insurance will never actually need to be paid out.

“Too big to fail”

Addressing the question of whether Too Big to Fail is a useful focus for bank regulation,
Nobel laureate Paul Krugman wrote:
My basic view is that banking, left to its own devices, inherently poses risks of
destabilizing runs; I’m a Diamond-Dybvig guy. To contain banking crises, the
government ends up stepping in to protect bank creditors. This in turn means that you
have to regulate banks in normal times, both to reduce the need for rescues and to limit
the moral hazard posed by the rescues when they happen.
And here’s the key point: it’s not at all clear that the size of individual banks makes much
difference to this argument.

I
NDIAN SCENARIO

In India, the deposit insurance backed by RBI is provided by Deposit Insurance and
Credit Guarantee Corporation (DICGC), a subsidiary of Reserve Bank of India

History (read through the history just to know the background of DICGC; need
not remember the same)
The concept of insuring deposits kept with banks received attention for the first time in
the year 1948 after the banking crises in Bengal. The question came up for reconsideration
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in the year 1949, but it was decided to hold it in abeyance till the Reserve Bank of India
ensured adequate arrangements for inspection of banks. Subsequently, in the year 1950,
the Rural Banking Enquiry Committee also supported the concept. Serious thought to the
concept was, however, given by the Reserve Bank of India and the Central Government
after the crash of the Palai Central Bank Ltd., and the Laxmi Bank Ltd. in 1960. The
Deposit Insurance Corporation (DIC) Bill was introduced in the Parliament on August 21,
1961. After it was passed by the Parliament, the Bill got the assent of the President on
December 7, 1961 and the Deposit Insurance Act, 1961 came into force on January 1, 1962.
The Deposit Insurance Scheme was initially extended to functioning commercial banks
only. This included the State Bank of India and its subsidiaries, other commercial banks
and the branches of the foreign banks operating in India.

Since 1968, with the enactment of the Deposit Insurance Corporation (Amendment) Act,
1968, the Corporation was required to register the 'eligible co-operative banks' as insured
banks under the provisions of Section 13 A of the Act. An eligible co-operative bank
means a co-operative bank (whether it is a State co-operative bank, a Central co-operative
bank or a Primary co-operative bank) in a State which has passed the enabling legislation
amending its Co-operative Societies Act, requiring the State Government to vest power in
the Reserve Bank to order the Registrar of Co-operative Societies of a State to wind up a
co-operative bank or to supersede its Committee of Management and to require the
Registrar not to take any action for winding up, amalgamation or reconstruction of a co-
operative bank without prior sanction in writing from the Reserve Bank of India.

Further, the Government of India, in consultation with the Reserve Bank of India,
introduced a Credit Guarantee Scheme in July 1960. The Reserve Bank of India was
entrusted with the administration of the Scheme, as an agent of the Central Government,
under Section 17 (11 A)(a) of the Reserve Bank of India Act, 1934 and was designated as the
Credit Guarantee Organization (CGO) for guaranteeing the advances granted by banks
and other Credit Institutions to small scale industries. The Reserve Bank of India
operated the scheme up to March 31, 1981.
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The Reserve Bank of India also promoted a public limited company on January 14, 1971,
named the Credit Guarantee Corporation of India Ltd. (CGCI). The main thrust of the
Credit Guarantee Schemes, introduced by the Credit Guarantee Corporation of India Ltd.,
was aimed at encouraging the commercial banks to cater to the credit needs of the
hitherto neglected sectors, particularly the weaker sections of the society engaged in non-
industrial activities, by providing guarantee cover to the loans and advances granted by
the credit institutions to small and needy borrowers covered under the priority sector.
With a view to integrating the functions of deposit insurance and credit guarantee, the
above two organizations (DIC & CGCI) were merged and the present Deposit Insurance
and Credit Guarantee Corporation (DICGC) came into existence on July 15, 1978.
Consequently, the title of Deposit Insurance Act, 1961 was changed to 'The Deposit
Insurance and Credit Guarantee Corporation Act, 1961 '.

Effective from April 1, 1981, the Corporation extended its guarantee support to credit
granted to small scale industries also, after the cancellation of the Government of India's
credit guarantee scheme. With effect from April 1, 1989, guarantee cover was extended to
the entire priority sector advances, as per the definition of the Reserve Bank of India.
However, effective from April 1, 1995, all housing loans have been excluded from the
purview of guarantee cover by the Corporation.

H
OW DOES DEPOSIT INSURANCE WORK?

1. Which banks are insured by the DICGC?

Commercial Banks: All commercial banks including branches of foreign banks
functioning in India, local area banks and regional rural banks are insured by the DICGC.
Cooperative Banks: All State, Central and Primary cooperative banks, also called urban
cooperative banks, functioning in States / Union Territories which have amended the
local Cooperative Societies Act empowering the Reserve Bank of India (RBI) to order the
Registrar of Cooperative Societies of the State / Union Territory to wind up a cooperative
bank or to supersede its committee of management and requiring the Registrar not to
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take any action regarding winding up, amalgamation or reconstruction of a co-operative

bank without prior sanction in writing from the RBI are covered under the Deposit
Insurance Scheme. At present all co-operative banks other than those from the State of
Meghalaya and the Union Territories of Chandigarh, Lakshadweep and Dadra and Nagar
Haveli are covered by the DICGC.
Primary cooperative societies are not insured by the DICGC.

2. What does the DICGC insure?

The DICGC insures all deposits such as savings, fixed, current, recurring, etc. deposits
except the following types of deposits
i. Deposits of foreign Governments;
ii. Deposits of Central/State Governments;
iii. Inter-bank deposits;
iv. Deposits of the State Land Development Banks with the State co-operative bank;
v. Any amount due on account of and deposit received outside India
vi. Any amount, which has been specifically exempted by the corporation with the
previous approval of Reserve Bank of India

3. What is the maximum deposit amount insured by the DICGC?

Each depositor in a bank is insured up to a maximum of 1,00,000 (Rupees One Lakh) for
both principal and interest amount held by him in the same right and same capacity as on
the date of liquidation/cancellation of bank's license or the date on which the scheme of
amalgamation/merger/reconstruction comes into force.

4. How will you know whether your bank is insured by the DICGC or not?
The DICGC while registering the banks as insured banks furnishes them with printed
leaflets for display giving information relating to the protection afforded by the
Corporation to the depositors of the insured banks. In case of doubt, depositor should
make specific enquiry from the branch official in this regard.
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5. What is the ceiling on amount of Insured deposits kept by one person in

different branches of a bank?
The deposits kept in different branches of a bank are aggregated for the purpose of
insurance cover and a maximum amount up to rupees one lakh is paid.

6. Does the DICGC insure just the principal on an account or both principal and
accrued interest?
The DICGC insures principal and interest upto a maximum amount of one lakh. For
example, if an individual had an account with a principal amount of 95,000 plus accrued
interest of 4,000, the total amount insured by the DICGC would be 99,000. If, however,
the principal amount in that account was one lakh, the accrued interest would not be
insured, not because it was interest but because that was the amount over the insurance
limit.

7. Can deposit insurance be increased by depositing funds into several different

accounts all at the same bank?
All funds held in the same type of ownership at the same bank are added together before
deposit insurance is determined. If the funds are in different types of ownership or are
deposited into separate banks they would then be separately insured.

8. Are deposits in different banks separately insured?

Yes. If you have deposits with more than one bank, deposit insurance coverage limit is
applied separately to the deposits in each bank.

9. If you have funds on deposit at two different banks, and those two banks are
closed on the same day, are your funds added together, or insured separately?
Your funds from each bank would be insured separately, regardless of the date of closure.

10. What is the meaning of deposits held in the same capacity and same right; and
deposits held in different capacity and different right?
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If an individual opens more than one deposit account in one or more branches of a bank
for example, Shri S.K. Pandit opens one or more savings/current account and one or more
fixed/recurring deposit accounts etc., all these are considered as accounts held in the
same capacity and in the same right. Therefore, the balances in all these accounts are
aggregated and insurance cover is available up to rupees one lakh in maximum.
If Shri S.K. Pandit also opens other deposit accounts in his capacity as a partner of a firm
or guardian of a minor or director of a company or trustee of a trust or a joint account,
say with his wife Smt. K. A. Pandit, in one or more branches of the bank then such
accounts are considered as held in different capacity and different right. Accordingly,
such deposits accounts will also enjoy the insurance cover up to rupees one lakh
separately.
It is further clarified that the deposit held in the name of the proprietary concern where a
depositor is the sole proprietor and the amount of Deposit held in his individual capacity
are aggregated and insurance cover is available up to rupees one lakh in maximum.

Illustrations

Savings Current FD Total Deposits

A/C A/C A/C Deposits Insured upto
Shri S. K. Pandit 17,200 22,000 80,000 1,19,200 1,00,000
(Individual)
Shri S. K. Pandit 75,000 50,000 1,25,000 1,00,000
(Partner of ABC & Co.)
Shri S. K. Pandit 7,800 80,000 87,800 87,800
(Guardian for Master
Ajit)
Shri S. K. Pandit 2,30,000 45,000 2,75,000 1,00,000
(Director, J.K. Udyog
Ltd.)
Shri S. K. Pandit jointly 7500 1,50,000 50000 2,07,500 1,00,000
with Smt. K. A. Pandit
 IBFS; B.Sc. Batch 2013-2016 10
Faculty: Sushma

Deposits held in joint accounts (revised w.e.f. April 26, 2007)

If more than one deposit accounts (Savings, Current, Recurring or Fixed deposit) are
jointly held by individuals in one or more branch of a bank say three individuals A, B & C
hold more than one joint deposit accounts in which their names appear in the same order
then all these accounts are considered as held in the same capacity and in the same right.
Accordingly, balances held in all these accounts will be aggregated for the purpose of
determining the insured amount within the limit of 1 lakh.
However, if individuals open more than one joint accounts in which their names are not
in the same order for example, A, B and C; C, B and A; C, A and B; A, C and B; or group of
persons are different say A, B and C and A, B and D etc. then, the deposits held in these
joint accounts are considered as held in the different capacity and different right.
Accordingly, insurance cover will be available separately up to rupees one lakh to every
such joint account where the names appearing in different order or names are different.
 IBFS; B.Sc. Batch 2013-2016 11
Faculty: Sushma

Illustrations
Account (i) First a/c holder- Maximum insured amount up
(Savings or Current A/C) "A" to 1 lakh
Second a/c
holder - "B"
Account (ii) First a/c holder - Maximum insured amount up to 1
"A" lakh
Second a/c holder
- "C"
Account (iii) First a/c holder - Maximum insured amount up to 1
"B" lakh
Second a/c holder
- "A"
Account (iv) at Branch ‘X’ of First a/c holder - Maximum insured amount up to 1
the bank "A" lakh
Second a/c holder
- "B"
Third a/c holder -
"C"
Account (v) First a/c holder - Maximum insured amount up to 1
"B" lakh
Second a/c holder
- "C"
Third a/c holder -
"A"
Account First a/c holder - The account will be clubbed with
(vi)( (Recurring or Fixed "A" the a/c at (i)
Deposit) Second a/c holder
- "B"
Account (vii) First a/c holder - The account will be clubbed with
At Branch ‘Y’ of the bank "A" the a/c at (iv)
Second a/c holder
- "B"
Third a/c holder -
"C"
Account (viii) First a/c holder - Maximum insured amount up to 1
"A" lakh
Second a/c holder
- "B"
Third a/c holder -
"D"
 IBFS; B.Sc. Batch 2013-2016 12
Faculty: Sushma

11. Who pays the cost of deposits insurance?

Deposit insurance premium is borne entirely by the insured bank.

12. When is the DICGC liable to pay?

If a bank goes into liquidation: The DICGC is liable to pay to each depositor through the
liquidator, the amount of his deposit up to rupees one lakh within two months from the
date of receipt of claim list from the liquidator.
If a bank is reconstructed or amalgamated / merged with another bank: The DICGC pays
the bank concerned, the difference between the full amount of deposit or the limit of
insurance cover in force at the time, whichever is less and the amount received by him
under the reconstruction / amalgamation scheme within two months from the date of
receipt of claim list from the transferee bank / Chief Executive Officer of the insured
bank/transferee bank as the case may be.

13. Does the DICGC directly deal with the depositors of failed banks?
No. In the event of a bank's liquidation, the liquidator prepares depositor wise claim list
and sends it to the DICGC for scrutiny and payment. The DICGC pays the money to the
liquidator who is liable to pay to the depositors. In the case of amalgamation / merger of
banks, the amount due to each depositor is paid to the transferee bank.

14. Can any insured bank withdraw from the DICGC coverage?
No. The deposit insurance scheme is compulsory and no bank can withdraw from it.

15. Can the DICGC withdraw deposit insurance coverage from any bank?
The Corporation may cancel the registration of an insured bank if it fails to pay the
premium for three consecutive periods. In the event of the DICGC withdrawing its
coverage from any bank for default in the payment of premium the public will be notified
through newspapers.
Registration of an insured bank stands cancelled if the bank is prohibited from receiving
fresh deposits; or its license is cancelled or a license is refused to it by the RBI; or it is
wound up either voluntarily or compulsorily; or it ceases to be a banking company or a
 IBFS; B.Sc. Batch 2013-2016 13
Faculty: Sushma

co-operative bank within the meaning of Section 36A(2) of the Banking Regulation Act,
1949; or it has transferred all its deposit liabilities to any other institution; or it is
amalgamated with any other bank or a scheme of compromise or arrangement or of
reconstruction has been sanctioned by a competent authority and the said scheme does
not permit acceptance of fresh deposits. In the event of the cancellation of registration of
a bank, deposits of the bank remain covered by the insurance till the date of the
cancellation.

16. What will be the Corporation’s liability to the banks on de-registration.

The Corporation has deposit insurance liability on liquidation etc. of "Insured banks" i.e.
banks which have been de-registered (a) on account of prohibition on receiving fresh
deposits or (b) on cancellation of license or it is found that license cannot be granted. The
liability of the Corporation in these cases is limited to the extent of deposits as on the
date of cancellation of registration of bank as an insured bank.
On liquidation etc. of other de-registered banks i.e. banks which have been de-registered
on other grounds such as nonpayment of premium or their ceasing to be eligible co-
operative banks under section 2(gg) of the DICGC Act, 1961, the Corporation will have no
liability.
Note: Information given above is to convey the basic provisions of the deposit insurance
scheme of the Corporation. The information is of a non-technical nature and is not
intended to be a legal interpretation of the deposit insurance scheme.
BASEL ACCORDS
 BASEL I

• Basel I norms, formally known as the Basel Accord or Basel Capital Accord, are a set
of international banking regulations developed by the Basel Committee on Banking
Supervision.

• These norms were first introduced in 1988.

• Aimed to establish minimum capital requirements for banks with the goal of ensuring
the stability and soundness of the global banking system.
 HERE'S A DETAILED EXPLANATION OF BASEL I NORMS:

Minimum Capital Requirements

• Basel I introduced the concept of minimum capital requirements that banks must hold
relative to their risk-weighted assets.

• The minimum capital adequacy ratio (CAR) under Basel I was set at 8%, meaning that
banks were required to maintain a minimum amount of capital equal to at least 8% of
their risk-weighted assets.
Risk Weighting
• Basel I categorized bank assets into broad risk categories and assigned specific risk
weights to each category.

• The risk weights were based on the perceived credit risk associated with different types
of assets.

• For example, cash and government securities were assigned a risk weight of 0%,
indicating they were considered low risk, while loans to private borrowers were
assigned higher risk weights based on factors such as the credit rating of the borrower
and the type of collateral.
Credit Risk

• The focus of Basel I was primarily on credit risk, which is the risk that borrowers may
default on their obligations.

• It aimed to ensure that banks held adequate capital to absorb potential losses arising
from loan defaults.
Simplicity

• One of the key features of Basel I was its simplicity.

• The framework provided a straightforward method for calculating capital requirements

based on the risk weights assigned to different asset classes.

• This simplicity made it easier for banks to comply with the regulations and for
regulators to monitor banks' capital adequacy.
Limitations

• Despite its simplicity, Basel I had several limitations.

• It did not adequately account for other types of risks, such as market risk and
operational risk, which became increasingly important as financial markets evolved.

• Additionally, the risk weights assigned to different asset classes were relatively crude
and did not always reflect the true level of risk.
International Adoption

• Basel I was widely adopted by countries around the world, although implementation
varied in some cases due to differences in national banking regulations and practices.

• However, its shortcomings became apparent over time, leading to calls for a more
comprehensive framework that would address the limitations of Basel I and better
reflect the complexities of modern banking.
Risk Weighting and Capital Adequacy:
Example: Consider a hypothetical bank with the following assets:
Cash: $100 million
Government securities: $200 million
Corporate loans: $300 million
Residential mortgages: $400 million

Calculation: Under Basel I, these assets would be assigned risk weights as follows:
Cash and government securities: 0%
Corporate loans: 100%
Residential mortgages: 50%
Capital Requirement: The bank's risk-weighted assets would be calculated as (0% * $100M) + (0% *
$200M) + (100% * $300M) + (50% * $400M) = $500M. Therefore, the minimum capital requirement
would be 8% of $500M, which is $40 million.
Impact on Lending Practices:

Case Study: In the years leading up to the implementation of Basel I, many banks held
insufficient capital to cover their lending activities adequately. As a result, they were
incentivized to increase their capital reserves by either raising additional capital or
reducing their lending activities.

Outcome: Some banks tightened their lending standards or increased interest rates to
compensate for the higher capital requirements imposed by Basel I. This led to a
temporary slowdown in lending activity, particularly for riskier borrowers who were
subject to higher capital charges.
International Implementation Variations:
Example: While most countries adopted Basel I, there were variations in its
implementation due to differences in national banking regulations and practices.

Case Study: European countries implemented Basel I with some modifications to

accommodate their unique banking systems and regulatory frameworks. For example,
some countries imposed stricter capital requirements or applied different risk weights to
certain asset classes based on local market conditions.

Outcome: These variations sometimes led to discrepancies in capital requirements across

different jurisdictions, highlighting the need for greater international coordination and
harmonization of banking regulations.
Criticism and Lessons Learned:
Example: Basel I was criticized for its simplicity and limited scope, particularly its focus on
credit risk to the exclusion of other types of risks, such as market risk and operational risk.

Case Study: The Basel I framework failed to anticipate and address the systemic risks that
contributed to the global financial crisis of 2007-2008. Inadequate capital buffers and lax
regulatory oversight allowed banks to take excessive risks, leading to widespread financial
instability.

Outcome: The shortcomings of Basel I underscored the need for a more comprehensive and
risk-sensitive regulatory framework, leading to the development of Basel II and subsequently
Basel III, which introduced more sophisticated risk measurement techniques and enhanced
capital standards to improve the resilience of the banking system.
 Basel II
Basel II, formally known as the International Convergence of Capital Measurement and Capital
Standards, is a set of international banking regulations developed by the Basel Committee on Banking
Supervision. It was introduced in 2004 as an updated framework to replace the original Basel Accord,
commonly referred to as Basel I, which was implemented in 1988. Basel II aimed to strengthen the
regulation, supervision, and risk management within the banking sector by providing a more
comprehensive and risk-sensitive approach to capital adequacy requirements.

Basel II introduced three pillars that form the framework for banking regulation:

Pillar 1: Minimum Capital Requirements:

This pillar establishes the minimum capital requirements that banks need to hold to cover various types
of risks they face, including credit risk, market risk, and operational risk.
Credit risk refers to the risk of financial loss resulting from the failure of a borrower to repay a loan or
meet its obligations.
Market risk refers to the risk of financial loss due to changes in market prices such as interest rates,
exchange rates, and equity prices.
Operational risk encompasses risks arising from internal processes, people, systems, or external events,
including legal and reputation risks.
Basel II introduced more sophisticated methods for calculating capital requirements, allowing banks to
use their internal models to estimate risk more accurately. This includes the use of the standardized
approach, internal ratings-based (IRB) approach, and advanced measurement approaches (AMA) for
different types of risks.

Pillar 2: Supervisory Review Process:

Pillar 2 focuses on the supervisory review process, where banking regulators evaluate banks' overall
capital adequacy and risk management practices.
Banks are required to conduct their internal assessments of their capital adequacy, taking into account
their specific risk profiles and operating environments.
Supervisors review these internal assessments and may require banks to hold additional capital if they
determine that the bank's capital levels are insufficient to cover their risks adequately.

Pillar 3: Market Discipline:

Pillar 3 aims to promote market discipline by enhancing the transparency of banks' risk profiles and
capital adequacy through disclosures.
Banks are required to provide regular and standardized disclosures about their risk exposures, capital
adequacy, and risk management practices to investors, regulators, and the public.
By providing more information to stakeholders, Pillar 3 encourages market participants to make more
informed decisions and exert pressure on banks to maintain sound risk management practices and
adequate capital levels.
Basel II represents a significant advancement in banking regulation by incorporating a more risk-
sensitive approach to capital adequacy requirements and promoting better risk management practices
within the banking sector. However, it also faced criticism, particularly in the aftermath of the 2007-
2008 financial crisis, for not adequately addressing certain systemic risks and for being too complex to
implement and enforce effectively. As a result, efforts have been made to further refine and enhance the
Basel framework, leading to the development of subsequent versions such as Basel III.

Basel III
Basel III is an international regulatory framework for banks that was developed by the Basel Committee
on Banking Supervision (BCBS), a global committee of banking supervisory authorities. It aims to
strengthen regulation, supervision, and risk management within the banking sector, with the primary
goal of promoting stability and resilience in the global financial system. Basel III builds upon the Basel
I and Basel II frameworks, introducing new requirements and enhancements to address weaknesses
exposed during the 2008 financial crisis.

Here's a detailed explanation of some key aspects of Basel III:

Capital Requirements:

Basel III introduces stricter capital requirements for banks, particularly focusing on the quality and
quantity of capital held by banks to ensure they have sufficient buffers to absorb losses during economic
downturns.
It introduces a minimum common equity tier 1 (CET1) capital requirement, which consists mainly of
common equity and retained earnings. CET1 capital is considered the highest quality capital as it
provides the most loss-absorption capacity.
Additionally, Basel III introduces new capital buffers, such as the capital conservation buffer (and the
countercyclical capital buffer, to further strengthen banks' resilience to periods of stress.

The Capital Conservation Buffer is an additional layer of capital that banks are required to hold on top
of their minimum regulatory capital requirements. It serves as a cushion that banks can draw upon
during periods of stress without breaching their minimum capital requirements.

The Countercyclical Capital Buffer (CCyB) is a macroprudential tool introduced by Basel III to address
systemic risks associated with credit cycles and to enhance the resilience of the banking system during
periods of excessive credit growth. Unlike the Capital Conservation Buffer, which applies uniformly to
all banks, the CCyB is a variable buffer that can be adjusted by regulators in response to prevailing
macroeconomic conditions.
Leverage Ratio:

Basel III introduces a leverage ratio as a supplementary measure to the risk-based capital requirements.
The leverage ratio is calculated by dividing a bank's Tier 1 capital by its total exposure.
Unlike risk-weighted assets used in traditional capital adequacy ratios, the leverage ratio provides a
simple measure of a bank's capital adequacy without adjustment for risk.

Liquidity Requirements:

Basel III introduces liquidity requirements to ensure banks maintain sufficient liquidity to meet their
obligations, even in times of stress.
The Liquidity Coverage Ratio (LCR) requires banks to hold enough high-quality liquid assets to cover
their net cash outflows over a 30-day stress period.
The Net Stable Funding Ratio (NSFR) aims to promote more stable funding structures in banks by
requiring banks to maintain a stable funding profile relative to the composition of their assets and
activities over a one-year horizon.

Counterparty Credit Risk:

Basel III enhances the treatment of counterparty credit risk by introducing requirements for measuring
and mitigating exposures arising from derivatives, securities financing transactions, and other trading
activities.
It introduces a standardized approach and an advanced approach for calculating capital requirements
for counterparty credit risk exposures, depending on the sophistication of a bank's risk management
systems.

Macroprudential Regulation:

Basel III incorporates macroprudential elements aimed at addressing systemic risks in the financial
system. These include the countercyclical capital buffer, which allows regulators to increase capital
requirements during periods of excessive credit growth to prevent the buildup of systemic risk.

Enhanced Disclosure and Transparency:

Basel III emphasizes enhanced disclosure and transparency requirements to improve market discipline
and enable stakeholders to better assess banks' risk profiles and capital adequacy.
Overall, Basel III represents a comprehensive set of reforms designed to strengthen the resilience of the
banking sector, enhance risk management practices, and promote financial stability in the global
economy. While the implementation of Basel III may pose challenges for banks in terms of compliance
costs and adjustments to business models, its overarching objective is to mitigate the likelihood and
severity of future financial crises.
Faculty: Sushma

Banking Ombudsman Scheme, 2006

1. What is the Banking Ombudsman Scheme?

The Banking Ombudsman Scheme enables an expeditious and inexpensive forum to bank
customers for resolution of complaints relating to certain services rendered by banks. The
Banking Ombudsman Scheme is introduced under Section 35 A of the Banking Regulation Act,
1949 by RBI with effect from 1995.

2. Who is a Banking Ombudsman?

The Banking Ombudsman is a senior official appointed by the Reserve Bank of India to redress
customer complaints against deficiency in certain banking services.

3. How many Banking Ombudsmen have been appointed and where are they located?
As on date, fifteen Banking Ombudsmen have been appointed with their offices located mostly
in state capitals.

4. Which are the banks covered under the Banking Ombudsman Scheme, 2006?
All Scheduled Commercial Banks, Regional Rural Banks and Scheduled Primary Co-operative
Banks are covered under the Scheme.

5. What are the grounds of complaints?

The Banking Ombudsman can receive and consider any complaint relating to the following
deficiency in banking services (including internet banking):
 non-payment or inordinate delay in the payment or collection of cheques, drafts, bills
etc.;
 non-acceptance, without sufficient cause, of small denomination notes tendered for any
purpose, and for charging of commission in respect thereof;
 non-acceptance, without sufficient cause, of coins tendered and for charging of
commission in respect thereof;
 failure to issue or delay in issue of drafts, pay orders or bankers’ cheques;
 non-adherence to prescribed working hours ;
Faculty: Sushma

 failure to provide or delay in providing a banking facility (other than loans and
advances) promised in writing by a bank;
 complaints from Non-Resident Indians having accounts in India in relation to their
remittances from abroad, deposits and other bank-related matters;
 refusal to open deposit accounts without any valid reason for refusal;
 levying of charges without adequate prior notice to the customer;
 forced closure of deposit accounts without due notice or without sufficient reason;
 refusal to close or delay in closing the accounts;
 non-adherence to the fair practices code;
 non-observance of Reserve Bank guidelines on engagement of recovery agents by
banks; and
 any other matter relating to the violation of the directives issued by the Reserve Bank in
relation to banking or other services, etc.

6. When can one file a complaint?

One can file a complaint before the Banking Ombudsman if the reply is not received from the
bank within a period of one month after the bank concerned has received one’s representation,
or the bank rejects the complaint, or if the complainant is not satisfied with the reply given by
the bank.

7. When will one’s complaint not be considered by the Ombudsman?

One’s complaint will not be considered if:

a. One has not approached his bank for redressal of his grievance first.
b. One has not made the complaint within one year from the date one has received the reply of
the bank or if no reply is received if it is more than one year and one month from the date of
representation to the bank.
c. The subject matter of the complaint is pending for disposal has already been dealt with at any
other forum like court of law, consumer court etc.
d. Frivolous or vexatious.
e. The institution complained against is not covered under the scheme.
Faculty: Sushma

f. The subject matter of the complaint is not within the ambit of the Banking Ombudsman.
g. If the complaint is for the same subject matter that was settled through the office of the
Banking Ombudsman in any previous proceedings.

8. What is the procedure for filing the complaint before the Banking Ombudsman?
One can file a complaint with the Banking Ombudsman simply by writing on a plain paper. One
can also file it online or by sending an email to the Banking Ombudsman.

9. Where can one lodge his/her complaint?

One may lodge his/ her complaint at the office of the Banking Ombudsman under whose
jurisdiction the bank branch complained against is situated.

10. Can a complaint be filed by one’s authorized representative?

Yes. The complaint can be filed by one’s authorized representative (other than an advocate).

11. Is there any cost involved in filing complaints with Banking Ombudsman?
No. The Banking Ombudsman does not charge any fee for filing and resolving customers’
complaints.

12. Is there any limit on the amount of compensation as specified in an award?

The amount, if any, to be paid by the bank to the complainant by way of compensation for any
loss suffered by the complainant is limited to the amount arising directly out of the act or
omission of the bank or Rs 10 lakhs, whichever is lower.

13. Can compensation be claimed for mental agony and harassment?

The Banking Ombudsman may award compensation not exceeding Rs. 1 lakh to the
complainant only in the case of complaints relating to credit card operations for mental agony
and harassment. The Banking Ombudsman will take into account the loss of the complainant’s
time, expenses incurred by the complainant, harassment and mental anguish suffered by the
complainant while passing such award.
Faculty: Sushma

14. What details are required in the application?

The complaint should have the name and address of the complainant, the name and address of
the branch or office of the bank against which the complaint is made, facts giving rise to the
complaint supported by documents, if any, the nature and extent of the loss caused to the
complainant, the relief sought from the Banking Ombudsman and a declaration about the
compliance of conditions which are required to be complied with by the complainant.

15. What happens after a complaint is received by the Banking Ombudsman?

The Banking Ombudsman endeavours to promote, through conciliation or mediation, a
settlement of the complaint by agreement between the complainant and the bank named in the
complaint.
If the terms of settlement (offered by the bank) are acceptable to one in full and final settlement
of one’s complaint, the Banking Ombudsman will pass an order as per the terms of settlement
which becomes binding on the bank and the complainant.

16. Can the Banking Ombudsman reject a complaint at any stage?

Yes. The Banking Ombudsman may reject a complaint at any stage if it appears to him that a
complaint made to him is:
 compensation sought from the Banking Ombudsman is beyond Rs 10 lakh .
 requires consideration of elaborate documentary and oral evidence and the proceedings
before the Banking Ombudsman are not appropriate for adjudication of such complaint
 that it is not pursued by the complainant with reasonable diligence
 in the opinion of the Banking Ombudsman there is no loss or damage or inconvenience
caused to the complainant.

17. What happens if the complaint is not settled by agreement?

If a complaint is not settled by an agreement within a period of one month, the Banking
Ombudsman proceeds further to pass an award. Before passing an award, the Banking
Ombudsman provides reasonable opportunity to the complainant and the bank, to present their
case.
It is up to the complainant to accept the award in full and final settlement of your complaint or
to reject it.
Faculty: Sushma

18. Is there any further recourse available if one rejects the Banking Ombudsman’s
decision?
If one is not satisfied with the decision passed by the Banking Ombudsman, one can approach
the appellate authority against the Banking Ombudsmen’s decision. Appellate Authority is
vested with a Deputy Governor of the RBI.
One can also explore any other recourse and/or remedies available to him/her as per the law.
The bank also has the option to file an appeal before the appellate authority under the scheme.

19. Is there any time limit for filing an appeal?

If one is aggrieved by the decision, one may, within 30 days of the date of receipt of the award,
appeal against the award before the appellate authority. The appellate authority may, if he/ she
is satisfied that the applicant had sufficient cause for not making an application for appeal
within time, also allow a further period not exceeding 30 days.

20. How does the appellate authority deal with the appeal?
The appellate authority may

i. dismiss the appeal; or

ii. allow the appeal and set aside the award; or
iii. send the matter to the Banking Ombudsman for fresh disposal in accordance with such
directions as the appellate authority may consider necessary or proper; or
iv. modify the award and pass such directions as may be necessary to give effect to the modified
award; or
v. pass any other order as it may deem fit.
 Indian Banking and Financial System
S.Y. B.Sc. (2013-16)
Sushma

How Kahneman’s and Tversky’s Noble Prize

Winning Prospect Theory can Improve Your
Finances

I finally did it!

A few weeks back, in a post about the behavior trap of Mental Accounting, I mentioned
that my Grandpa passed on a few shares of stock to me. When the stock was given to
me, it was worth around $30 a share. I sold it on 4/7/2011 for $3.04.
It hurts thinking about the money I lost from holding onto that stock. But what’s done
is done.
Instead, of regretting this situation, the better use of time is to look at the psychological
factors that played a role in my irrational behavior. Specifically, why did I continue to
hold onto this stock, as it plummeted to $20, to $10, to $5, to $1.50, and back up to $3?
The entire time the stock plummeted, I knew it was the wrong thing to do. I’ve read
research explaining that once a stock gets that low, it rarely goes back up. But yet, I
couldn’t get myself to sell it. For whatever reason, I thought my situation was
different.
Recently, while reading about Kahneman’s and Tversky’s prospect theory, I had an
“aha” type moment. Their work, which they named prospect theory, perfectly explains
my incredibly stupid decision to hold onto this stock.

Principles of Prospect Theory

The underlying principles of prospect theory weren’t discovered overnight. Kahneman’s
and Tversky’s goal was to develop a framework of how people manage risk and
uncertainty. They did this with multiple studies, over a 30 year period.

Page 1 of 6
 Indian Banking and Financial System
S.Y. B.Sc. (2013-16)
Sushma

In 2002, Kahneman was awarded the Noble Prize in Economics for his work.
Unfortunately, at that time, Tversky had passed, and wasn’t able to share the
recognition.
Over a 30 year period, Kahneman and Tversky came to the following conclusions as to
how people manage risk and uncertainty.
1. Loss Aversion – The pain of loss is greater than the pleasure of an equal gain.
For example, the pain from losing a $100 bill is worse than the pleasure from
finding a $100 bill.
2. Reference Points – Decisions are made using reference points. These reference
points change over time. For example, would you drive to a new dealership 30
minutes away, to save $20 on the purchase price of a $20,000 car? Probably not.
Now, have you ever waited in line 30 minutes for free ice cream, which costs $3?
3. Break Even Effect – People seek risky behavior, for a chance to “break even.”
For example, you bought a stock at $30, that’s now down to $20. Wanting to
break even, you purchase more shares at $20.
4. Over-weigh Small Probabilities – People tend to severely over-weigh
extremely small probabilities. There are actually some people who think they will
win the lottery.
5. Under-weigh Large Probabilities – People tend to under-weigh the chance of a
highly probable event from occurring. People invest thinking that there is “no
way they can lose,” then; they’re shocked once their portfolio is down.

Ways to Apply the Principles of Prospect Theory to Improve Your Financial

Decision Making

Page 2 of 6
 Indian Banking and Financial System
S.Y. B.Sc. (2013-16)
Sushma

Beyond offering an explanation as to why I held onto my stock (I wanted to break even,
I was avoiding taking the loss, I used a reference point of $30 for the price per share),
the principles of prospect theory explains many other irrational financial decisions that
we make on a daily basis. The next step then is to look at specific ways you can apply
these principles to help improve your finances.
# 1 – Have Default Reference Points
Like it or not, your brain is going to continue to take shortcuts, as it does when it uses
reference points... Instead of avoiding reference points all together and relying on
critical thinking, which is extremely hard under stress, you’re better off to continue to
use reference points. However, instead of using “spur of the moment” reference points,
like you did when you decided to not drive 30 minutes to save $20 on a new car, you
can create default reference points in advance.
For example, what if you looked at saving $20 not as the chance to save .001% but as an
opportunity to buy something for $20 that fulfills you? Personally, I use 3 default
reference points that I refer back to for making financial decisions.
1. $10 = A Book – Every chance I have to save $10, is another chance I have to buy
a book. Therefore, driving 30 minutes would have allowed me to buy two new
books.
2. $100 = A Nice Dinner - Every time I have a chance to save $100, I look at it as a
chance to go out to a nice dinner with my wife, Natalie.
3. $1,000 = A Trip – I feel that I can get to anyone in the world for $1,000.
Therefore, every time I have a chance to save in increments of $1,000, I look at is
as a trip.
Putting this all together, imagine now I’m choosing between two apartments.

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 Indian Banking and Financial System
S.Y. B.Sc. (2013-16)
Sushma

 Apartment ‘A’ – Good location, nice kitchen, two bathrooms for $1,200 a
month.
 Apartment ‘B’ – Average location, average kitchen, 1.5 bathrooms for
$1,000 a month.
Over a year, the difference in cost between A or B is $2,400. Or, using my default
reference points, the difference in cost is 2 trips, 2 nice dinners, and 20 books.
Now, when I’m sitting in the Realtor’s office under pressure, with 2 people waiting
anxiously for me to sign, I can make a better decision then saying, “Oh, it’s just $200 a
month.”
# 2 – Match the Market with Index Funds
It’s really hard, as in almost impossible, to beat the market consistently. Out of the
300,000 million plus people in the U.S., only a handful of people have beaten the stock
market’s returns over a 40 year period. Yet, year after year, the majority of investors
try.
This is a prime example of how people over-weigh small probabilities.
# 3 – Rebalance on a Schedule
Prospect theory explains why investors sell winning stocks too soon, and hold on to
loosing stocks too long. To contradict this behavior, stick to a rebalancing schedule. At
specific times set in advance, rebalance to your desired asset allocation. If this sounds
complicated, invest in a targeted retirement fund.

Kahneman’s and Tversky’s Prospect Theory: Conclusion

There is a lot more to Kahneman’s and Tversky’s prospect theory. The purpose of
this post was to introduce the basic concept, and list a few tactical things you can do
today, to help make better financial decisions.

Page 4 of 6
 Indian Banking and Financial System
S.Y. B.Sc. (2013-16)
Sushma

In the comments, mention if you’ve ever made any bad financial decisions that are
attributed to:
1. Wanting to avoid a loss
2. The incorrect use of reference points
3. Your desire to break even
4. Over-weighing small probabilities
5. Under-weighing large probabilities

Page 5 of 6
 Indian Banking and Financial System
S.Y. B.Sc. (2013-16)
Sushma

Definition of 'Prospect Theory'

 A theory that people value gains and losses differently and, as such, will base
decisions on perceived gains rather than perceived losses
 Thus, if a person were given two equal choices, one expressed in terms of
possible gains and the other in possible losses, people would choose the former.
 Also known as "loss-aversion theory"
 To demonstrate, say one investor was presented with the same mutual fund
by two different financial advisors. The first tells the investor that the mutual
fund has had an average return of 7% over the past five years. The second
advisor tells the investor that the mutual fund has seen above-average returns in
the past 10 years but has been declining in recent years. According to prospect
theory, even though the investor is presented with the same mutual fund, he or
she is more likely to buy the mutual fund from the first advisor, who expressed
the rate of return as an overall 7% gain, rather a combination of both high
returns and losses.

Page 6 of 6
 Indian Banking and Financial System (403)
S Y B.Sc. (Batch 2014-17)
Faculty: Sushma

Prospect Theory
Conventionally, it is believed the net effect of the gains and losses involved with each choice are combined to
present an overall evaluation of whether a choice is desirable. Academics tend to use "utility" to describe
enjoyment and contend that we prefer instances that maximize our utility.

However, research has found that we don't actually process information in such a rational way. In 1979,
Kahneman and Tversky presented an idea called prospect theory, which contends that people value gains and
losses differently, and, as such, will base decisions on perceived gains rather than perceived losses. Thus, if a
person were given two equal choices, one expressed in terms of possible gains and the other in possible losses,
people would choose the former - even when they achieve the same economic end result.

According to prospect theory, losses have more poignant impact than an equivalent amount of gains. For
example, in a traditional way of thinking, the amount of utility gained from receiving $50 should be equal to a
situation in which you gained $100 and then lost $50. In both situations, the end result is a net gain of $50.

However, despite the fact that you still end up with a $50 gain in either case, most people view a single gain of
$50 more favorably than gaining $100 and then losing $50.

Substantiation for Irrational Behavior

Kahneman and Tversky conducted a series of studies in which subjects answered questions that involved making
judgments between two monetary decisions that involved prospective losses and gains. For example, the
following questions were used in their study:
1) You have $1,000 and you must pick one of the following choices:
 Choice A: You have a 50% chance of gaining $1,000, and a 50% chance of gaining $0.
 Choice B: You have a 100% chance of gaining $500.
 Indian Banking and Financial System (403)
S Y B.Sc. (Batch 2014-17)
Faculty: Sushma

2) You have $2,000 and you must pick one of the following choices:
 Choice A: You have a 50% chance of losing $1,000, and 50% of losing $0.
 Choice B: You have a 100% chance of losing $500.

The results of this study showed that an overwhelming majority of people chose "B" for question 1 and "A" for
question 2. The implication is that people are willing to settle for a reasonable level of gains (even if they have a
reasonable chance of earning more), but are willing to engage in risk-seeking behaviors where they can limit
their losses. In other words, losses are weighted more heavily than an equivalent amount of gains.

It is this line of thinking that created the asymmetric value function:

This function is a representation of the difference in utility (amount of pain or joy) that is achieved as a result of
a certain amount of gain or loss. It is crucial to note that not everyone would have a value function that looks
exactly like this; this is the general trend. The most evident feature is how a loss creates a greater feeling of pain
compared to the joy created by an equivalent gain. For example, the absolute joy felt in finding $50 is a lot less
than the absolute pain caused by losing $50.
 Indian Banking and Financial System (403)
S Y B.Sc. (Batch 2014-17)
Faculty: Sushma

The prospect theory can be used to explain quite a few illogical financial behaviors. For example, there are
people who do not wish to put their money in the bank to earn interest or who refuse to work overtime
because they don't want to pay more taxes. Although these people would benefit financially from the additional
after-tax income, prospect theory suggests that the benefit (or utility gained) from the extra money is not
enough to overcome the feelings of loss incurred by paying taxes.

Prospect theory also explains the occurrence of the disposition effect, which is the tendency for investors to
hold on to losing stocks for too long and sell winning stocks too soon. The most logical course of action would
be to hold on to winning stocks in order to further gains and to sell losing stocks in order to prevent escalating
losses.
 Non-Banking Financial Company

1. What is a Non-Banking Financial Company (NBFC)?

A Non-Banking Financial Company (NBFC) is a company registered under the Companies Act,
1956 engaged in the business of loans and advances, acquisition of
shares/stocks/bonds/debentures/securities issued by Government or local authority or other
marketable securities of a like nature, leasing, hire-purchase, insurance business, chit business
but does not include any institution whose principal business is that of agriculture activity,
industrial activity, purchase or sale of any goods (other than securities) or providing any
services and sale/purchase/construction of immovable property. A non-banking institution
which is a company and has principal business of receiving deposits under any scheme or
arrangement in one lump sum or in installments by way of contributions or in any other
manner, is also a non-banking financial company (Residuary non-banking company).

2. NBFCs perform functions similar to banks. What is the difference between banks &
NBFCs ?
NBFCs lend and make investments and hence their activities are akin to that of banks; however
there are a few differences as given below:
i. NBFC cannot accept demand deposits;
ii. NBFCs do not form part of the payment and settlement system and cannot issue cheques
drawn on itself;
iii. deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is not
available to depositors of NBFCs, unlike in case of banks.

3. Is it necessary that every NBFC should be registered with RBI?

In terms of of the RBI Act, 1934, no Non-banking Financial company can commence or carry
on business of a non-banking financial institution without a) obtaining a certificate of
registration from the Bank and without having a Net Owned Funds of Rs. 25 lakhs (Rs two
crore since April 1999). However, in terms of the powers given to the Bank to obviate dual
regulation, certain categories of NBFCs which are regulated by other regulators are exempted
from the requirement of registration with RBI viz. Venture Capital Fund/Merchant Banking
companies/Stock broking companies registered with SEBI, Insurance Company holding a valid

Page 1 of 3
Certificate of Registration issued by IRDA, Nidhi companies, Chit companies, Housing Finance
Companies regulated by National Housing Bank, Stock Exchange or a Mutual Benefit
company.
Category of Companies Regulator
Chit Funds Respective State Governments
Insurance companies IRDA
Housing Finance Companies NHB
Venture Capital Fund SEBI
Merchant Banking companies SEBI
Stock broking companies SEBI
Nidhi Companies Ministry of corporate affairs, Government of
India

4. What are the different types/categories of NBFCs registered with RBI?

NBFCs are categorized a) in terms of the type of liabilities into Deposit and Non-Deposit
accepting NBFCs, b) non deposit taking NBFCs by their size into systemically important and
other non-deposit holding companies and c) by the kind of activity they conduct. Within this
broad categorization the different types of NBFCs are as follows:
i. Asset Finance Company(AFC) : An AFC is a company which is a financial institution
carrying on as its principal business the financing of physical assets supporting
productive/economic activity, such as automobiles, tractors, lathe machines, generator
sets, earth moving and material handling equipments, moving on own power and
general purpose industrial machines. Principal business for this purpose is defined as
aggregate of financing real/physical assets supporting economic activity and income
arising wherefrom is not less than 60% of its total assets and total income respectively.
ii. Investment Company (IC): IC means any company which is a financial institution
carrying on as its principal business the acquisition of securities.
iii. Loan Company (LC): LC means any company which is a financial institution carrying
on as its principal business the providing of finance whether by making loans or
advances or otherwise for any activity other than its own but does not include an Asset
Finance Company.

Page 2 of 3
 iv. Infrastructure Finance Company (IFC): IFC is a non-banking finance company a)
which deploys at least 75 per cent of its total assets in infrastructure loans, b) has a
minimum Net Owned Funds of Rs. 300 crore, c) has a minimum credit rating of ‘A ‘or
equivalent d) and a CRAR1 of 15%.
v. Systemically Important Core Investment Company (CIC-ND-SI): CIC-ND-SI is an
NBFC carrying on the business of acquisition of shares and securities.
vi. Infrastructure Debt Fund: Non- Banking Financial Company (IDF-NBFC): IDF-
NBFC is a company registered as NBFC to facilitate the flow of long term debt into
infrastructure projects.
vii. Non-Banking Financial Company - Micro Finance Institution (NBFC-
MFI): NBFC-MFI is a non-deposit taking NBFC giving micro loans to target groups as
identified by the Regulatory Body.
viii. Non-Banking Financial Company – Factors (NBFC-Factors): NBFC-Factor is a
non-deposit taking NBFC engaged in the principal business of factoring.

5. What are the salient features of NBFCs regulations which the depositor may note at
the time of investment?
Some of the important regulations relating to acceptance of deposits by NBFCs are as under:
i. The NBFCs are allowed to accept/renew public deposits for a minimum period of 12
months and maximum period of 60 months. They cannot accept deposits repayable on
demand.
ii. NBFCs cannot offer interest rates higher than the ceiling rate prescribed by RBI from
time to time. The present ceiling is 12.5 per cent per annum. The interest may be paid
or compounded at rests not shorter than monthly rests.
iii. NBFCs cannot offer gifts/incentives or any other additional benefit to the depositors.
iv. NBFCs (except certain AFCs) should have minimum investment grade credit rating.
v. The deposits with NBFCs are not insured.
vi. The repayment of deposits by NBFCs is not guaranteed by RBI.
vii. Certain mandatory disclosures are to be made about the company in the Application
Form issued by the company soliciting deposits.

1 Capital to Risk Assets Ratio (CRAR)

Page 3 of 3
 Indian Banking and Financial System (403)
S Y B.Sc. (Batch 2014-17)
Faculty: Sushma

MONEY MARKET

What is Money Market?

Money market provides investment avenues of short term tenor. Money market transactions are
generally used for funding the transactions in other markets including Government securities
market and meeting short term liquidity mismatches. By definition, money market is for a
maximum tenor of up to one year. Within the one year, depending upon the tenors, money market
is classified into:
Overnight market - The tenor of transactions is one working day.
Notice money market – The tenor of the transactions is from 2 days to 14 days.
Term money market – The tenor of the transactions is from 15 days to one year.

Refer to the definitions on the following page.

Indian Banking and Financial System (403)
S Y B.Sc. (Batch 2014-17)
Faculty: Sushma
 Indian Banking and Financial System (403)
S Y B.Sc. (Batch 2014-17)
Faculty: Sushma

Treasury Bills (T-bills)

Types
Treasury bills or T-bills, which are money market instruments, are short term debt instruments issued by the
Government of India and are presently issued in three tenors, namely, 91 day, 182 day and 364 day. Treasury
bills (T-bills) offer short-term investment opportunities, generally up to one year. They are thus useful in
managing short-term liquidity. There are no treasury bills issued by State Governments.
Amount
Treasury bills are available for a minimum amount of Rs.25, 000 and in multiples of Rs. 25,000. Treasury bills
are issued at a discount and are redeemed at par.
Treasury bills are zero coupon securities and pay no interest. They are issued at a discount and redeemed at the
face value at maturity. For example, a 91 day Treasury bill of Rs.100/- (face value) may be issued at say Rs.
98.20, that is, at a discount of say, Rs.1.80 and would be redeemed at the face value of Rs.100/-. The return
to the investors is the difference between the maturity value or the face value (that is Rs.100) and the issue
price. The Reserve Bank of India conducts auctions usually every Wednesday to issue T-bills. Payments for the
T-bills purchased are made on the following Friday. The Reserve Bank releases an annual calendar of T-bill
issuances for a financial year in the last week of March of the previous financial year. The Reserve Bank of India
also announces the exact dates of auction, the amount to be auctioned and payment dates by issuing press
releases prior to every auction.
Participation
Auctions happen through competitive bidders.1 Provident funds can participate in all T-bill auctions either as
competitive bidders or as non-competitive bidders2. Participation as non-competitive bidders would mean that
provident funds need not quote the price at which they desire to buy these bills. The Reserve Bank allots bids to

1
Competitive Bidding: In a competitive bidding, an investor bids at a specific price / yield and is allotted securities if the price / yield
quoted is within the cut-off price / yield. Competitive bids are made by well informed investors such as banks, financial institutions,
primary dealers, mutual funds, and insurance companies.
2
With a view to providing retail investors, who may lack skill and knowledge to participate in the auction directly, an opportunity to
participate in the auction process, the scheme of non-competitive bidding in dated securities was introduced in January 2002. Non-
competitive bidding is open to individuals, Hindu Undivided Families (HUFs), Regional Rural Banks (RRBs), co-operative banks, firms,
companies, corporate bodies, institutions, provident funds, and trusts. Under the scheme, eligible investors apply for a certain amount of
securities in an auction without mentioning a specific price / yield. Such bidders are allotted securities at the weighted average price / yield
of the auction.
 Indian Banking and Financial System (403)
S Y B.Sc. (Batch 2014-17)
Faculty: Sushma

the non-competitive bidders at the weighted average price of the competitive bids accepted in the auction.
Allocations to non-competitive bidders are in addition to the amount notified for sale. In other words,
provident funds do not face any uncertainty in purchasing the desired amount of T-bills from the auctions.

Where to purchase from?

T-bills auctions are held on the Negotiated Dealing System (NDS) and the members electronically submit
their bids on the system. Non-competitive bids are routed through the respective custodians or any bank or PD
which is an NDS member.
MONEY MARKET INSTRUMENTS IBFS FACULTY: SUSHMA

Commercial Paper (CP)

1. What is Commercial Paper (CP)?

Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note (promissory note is a
financial instrument that contains a written promise by one party to pay another party a definite sum of money either on
demand or at a specified future date.)

2. When it was introduced?

It was introduced in India in 1990.

3. Why it was introduced?

It was introduced in India in 1990 with a view to enabling highly rated corporate borrowers to diversify their sources of short-term
borrowings and to provide an additional instrument to investors. Subsequently, primary dealers 1 and all-India financial
institutions 2 were also permitted to issue CP to enable them to meet their short-term funding requirements for their operations.

4. Who can issue CP?

Corporates, primary dealers (PDs) and the All-India Financial Institutions (FIs) are eligible to issue CP.

1
A primary dealer is a firm that buys government securities directly from a government, with the intention of reselling them to others, thus acting as a market maker of
government securities.
2
Functionally, All-India institutions can be classified as (i) term-lending institutions (IFCI Ltd., IDBI, IDFC Ltd., IIBI Ltd.) extending long-term finance to different industrial
sectors, (ii) refinancing institutions (NABARD, SIDBI, NHB) extending refinance to banking as well as non-banking intermediaries for finance.
MONEY MARKET INSTRUMENTS IBFS FACULTY: SUSHMA

5. Whether all the corporates would automatically be eligible to issue CP?

No. A corporate would be eligible to issue CP provided the tangible net worth of the company, as per the latest audited balance
sheet, is not less than Rs. 4 crore.

6. Is there any rating requirement for issuance of CP? And if so, what is the rating requirement?

Yes. All eligible participants shall obtain the credit rating for issuance of Commercial Paper either from Credit Rating Information
Services of India Ltd. (CRISIL) or the Investment Information and Credit Rating Agency of India Ltd. (ICRA) or the Credit
Analysis and Research Ltd. (CARE) or the FITCH Ratings India Pvt. Ltd. or such other credit rating agency (CRA) as may be
specified by the Reserve Bank of India from time to time, for the purpose.

The minimum credit rating shall be A-2 [As per rating symbol and definition prescribed by Securities and Exchange Board of India
(SEBI)].

The issuers shall ensure at the time of issuance of CP that the rating so obtained is current and has not fallen due for review.

7. What is the minimum and maximum period of maturity prescribed for CP?

CP can be issued for maturities between a minimum of 7 days and a maximum of up to one year from the date of issue. However, the
maturity date of the CP should not go beyond the date up to which the credit rating of the issuer is valid.

8. In what denominations a CP that can be issued?

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

MONEY MARKET INSTRUMENTS IBFS FACULTY: SUSHMA

9. How long can the CP issue remain open?

The total amount of CP proposed to be issued should be raised within a period of two weeks from the date on which the issuer opens
the issue for subscription.

10. Who can invest in CP?

Individuals, banking companies, other corporate bodies (registered or incorporated in India) and unincorporated bodies, Non-
Resident Indians (NRIs) and Foreign Institutional Investors (FIIs) etc. can invest in CPs. However, investment by FIIs would be
within the limits set for them by Securities and Exchange Board of India (SEBI) from time-to-time.

11. Whether CP can be held in dematerialized form?

Yes. CP can be issued either in the form of a promissory note or in a dematerialized form; banks, FIs and PDs can hold CP only in
dematerialized3 form.

12. Whether CP is always issued at a discount?

Yes. CP will be issued at a discount to face value4 as may be determined by the issuer.

3
Replace (physical records or certificates) with a paperless computerized system.
4
Discount to Face Value Example: When someone buys a Rs. 1000/- commercial paper, he may pay only Rs. 900/-. When the paper matures, the issuer then reimburses the
investor the full face value or Rs. 1000/-. The difference between the face value (Rs. 1000/-) and the purchase price (Rs. 900/-) is the discount. Because the investor receives Rs.
100/- more on maturity than was paid at purchase, this is the interest received on the investment. In this example, the extra Rs. 100/- at maturity translates into a 10 percent
return on the investment.
MONEY MARKET INSTRUMENTS IBFS FACULTY: SUSHMA

13. Whether CPs are traded in the secondary market?

Yes. CPs are actively traded in the OTC5 market.

5
OVER-THE-COUNTER
 Indian Banking and Financial System (403)
S Y B.Sc. (Batch 2014-17)
Faculty: Sushma

Call Money Market

1. Introduction
The money market is a market for short-term financial assets that are close substitutes of money. The most
important feature of a money market instrument is that it is liquid and can be turned into money quickly at low
cost and provides an avenue for equilibrating the short-term surplus funds of lenders and the requirements of
borrowers. The call/notice money market forms an important segment of the Indian Money Market. Under
call money market, funds are transacted on an overnight basis and under notice money market, funds are
transacted for a period between 2 days and 14 days.

Why Call Money?

Commercial banks have to maintain a minimum cash balance known as the cash reserve ratio. Call money is a
method by which banks lend to each other to be able to maintain the cash reserve ratio. The interest rate paid
on call money is known as the call rate. It is a highly volatile rate that varies from day to day and sometimes
even from hour to hour. It is the most sensitive section of the money market and the changes in the demand for
and supply of call loans are promptly reflected in call rates.

Definition of Call Money Rate

Call money rate is the rate at which short term funds are borrowed and lent in the money market.

Description
The duration of the call money loan is 1 day. Banks resort to these type of loans to fill the asset liability
mismatch, comply with the statutory CRR and SLR requirements and to meet the sudden demand for funds.
RBI, banks, primary dealers, etc. are the participants of the call money market. Demand and supply of liquidity
affect the call money rate. A tight liquidity condition leads to a rise in call money rate and vice versa.
 Indian Banking and Financial System (403)
S Y B.Sc. (Batch 2014-17)
Faculty: Sushma

2. Participants
Scheduled commercial banks (excluding RRBs1), co-operative banks (other than Land Development Banks2)
and Primary Dealers (PDs)3, are permitted to participate in call/notice money market both as borrowers and
lenders.

3. Prudential Limits
3.1 The prudential limits in respect of both outstanding borrowing and lending transactions in call/notice
money market for scheduled commercial banks, co-operative banks4 and PDs are as follows:-

1
Regional Rural Banks
2
The long-term finance required by the agriculturists for the purchase of agricultural machinery and for effecting permanent improvements
on land cannot be provided by commercial banks and co-operative banks for the reason that these institutions obtain most of their funds in
the shape of short-term deposits. The necessity therefore has arisen for the establishment of the institutions with the object of providing
long-term credit to agriculturists at moderate rates of interest and providing for the repayment of loans in easy annual or semiannual
installments spread over a number of years. These institutions are the Land Development Banks. Land Development Banks have developed
a special technique for conducting their business. They obtain their funds, not in the shape of short-term deposits like commercial banks
but by the issue of long dated debentures sometimes carrying State Government guarantee with regard to payment of interest and
repayment of principal. Thus, they are able to lend their money for long periods to agriculturists. Example, Progoti Co-operative Land
Development Bank Limited.
3
In 1995, the Reserve Bank of India (RBI) introduced the system of Primary Dealers (PDs) in the Government Securities (G-Sec) Market.
The objectives of the PD system are to strengthen the infrastructure in G-Sec market, development of underwriting and market making
capabilities for G-Sec outside the RBI, improve secondary market trading system and to make PDs an effective conduit for open market
operations (OMO).
4
Co-operative Banks are banks that operate on the principles of co-operation such as voluntary and open membership; democratic member
control; member economic participation; autonomy and independence in functioning; provision of education, training and information to
members; co-operation among co-operatives and concern for community. It should be noted that co-operative banks are subject to dual
control. The incorporation, regulation and winding up of co-operatives constitute State subject and are governed by the State laws on co-
operative societies. The co-operative functions are under the domain of the Registrar of Co-operative Societies for concerned State. The
banking related functions are under the domain of Reserve Bank of India.
 Indian Banking and Financial System (403)
S Y B.Sc. (Batch 2014-17)
Faculty: Sushma

Table: Prudential Limits for Transactions in Call / Notice Money Market

Sr. Participant Borrowing Lending
No.
1 Scheduled On a fortnightly average basis, borrowing On a fortnightly average
Commercial outstanding should not exceed 100 per basis, lending outstanding
Banks cent of capital funds (i.e., sum of Tier I5 should not exceed 25 per
and Tier II6 capital) of latest audited cent of their capital funds.
balance sheet. However, banks are However, banks are
allowed to borrow a maximum of 125 per allowed to lend a maximum
cent of their capital funds on any day, of 50 per cent of their
during a fortnight. capital funds on any day,
during a fortnight.
2 Co-operative Outstanding borrowings of State Co- No limit.
Banks operative Banks / District Central Co-
operative Banks / Urban Co-operative
Banks in call / notice money market, on a
daily basis should not exceed 2.0 per cent
of their aggregate deposits as at end March
of the previous financial year.
3 PDs PDs are allowed to borrow, on average in PDs are allowed to lend in
a reporting fortnight, up to 225 per cent call/notice money market,
of their net owned funds (NOF) as at end- on average in a reporting
March of the previous financial year. fortnight, up to 25 per cent
of their NOF.

5
Tier I is a term used to refer to one of the components of regulatory capital. It consists mainly of share capital and disclosed reserves
(minus goodwill, if any). Tier I items are deemed to be of the highest quality because they are fully available to cover losses.
6
Tier II refers to one of components of regulatory capital. Also known as supplementary capital, it consists of certain reserves and certain
types of subordinated debt. Tier II items qualify as regulatory capital to the extent that they can be used to absorb losses arising from a
bank's activities. Tier II's capital loss absorption capacity is lower than that of Tier I capital.
 Indian Banking and Financial System (403)
S Y B.Sc. (Batch 2014-17)
Faculty: Sushma

4. Interest Rate
4.1 Eligible participants are free to decide on interest rates in call/notice money market.
4.2 Calculation of interest payable would be based on the methodology given in the Handbook of Market
Practices brought out by the Fixed Income Money Market and Derivatives Association of India (FIMMDA).

5. Dealing Session
Deals in the Call/Notice/Term money market can be done from 9:00 am to 5:00 pm on weekdays and from
9:00 am to 2:00 pm on Saturdays or as specified by RBI from time to time.

6. Documentation
Eligible participants may adopt the documentation suggested by FIMMDA from time to time.
 Certificate of Deposits
1. Introduction
Certificate of Deposit (CD) is a negotiable money market instrument and issued in
dematerialized form or as a Usance1 Promissory Note against funds deposited at a bank or
other eligible financial institution for a specified time period. Guidelines for issue of CDs are
presently governed by various directives issued by the Reserve Bank of India (RBI), as
amended from time to time.

2. Eligibility
CDs can be issued by (i) scheduled commercial banks {excluding Regional Rural Banks and
Local Area Banks}; and (ii) select All-India Financial Institutions (FIs) that have been
permitted by RBI to raise short-term resources within the umbrella limit fixed by RBI.

3. Aggregate Amount
3.1 Banks have the freedom to issue CDs depending on their funding requirements.
3.2 An FI can issue CD within the overall umbrella limit prescribed from time-to-time.

4. Minimum Size of Issue and Denominations

Minimum amount of a CD should be Rs.1 lakh, i.e., the minimum deposit that could be accepted
from a single subscriber should not be less than Rs.1 lakh, and in multiples of Rs. 1 lakh
thereafter.

5. Investors
CDs can be issued to individuals, corporations, companies (including banks and PDs), trusts,
funds, associations, etc. Non-Resident Indians (NRIs) may also subscribe to CDs, but only on
non-repatriable basis, which should be clearly stated on the Certificate. Such CDs cannot be
endorsed to another NRI in the secondary market.

1
the time allowed for the payment
6. Maturity
6.1 The maturity period of CDs issued by banks should not be less than 7 days and not more
than one year, from the date of issue.
6.2 The FIs can issue CDs for a period not less than 1 year and not exceeding 3 years from the
date of issue.

7. Discount / Coupon Rate

CDs may be issued at a discount on face value. Banks / FIs are also allowed to issue CDs on
floating rate basis provided the methodology of compiling the floating rate is objective,
transparent and market-based. The issuing bank / FI is free to determine the discount /
coupon rate. The interest rate on floating rate CDs would have to be reset periodically in
accordance with a pre-determined formula that indicates the spread over a transparent
benchmark. The investor should be clearly informed of the same.

8. Reserve Requirements
Banks have to maintain appropriate reserve requirements, i.e., cash reserve ratio (CRR) and
statutory liquidity ratio (SLR), on the issue price of the CDs.

9. Transferability
CDs in physical form are freely transferable by endorsement and delivery. CDs in demat form
can be transferred as per the procedure applicable to other demat securities. There is no lock-in
period for the CDs.

10. Loans / Buy-backs

Banks / FIs cannot grant loans against CDs. Furthermore, they cannot buy-back their own
CDs before maturity. However, the RBI may relax these restrictions for temporary periods
through a separate notification.

11. Format of CDs

Banks / FIs should issue CDs only in dematerialized form. However, according to the
Depositories Act, 1996, investors have the option to seek certificate in physical form.
Accordingly, if an investor insists on physical certificate, the bank / FI may inform the Chief
General Manager, Financial Markets Department, Reserve Bank of India.

12. Security Aspect

Since CDs in physical form are freely transferable by endorsement and delivery, it will be
necessary for banks/FIs to see that the certificates are printed on good quality security paper
and necessary precautions are taken to guard against tampering with the document. They
should be signed by two or more authorized signatories.
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C
apital market is a market where buyers and sellers engage in trade of financial
securities like bonds, stocks, etc. The buying/selling is undertaken by
participants such as individuals and institutions.
Capital markets help channelize surplus funds from savers to institutions which then
invest them into productive use. Generally, this market trades mostly in long-term
securities.
Capital market consists of primary markets and secondary markets. Primary markets deal
with trade of new issues of stocks and other securities, whereas secondary market deals
with the exchange of existing or previously-issued securities. Another important division
in the capital market is made on the basis of the nature of security traded, i.e. stock
market and bond market.
In simple language, capital market is the market for buying and selling equity and debt
instruments.

Equity vs. Debt

When we invest money with a business entity, it can either be in the capacity of
becoming a partner in the business or we can lend money to the business entity for a
defined time period.

Equity
 In the first capacity, we participate in the ownership of the business and have an
equitable right (legally enforceable right) in the business, to the extent of our share
in it.
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 Thus, we become an “equity” or “share” holder – both terms are synonymous in the
investment parlance.
 As an equity investor, we are entitled to distribution of profits and in the event the
business is liquidated at some stage, we are entitled to our share of the net assets
left over.

Debt
 In this case, we have a debt that we have to recover from the business in
accordance with an agreed repayment schedule and we are entitled to
compensation for the use of our money (interest).
 The money we invest with government and banks is also in the category of debt.
 From the point of view of the borrowing entity, we are a creditor and we rank
senior to equity in the event of liquidation i.e. creditors will be paid off first and
whatever is left over after that will go to the equity holders (owners).

Two Types of Risk that Affect Investment

Risk to Principal
 First and foremost, the risk to the principal is affected by the reliability of the
borrower.
 The Government is considered a safe borrower, i.e., we do not expect it to default.
We normally also place a fair amount of reliance on banks and expect that they
have a low likelihood of default.
 In the case of other businesses, we place reliance on the specific business entity,
depending on who is running the business and what type of business it is.
 This is also referred to as “credit risk.”
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Inflation Risk
 The second type of risk is the underlying inflation rate – we clearly want an
interest rate that will not fall short of the inflation rate during the period of the
investment. Otherwise we will not retain the purchasing power of our principal.
 This is also referred to as “interest rate risk”.
Interest Rate vs. Inflation Rate
 The interest rate that a borrower has to pay will normally have to be in excess of
the expected inflation rate.
 Please note that, whereas the interest rate has to be agreed at the time of
borrowing, the inflation rate for the borrowing period can only be guessed at.
 This, in itself, generates a new risk: the longer the period of borrowing, the riskier
it is to guess the inflation rate.

The Benchmark Rate

 The Government is considered a “safe” borrower and it is the interest rate the
Government has to pay that is used as the benchmark for other borrowers.
 The government is considered to have “zero” risk (of default) and should be able to
attract debt at an interest rate slightly over the expected inflation rate.
 As has also been stated earlier, the reliability of the “inflation estimate” diminishes
with the length of life of the debt (normally referred to as tenure or tenor of the
security), i.e., it is more difficult and more risky to predict the direction of
economic forces over longer time-frames.
 We, therefore, find that Treasury Bills (normally up to one-year Government
bonds) carry the lowest effective interest rate and longer tenor Government bonds
have to offer a higher rate of return.
 All the commercial borrowers (normally termed as corporate sector) have to offer
rates higher than the benchmark (Government’s borrowing rate) for that tenor.
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The Primary Market

• Primary Market is the market for new issues; market for fresh capital.
• Also called the new issues market
• Primarily, issues can be classified as a Public, Rights or Preferential issues (also
known as private placements). While public and rights issues involve a detailed
procedure, private placements or preferential issues are relatively simpler.

Please Note: Further Public Offering is known as “Follow-on Public Offering”

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A private placement is an issue of shares or of convertible securities by a company to a

select group of persons under Section 81 of the Companies Act, 1956 which is neither a
rights issue nor a public issue. This is a faster way for a company to raise equity capital.

A private placement of shares or of convertible securities by a listed company is generally

known by name of preferential allotment. A listed company going for preferential
allotment has to comply with the requirements contained in Chapter XIII of SEBI (DIP 1)
Guidelines pertaining to preferential allotment in SEBI (DIP) guidelines which include
pricing, disclosures in notice etc, in addition to the requirements specified in the
Companies Act.
Preferential Allotment is the process by which allotment of securities/shares is done on a
preferential basis to a select group of investors.
For raising funds, it is not always preferable or feasible for a company to issue securities
to the public at large as it is time consuming as well as an expensive option. In such
situations, the securities can be offered to a comparatively smaller group of select
individuals.

1
DIP - Disclosure and Investor Protection
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A Qualified Institutions Placement is a private placement of equity shares or securities

convertible into equity shares by a listed company to Qualified Institutions Buyers2 only
in terms of provisions of Chapter XIIIA of SEBI (DIP) guidelines.

Initial Public Offering (IPO): The first sale of stock by a private company to the public;
Initial Public Offering (IPO) is when an unlisted company makes a fresh issue of
securities for the first time to the public. This paves way for listing and trading of the
issuer’s securities.
IPOs are often issued by smaller, younger companies seeking the capital to expand, but
can also be done by large privately owned companies looking to become publicly traded.
Initial Public Offer (IPO) is a process through which an unlisted Company can be listed
on the stock exchange by offering its securities to the public in the primary market. In an
IPO, the issuer obtains the assistance of an underwriting firm, which helps it determine
what type of security to issue (common or preferred), the best offering price and the time
to bring it to market.

The IPO Process in India

The IPO process in India consists of the following steps: -
I. Appointment of merchant banker and other intermediaries
II. Registration of offer document
III. Marketing of the issue
IV. Post- issue activities

2
Qualified Institutional Buyers are those institutional investors who are generally perceived to possess expertise and
the financial muscle to evaluate and invest in the capital markets. A ‘Qualified Institutional Buyer’ shall mean: a. public
financial institution as defined in section 4A of the Companies Act, 1956; b. scheduled commercial banks; c. mutual
funds; d. foreign institutional investor registered with SEBI; e. multilateral and bilateral development financial
institutions; f. venture capital funds registered with SEBI. g. foreign venture capital investors registered with SEBI. h.
State Industrial Development Corporations. i. insurance companies registered with the Insurance Regulatory and
Development Authority (IRDA). j. Provident Funds k. Pension Funds. These entities are not required to be registered
with SEBI as QIBs. Any entities falling under the categories specified above are considered as QIBs for the purpose of
participating in primary issuance process.
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I. Appointment of Merchant Banker and Other Intermediaries

Merchant Bankers to the issue or Book Running Lead Managers (BRLM), syndicate
members, Registrars to the Issue, Bankers to the Issue, Auditors of the company,
Underwriters to the Issue, Solicitors, etc. are the intermediaries to an issue. The issuer
discloses the addresses, telephone/fax numbers and email addresses of these
intermediaries. In addition to this, the issuer also discloses the details of the compliance
officer appointed by the company for the purpose of the issue.
Underwriters to the Issue: An entity that administers the public issuance and
distribution of securities from a corporation or other issuing body. Underwriting involves
a commitment from the underwriter to subscribe to the shares of a particular company to
the extent it is under subscribed by the public. Underwriters generally receive
underwriting fees from their issuing clients.

Who is eligible to be a BRLM?

A Merchant banker possessing a valid SEBI registration in accordance with the SEBI
(Merchant Bankers) Regulations, 1992 is eligible to act as a Book Running Lead Manager
to an issue.

What is the role of a Lead Manager? (Pre issue)

In the pre-issue process, the Lead Manager (LM) takes up the due diligence of company’s
operations/ management/ business plans/ legal etc. Other activities of the LM include
drafting and design of Offer documents, Prospectus, statutory advertisements and
memorandum containing salient features of the Prospectus. The BRLMs shall ensure
compliance with stipulated requirements and completion of prescribed formalities with
the Stock Exchanges, Registrar of Companies (RoC) and SEBI including finalization of
Prospectus and RoC filing. Appointment of other intermediaries viz., Registrar(s),
Printers, Advertising Agency and Bankers to the Offer is also included in the pre-issue
processes. The LM also draws up the various marketing strategies for the issue. A
merchant banker is required to do the necessary due diligence in case of QIP mechanism.
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Registrar to the Issue: The Registrar finalizes the list of eligible allottees after deleting
the invalid applications and ensures that the corporate action for crediting of shares to
the demat accounts of the applicants is done and the dispatch of refund orders to those
applicable are sent. The LM coordinates with the Registrar to ensure follow up so that
that the flow of applications from collecting bank branches, processing of the applications
and other matters till the basis of allotment is finalized, dispatch security certificates and
refund orders completed and securities listed.

Bankers to the Issue: Bankers to the issue, as the name suggests, carry out all the
activities of ensuring that the funds are collected and transferred to the respective
accounts. The Lead Merchant Banker shall ensure that Bankers to the Issue are appointed
in all the mandatory collection centers as specified in DIP Guidelines. The LM also
ensures follow-up with bankers to the issue to get quick estimates of collection and
advising the issuer about closure of the issue, based on the correct figures.

II. Registration of the Offer Document

For registration, copies of the draft prospectus should be filed with SEBI. The draft
prospectus filed is treated as a public document. The LM also files the document with all
listed stock exchanges. Similarly, SEBI uploads the document on its website
www.sebi.com. Any amendments to be made in the prospectus should be done within
21days of filing the offer document. Thereafter the offer document is deemed to have been
cleared by SEBI.

III. Marketing of the Issue

Involves:
 Timing of the Issue
 Retail distribution
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 Reservation of the Issue

 Advertising Campaign

IV. Post-Issue Activities

Involve:
 Principles of Allotment
 Formalities Associated With Listing
The post issue activities including management of accounts, coordinate non-
institutional allocation, intimation of allocation and dispatch of refunds to bidders
etc. are performed by the LM. The post offer activities for the Offer will involve
essential follow-up steps, which include the finalization of trading and dealing of
instruments and dispatch of certificates and demat of delivery of shares, with the
various agencies connected with the work such as the Registrar(s) to the Offer and
Bankers to the Offer and the bank handling refund business. The merchant banker
shall be responsible for ensuring that these agencies fulfill their functions and enable
it to discharge this responsibility through suitable agreements with the Company.

Who decides the price of an issue?

Indian primary market ushered in an era of free pricing in 1992. Following this, the
guidelines have provided that the issuer in consultation with Merchant Banker shall
decide the price. There is no price formula stipulated by SEBI. SEBI does not play any role
in price fixation. The company and merchant banker are however required to give full
disclosures of the parameters which they had considered while deciding the issue price.
There are two types of issues one where company and Lead Manager fix a price (called
fixed price) and other, where the company and Lead Manager stipulate a floor price or a
price band and leave it to market forces to determine the final price (price discovery
through book building process).
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What are Fixed Price offers?

An issuer company is allowed to freely price the issue. The basis of issue price is disclosed
in the offer document where the issuer discloses in detail about the qualitative and
quantitative factors justifying the issue price.

What does “price discovery through book building process” mean?

“Book Building” means a process undertaken by which a demand for the securities
proposed to be issued by a body corporate is elicited and built up and the price for the
securities is assessed on the basis of the bids obtained for the quantum of securities
offered for subscription by the issuer. This method provides an opportunity to the market
to discover price for securities.

Difference between Book Building Issue and Fixed Price Issue

In Book Building, securities are offered at prices above or equal to the floor prices,
whereas securities are offered at a fixed price in case of a public issue. In case of Book
Building, the demand can be known everyday as the book is built. But in case of the
public issue, the demand is known at the close of the issue.

Terms You Should Know:

Bid A bid is the demand for a security on behalf of an investor that is entered by the
syndicate/sub-syndicate members in the system. The two main components of a bid are
the price and the quantity.

Bidder The person who has placed a bid in the Book Building process.

Book Running Lead Manager The lead merchant bankers appointed by the Issuer
Company are referred to as the Book Running Lead Managers. The names of the Book
Running Lead Managers are mentioned in the offer document of the Issuer Company.
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Floor Price The minimum offer price below which bids cannot be entered. The Issuer
Company in consultation with the Book Running Lead Managers fixes the floor price.

Merchant Banker An entity registered under the Securities and Exchange Board of India
(Merchant Bankers) Regulations, 1999.

Syndicate Members The Book Running Lead Managers to the issue appoint the
Syndicate Members, who enter the bids of investors in the book building system.

Order Book It is an 'electronic book' that shows the demand for the shares of the
company at various prices on a real time basis.

How does Book Building work?

Book building is a process of price discovery. Hence, the Red Herring prospectus 3 does
not contain a price. Instead, the red herring prospectus contains either the floor price of
the securities offered through it or a price band along with the range within which the
bids can move. The applicants bid for the shares quoting the price and the quantity that
they would like to bid at. After the bidding process is complete, the ‘cut-off’ price is
arrived at. The basis of Allotment is then finalized and letters allotment/refund is
undertaken. The final prospectus with all the details including the final issue price and
the issue size is filed with RoC, thus completing the issue process.

3
“Red Herring Prospectus (RHP)” is a prospectus which does not have details of either price or number of shares being
offered or the amount of issue. This means that in case price is not disclosed, the number of shares and the upper and
lower price bands are disclosed. On the other hand, an issuer can state the issue size and the number of shares are
determined later. In the case of book-built issues, it is a process of price discovery and the price cannot be determined
until the bidding process is completed. Hence, such details are not shown in the Red Herring prospectus filed with the
Registrar of Companies in terms of the provisions of the Companies Act. Only on completion of the bidding process,
the details of the final price are included in the offer document. The offer document filed thereafter with ROC is called
a prospectus.
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What is a price band?

The red herring prospectus may contain either the floor price for the securities or a price
band within which the investors can bid. The spread between the floor and the cap
(ceiling) of the price band shall not be more than 20%.

Who decides the price band?

It may be understood that the regulatory mechanism does not play a role in setting the
price for issues. It is up to the company to decide on the price or the price band, in
consultation with Merchant Bankers. The basis of issue price is disclosed in the offer
document. The issuer is required to disclose in detail about the qualitative and
quantitative factors justifying the issue price.

Cut Off Price

In Book building issue, the issuer is required to indicate either the price band or a floor
price in the red herring prospectus. The actual discovered issue price can be any price in
the price band or any price above the floor price. This issue price is called “Cut off price”.
This is decided by the issuer and LM after considering the book and investors’ appetite for
the stock.
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Fixed Price at which the Demand for the 100 % advance 50 % of the shares
Price securities are offered securities payment is required offered are
Issues and would be offered is known to be made by the reserved for
allotted is made only after the investors at the time applications below
known in advance to closure of the of application. Rs. 1 lakh and the
the investors issue balance for higher
amount
applications.
Book A 20 % price band is Demand for the 10 % advance 50 % of shares
Building offered by the issuer securities payment is required offered are
Issues within which offered, and at to be made by the reserved for QIBS,
investors are various prices, is QIBs along with the 35 % for small
allowed to bid and available on a application, while investors and the
the final price is real time basis other categories of balance for all
determined by the on the website investors have to pay other investors.
issuer only after during the 100 % advance along
closure of the bidding period. with the application.
bidding.

How is the Retail Investor defined as?

‘Retail individual investor’ means an investor who applies or bids for securities of or for a
value of not more than Rs.1, 00,000.

Can a retail investor also bid in a book-built issue?

Yes. He can bid in a book-built issue for a value not more than Rs.1, 00,000.

Can the bid be changed/revised?

Yes. The investor can change or revise the quantity or price in the bid using the form for
changing/revising the bid that is available along with the application form. However, the
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entire process of changing of revising the bids shall be completed within the date of
closure of the issue.

More about Book Building

Book Building is essentially a process used by companies raising capital through Public
Offerings-both Initial Public Offers (IPOs) and Follow-on Public Offers (FPOs) to aid
price and demand discovery. It is a mechanism where, during the period for which the
book for the offer is open, the bids are collected from investors at various prices, which
are within the price band specified by the issuer. The process is directed towards both the
institutional as well as the retail investors. The issue price is determined after the bid
closure based on the demand generated in the process.

The Process:
 The Issuer who is planning an offer nominates lead merchant banker(s) as 'book
runners'.
 The Issuer specifies the number of securities to be issued and the price band for the
bids.
 The Issuer also appoints syndicate members with whom orders are to be placed by
the investors.
 The syndicate members input the orders into an 'electronic book'. This process is
called 'bidding' and is similar to open auction.
 The book normally remains open for a period of 5 days.
 Bids have to be entered within the specified price band.
 Bids can be revised by the bidders before the book closes.
 On the close of the book building period, the book runners evaluate the bids on the
basis of the demand at various price levels.
 The book runners and the Issuer decide the final price at which the securities shall be
issued.
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 Generally, the numbers of shares are fixed; the issue size gets frozen based on the
final price per share.
 Allocation of securities is made to the successful bidders. The rest get refund orders.

Guidelines for Book Building

Rules governing Book building are covered in Chapter XI of the Securities and Exchange
Board of India (Disclosure and Investor Protection) Guidelines 2000.

Anchor Investor
 An anchor investor in a public issue refers to a qualified institutional buyer making
an application for a value of Rs. 10 crore or more through the book-building
process.
 Securities and Exchange Board of India introduced the concept of "anchor
investor" in public issues in July 2009 with a view to create a significant impact on
pricing of initial public offers. Since equity markets are volatile, it is believed that
companies going for initial public offering (IPO) would benefit from anchor
investors.

What is the significance of an anchor investor?

An anchor investor can attract investors to public offers before they hit the market to
infuse confidence. The volume and value of anchor subscriptions will serve as an
indicator of the company's reputation and soundness of the offer. Finally, the anchor
investor sets a benchmark and gives a guideline for issue pricing and interest among
Qualified Institutional Buyers (QIBs).
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What are the conditions stipulated for an anchor investor?

Up to 30% of the portion available for allocation to qualified institutional buyers
(QIBs) is required to be made available to anchor investor(s) for allocation.
An anchor investor is required to make an application for a minimum value of Rs.
10 crore in a public issue.
Allocation of shares to anchor investors is made on a discretionary basis and
subject to a minimum number of two such investors for allocation of up to Rs. 250
crore and five such investors for allocation of more than Rs. 250 crore.
Company has a right to reject the anchor investor's bid. An anchor investor is
required to pay a margin of at least 25% on application with the balance to be paid
within two days of the date of closure of the issue.
If the price fixed as a result of book building is higher than the price at which the
allocation is made to anchor investor, he is required to bring in the additional
amount.
However, if the price fixed as a result of book building is lower than the price at
which the allocation is made to such investors, the excess amount is not refunded.
The number of shares allocated to anchor investors, and the price at which the
allocation is made, is made available in public domain by the merchant banker
before opening of the issue.
There is a lock-in of 30 days on the shares allotted from the date of allotment in
the public issue. Neither the merchant bankers nor any person related to the
promoter/promoter group/merchant bankers in the concerned public issue can
apply under anchor investor category.
The parameters for selection of anchor investor are required to be clearly
identified by the merchant banker and are made available as part of records of the
merchant banker for inspection by the board.
Getting an anchor investor would ensure greater certainty and better price
discovery in the issue process. If some investor is ready to come in with prior
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commitment, it enhances the issuer company's ability to sell the issue and
generate more confidence in the minds of other investors.

Green-shoe Option
A Green Shoe option means an option of allocating shares in excess of the shares included
in the public issue and operating a post-listing price stabilizing mechanism for a period
not exceeding 30 days in accordance with the provisions of Chapter VIIIA of DIP
Guidelines, which is granted to a company to be exercised through a Stabilizing Agent.
This is an arrangement wherein the issue would be over allotted to the extent of a
maximum of 15% of the issue size. From an investor’s perspective, an issue with green
shoe option provides more probability of getting shares and also that post listing price
may show relatively more stability as compared to market.

Rights Issue

What is it?
• Cash-strapped companies can turn to rights issues to raise money when they really
need it.
• In these rights offerings, companies grant existing shareholders a chance to buy new
shares at a discount to the current trading price.

Defining a Rights Issue and Why It's Used

• A rights issue is an invitation to existing shareholders to purchase additional new
shares in the company.
• More specifically, this type of issue gives existing shareholders securities called
"rights," which, give the shareholders the right to purchase new shares at a discount
to the market price on a stated future date.
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• The company is giving shareholders a chance to increase their exposure to the stock
at a discount price.

How Rights Issues Work

• Let's say you own 1,000 shares in Wobble Telecom, each of which is worth $5.50.
• The company is in a bit of financial trouble and sorely needs to raise cash to cover its
debt obligations. Wobble therefore announces a rights offering, in which it plans to
raise $30 million by issuing 10 million shares to existing investors at a price of $3
each. But this issue is a three-for-10 rights issue.
• In other words, for every 10 shares you hold, Wobble is offering you another three at
a deeply discounted price of $3.
• This price is 45% less than the $5.50 price at which Wobble stock trades.
As a shareholder, you essentially have three options when considering what to do in
response to the rights issue. You can
• (1) subscribe to the rights issue in full,
• (2) ignore your rights or
• (3) sell the rights to someone else. In some cases, rights are not transferable. These
are known as "non-renounceable rights". But in most cases, your rights allow you to
decide whether you want to take up the option to buy the shares or sell your rights to
other investors or to the underwriter. Rights that can be traded are called
"renounceable rights."

What's not great about a rights issue?

• The shares do not come free of cost.
• Bonus shares are offered free of cost. They are a gift. A bonus.
• A rights issue will need you to buy the shares. They do not come free.

What's great about a rights issue?

• The good news is that the shares will be cheaper than the current market rate.
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• When a company offers new shares via a rights issue, it is usually at a discount to
the current market rate.

What this means is that if the market price of the share is Rs 100, the company may
offer the shares for Rs. 90. So you get more shares at a cheaper rate than what you
would get if you buy it from the market.

Let's take the example of the Bata India stock. The price of the shares was moving
between Rs. 80 to Rs 90 when the rights issue was first announced in February (of a
given year). The price of each share in this rights issue was only Rs. 54. However, after
the announcement of the rights issue, the share price fluctuated widely between Rs. 75
and Rs. 100.
Generally, the price will go up because investors now want to buy the shares so that they
can avail of the rights issue.

Understanding a stock split: Can you pick up however many shares you want?
No. That will not be possible. A rights issue is offered in proportion to your existing
holding.

The company may come out with a 2 for 1 rights issue.

This will give the shareholder who has 1 share, the chance to buy 2 additional shares.
So, if you own 100 shares, you will get the chance to buy 200 additional shares.

Who gets the rights issue?

• The company will make an announcement that it is offering the rights issue to
all shareholders (those who own the shares of the company) on a particular date.
This date is called the record date.
• After the rights announcement but before the record date, the shares are known as
cum-rights. Even if you do not currently own the shares but if you buy them at that
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time, you will get the rights issue. On the record date, they become ex-rights. If you
buy them after this day, you do not get the rights issue.

What if you don't want the shares?

• In a bonus issue, you are just given the shares and do not have a chance to say no
(why would you say no if they are free?).
• In the case of a rights issue, you are given the option to decline (since you are paying
for it).
• You may refuse to subscribe to the rights issue and just let your "right" lapse. In
which case you get nothing.
• Or you can renounce your shares in favour of another person for a price.

Further Public Offering OR “Follow-on Public Offering”

 Also known as subsequent or seasoned public offering
 An FPO is when an already listed company makes either a fresh issue of securities
to the public or an offer for sale to the public, through an offer document. An offer
for sale in such scenario is allowed only if it is made to satisfy listing or continuous
listing obligations.
Reverse Book Building

1
 Question

• Does an IPO require listing on the stock exchange?

2
 Answer

• Initial Public Offer (IPO) is a process through which an

unlisted Company can be listed on the stock exchange by
offering its securities to the public in the primary market.

3
 Listing
Listing means admission of securities to dealings on a
recognized stock exchange.

The objectives of listing are mainly to :

• provide liquidity to securities;
• mobilize savings for economic development;
• protect interest of investors by ensuring full disclosures.

4
 Listing…

• For the purpose of listing, a company is required to enter

into a listing agreement with the stock exchange.

5
 De-listing
• The term “de-listing” of securities means permanent removal of
securities of a listed company from a stock exchange and is,
therefore, different from “suspension” or “withdrawal” of
admission to dealings of listed securities, which the stock
exchanges can resort to for a limited period.

• As a consequence of de-listing, the securities of that company

would no longer be traded at that stock exchange subject to certain
condition as per SEBI (De-listing of Securities) Guidelines 2003.

6
 De-listing…
There are of two types of de-listing of
securities.
• Compulsory de-listing refers to permanent removal of
securities of a listed company from a stock exchange as a
penalizing measure at the behest of the stock exchange for
not making submissions/comply with various requirements
set out in the listing agreement within the time frames
prescribed.
• In voluntary de-listing, a listed company decides on its
own to permanently remove its securities from a stock
exchange.
7
 Why Does Company seek de-listing of securities?
→Market conditions are so depressed, the acquirer or promoter of a
company can exploit the opportune moment for acquisition of the
remaining securities from the shareholders through de-listing

→On account of de-listing, boards of companies enjoy the sole decision

making powers, greater independence in investment decisions and
freedom from the regulatory Environment. These factors however do
not lead to good corporate governance.

→In the liberalized economy, the regulatory framework relating to FDI

norms permits foreign companies to hold 100 per cent equity in many
key sectors
8
 Reverse Book Building
• The reverse book building is an efficient price discovery
mechanism of de-listing of securities, which is provided for
capturing the sell orders on online basis from the
shareholders through respective BRLM.

• In the reverse book-building scenario, the acquirer or

promoter of a company offers to get back shares from the
shareholders.

9
 Reverse Book Building…
• It is a mechanism where, during the period for which the
reverse book building is open, offers are collected at
various prices, which are above or equal to the floor price
from the share holders through trading members appointed
by the acquirer or promoter of a company.

10
 Reverse Book Building…
• The reverse book building price (i.e. final price/ exit price)
is determined by BRLM in consultation with the acquirer or
promoter of the company after the offer closing date in
accordance with the SEBI (De-listing of Securities)
Guidelines, 2003.

11
 Exit opportunity available for investors in case of
de-listing
• The offer price has a floor price, which is fixed for de-listing of
securities below which no offer can be accepted.
• The floor price is the average of 26 weeks traded price quoted on
the stock exchange where the shares of the company are most
frequently traded preceding 26 weeks from the date of public
announcement is made.
• There is no ceiling on the maximum price.
• The buy back price is determined after the offer closing date
• The main parties who are directly associated with de-listing of
securities through reverse book building method are the acquirer/
promoter of a company, the BRLM, the trading members and
existing shareholders of the company 12
13
• The final offer price (exit price) shall be determined as the
price at which the maximum number of shares has been offered.

• The acquirer shall have the choice to accept the price.

• If the price is accepted then the acquirer shall be required to

accept all offers up to and including the final price but may
not have to accept higher priced offers, subject to provision
relating to compulsory de-listing of companies by stock
exchanges.
14
• From the illustration, it is found
that while floor price is fixed at
Rs. 240/-, the final price (i.e. exit
price) determined by reverse book
building mechanism is Rs. 260/-
at which the maximum number of
shares has been offered. If the
acquirers accept final price, they
have to accept offers up to and
including the final price i.e. 480
shares (i.e. 100+164+216 shares)
at the final price of Rs. 260/-.

15
 Delisting of shares
TNN Dec 30, 2007, 04.51am IST
Source:

http://articles.economictimes.indiatimes.com/2007-12-30/news/28388963_1_voluntary-
delisting-stock-exchanges-book-building

Delisting of shares is also referred to as Reverse Book Building. The Reverse Book
Building is a mechanism provided for capturing the sell orders on online basis from the
share holders through respective Book Running Lead Managers (BRLMs) which can be
used by companies intending to delist their shares through buy back process.

In the Reverse Book Building scenario, the Acquirer/Company offers to buy back shares
from the share holders. The Reverse Book Building is basically a process used for efficient
price discovery. During the period for which the Reverse Book Building is open, offers are
collected from the share holders at various prices, which are above or equal to the floor
price. The buyback price is determined after the offer closing date.

The Securities and Exchange Board of India had issued the SEBI (Delisting of Securities)
Guidelines 2003' for delisting of shares from stock exchanges. The guidelines provide the
overall framework for voluntary delisting by a promoter.

The Company /acquirer needs to appoint designated BRLMs for accepting offers from the
share holders. The company/acquirer intending to delist its shares through Book Building
process is identified by way of a symbol assigned to it by a BRLM. Orders for the offer
shall be placed by the shareholders only through the designated trading members, duly
approved by the Exchange.

The designated trading members shall ensure that the security /share holders deposit the
securities offered with the trading members prior to placement of an order. The offer
shall be open for 'n' number of days. The BRLM shall intimate the final acceptance price
and provide the valid accepted order file to the National Securities Clearing Corporation
Limited.

The process is used by the companies to reduce their floating capital so as to enable them
to get delisted from the stock exchanges. Listing on stock exchanges entails a number of
compliances. In order to avoid such compliances, many companies are opting to get
delisted. Moreover, the process can also be used in case of acquisition process of another
company by the acquirer.

SEBI guidelines are applicable to delisting of securities of companies. These guidelines apply
to the following:
Voluntary delisting being sought by the promoters of a company - Companies which may
be compulsorily delisted by the stock exchanges. If a person in control of the
management is seeking to consolidate his holding in a company, he would do so in a
manner which would result in the public shareholding or in the listing agreement that
may have the effect of company being delisted.

Promoters of the companies who voluntarily seek to delist their securities from all or
some of the stock exchanges - Any acquisition of shares of the company (either by a
promoter or by any other person) or scheme or arrangement, by whatever name referred
to, consequent to which the public shareholding falls below the minimum limit specified
in the listing conditions or listing agreement that may result in delisting of securities The
Stock Exchange provides online reverse book building for promoters /acquirers through
its trading networks which span various cities and towns across India.

The shareholders get the amount discovered through the reverse book building process.
The shareholders who choose to hold back the shares may suffer because there is no
liquidity for the stock. However, they are entitled to all the shareholder benefits - voting,
dividends, bonus etc. as may be applicable.
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Derivatives

D
erivatives
A derivative is a financial instrument whose value depends on or is
derived from the value of an underlying asset. The derivative itself is merely
a contract between two or more parties. Its value is determined by fluctuations in the
underlying asset. The most common underlying assets include stocks, bonds,
commodities, currencies, and market indexes.
Examples:
EQUITY DERIVATIVE: A derivative instrument with underlying assets based on equity
securities. An equity derivative's value will fluctuate with changes in its underlying asset's
equity, which is usually measured by share price.
PROPERTY DERIVATIVE: A type of financial product that fluctuates in value depending
on the changes in the value of a real estate asset

Futures: What are they?

Futures is a financial contract obligating the buyer to purchase an asset (or the seller to
sell an asset), such as a physical commodity or a financial instrument, at a predetermined
future date and price. Futures contracts detail the quality and quantity of the underlying
asset; they are standardized to facilitate trading on a futures exchange.

Note: If you buy a futures contract, you are basically agreeing to buy something that a
seller may have not yet produced for a set price. Buyers and sellers in the futures market
primarily enter into futures contracts to hedge risk or speculate rather than to exchange
physical goods (which is the primary activity of the cash/spot market). Therefore, futures
are used as financial instruments by not only producers and consumers but
also speculators.
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Case1:
John wants to buy a laptop, which costs Rs. 50,000 but owing to cash shortage at the
moment, he decides to buy it at a later period say 2 months from today. However, he feels
that after 2 months the prices of laptops may increase due to increase in
input/manufacturing costs. To be on the safe side, John enters into a contract with the
laptop manufacturer stating that 2 months from now he will buy the laptop for Rs.
50,000. In other words, he is being cautious and agrees to buy the laptop at today's price 2
months from now. The contract thus entered into will be settled at maturity. What is the
benefit of such a contract to the laptop manufacturer? In this case, the manufacturer gets
an assured customer. The manufacturer will deliver the asset to John at the end of two
months and John in turn will pay cash on delivery.
Thus, a futures contract is the simplest mode of a derivative transaction. It is an
agreement to buy or sell a specific quantity of an asset at a certain future time for
a specified price.

Case 2:
Let's say, for example, that you decide to subscribe to cable TV. As the buyer, you enter
into an agreement with the cable company to receive a specific number of cable channels
at a certain price every month for the next year. This contract made with the cable
company is similar to a futures contract, in that you have agreed to receive a product at a
future date, with the price and terms for delivery already set. You have secured your price
for now and the next year - even if the price of cable rises during that time. By entering
into this agreement with the cable company, you have reduced your risk of higher prices.

Futures: Brief History

Before the North American futures market originated around 150 years ago, farmers
would grow their crops and bring them to market in the hope of selling their inventory.
But without any indication of demand, supply often exceeded what was needed and
unsold crops were left to rot in the streets! Conversely, when a given commodity - wheat,
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for instance - was out of season, the goods made from it became very expensive because
the crop was no longer available.
In the mid-nineteenth century, central grain markets were established and a central
marketplace was created for farmers to bring their commodities and sell them either for
immediate delivery (spot trading) or for forward delivery. The latter contracts - forward
contracts - were the forerunners to today's futures contracts. In fact, this concept saved
many a farmer the loss of crops and helped stabilize supply and prices in the off-season.

The Players
The players in the futures market fall into two categories: hedgers and speculators.

Hedgers
Farmers, manufacturers, importers and exporters can all be hedgers. A hedger buys or
sells in the futures market to secure the future price of a commodity intended to be sold
at a later date in the cash market. This helps protect against price risks.

Speculators
Other market participants, however, do not aim to minimize risk but rather to benefit
from the inherently risky nature of the futures market. These are the speculators, and
they aim to profit from the very price change. Speculators aim to maximize their profits.

Unlike the hedger, the speculator does not actually seek to own the commodity in
question. Rather, he or she will enter the market seeking profits by offsetting rising and
declining prices through the buying and selling of contracts.

How the Market Works

Short & Long
Futures contract is an agreement between two parties:
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i) the short position - the party who agrees to deliver a commodity for the agreed upon
price, and
ii) the long position - the party who agrees to receive a commodity and pay the agreed
upon price.
Every contract that is traded has a short and long position.

A hedger who goes short - that is, enters into a futures contract by agreeing to sell and
deliver the underlying at a set price - is looking to make a gain from declining price levels.
The short possessor of the contract (the sellers of the commodity) will want to secure as
high a price as possible. Let's say that Sara did some research and came to the conclusion
that the price of oil was going to decline over the next six months. She could sell a
contract today. This strategy is called going short and is used when hedgers/speculators
take advantage of a declining market.

When a hedger goes long - that is, enters a contract by agreeing to buy and receive
delivery of the underlying at a set price - it means that he or she is trying to gain from an
anticipated future price increase. The holders of the long position in futures contracts
(the buyers of the commodity), are trying to secure as low a price as possible. For
example, let's say that, with an initial margin of $2,000 in June, Joe the speculator buys
one September contract of gold at $350 per ounce, for a total of 1,000 ounces or $350,000.
By buying in June, Joe is going long, with the expectation that the price of gold will rise by
the time the contract expires in September.
The futures contract, however, provides a definite price certainty for both parties, which
reduces the risks associated with price volatility.

The "price" of a futures contract is represented by the agreed-upon price of the

underlying commodity or financial instrument that will be delivered in the future.
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In every futures contract, everything is specified: the quantity and quality of the
commodity, the specific price per unit, and the date and method of delivery.

Margin
 In the futures market, margin refers to the initial deposit of "good faith" made into
an account in order to enter into a futures contract. This margin is referred to as
good faith because it is this money that is used to debit any day-to-day losses.
 When you open a futures contract, the futures exchange will state a minimum
amount of money that you must deposit into your account. This original deposit of
money is called the initial margin. When your contract is liquidated, you will be
refunded the initial margin plus or minus any gains or losses that occur over the
span of the futures contract.
 In other words, the amount in your margin account changes daily as the market
fluctuates in relation to your futures contract. The minimum-level margin is
determined by the futures exchange and is usually 5% to 10% of the futures
contract. These predetermined initial margin amounts are continuously under
review: at times of high market volatility, initial margin requirements can be
raised.
 The initial margin is the minimum amount required to enter into a new futures
contract, but the maintenance margin is the lowest amount an account can reach
before needing to be replenished. For example, if your margin account drops to a
certain level because of a series of daily losses, brokers are required to make a
margin call and request that you make an additional deposit into your account to
bring the margin back up to the initial amount.
 Let's say that you had to deposit an initial margin of $1,000 on a contract and the
maintenance margin level is $500. A series of losses dropped the value of your
account to $400. This would then prompt the broker to make a margin call to you,
requesting a deposit of an additional amount to bring the account back up to the
required margin level.
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 Word to the wise: when a margin call is made, the funds usually have to be
delivered immediately. If they are not, your position can be liquidated completely
in order to make up for any losses.
Let’s Simplify
Parties to the Futures Contract: FARMER & BAKER
Commodity Type Futures Maturity Quantity Price Contract Margin Margin Amount
Traded Contract Date/ Traded Locked Value %
Entered Expiry
Into Date
Wheat Lokwan 12 12 May, 100 kgs Rs.33/kg 100 kgs * 20% Rs.660/-
February, 2015 33 Rs. =
2015 Rs.3300/-

Date Price FARMER BAKER

Marked-to-Market (MTM) Marked-to-Market (MTM)
13 February, Rs. -100 +100
2015 34/kg The farmer, as the holder of The baker, in the long position,
the short position, has lost Re. has profited by Re. 1 per kg.
1 per kg. because the selling because the price he is obliged to
price just increased from the pay is less than what the rest of
future price at which he is the market is obliged to pay in for
obliged to sell his wheat. wheat.
14 February, Rs. +200 -200
2015 31/kg The farmer, in the short position, The baker, as the long position, has
has gained Rs. 2 per kg. because lost by Rs. 2 per kg. because the
the selling price just fell from the futures price he has agreed to is more
future price. than the prevalent price on the day.
As the market moves every day, these kinds of adjustments are made accordingly.
Futures positions are settled on a daily basis, which means that gains and losses from a day's trading
are deducted or credited to a person's account each day.
What if the contract is settled at Rs.36 per kg?

 If the contract is settled at Rs.36 per kg, the farmer would lose Rs. 300/- on the
futures contract and the baker would have made Rs. 300/- on the contract.
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 But after the settlement of the futures contract, the baker still needs wheat to
make bread, so he will in actuality buy his wheat in the cash market for Rs. 36 per
kg. (a total of Rs. 3600/-) because that's the price of wheat in the cash market
when he closes out his contract. However, technically, the baker’s futures profits of
Rs. 300/- go towards his purchase, which means he still pays his locked-in price of
Rs. 33 per kg. (Rs. 3600 – Rs. 300 = Rs. 3,300). The farmer, after also closing out the
contract, can sell his wheat on the cash market at Rs. 36 per kg. but because of his
losses from the futures contract with the baker, the farmer still actually receives
only Rs. 33/- per kg. In other words, the farmer's loss in the futures contract is
offset by the higher selling price in the cash market - this is referred to as hedging.

Leverage: The Double-Edged Sword

In the futures market, leverage refers to having control over large cash amounts of
commodities with comparatively small levels of capital. In other words, with a relatively
small amount of cash, you can enter into a futures contract that is worth much more than
you initially have to pay (deposit into your margin account). It is said that in the futures
market, more than any other form of investment, price changes are highly leveraged,
meaning a small change in a futures price can translate into a huge gain or loss.

Futures positions are highly leveraged because the initial margins that are set by the
exchanges are relatively small compared to the cash value of the contracts in question
(which is part of the reason why the futures market is useful but also very risky). The
smaller the margin in relation to the cash value of the futures contract, the higher the
leverage.

Speculators in the futures market can use different strategies to take advantage of rising
and declining prices. The most common are known as going long, going short and
spreads.
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Spreads
As you can see, going long and going short are positions that basically involve the buying
or selling of a contract now in order to take advantage of rising or declining prices in the
future. Another common strategy used by futures traders is called "spreads."
Spreads involve taking advantage of the price difference between two different contracts
of the same commodity. Spreading is considered to be one of the most conservative forms
of trading in the futures market because it is much safer than the trading of long/short
futures contracts.

There are many different types of spreads, including:

Calendar Spread - This involves the simultaneous purchase and sale of two
futures of the same type, having the same price, but different delivery dates.
Intermarket Spread - Here the investor, with contracts of the same month,
goes long in one market and short in another market. For example, the investor
may take Short June Wheat and Long June Pork Bellies.

Problem 1
Albert sold a January Infosys futures contract for Rs. 53,800 on January 15. For this
he had to pay an initial margin of Rs. 4,304. The futures contract is for the delivery
of 200 shares. On January 25, the shares of the company traded at Rs. 252. How
much profit/loss did he make?
Solution to Problem 1
Rs. 53,800 /200 shares = Rs. 269 per share [lock-in price]
On January 25, the shares of the company traded at Rs. 252.
Rs. 269 - Rs. 252 = Rs. 17 per share
Rs. 17 x 200 shares = Rs. 3400 PROFIT
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Problem 2
On February 15, Angel bought one ACC futures contract that cost her Rs. 26,900.
For this she had to pay an initial margin of Rs. 2,152. The contract is for the
delivery of 200 shares. On February 28, ACC shares traded at Rs. 128/-. How much
profit/loss did she make?
Solution to Problem 2
Rs. 26,900/ 200 shares = Rs. 134.50/- per share [lock-in price]
On February 25, the shares of the company traded at Rs. 128/-
Rs. 134.50 - Rs. 128 = Rs. 6.50 per share
Rs. 6.50 x 200 shares = Rs. 1300 LOSS
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The Economic Purpose of Futures Markets and

How They Work
o Futures markets allow commodities producers and consumers to engage in “hedging” in
order to limit the risk of losing money as commodity prices change.
o For example, a Kansas wheat farmer who plants a crop runs the risk of losing money if the
price of wheat falls before harvest and sale.
o The farmer can minimize this risk by selling wheat futures contracts, which guarantee
that the farmer will receive a predetermined price.
o Hedging helps the economy function by allowing commodities producers (such as
farmers) and consumers (such as millers) to conduct their businesses with greater
certainty over how much they can expect to earn from and pay for commodities.

Futures Contracts
FEATURES
o Futures contracts typically are traded on organized exchanges that set standardized terms
for the contracts.
o Futures contracts allow hedging.
o For example, a farmer who wants to deliver wheat to a grain elevator near Topeka might
find Chicago Board of Trade (CBOT) wheat futures contracts useful for hedging.
o Futures contracts may be liquidated by offsetting without actual delivery.
o The purpose of the delivery provision is to ensure convergence between the futures price
and the cash market price.
EXCHANGES
o Exchanges set standardized contract terms, including the amount of the commodity to be
delivered (the contract size), delivery months, the last trading day, the delivery locations,
and acceptable qualities or grades of the commodity.
o The exchange specifies that different varieties and grades can be delivered.
o Futures trades made on an exchange are cleared through a “clearing house,” which acts as
the buyer to all sellers and the seller to all buyers.
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o When a futures contract is bought or sold, it is technically bought from or sold to the
clearing house rather than the party with whom the transaction was executed on the
trading floor or through an electronic trading platform.
MARGIN
o Futures traders are not required to pay the entire value of a contract. Instead, they are
required to post a “margin” that is typically a certain percentage of the total value of the
contract.
o Margins in the futures markets are designed to ensure that traders can meet their
financial obligations.
o When a futures trader enters into a futures position, he or she is required to post initial
margin of an amount specified by the exchange or clearing house. Thereafter, the position
is “marked to the market” daily.
o If the futures position loses value when the market moves against it—if, for example, you
are buying and the market goes down—the amount of money in the margin account will
decline accordingly.
o If the amount of money in the margin account falls below the specified maintenance
margin (which is set at a level less than or equal to the initial margin), the futures trader
will be required to post additional variation margin to bring the account up the initial
margin level.
o On the other hand, if the futures position is profitable, the profits will be added to the
margin account.
o Brokers often require their customers to maintain funds in their margin accounts that
exceed the levels specified by an exchange.

MARGIN EXAMPLE
o Suppose the initial and maintenance margins on a wheat contract are $650 per contract.
o A farmer who sells 10 contracts must deposit at least $6,500 with the clearing house
through a broker to cover the margins.
o Each day the position is marked to market. If the market moves in the farmer's favor—the
futures price declines on a particular day—the farmer’s margin account is credited with
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the accrued profit for that day. If the futures price rises, the margin account is debited
with the accrued loss.
o On any day when the margin account falls below $6,500, the farmer is required to post
variation margin to bring the account back up to at least $6,500.

HEDGING EXAMPLE
o A CBOT contract provides for delivery of 5,000 bushels of wheat in Chicago.
o A farmer plants wheat during the spring with an expected harvest of 50,000 bushels.
o Currently, the CBOT contract for delivery during December (the first new crop contract
month for spring wheat) is trading at $3.50 per bushel.
o The farmer knows that he or she can earn a reasonable profit at $3.50 per bushel.
o By planting, the farmer is betting that the price of wheat will not decline before sale.
o The farmer can hedge this bet by establishing a “short” futures position at the current
price of $3.50 per bushel.
o Since each futures contract provides for delivery of 5,000 bushels and the expected
harvest is 50,000 bushels, the farmer would sell 10 futures contracts.
o At harvest, the weather has been ideal and the farmer harvests 50,000 bushels of wheat.
o In fact, there has been a bumper crop and the price of wheat has declined to $3.00 per
bushel.
o The farmer now has 50,000 bushels in his silo and is short 50,000 bushels on the futures
market.
o The farmer now needs to get out of this hedged position. A way is to make delivery
pursuant to the terms of the 10 futures contracts at a specified delivery location during
the delivery period.
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Commodity Futures
Transactions Transactions
During the spring, a $175,000 On May 1, the $175,000
farmer plants 50,000 farmer sells 10
bushels of wheat with CBOT wheat
an expected selling futures contracts
price $3.50/bushel. for December
delivery at $3.50
per bushel.
During autumn, the $150,000 During autumn, $150,000
farmer harvests 50,000 the farmer
bushels of wheat and harvests 50,000
on December 1, sells it bushels of wheat
for $3.00/bushel in and on
Topeka. December 1,
sells it for
$3.00/bushel in
Topeka.
The farmer loses 50 -$25,000 The futures +$25,000
cents per bushel in the market gain for
spot market. the farmer is 50
cents per bushel.
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o If the price of wheat had risen to $4.00 per bushel, the farmer would have lost 50 cents
per bushel on the futures trade, but would have been able to sell the wheat for $4.00 per
bushel

Commodity Futures
Transactions Transactions
During the spring, a $175,000 On May 1, the $175,000
famer plants 50,000 farmer sells 10
bushels of wheat with CBOT wheat
an expected selling futures contracts
price $3.50/bushel. for December
delivery at $3.50
per bushel.
During autumn, the $200,000 During autumn, $200,000
farmer harvests 50,000 the farmer
bushels of wheat and harvests 50,000
on December 1, sells it bushels of wheat
for $4.00/bushel in and on
Topeka. December 1,
sells it for
$4.00/bushel in
Topeka.
The farmer gains 50 $25,000 The futures -$25,000
cents per bushel in the market loss for
spot market. the farmer is 50
cents per bushel.

o Sometimes the price of wheat goes up and sometimes it goes down, but hedging provides
the farmer with the peace of mind of knowing what his gain will be, regardless of price
changes.
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THE ROLE OF THE SPECULATOR

o A speculator is a trader who does not produce or consume commodities, but rather risks
his or her own capital trading commodity futures or options in the hope of making a
profit on price changes
o While speculation is not considered one of the economic purposes of futures markets,
speculators do help make futures markets function better by providing liquidity, or the
ability to buy and sell futures contracts quickly without materially affecting the price
 OPTIONS
An option is a contract to buy or sell a specific financial product officially known as the
option’s underlying instrument or underlying interest. For equity options, the underlying
instrument is a stock.
Options are categorized as derivative securities because their value is derived in part from
the value and characteristics of the underlying security.

An option is a contract that gives the buyer the right, but not the obligation, to buy or sell
(depending on the type of option) an underlying asset at a specific price on or before a
certain date. An option, just like a stock or bond, is a security. It is also a binding contract
with strictly defined terms and properties.

The idea behind an option is present in many everyday situations. Say, for example, that
you discover a house that you'd love to purchase. Unfortunately, you don't have the cash
to buy it for another three months. You talk to the owner and negotiate a deal that gives
you an option to buy the house in three months for a price of Rs. 2,oo,oo,ooo/- [2 Crores].
The owner agrees, but for this option, you pay a price of Rs. 3,oo,000/- [3 lakhs].

Now, consider two theoretical situations that might arise:

1. It's discovered that the house is actually the true birthplace of a celebrity! As a
result, the market value of the house skyrockets to Rs. 4,oo,oo,ooo/- [4 Crores].
Because the owner sold you the option, he is obligated to sell you the house for Rs.
2,oo,oo,ooo/- [2 Crores]. In the end, you stand to make a profit of Rs. 1,97,00,000/-
(Rs. 4,oo,oo,ooo - Rs. 2,oo,oo,ooo - Rs. 3,oo,000).
2. While touring the house, you discover not only that the walls are chock-full of
asbestos, but also that the ghost of a previous resident haunts the master bedroom;
furthermore, a family of super-intelligent rats have built a fortress in the

Page 1 of 8
 basement. Though you originally thought you had found the house of your
dreams, you now consider it worthless. On the upside, because you bought an
option, you are under no obligation to go through with the sale. Of course, you
still lose the Rs. 3,oo,000/- price of the option.
This example demonstrates two very important points.
 First, when you buy an option, you have a right but not an obligation to do
something. You can always let the expiration date go by, at which point the option
becomes worthless. If this happens, you lose 100% of your investment, which is the
money you used to pay for the option.
 Second, an option is merely a contract that deals with an underlying asset. For this
reason, options are called derivatives, which means an option derives its value from
something else. In our example, the house is the underlying asset. Most of the time,
the underlying asset is a stock or an index.
A stock option contract's unit of trade is the number of shares of underlying stock which
are represented by that option. Generally speaking, stock options have a unit of trade of
100 shares. This means that one option contract represents the right to buy or sell 100
shares of the underlying security.
At a premium
When you buy an option, the purchase price is called the premium. If you sell an option,
the premium is the amount you receive. The premium isn’t fixed and changes
constantly—so the premium you pay today is likely to be higher or lower than the
premium yesterday or tomorrow. What those changing prices reflect is the give and take
between what buyers are willing to pay and what sellers are willing to accept for the
option. The point at which there’s agreement becomes the price for that transaction, and
then the process begins again. If you buy options, you start out with what’s known as a
net debit. That means you’ve spent money you might never recover if you don’t sell your
option at a profit or exercise it. And if you do make money on a transaction, you must
subtract the cost of the premium from any income you realize to find your net profit. As a
seller, on the other hand, you begin with a net credit because you collect the premium. If

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the option is never exercised, you keep the money. If the option is exercised, you still get
to keep the premium, but are obligated to buy or sell the underlying stock if you’re
assigned.

Little More about Options

The options contract itself is very precise. It establishes a specific price, called the strike
price, at which the contract may be exercised, or acted on. The strike price, or exercise
price, of an option is the specified price at which the underlying asset can be bought or
sold by the holder, or buyer, of the option contract if he exercises his right against a
writer, or seller, of the option. To exercise your option is to exercise your right to buy (in
the case of a call) or sell (in the case of a put) the underlying asset at the specified strike
price of the option. In other words, the price at which an underlying asset can be
purchased or sold is called the strike price. And it has an expiration date. When an
option expires, it no longer has value and no longer exists.

Options come in two varieties, calls and puts, and you can buy or sell either type. You
make those choices—whether to buy or sell and whether to choose a call or a put—based
on what you want to achieve as an options investor.

Calls and Puts

The two types of options are calls and puts:
1. A call gives the holder the right to buy an asset at a certain price within a specific
period of time. Calls are similar to having a long position on the underlying asset.
Buyers of calls hope that the value of the underlying asset will increase
substantially before the option expires.
2. A put gives the holder the right to sell an asset at a certain price within a specific
period of time. Puts are very similar to having a short position on the underlying
asset. Buyers of puts hope that the price of the underlying asset will fall before the
option expires.

Page 3 of 8
Briefly thus, if you buy a call, you have the right to buy the underlying instrument at the
strike price on or before the expiration date. If you buy a put, you have the right to sell
the underlying instrument on or before expiration.
The simple calls and puts we've discussed are sometimes referred to as plain
vanilla options.

The Value of Options

If the strike price of a call option is less than the current market price of the underlying
security, the call is said to be in-the-money because the holder of this call has the right to
buy the stock at a price which is less than the price he would have to pay to buy the stock
in the stock market. Likewise, if a put option has a strike price that is greater than the
current market price of the underlying security, it is also said to be in-the-money because
the holder of this put has the right to sell the stock at a price which is greater than the
price he would receive selling the stock in the stock market. The converse of in-the-
money is, not surprisingly, out-of-the-money. If the strike price equals the current market
price, the option is said to be at the-money.
The amount by which an option is in-the-money is referred to as intrinsic value. Intrinsic
value is the amount by which the option is in-the-money.

Page 4 of 8
ALL THIS APPEARS SIMPLE BUT COMPLEXITY ARISES THE MOMENT WE
INTRODUCE 2 NEW TERMS: WRITER & HOLDER

There are four types of participants in options markets depending on the position they
take:
1. Buyers of calls
2. Sellers of calls
3. Buyers of puts
4. Sellers of puts
People who buy options are called holders and those who sell options are called writers.

You need to understand what the following means:

Page 5 of 8
Buying Calls
Writing Calls

Buying Puts
Writing Puts

Buying Calls or Holding Calls

A call option contract gives its holder (buyer) the right to buy the underlying asset at the
given strike price on or before the expiration date of the contract.

Writing Calls or Selling calls

As a call writer, you obligate yourself to sell, at the strike price, the underlying asset upon
being assigned an exercise notice. For assuming this obligation, you are paid a premium
at the time you sell the call.

Page 6 of 8
Buying puts or Holding Puts
A put option contract gives its holder the right to sell the underlying asset at the given
strike price on or before the expiration date of the contract.

Writing Puts or Selling Puts

Selling a put obligates you to buy the underlying asset at the option's strike price upon
assignment of an exercise notice. You are paid a premium when the put is written to
partially compensate you for assuming this risk. As a put writer, you must be prepared to
buy the underlying asset at any time during the life of the option.

As a writer, you have no control over whether or not a contract is exercised, and you need
to recognize that exercise is always possible at any time until the expiration date.

Types of Options
There are two main types of options:
 American options can be exercised at any time between the date of purchase and
the expiration date. Most exchange-traded options are of this type.
 European options are different from American options in that they can only be
exercised at the end of their lives.
The distinction between American and European options has nothing to do with
geographic location.

Options allow you to participate in price movements without committing the large
amount of funds needed to buy stock outright. Whether you are a conservative or
growth-oriented investor, or even a short-term, aggressive trader, your broker can help
you select an appropriate options strategy. Despite their many benefits, options involve
risk and are not suitable for everyone. An investor who desires to utilize options should
have well-defined investment objectives suited to his particular financial situation and a
plan for achieving these objectives. The successful use of options requires a willingness to

Page 7 of 8
learn what they are, how they work, and what risks are associated with particular options
strategies. Armed with an understanding of the fundamentals, and with additional
information and assistance that is readily available from many brokerage firms and other
sources, individuals seeking new investment opportunities in today's markets will find
options trading challenging, often fast moving, and potential rewarding.

Page 8 of 8
What is cryptocurrency?

Cryptocurrency, or crypto for short, is a digital form of money that operates on a decentralized network.
Here are some key points to understand it:
• Digital and Secure: Unlike physical cash, cryptocurrencies exist only electronically.
Cryptography, a complex coding method, secures transactions and protects against
counterfeiting.
• Decentralized: Unlike traditional currencies controlled by governments or central banks,
cryptocurrencies operate on a distributed ledger called blockchain. This means there's no single
authority managing them.
• Transactions: Cryptocurrencies can be used to buy and sell goods or services from merchants
who accept them. You can also trade them on cryptocurrency exchanges.
Here's a comparison to traditional currency to help understand the concept better:
• Imagine traditional money as being printed by a central bank and carried around in wallets or
deposited in banks.
• Cryptocurrency, on the other hand, exists on a digital ledger accessible to everyone on the
network. Transactions are secured by cryptography and recorded on the blockchain.
If you'd like to know more about how cryptocurrencies are bought, sold or used, or the potential
advantages and disadvantages, I can provide that information as well.

Blockchain technology: The foundation of cryptocurrencies

Blockchain technology is the underlying foundation that allows cryptocurrencies to function. You can
think of blockchain as a secure, public record of transactions spread across a vast network of computers.
This eliminates the need for a central authority, like a bank, to verify and process transactions.
Here's a deeper dive into how it works:
• Distributed Ledger: Blockchains don't rely on a single database. Instead, the information is
spread across multiple computers on the network. This makes it very secure and resistant to
tampering.
• Immutable Records: Transactions are bundled together into blocks, and each block is linked
to the one before it, creating a chronological chain. Once a transaction is recorded in a block, it
cannot be changed.
• Cryptography: Blockchain technology uses cryptography to ensure the security of
transactions. Cryptography involves complex mathematical algorithms that make it very
difficult to forge or alter data on the blockchain.
Bitcoin: The pioneering cryptocurrency and its impact
Bitcoin holds a unique place in the world of finance and technology. Launched in 2009, it's considered
the pioneering cryptocurrency, paving the way for a whole new asset class. Let's explore its impact:
As a digital currency:
• Decentralization: Bitcoin challenged the traditional financial system by offering a
decentralized alternative. Transactions occur directly between users without a bank as
intermediary.
• Borderless payments: Bitcoin transactions can happen anywhere in the world with an internet
connection, potentially offering faster and cheaper international payments compared to
traditional banking systems.
• Volatility: Bitcoin's value can fluctuate significantly, making it a risky investment but also a
potentially lucrative one.
Beyond just a currency:
• Blockchain Technology: Bitcoin's underlying technology, blockchain, has emerged as a
revolutionary innovation. This secure and transparent public ledger system holds immense
potential for various industries beyond finance.
• Inspired innovation: Bitcoin's success has led to the creation of thousands of other
cryptocurrencies (altcoins) and the exploration of decentralized applications (dApps) built on
blockchain technology.
Impact on global finance:
• Financial Inclusion: Bitcoin offers financial tools to those who might be excluded from
traditional banking systems, particularly in developing nations.
• Investment Potential: Bitcoin has attracted a global audience of investors seeking high returns,
though its volatility is a significant factor.
Challenges and considerations:
• Regulation: The global regulatory landscape for cryptocurrency is still evolving, creating
uncertainty for some investors and businesses.
• Environmental Impact: Bitcoin mining, the process of creating new bitcoins, requires
significant computing power and electricity, raising concerns about its environmental footprint.
• Security risks: Cryptocurrency exchanges and wallets can be vulnerable to hacking, and stolen
cryptocurrencies may be difficult to recover.

The Altcoin Menagerie:

• Definition: In essence, any cryptocurrency other than Bitcoin falls under the altcoin umbrella.
This encompasses a massive and diverse range of digital assets, each with unique features and
purposes.
 • Innovation and Experimentation: Altcoins often represent innovation and experimentation
within the cryptocurrency space. They explore different functionalities, address limitations of
Bitcoin, and cater to specific use cases.
Examples of Altcoins:
• Ether (ETH): The second-largest cryptocurrency by market cap, Ether fuels the Ethereum
network, a popular platform for decentralized applications (dApps) and smart contracts.
• Stablecoins: These altcoins aim to peg their value to a stable asset like the US dollar, offering
price stability unlike Bitcoin's fluctuations. Examples include Tether (USDT) and USD Coin
(USDC).
• Utility Tokens: These tokens provide access to specific features or services within a blockchain
ecosystem. For instance, Chainlink (LINK) facilitates secure data feeds for smart contracts.

Cryptocurrency exchanges: Trading platforms for digital assets

Cryptocurrency exchanges are the platforms where you can buy, sell, and trade cryptocurrencies. They
function like online marketplaces specifically designed for digital assets.

Cryptocurrency wallets: Securing and managing digital currencies

Cryptocurrency wallets are essential tools for anyone venturing into the world of cryptocurrencies. They
act as secure digital vaults to store your crypto holdings and allow you to interact with the blockchain
network. Here's a breakdown of what crypto wallets are and how they function:
Storing Your Crypto Keys:
• Unlike traditional wallets that hold physical cash, crypto wallets don't actually store your
cryptocurrency. Instead, they securely store cryptographic keys.
• These keys are critical for accessing and managing your cryptocurrency on the blockchain.
There are two main types of keys:
o Public Key: This acts like your bank account number, allowing others to send you
cryptocurrency.
o Private Key: This is akin to your ATM PIN, essential for authorizing outgoing
transactions from your crypto holdings.
Types of Cryptocurrency Wallets:
There are various crypto wallet options, each with its own advantages and security considerations:
• Hot Wallets: These are software wallets that are readily accessible on your computer,
smartphone, or even web browsers. They offer convenient access but can be more susceptible
to hacking if not chosen carefully. Popular examples include MetaMask and Coinbase Wallet.
 • Cold Wallets: These are hardware devices resembling USB drives that store your private keys
offline. They provide the highest level of security but offer less convenience compared to hot
wallets. Ledger and Trezor are well-known cold wallet brands.
• Custodial vs Non-Custodial Wallets: Custodial wallets are hosted by a third party (like an
exchange) that manages your private keys for you. Non-custodial wallets, on the other hand,
give you complete control over your private keys, placing the responsibility for security on you.

Decentralized Finance (DeFi): Transforming traditional finance with cryptocurrencies

DeFi Applications (DApps):

DeFi offers a wide range of financial services through DApps. Here are some popular examples:
• Lending and Borrowing: DeFi platforms allow users to lend their crypto holdings to others
and earn interest, or borrow cryptocurrencies without relying on traditional banks.
• Decentralized Exchanges (DEXs): These P2P marketplaces enable users to trade
cryptocurrencies directly with each other, eliminating the need for centralized exchanges.
• Yield Farming: This involves strategically depositing crypto assets in DeFi protocols to
generate high returns, but comes with inherent risks and complexities.

Cryptocurrency regulations: Navigating the legal landscape

Cryptocurrencies are a relatively new asset class, and as such, the regulatory landscape surrounding
them is still evolving. There's no single global standard, and regulations vary considerably by country.
Here's a breakdown of what you need to know:
A Patchwork of Regulations:
• Governments around the world are taking different approaches to regulating cryptocurrencies.
Some countries, like Japan and Singapore, have adopted relatively permissive frameworks,
while others, like China, have taken a much stricter stance, even banning cryptocurrency
transactions altogether.
• The regulatory approach often depends on how a particular country views cryptocurrency. Is it
seen as a currency, a commodity, or a security? This classification can significantly impact the
regulations that apply.
Cryptocurrency mining: Powering the blockchain and earning rewards

Cryptocurrency mining plays a crucial role in the world of cryptocurrencies. It's the process that
validates transactions on a blockchain network and secures the entire system. Here's a breakdown of
how mining works and the potential rewards it offers:
The Engine of the Blockchain:
• Think of miners as the network's bookkeepers, constantly verifying and recording transactions
on the blockchain. They use powerful computers to solve complex mathematical puzzles.
• The first miner to solve the puzzle gets to add a new block of transactions to the blockchain and
earns a reward in cryptocurrency. This process secures the network by making it
computationally expensive and nearly impossible to tamper with transaction records.

Security and privacy in cryptocurrencies: Protecting digital assets and personal

Information

Security and privacy are paramount when dealing with cryptocurrencies, considering the digital nature
of these assets and the potential risks involved. Here's a breakdown of the key considerations to ensure
the safety of your crypto holdings and personal information:

Securing Your Cryptocurrencies:

Strong Passwords and Two-Factor Authentication (2FA): Always use strong, unique passwords for your
cryptocurrency wallets and exchanges. Enable 2FA whenever possible for an extra layer of security.

Choosing Reliable Wallets: Select reputable and secure cryptocurrency wallets, considering both hot
wallets for convenience and cold wallets for maximum security depending on your needs. Store your
recovery phrases or private keys securely, ideally offline.

Beware of Phishing Scams: Phishing attacks are a common threat in the crypto space. Don't click on
suspicious links or download attachments from unknown senders. Double-check website addresses
before entering your login credentials.

Keeping Software Updated: Ensure your devices and cryptocurrency wallets have the latest security
updates installed. This helps patch vulnerabilities that could be exploited by hackers.
Best Practices for Overall Security and Privacy:
• Educate Yourself: Stay informed about common cryptocurrency scams and security
vulnerabilities. The more you know, the better equipped you are to protect yourself.
• Diversification: Don't store all your cryptocurrency holdings in a single wallet. Consider
diversifying across different wallets and platforms to mitigate risk.
• Be Wary of Investment Advice: The crypto space can be volatile and rife with scams. Be
cautious of unsolicited investment advice, especially online.
• Use a Secure Connection: When accessing your cryptocurrency wallets or exchanges, ensure
you're using a secure internet connection, preferably not public Wi-Fi.
 NABARD - National Bank for
Agriculture and Rural
Development
[UPSC Notes]

What is NABARD?
The NABARD- National Bank for Agriculture and Rural Development was established in July
1982 by combining RBI’s Agriculture Credit Department, Agriculture Refinance and
Development Corporation, and Rural Planning and Credit Cell. The headquarters of NABARD is
located in Mumbai

• The objective of NABARD is to meet the rural development and credit needs of
agriculture.
• NABARD was envisioned as the apex baking institution for the entire rural credit system.
• It also provides funding to rural credit institutions and coordinates with their operations.
• NABARD started its operations with a share capital of RS. 1400 crores. Further RBI’s
Agricultural Credit Funds transferred 1400 crores.
• NABARD has so many branches across India.

Establishment of NABARD
From the early stages of planning, the Government was aware of the importance of institutional
credit to boost the rural economy.

• The RBI at the insistence of the Indian Government, constituted a Committee to Review
the CRAFICARD(Committee to Review the Arrangements For Institutional Credit for
Agriculture and Rural Development) in 1979, and it was chaired by Shri B. Sivaraman, a
former member of the Planning Commission.
• CRAFICARD outlined the need for institutions to provide undivided attention, direction,
and focus to the credit-related issues related to rural development.
• As a result, NABARD was founded in 1982 as a statutory body under the Parliamentary
Act- National Bank for Agriculture and Rural Development Act, 1981. In July 1982 late
PM Smt. Indira Gandhi dedicated it to the service of the nation.
• Before the formation of NABARD, RBI was the apex body to support the Rural economy
of India.
• After the formation of NABARD, the functions of 3 institutes of RBI namely, ACD (
Agricultural Credit Department), RPCC (Rural Planning and Credit Cell), and ARDC
(Agricultural Refinance and Development Corporation) were transferred to NABARD.
 • Currently, NABARD is fully owned by the Indian government as a result of changes in
the share capital composition between RBI and the government of India.

Functions of NABARD
NABARD has three functions namely- Financial function, Developmental functions, and
supervision functions.

Financial Functions of NABARD

• NABARD offers financial assistance to the farm sector through refinancing a wide range
of agriculture and allied activities.
• State cooperative banks, commercial banks, state land development banks, and regional
rural banks are eligible for refinancing.
• NABARD is also empowered to extend the loans and advances against the stock
security and promissory notes.
• Additionally, to fund seasonal agricultural operations, NABARD also makes short-term
loans to Regional Rural Banks, and Co-operative Banks.

Developmental Functions of NABARD

• NABARD is involved in development activities as well, coordinates rural credit agencies,

and helps to address rural and agricultural issues.
• To assist the boosting rural and agricultural development research, NABARD has RDF
(Research and Development Fund)
• NABARD has also the power to establish a “ Reserve Fund” or any other funds it finds
appropriate.

Supervisory Functions of NABARD

• Banking Regulation Act 1949 gave the power to NABARD to inspect the operations of
cooperative banks, and Regional Rural Banks.
• Before granting permission to open a new branch, the Reserve Bank of India must
receive a recommendation from NABARD.

Relation between NABARD and RBI

The Reserve Bank of India or RBI is the central bank of India. It has the sole right to regulate
the baking sector and supervise various banks in the country. It also includes NABARD.

• Many regulatory and developmental works are done with the cooperation of RBI and
NABARD.
• Reserve Bank of India also provides 3 directors to the Board of Directors of NABARD.
• NABARD also provides recommendations to RBI on the issue of licenses to Cooperative
Banks, Regional Rural Banks, and the opening of new branches by the State
Cooperative Banks.
Governance of NABARD
The affairs of NABARD are governed by the Board of Directors, and these Board of Directors
are appointed by the Government of India.

• The chairperson and other directors( excluding those who are elected by central
government officials, and shareholders) will be appointed by the Central Government in
consultation with the Reserve Bank of India.
• The NABARD Amendment Bill 2017 was passed in 2018, and it gives power to the
Union Government to increase NABARD’s capital from Rs. 5,000 crore to Rs. 30,000
crore.
• The Board of Directors constitutes the Executive Committee that includes a prescribed
number of directors. These directors will be referred to as Executive Directors.
• The Executive Committee will perform functions as prescribed or delegated to it by the
Board.

NABARD’s Contribution
NABARD has been able to touch every aspect of the rural economy in terms of Developmental,
Financial, and Supervision functions. Below we have discussed its contribution to each function.

Financial Contribution of NABARD

• Short-Term Loans- Crop Loans are provided to the farmers by financial institutions for
crop production which ensures food security in the country. During the year 2020-2021
NABARD paid out ₹95,731 crores for Seasonal Agricultural Operations and ₹11,733
crores for other than seasonal agriculture operations to Cooperative Banks and RRBs.
• Long-term Loans- long-term refinance by NABARD provides credit to financial
institutions for a wide range of activities. It encompasses non-farm and farm activities
with 18 months to 5 years of the tenor.
• Pradhan Mantri Awaas Yojana - Grameen (PMAY-G)- NABADRD sanctioned an amount
of ₹20,000 crores and released ₹19999.80 crores during 2020-21 to NRIDA under
PMAY-G.
• RIDF (Rural Infrastructure Development Fund ) was set up with NABARD in 1995–96 by
the Reserve Bank of India for supporting infrastructure projects in rural areas.
• NIDA (NABARD Infrastructure Development Assistance) has been established to
complement RIDF
• Union Government created Warehouse Infrastructure Fund (WIF) in the year 2013-14
with NABARD with a corpus of Rs 5,000 crore. It provides loans to meet the needs for
the agricultural commodities, and scientific warehousing infrastructure in India.
• Credit Facility to Federations (CFF) provided short-term credit facilities to state
government entities.
• Dairy Processing and Infrastructure Development Fund (DIDF) aims to modernize the
infrastructure for milk processing and value addition which will further ensure the
maximum price realization by the major producers.
• Fisheries and Aquaculture Infrastructure Development Fund (FIDF)- NABARD will fund
the development of fisheries and aquaculture infrastructure in the country.
 • Rural Infrastructure Assistance to State Governments (RIAS)- It was launched by
NABARD to provide financial support to the state governments in the Eastern Region to
create an infrastructure that would support rural livelihoods.
• KishanBhandars has been built which will be sued by the Traders/Farmers/ Producers to
locate the geotagged assets.
• Food Process Fund (FPF) was established to promote the food processing industries in
the country. Indian Government instituted FPF in NABDARD in 2014-15
• Geo Tagging of Warehouses- NABARD took the responsibility of developing a web-
based Agri-Storage Information System which will capture Geo-spatial coordinates and
details of the infrastructure.

Developmental Contribution of NABARD

Let’s take a look at some achievements of NABARD.

• Kishan Credit Card (KCC) Scheme for farmers was designed by NABARD with the
association of RBI in August 1998 for providing crop loans.
• RuPayKisan Cards(RKCs) has proven to be revolutionary technology by helping the
rural financial institutions in providing RKSs to all farmer clients.
• Providing marketing opportunities to the rural artisans and producers, facilitated has
facilitated their participation in various exhibitions in India.
• Self Help Group-Bank Linkage Programme (SHG-BLP) was launched by NABARD in
1992 to empower self-help groups.
• EShakti project was launched on March 15th in 2 districts to digitize Self Help Groups.
This project was a success.
• Micro-Enterprise Development Programme (MEDP) and Livelihood and Enterprise
Development Programme (LEDP) were launched by NABARD to boost the micro-
entrepreneurship movement.
• NABARD has promoted many skill development programs among the rural youth and
encouraged them to start an enterprise in the rural off-farm sector. It has tried to address
the skill in rural India through many skill development programs.
• Agri-Business Incubation Centres (ABICs) were supported by NABARD to develop a
supportive ecosystem for Agri entrepreneurs.
• NABARD has also set up Catalytic Capital Fund which aims to support Agri and Rural
startups.
• NABARD is one of the nodal agencies for implementing CLCSS (Credit Linked Capital
Subsidy Scheme) for Technology Upgradation of Micro & Small Enterprises of the Indian
Government.

Challenges for NABARD

Being an offspring of the Reserve Bank of India, NABARD shares its parent institution’s ethos,
work culture, and development orientation.

• The transfer of 0.4 equity of RBIs to NABARD has resulted in a significant disadvantage
for both NABARD and RBI.
• Due to this the role of RBI or participation in NABARD’s operation has weakened.
• NABARD borrowings account for 80% of its resources, so the cost of financing has
risen.
• A small portion of the NABARD credit fund goes to the northeastern state.

• The Bank penetration in insurgency-affected states should be increased, as currently, it

is low.
 Overview of United States’ (U.S.) money and capital markets:
Exploring the financial landscape in the U.S.

The U.S. financial landscape is a complex ecosystem with two main components: the money market
and the capital market. They serve different purposes and cater to varying investment horizons. Here's
a breakdown:

Money Market:
Focus: Short-term (less than a year) borrowing and lending
Participants: Businesses, governments, banks, and financial institutions
Instruments: Treasury bills (T-bills), certificates of deposit (CDs), commercial paper
Purpose: Meets short-term liquidity needs. Companies might need cash to cover payroll until they
receive payments from customers, for instance.
Risk & Return: Lower risk, lower potential return compared to capital markets. T-bills are considered
nearly risk-free, with correspondingly low-interest rates.

Capital Market:
Focus: Long-term investments (more than a year)
Participants: Businesses seeking capital for growth, governments issuing bonds, and investors looking
for returns
Instruments: Stocks, bonds (corporate & government), derivatives
Purpose: Raises capital for companies and governments, offers investors opportunities for growth and
income.
Risk & Return: Higher risk, higher potential return compared to money markets. Stocks can be
volatile but offer the chance for significant capital appreciation. Bonds offer steady income but lower
potential returns.

Key features of U.S. Money and Capital Markets:

Size and Depth: The U.S. boasts the world's largest and most liquid financial markets, attracting
domestic and international investors.
Regulation: A robust regulatory framework ensures market stability and investor protection. The
Securities and Exchange Commission (SEC) is a key player.
Diversity: The U.S. offers a vast array of investment options, from publicly traded stocks on
exchanges like the New York Stock Exchange (NYSE) and the Nasdaq to private equity markets for
non-public companies.
Understanding these markets is crucial for businesses seeking funding and individuals planning their
investments.

Introduction to London money and capital markets: Understanding the financial hub of
London

London: A Global Financial Powerhouse

London is a behemoth in the world of finance, consistently ranking as a top global financial center.
Understanding its money and capital markets is vital to grasp the city's influence and the intricate
workings of global finance. Here's an introductory look:

London's Money Market:

A Hub for Short-Term Deals: London's money market is a well-oiled machine for short-term
borrowing and lending, typically less than a year.
Key Players: Major banks, financial institutions, and the Bank of England (BOE), the UK's central
bank, are all active participants.
Instruments: Treasury bills (T-bills), certificates of deposit (CDs), repurchase agreements (repos), and
commercial paper are commonly traded instruments.
Lifeblood of Liquidity: These markets ensure smooth day-to-day operations for businesses and banks
by providing access to quick funding.

London's Capital Market:

Powerhouse for Long-Term Investment: Companies and governments raise long-term capital here
through various instruments.
Global Reach: London's capital market attracts investors worldwide due to its stability, diverse
offerings, and adherence to regulations.
Investment Options Galore: Stocks, bonds (corporate and government), derivatives, and alternative
investments like private equity are all available.
Funding Growth and Innovation: Businesses tap into this market to fuel expansion and development
projects.

Key Features of London's Financial Markets:

Deep History and Reputation: London's financial roots run deep, fostering trust and stability that
attracts investors.
Skilled Workforce and Infrastructure: A highly skilled workforce and robust financial infrastructure
support efficient market operations.
Innovation and Adaptability: London's markets constantly evolve with new products and services to
meet changing needs.
By understanding these core aspects, you gain a solid foundation for exploring the intricacies of
London's money and capital markets. These markets play a pivotal role in shaping global financial
flows and offer vast opportunities for businesses and investors alike.

External Commercial Borrowings (from Indian perspective)

External Commercial Borrowings (ECBs) are a way for Indian companies to access foreign currency
loans. Here's a breakdown of ECBs:
What are ECBs?
• Loans raised by Indian resident entities from non-resident lenders in foreign currency.
• Commonly used by Indian corporates and Public Sector Undertakings (PSUs) to fund their
operations.
Benefits of ECBs:
• Potentially Lower Interest Rates: Foreign currency loans can be cheaper than rupee
denominated loans, especially when interest rates are low abroad.
• Diversification of Funding Sources: ECBs help companies reduce dependence on domestic
lenders and tap into foreign capital markets.
Types of ECBs:
• Commercial bank loans
• Buyers' credit and suppliers' credit: Financing provided by foreign suppliers for purchases.
• Securitised instruments: Bonds and other instruments representing debt obligations.
• Foreign Currency Convertible Bonds (FCCBs): Bonds issued by Indian companies in
foreign currency, with principal and interest payments also in foreign currency.
Regulations and Approvals:
• ECBs are governed by the Foreign Exchange Management Act (FEMA).
• There are two routes for raising ECBs:
o Automatic Route: Streamlined process for eligible borrowers meeting specific
criteria like minimum maturity and end-use of funds.
o Approval Route: Requires permission from the Reserve Bank of India (RBI) for
cases not covered under the automatic route.
Things to Consider with ECBs:
• Currency Fluctuations: Borrowing in foreign currency exposes the borrower to exchange
rate risks.
 • Repayment Obligations: ECBs typically have a longer repayment period than domestic
loans, requiring careful financial planning.
• Compliance Requirements: Borrowers must adhere to FEMA regulations and RBI
guidelines.
Overall, ECBs are a valuable tool for Indian companies seeking foreign currency funding, but
careful consideration of risks and regulations is crucial.

Global Depository Receipts (GDRs)

Global Depository Receipts (GDRs): Stepping onto the International Stock Exchange Stage
Global Depository Receipts (GDRs) are financial instruments that act like passports for foreign
companies seeking to raise capital on international stock exchanges outside their home country. Here's
a closer look at GDRs:
What are GDRs?
• Certificates issued by a depository bank: This bank holds shares of a foreign company and
issues GDRs representing those shares.
• Traded on international exchanges: GDRs allow investors to buy shares of a foreign
company on their local exchange, often denominated in a major currency like US dollars.
How GDRs Work:
1. The Issuing Company (Foreign Company): A company from Country A decides to raise
capital from investors in Country B.
2. Depository Bank: A bank in Country B acts as the custodian, holding the underlying shares
of the foreign company.
3. GDR Issuance: The depository bank issues GDRs, each representing a specific number of
shares in the foreign company.
4. Trading on Exchange: GDRs are listed and traded on a stock exchange in Country B,
allowing investors there to buy and sell them.
Benefits of GDRs for Issuing Companies:
• Access to International Capital: GDRs open doors to a wider pool of investors, potentially
raising more funds for growth.
• Increased Liquidity: GDR listings can enhance the liquidity of the company's shares,
making them more attractive to investors.
• Enhanced Brand Recognition: A GDR listing can raise a company's profile on the global
investment stage.
Benefits of GDRs for Investors:
• Invest in Foreign Companies: GDRs provide a convenient way to invest in companies from
other countries without dealing directly with foreign markets.
• Currency Convenience: GDRs are often denominated in major currencies, reducing foreign
exchange hassles for investors.
• Potential for Diversification: GDRs can help investors diversify their portfolios by including
stocks from emerging markets.
Things to Consider with GDRs:
• Currency Fluctuations: Exchange rate movements can impact the value of GDRs for
investors.
• Political and Economic Risks: Investors are exposed to the political and economic risks of
the foreign company's home country.
• Liquidity Risks: GDRs for companies from smaller markets may have lower trading
volumes compared to major companies.
Overall, GDRs are a bridge between companies and international investors. They offer
companies access to global capital and investors a chance to diversify their portfolios. However,
careful consideration of the associated risks is essential before investing in GDRs.

American Depository Receipts

American Depositary Receipts (ADRs) are a type of GDR, specifically designed for trading on US
stock exchanges. They function similarly to GDRs but cater to US investors looking to invest in
foreign companies. Here's a breakdown of ADRs:
What are ADRs?
• Negotiable certificates issued by a US bank representing shares of a foreign company.
• Traded on US stock exchanges like the New York Stock Exchange (NYSE) or Nasdaq.
• Denominated in US dollars for convenient buying and selling by US investors.
How ADRs Work:
1. Foreign Company: A company from a country outside the US seeks to raise capital from US
investors.
2. Depositary Bank: A US bank acts as the custodian, holding the underlying shares of the
foreign company.
3. ADR Issuance: The depository bank issues ADRs, each representing a specific number of
shares in the foreign company (usually one share but can vary).
4. Trading on US Exchanges: ADRs are listed and traded on US stock exchanges, allowing US
investors to buy and sell them with ease.
Benefits of ADRs for Investors:
• Invest in Foreign Companies: ADRs provide a simple way for US investors to participate in
the growth of foreign companies without dealing with foreign markets directly.
• Convenience and Transparency: Trading in US dollars on familiar exchanges simplifies the
process and reduces foreign exchange complexities.
• Potential for Diversification: ADRs can help US investors diversify their portfolios by
including stocks from foreign markets with different economic conditions.
Benefits of ADRs for Issuing Companies:
• Access to US Capital: ADRs open doors to the vast pool of US investors, offering significant
capital raising opportunities.
• Increased Liquidity: ADR listings can enhance the overall liquidity of the company's shares,
attracting a broader investor base.
• Enhanced Brand Recognition: A US listing can raise the company's profile among
American investors.
Things to Consider with ADRs:
• Currency Fluctuations: Changes in exchange rates can impact the value of ADRs for both
investors and the issuing company.
• Foreign Market Risks: Investors are still exposed to the political and economic risks of the
foreign company's home country.
• ADR Fees: Depositary banks may charge fees associated with holding the underlying shares
and administering the ADR program.
• Tax Implications: Dividends received from ADRs may be subject to different tax treatments
compared to regular US stocks.
Overall, ADRs are a valuable tool for both US investors seeking international exposure and
foreign companies aiming to tap into the US capital markets. However, understanding the
associated risks and fees is crucial before investing in ADRs.

Eurocurrency market
The eurocurrency market is a global marketplace for short-term borrowing and lending of currencies
outside of their home country. Here's a breakdown of this dynamic financial arena:
What is the Eurocurrency Market?
• Imagine US dollars deposited in a bank in London. Those dollars become Eurodollars, a type
of eurocurrency.
• The eurocurrency market deals in these currency deposits outside their home markets.
• Major players include banks, multinational corporations, investment firms, and hedge funds.
Why the Eurocurrency Market Exists?
• This market offers several advantages over traditional domestic banking:
o Lower Interest Rates (for Borrowers): Borrowers can sometimes find more
attractive interest rates compared to their domestic banks.
o Higher Interest Rates (for Lenders): Lenders may earn higher returns on their
deposits compared to domestic options.
o Less Regulation: Eurocurrency transactions are often subject to fewer regulations
than domestic banking, making them potentially faster and more flexible.
Examples of Eurocurrency:
• Eurodollar: US dollars deposited outside the United States (most common type)
• Euroyen: Japanese yen deposited outside Japan
• Eurosterling: British pounds deposited outside the United Kingdom
Key Features of the Eurocurrency Market:
• Short-Term Focus: Transactions typically involve maturities of less than a year, similar to
money markets.
• Global Reach: The eurocurrency market operates in major financial centers worldwide, not
just in Europe.
• Highly Liquid: Large volumes are traded daily, ensuring easy entry and exit for participants.
Benefits of the Eurocurrency Market:
• Increased Efficiency: Provides more options for borrowers and lenders to find the best rates.
• Financial Innovation: Has driven the development of new financial instruments and risk
management techniques.
• Global Investment Opportunities: Contributes to a more interconnected and diverse global
financial system.
Things to Consider with the Eurocurrency Market:
• Currency Fluctuations: Borrowers are exposed to exchange rate risks if they borrow in a
currency different from their own.
• Creditworthiness Risks: As with any lending, there's a risk of default by borrowers. Careful
evaluation is needed.
• Less Regulation: While offering flexibility, less regulation can also mean potentially higher
risks for lenders.
By understanding the eurocurrency market, you gain insight into a crucial component of global
finance. It facilitates cross-border financial flows, offering opportunities and challenges for
participants worldwide.
Eurobond market
The Eurobond market is a significant player in the world of international finance, allowing for the
issuance and trading of debt instruments, specifically bonds, denominated in a currency other than
the issuer's home currency. Here's a closer look at this unique market:
Understanding Eurobonds:
• Imagine a German company issuing bonds denominated in US dollars. These are Eurobonds,
as they're not issued in the company's home currency (euros) but cater to a global investor
base.
• Eurobonds are popular because they offer flexibility and reach for issuers and diversification
for investors.
Benefits of Eurobond Market for Issuers:
• Access to Global Capital: Companies can tap into a vast pool of international investors,
potentially raising more funds than in their domestic market.
• Favorable Interest Rates: Issuers may find better interest rates compared to borrowing in
their home currency.
• Diversification of Funding Sources: Eurobonds reduce dependence on domestic lenders,
spreading financial risk.
Benefits of Eurobond Market for Investors:
• Currency Diversification: Investors can gain exposure to different currencies, potentially
hedging against fluctuations in their home currency.
• Fixed Income Potential: Eurobonds offer regular interest payments and eventual return of
principal, providing a steady income stream.
• Investment Opportunities: The Eurobond market offers a wider range of investment options
compared to some domestic markets.
Key Features of the Eurobond Market:
• Global Reach: Eurobonds are issued and traded in major financial centres worldwide.
• Variety of Issuers: Governments, corporations, and supranational organizations can all be
Eurobond issuers.
• Multiple Currencies: Eurobonds can be denominated in various currencies, including USD,
EUR, and JPY.
• Regulation: Eurobonds are generally subject to less regulation compared to domestic bonds,
but regulations can vary depending on the issuer's location.
Things to Consider with Eurobonds:
• Currency Fluctuations: Both issuers and investors are exposed to currency exchange rate
risks.
• Creditworthiness Risks: Investors need to assess the creditworthiness of the issuer, as with
any bond investment.
 • Interest Rate Risks: Changes in interest rates can affect the value of Eurobonds in the
secondary market.
By understanding the Eurobond market, you gain insight into a powerful tool for international
finance. It allows for efficient capital raising and global investment opportunities, but careful
consideration of the associated risks is crucial for both issuers and investors.