FINANCIAL SERVICES Notes

❖ Characteristics/ Features of Financial Services

From the following characteristics of financial services, we can understand their
nature

1. Intangibility: Financial services are intangible. Therefore, they cannot be

standardized or reproduced in the same form. The institutions supplying the
financial services should have a Financial 3 Services better image and confidence
of the customers. Otherwise, they may not succeed. They have to focus on quality
and innovation of their services. Then only they can build credibility and gain the
trust of the customers.

2. Inseparability: Both production and supply of financial services have to be

performed simultaneously. Hence, there should be perfect understanding between
the financial service institutions and its customers.

3. Perishability: Like other services, financial services also require a match

between demand and supply. Services cannot be stored. They have to be supplied
when customers need them.

4. Variability: In order to cater a variety of financial and related needs of

different customers in different areas, financial service organisations have to offer
a wide range of products and services. This means the financial services have to
be tailor-made to the requirements of customers. The service institutions
differentiate their services to develop their individual identity.

5. Dominance of human element: Financial services are dominated by human

element. Thus, financial services are labour intensive. It requires competent and
skilled personnel to market the quality financial products.

6. Information-based: Financial service industry is an information-based

industry. It involves creation, dissemination and use of information. Information
is an essential component in the production of financial services.

7. Customer Orientation: Financial services companies make a detailed study

on needs and wants of consumers. Accordingly, different types of innovative
products and services are introduced to cater to the requirements of various
buyers. Thus customer orientation is the key feature of all the financial services.
8. Dynamism: Dynamism is another important feature of financial services.
Financial services firms are constantly engaged in researching new financial
products and services based on the socioeconomic changes like the changes in
the level of income of people, investing habits of investors, liquidity flow in the
market and so on.

❖ Types of Financial Services

Financial service institutions render a wide variety of services to meet the
requirements of individual users. These services may be summarized as below:

1. Provision of funds:

(a) Venture capital

(b) Banking services

(c) Asset financing

(d) Trade financing

(e) Credit cards

(f) Factoring and forfaiting

2. Managing investible funds:

(a) Portfolio management

(b) Merchant banking

(c) Mutual and pension funds

3. Risk financing:

(a) Project preparatory services

(b) Insurance

(c) Export credit guarantee

4. Consultancy services:

(a) Project preparatory services

(b) Project report preparation

(c) Project appraisal

(d) Rehabilitation of projects

(e) Business advisory services

(f) Valuation of investments

(g) Credit rating

(h) Merger, acquisition and reengineering

5. Market operations:

(a) Stock market operations

(b) Money market operations

(c) Asset management

(d) Registrar and share transfer agencies

(e) Trusteeship

(f) Retail market operation

(g) Futures, options and derivatives

6. Research and development:

(a) Equity and market research

(b) Investor education

(c) Training of personnel

(d) Financial information services

❖ Scope of Financial Services

The scope of financial services is very wide. This is because it covers a wide
range of services.

The financial services can be broadly classified into two: (a) fund based services
and (b) non-fund services (or fee-based services)

Fund based Services

The fund based or asset based services include the following:

1. Underwriting

2. Dealing in secondary market activities

3. Participating in money market instruments like CPs, CDs etc.

4. Equipment leasing or lease financing

5. Hire purchase

6. Venture capital

7. Bill discounting.

8. Insurance services

9. Factoring

10. Forfeiting

11. Housing finance

12. Mutual fund

Non-fund based Services

Today, customers are not satisfied with mere provision of finance. They expect
more from financial service companies. Hence, the financial service companies
or financial intermediaries provide services on the basis of non-fund activities
also. Such services are also known as fee based services. These include the
following:

1. Securitisation

2. Merchant banking

3. Credit rating

4. Loan syndication

5. Business opportunity related services

6. Project advisory services

7. Services to foreign companies and NRIs.

8. Portfolio management

9. Merger and acquisition

10. Capital restructuring

11. Debenture trusteeship

12. Custodian services

13. Stock broking

The most important fund based and non-fund based services (or types of services)
may be briefly discussed as below:

A. Asset/Fund Based Services

1. Equipment leasing/Lease financing: A lease is an agreement under which a

firm acquires a right to make use of a capital asset like machinery etc. on payment
of an agreed fee called lease rentals. The person (or the company) which acquires
the right is known as lessee. He does not get the ownership of the asset. He
acquires only the right to use the asset. The person (or the company) who gives
the right is known as lessor.

2. Hire purchase and consumer credit: Hire purchase is an alternative to leasing.

Hire purchase is a transaction where goods are purchased and sold on the
condition that payment is made in instalments. The buyer gets only possession of
goods. He does not get ownership. He gets ownership only after the payment of
the last instalment. If the buyer fails to pay any instalment, the seller can repossess
the goods. Each instalment includes interest also.

3. Bill discounting: Discounting of bill is an attractive fund based financial

service provided by the finance companies. In the case of time bill (payable after
a specified period), the holder need not wait till maturity or due date. If he is in
need of money, he can discount the bill with his banker. After deducting a certain
amount (discount), the banker credits the net amount in the customer’s account.
Thus, the bank purchases the bill and credits the customer’s account with the
amount of the bill less discount. On the due date, the drawee makes payment to
the banker. If he fails to make payment, the banker will recover the amount from
the customer who has discounted the bill. In short, discounting of bill means
giving loans on the basis of the security of a bill of exchange.
4. Venture capital: Venture capital simply refers to capital which is available for
financing the new business ventures. It involves lending finance to the growing
companies. It is the investment in a highly risky project with the objective of
earning a high rate of return. In short, venture capital means long term risk capital
in the form of equity finance.

5. Housing finance: Housing finance simply refers to providing finance for

house building. It emerged as a fund based financial service in India with the
establishment of National Housing Bank (NHB) by the RBI in 1988. It is an apex
housing finance institution in the country. Till now, a number of specialised
financial institutions/companies have entered in the filed of housing finance.
Some of the institutions are HDFC, LIC Housing Finance, Citi Home, Ind Bank
Housing etc

6. Insurance services: Insurance is a contract between two parties. One party is

the insured and the other party is the insurer. Insured is the person whose life or
property is insured with the insurer. That is, the person whose risk is insured is
called insured. Insurer is the insurance company to whom risk is transferred by
the insured. That is, the person who insures the risk of insured is called insurer.
Thus insurance is a contract between insurer and insured. It is a contract in which
the insurance company undertakes to indemnify the insured on the happening of
certain event for a payment of consideration. It is a contract between the insurer
and insured under which the insurer undertakes to compensate the insured for the
loss arising from the risk insured against.

According to Mc Gill, “Insurance is a process in which uncertainties are made

certain”. In the words of Jon Megi, “Insurance is a plan wherein persons
collectively share the losses of risks”.

Thus, insurance is a device by which a loss likely to be caused by uncertain event

is spread over a large number of persons who are exposed to it and who
voluntarily join themselves against such an event. The document which contains
all the terms and conditions of insurance (i.e. the written contract) is called the
‘insurance policy’. The amount for which the insurance policy is taken is called
‘sum assured’. The consideration in return for which the insurer agrees to make
good the loss is known as ‘insurance premium’. This premium is to be paid
regularly by the insured. It may be paid monthly, quarterly, half yearly or yearly.

7. Factoring: Factoring is an arrangement under which the factor purchases the

account receivables (arising out of credit sale of goods/services) and makes
immediate cash payment to the supplier or creditor. Thus, it is an arrangement in
which the account receivables of a firm (client) are purchased by a financial
institution or banker. Thus, the factor provides finance to the client (supplier) in
respect of account receivables. The factor undertakes the responsibility of
collecting the account receivables. The financial institution (factor) undertakes
the risk. For this type of service as well as for the interest, the factor charges a fee
for the intervening period. This fee or charge is called factorage.

8. Forfaiting: Forfaiting is a form of financing of receivables relating to

international trade. It is a non-recourse purchase by a banker or any other financial
institution of receivables arising from export of goods and services. The exporter
surrenders his right to the forfaiter to receive future payment from the buyer to
whom goods have been supplied. Forfaiting is a technique that helps the exporter
sells his goods on credit and yet receives the cash well before the due date. In
short, forfaiting is a technique by which a forfaitor (financing agency) discounts
an export bill and pay ready cash to the exporter. The exporter need not bother
about collection of export bill. He can just concentrate on export trade.

9. Mutual fund: Mutual funds are financial intermediaries which mobilise

savings from the people and invest them in a mix of corporate and government
securities. The mutual fund operators actively manage this portfolio of securities
and earn income through dividend, interest and capital gains. The incomes are
eventually passed on to mutual fund shareholders.

Non-Fund Based/Fee Based Financial Services

1. Merchant banking: Merchant banking is basically a service banking,

concerned with providing non-fund based services of arranging funds rather than
providing them. The merchant banker merely acts as an intermediary. Its main
job is to transfer capital from those who own it to those who need it. Today,
merchant banker acts as an institution which understands the requirements of the
promoters on the one hand and financial institutions, banks, stock exchange and
money markets on the other. SEBI (Merchant Bankers) Rule, 1992 has defined a
merchant banker as, “any person who is engaged in the business of issue
management either by making arrangements regarding selling, buying or
subscribing to securities or acting as manager, consultant, advisor, or rendering
corporate advisory services in relation to such issue management”.

2. Credit rating: Credit rating means giving an expert opinion by a rating agency
on the relative willingness and ability of the issuer of a debt instrument to meet
the financial obligations in time and in full. It measures the relative risk of an
issuer’s ability and willingness to repay both interest and principal over the period
of the rated instrument. It is a judgement about a firm’s financial and business
prospects. In short, credit rating means assessing the creditworthiness of a
company by an independent organisation.

3. Stock broking: Now stock broking has emerged as a professional advisory

service. Stock broker is a member of a recognized stock exchange. He buys, sells,
or deals in shares/securities. It is compulsory for each stock broker to get
himself/herself registered with SEBI in order to act as a broker. As a member of
a stock exchange, he will have to abide by its rules, regulations and bylaws.

4. Custodial services: In simple words, the services provided by a custodian are

known as custodial services (custodian services). Custodian is an institution or a
person who is handed over securities by the security owners for safe custody.
Custodian is a caretaker of a public property or securities. Custodians are
intermediaries between companies and clients (i.e. security holders) and
institutions (financial institutions and mutual funds). There is an arrangement and
agreement between custodian and real owners of securities or properties to act as
custodians of those who hand over it. The duty of a custodian is to keep the
securities or documents under safe custody. The work of custodian is very risky
and costly in nature. For rendering these services, he gets a remuneration called
custodial charges.

Thus custodial service is the service of keeping the securities safe for and on
behalf of somebody else for a remuneration called custodial charges.

5. Loan syndication: Loan syndication is an arrangement where a group of banks

participate to provide funds for a single loan. In a loan syndication, a group of
banks comprising 10 to 30 banks participate to provide funds wherein one of the
banks is the lead manager. This lead bank is decided by the corporate enterprises,
depending on confidence in the lead manager. A single bank cannot give a huge
loan. Hence a number of banks join together and form a syndicate. This is known
as loan syndication. Thus, loan syndication is very similar to consortium
financing.

6. Securitisation (of debt): Loans given to customers are assets for the bank.
They are called loan assets. Unlike investment assets, loan assets are not tradable
and transferable. Thus loan assets are not liquid. The problem is how to make the
loan of a bank liquid. This problem can be solved by transforming the loans into
marketable securities. Now loans become liquid. They get the characteristic of
marketability. This is done through the process of securitization. Securitisation is
a financial innovation. It is conversion of existing or future cash flows into
marketable securities that can be sold to investors. It is the process by which
financial assets such as loan receivables, credit card balances, hire purchase
debtors, lease receivables, trade debtors etc. are transformed into securities. Thus,
any asset with predictable cash flows can be securitised.

❖ Difference between Bank & NBFC

Major differences with perspective to loan

• Banks are more stringent when it comes to paperwork, requirements, and

eligibility while processing your loan application. Your credit score also
needs to be above acceptable levels as well. The upside of going through
greater scrutiny is that loan applicants can get lower processing fees and
lower interest rates. Banks may also offer discounts to women, which most
NBFCs don’t at the moment.
• While NBFCs have a faster loan processing time which means applicants
can get loan approval and disbursal faster. NBFCs can be more accepting
of lower credit scores, and they balance their risks by charging higher
interest rates. While taking home loans as well, the paperwork
requirements for NBFCs may be less stringent than banks. NBFCs too must
be careful to keep their bad debt and NPAs under check since they lend
largely to the retail sector largely and not to the corporate sector.

❖ Factoring
Factoring is a service of financial nature involving the conversion of credit
bills into cash. Accounts receivables, bills recoverable and other credit
dues resulting from credit sales appear, in the books of accounts as book
credits. Here the risk of credit, risk of credit worthiness of the debtor and
as number of incidental and consequential risks are involved. These risks
are taken by the factor which purchase these credit receivables without
recourse and collects the m when due. These balance-sheet items are
replaced by cash received from the factoring agent.

History
Roman
Factoring has not been documented as having been used by the Romans.
However, the word ‗factoring‘ has a Roman root. It is derived from the Latin
verb ‘facio‘ which can be translated as ―he who does things‖. In Roman times
this referred to agent of a property owner, i.e., his business manager. Though
the root word has nothing to do with the industry, as they attempt to help their
clients thro ugh their financial problem.
History Factoring in India
Banks provide generally bill collection and bill discounting and with recourse.
They provide working capital finance based on these bills classified by a mounts
maturity wise. Such bills if accumulated in large quantities will burden the
liquidity and solvency position of the company and reduces the credit limits from
the banks. It is therefore felt necessary that the company assigns these book debts
to a factor for taking them off from the balance sheet. This reduces the workload,
increases the solvency and improves the liquidity position of the company.
• Vaghul Committee report on money market reforms has confirmed the
need for factoring services to be developed in India as part of the money
market instruments. Many new instruments were already introduced like
Participation certificates, Commercial papers, Certificate of deposits etc.,
but the factoring service has not developed to any significant extent in
India.
Objectives of Factoring
Factoring is a method of converting receivables into cash. There are certain
objectives of factoring. The important objectives are as follows:

1. To relieve from the trouble of collecting receivables so as to concentrate in

sales and other major areas of business.

2. To minimize the risk of bad debts arising on account of non-realisation of credit

sales.

3. To adopt better credit control policy.

4. To carry on business smoothly and not to rely on external sources to meet

working capital requirements.

5. To get information about market, customers’ credit worthiness etc. so as to

make necessary changes in the marketing policies or strategies.

❖ Types of Factoring
There are different types of factoring. These may be briefly discussed as follows:

1. Notified factoring
Here, the customer is intimated about the assignment of debt to a factor,
also directed to make payments to the factor instead of to the fir m. This is
invariably done by a legend and the invoice has been assigned to or sold to
the factor.
2. Non-notified or confidential factoring
Under this facility, the supplier/factor arrangement is not declared to the
customer unless or until there is a breach of the agreement on the part of
the client, or exceptionally, where the factor considers himself to be at risk.
3. Bank Participation Factoring
The client creates a floating charge on the factoring reserves in favour of
banks and borrow against these reserves.
 4. Recourse Factoring: In this type of factoring, the factor only manages the
receivables without taking any risk like bad debt etc. Full risk is borne by
the firm (client) itself.
5. Non-Recourse Factoring: Here the firm gets total credit protection
because complete risk of total receivables is borne by the factor. The client
gets 100% cash against the invoices (arising out of credit sales by the client)
even if bad debts occur. For the factoring service, the client pays a
commission to the factor. This is also called full factoring.
6. Maturity Factoring: In this type of factoring, the factor does not pay any
cash in advance. The factor pays clients only when he receives funds
(collection of credit sales) from the customers or when the customers
guarantee full payment.
7. Advance Factoring: Here the factor makes advance payment of about 80%
of the invoice value to the client.
8. Invoice Discounting: Under this arrangement the factor gives advance to
the client against receivables and collects interest (service charge) for the
period extending from the date of advance to the date of collection.
9. Undisclosed Factoring: In this case the customers (debtors of the client)
are not at all informed about the factoring agreement between the factor
and the client. The factor performs all its usual factoring services in the
name of the client or a sales company to which the client sells its book
debts. Through this company the factor deals with the customers. This type
of factoring is found in UK.
10. Cross boarder factoring: It is similar to domestic factoring except that
there are four parties, viz,
a) Exporter,

b) Export Factor,

c) Import Factor, and

d) Importer.

It is also called two-factor system of factoring. Exporter (Client) enters into

factoring arrangement with Export Factor in his country and assigns to him export
receivables. Export Factor enters into arrangement with Import Factor and has
arrangement for credit evaluation & collection of payment for an agreed fee.
Notation is made on the invoice that importer has to make payment to the Import
Factor. Import Factor collects payment and remits to Export Factor who passes
on the proceeds to the Exporter after adjusting his advance, if any. Where foreign
currency is involved, factor covers exchange risk also.
Features (Nature) of Factoring

From the following essential features of factoring, we can understand its nature:

1. Factoring is a service of financial nature. It involves the conversion of credit

bills into cash. Account receivables and other credit dues resulting from credit
sales appear in the books of account as book credits.

2. The factor purchases the credit/receivables and collects them on the due date.
Thus the risks associated with credit are assumed by the factor.

3. A factor is a financial institution. It may be a commercial bank or a finance

company. It offers services relating to management and financing of debts arising
out of credit sales. It acts as a financial intermediary between the buyer (client
debtor) and the seller (client firm).

4. A factor specialises in handling and collecting receivables in an efficient

manner.

5. Factor is responsible for sales accounting, debt collection, credit (credit

monitoring), protection from bad debts and rendering of advisory services to its
clients.

6. Factoring is a technique of receivables management. It is used to release funds

tied up in receivables (credit given to customers) and to solve the problems
relating to collection, delays and defaults of the receivables.

Functions of a Factor

Factor is a financial institution that specialises in buying accounts receivables

from business firms. A factor performs some important functions. These may be
discussed as follows:

1. Provision of finance: Receivables or book debts is the subject matter of

factoring. A factor buys the book debts of his client. Generally a factor gives
about 80% of the value of receivables as advance to the client. Thus the
nonproductive and inactive current assets i.e. receivables are converted into
productive and active assets i.e. cash.

2. Administration of sales ledger: The factor maintains the sales ledger of every
client. When the credit sales take place, the firm prepares the invoice in two
copies. One copy is sent to the customers. The other copy is sent to the factor.
Entries are made in the ledger under open-item method. In this method each
receipt is matched against the specific invoice. The customer’s account clearly
shows the various open invoices outstanding on any given date. The factor also
gives periodic reports to the client on the current status of his receivables and the
amount received from customers. Thus the factor undertakes the responsibility of
entire sales administration of the client.

3. Collection of receivables: The main function of a factor is to collect the credit

or receivables on behalf of the client and to relieve him from all
tensions/problems associated with the credit collection. This enables the client to
concentrate on other important areas of business. This also helps the client to
reduce cost of collection.

4. Protection against risk: If the debts are factored without resource, all risks
relating to receivables (e.g., bad debts or defaults by customers) will be assumed
by the factor. The factor relieves the client from the trouble of credit collection.
It also advises the client on the creditworthiness of potential customers. In short,
the factor protects the clients from risks such as defaults and bad debts.

5. Credit management: The factor in consultation with the client fixes credit limits
for approved customers. Within these limits, the factor undertakes to buy all trade
debts of the customer. Factor assesses the credit standing of the customer. This is
done on the basis of information collected from credit relating reports, bank
reports etc. In this way the factor advocates the best credit and collection policies
suitable for the firm (client). In short, it helps the client in efficient credit
management.

6. Advisory services: These services arise out of the close relationship between a
factor and a client. The factor has better knowledge and wide experience in the
field of finance. It is a specialised institution for managing account receivables.
It possesses extensive credit information about customer’s creditworthiness and
track record. With all these, a factor can provide various advisory services to the
client. Besides, the factor helps the client in raising finance from banks/financial
institutions.

Advantages of Factoring

A firm that enters into factoring agreement is benefited in a number of ways.

Some of the important benefits of factoring are summarised as follows:
1. Improves efficiency: Factoring is an important tool for efficient receivables
management.Factors provide specialised services with regard to sales ledger
administration, credit control etc. Factoring relieves the clients from botheration
of debt collection.

2. Higher credit standing: Factoring generates cash for the selling firm. It can use
this cash for other purposes. With the advance payment made by factor, it is
possible for the client to pay off his liabilities in time. This improves the credit
standing of the client before the public.

3. Reduces cost: The client need not have a special administrative setup to look
after credit control. Hence it can save manpower, time and effort. Since the
factoring facilitates steady and reliable cash flows, client can cut costs and
expenses. It can avail cash discounts. Further, it can avoid production delays.

4. Additional source: Funds from a factor is an additional source of finance for

the client. Factoring releases the funds tied up in credit extended to customers and
solves problems relating to collection, delays and defaults of the receivables.

5. Advisory service: A factor firm is a specialised agency for better management

of receivables. The factor assesses the financial, operational and managerial
capabilities of customers. In this way the factor analyses whether the debts are
collectable. It collects valuable information about customers and supplies the
same for the benefits of its clients. It provides all management and administrative
support from the stage of deciding credit extension to the customers to the final
stage of debt collection. It advocates the best credit policy suitable for the firm.

6. Acceleration of production cycle: With cash available for credit sales, client
firm’s liquidity will improve. In this way its production cycle will be accelerated.

7. Adequate credit period for customers: Customers get adequate credit period for
payment of assigned debts.

8. Competitive terms to offer: The client firm will be able to offer competitive
terms to its buyers. This will improve its sales and profits.

Limitations of Factoring

The main limitations of factoring are outlined as below:

1. Factoring may lead to over-confidence in the behaviour of the client. This

results in overtrading or mismanagement.
2. There are chances of fraudulent acts on the part of the client. Invoicing against
non-existent goods, duplicate invoicing etc. are some commonly found frauds.
These would create problems to the factors.

3. Lack of professionalism and competence, resistance to change etc. are some of

the problems which have made factoring services unpopular.

4. Factoring is not suitable for small companies with lesser turnover, companies
with speculative business, companies having large number of debtors for small
amounts etc.

5. Factoring may impose constraints on the way to do business. For non - recourse
fac–oring most factors will want to pre- approve customers. This may cause
delays. Further ,the factor will apply credit limits to individual customers.

Modus of Operations of Factoring

The following are the steps for factoring:

1. The customer places an order with the seller (client).
2. The factor and the seller enter into a factoring agreement about the various
terms of factoring.
3. Sale contract is entered into with the buyer and the goods are delivered.
4. The invoice with the notice to pay the factor is sent alongwith.
5. The copy of invoice covering the above sale to the factor, who maintains
the sale ledger.
6. The factor prepays 80% of the invoice value.
7. The monthly statement are sent by the factor to the buyer.
8. Follow up action is initiated if there are any unpaid invoices.
9. The buyer settles the invoices on the expiry of the credit period allowed.
10.The balance 20% less the cost of factoring is paid by the factor to the client.

❖ Difference between Factoring And Forfeiting

The following are differences between factoring and forfeiting
 ❖ Difference between Bill Discounting and Factoring
Bills Discounting Factoring
1. Finance alone is provided. 1. In addition to the provision of finance,
several other services like maintenance of
sales ledger,
advisory services etc. are provided.
2. Advances are made against bills. 2. Receivables are purchased by assignment.
3. Drawer or holder is the collector of 3. Factor is the collector of receivables.
receivables.
4. It is individual transaction-oriented. 4. Bulk finance is provided (i.e., based on
whole turnover)
5. It is not an off-balance sheet method of 5. It is off-balance sheet method finance.
finance.
6. Stamp duty is charged on bills. 6. No stamp duty is charged on invoices.

7. The grace period for payment is usually 3 7. The grace period is higher.
days.
8. Does not involve assignment of debts. 8. It involves assignment of debts.

9. Bills discounted may be rediscounted 9. Debts purchased cannot be rediscounted;

several times before the due date. they can only be refinanced.
10. It is always with recourse. 10.It may be with or without recourse.

❖ Forfaiting

Generally there is a delay in getting payment by the exporter from the importer.
This makes it difficult for the exporter to expand his export business. However,
for getting immediate payment, the concept of forfeiting shall come to the help
of exporters. The concept of forfaiting was originally developed to help finance
German exports to Eastern block countries. In fact, it evolved in Switzerland in
mid 1960s.
Meaning of Forfaiting
The term ‘forfait’ is a French world. It means ‘to surrender something’ or ‘give
up one’s right’. Thus forfaiting means giving up the right of exporter to the
forfaitor to receive payment in future from the importer.

Characteristics of Forfaiting
The main characteristics of forfaiting are:
1. It is 100% financing without recourse to the exporter.
2. The importer’s obligation is normally supported by a local bank guarantee (i.e.,
‘aval’).
3. Receivables are usually evidenced by bills of exchange, promissory notes or
letters of credit.
4. Finance can be arranged on a fixed or floating rate basis.
5. Forfaiting is suitable for high value exports such as capital goods, consumer
durables,
vehicles, construction contracts, project exports etc.
6. Exporter receives cash upon presentation of necessary documents, shortly after
shipment.

Advantages of Forfaiting
The following are the benefits of forfaiting:
1. The exporter gets the full export value from the forfaitor.
2. It improves the liquidity of the exporter. It converts a credit transaction into a
cash transaction.
3. It is simple and flexible. It can be used to finance any export transaction. The
structure of
finance can be determined according to the needs of the exporter, importer, and
the forfaitor.
4. The exporter is free from many export credit risks such as interest rate risk,
exchange rate risk, political risk, commercial risk etc.
5. The exporter need not carry the receivables into his balance sheet.
6. It enhances the competitive advantage of the exporter. He can provide more
credit. This
increases the volume of business.
7. There is no need for export credit insurance. Exporter saves insurance costs.
He is relieved
from the complicated procedures also.
8. It is beneficial to forfaitor also. He gets immediate income in the form of
discount. He can also sell the receivables in the secondary market or to any
investor for cash.
Mechanism:
Step 1:The exporter approaches a forfaiter before finalizing the transaction’s
structure with the importer.
Step 2:Once the forfaiter commits to the deal and sets the discount rate, the
exporter can incorporate the discount into the selling price.
Step 3:The exporter then accepts a commitment issued by the forfaiter, signs the
contract with the importer, and obtains, if required, a guarantee from the
importer’s bank that provides the documents required to complete the forfaiting.
Step 4:The exporter delivers the goods to the importer and delivers the
documents to the forfaiter who verifies them and pays for them as agreed in the
commitment. Since this payment is without recourse, the exporter has no further
interest in the financial aspects of the transaction and it is the forfaiter who must
collect the future payments due from the importer.
 ❖ Merchant Banking

The word ‘merchant banking’ was originated among the Dutch and Scottish
traders. Later on it was developed and professionalised in the UK and the USA.
Now this has become popular throughout the world.

Meaning and Definition of Merchant Banking

Merchant banking is non-banking financial activity. But it resembles banking

function. It is a financial service. It includes the entire range of financial services.

The term merchant banking is used differently in different countries. So there is

no universal definition for merchant banking. We can define merchant banking
as a process of transferring capital from those who own it to those who use it.
According to Random House Dictionary,

“merchant bank is an organization that underwriters securities for corporations,

advices such clients on mergers and is involved in the ownership of commercial
ventures. These organizations are sometimes banks which are not merchants and
sometimes merchants who are not bankers and sometimes houses which neither
merchants nor banks”. According to SEBI (Merchant Bankers)

Rules 1992, “A merchant banker has been defined as any person who is engaged
in the business of issue management either by making arrangements regarding
selling, buying or subscribing to securities or acting as manager, consultant
advisor or rendering corporate advisory services in relation to such issue
management”. In short, “merchant bank refers to an organization that underwrites
securities and advises such clients on issues like corporate mergers, involving in
the ownership of commercial ventures”.

Thus merchant banking involves a wide range of activities such as management

of customer services, portfolio management, credit syndication, acceptance credit,
counseling, insurance, preparation of feasibility reports etc. It is not necessary for
a merchant banker to carry out all the above mentioned activities. A merchant
banker may specialise in one activity, and take up other activities, which may be
complementary or supportive to the specialized activity.

In short, merchant banking involves servicing any financial need of the client.
Difference between Merchant Bank and Commercial Bank Merchant banks are
different from commercial banks. The following are the important differences
between merchant banks and commercial banks:
1. Commercial banks basically deal in debt and debt related finance. Their
activities are clustered around credit proposals, credit appraisal and loan sanctions.
On the other hand, the area of activity of merchant bankers is equity and equity
related finance. They deal with mainly funds raised through money market and
capital market.

2. Commercial banks’ lending decisions are based on detailed credit analysis of

loan proposals and the value of security offered. They generally avoid risks. They
are asset oriented. But merchant bankers are management oriented. They are
willing to accept risks of business.

3. Commercial banks are merely financiers. They do not undertake project

counselling, corporate counselling, managing public issues, underwriting public
issues, advising on portfolio management etc. The main activity of merchant
bankers is to render financial services for their clients. They undertake project
counselling, corporate counselling in areas of capital restructuring, mergers,
takeovers etc., discounting and rediscounting of short-term paper in money
markets, managing and underwriting public issues in new issue market and acting
as brokers and advisors on portfolio management.

Functions (Services) of Merchant Bankers (Scope of Merchant Banking)

(Lead Manager)

Merchant banks have been playing an important role in procuring the funds for
capital market for the corporate sector for financing their operations. They
perform some valuable functions. The functions of merchant banks in India are
as follows:

1. Corporate counselling: One of the important functions of a merchant banker is

corporate counselling. Corporate counselling refers to a set of activities
undertaken to ensure efficient functioning of a corporate enterprise through
effective financial management. A merchant banker guides the client on aspects
of organizational goals, vocational factors, organization size, choice of product,
demand forecasting, cost analysis, allocation of resources, investment decisions,
capital and expenditure management, marketing strategy, pricing methods etc.

The following activities are included in corporate counselling:

(a) Providing guidance in areas of diversification based on the Government’s

economic and licensing policies.
(b) Undertaking appraisal of product lines, analyzing their growth and
profitability and forecasting future trends.

(c) Rejuvenating old-line companies and ailing sick units by appraising their
technology and process, assessing their requirements and restructuring their
capital base.

(d) Assessment of the revival prospects and planning for rehabilitation through
modernization and diversification and revamping of the financial and
organizational structure.

(e) Arranging for the approval of the financial institutions/banks for schemes of
rehabilitation involving financial relief, etc.

(f) Monitoring of rehabilitation schemes.

(g) Exploring possibilities for takeover of sick units and providing assistance in
making consequential arrangements and negotiations with financial
institutions/banks and other interests/authorities involved.

2. Project counselling: Project counselling relates to project finance. This

involves the study of the project, offering advisory services on the viability and
procedural steps for its implementation. Project counselling involves the
following activities:

(a) Undertaking the general review of the project ideas/project profile.

(b) Providing advice on procedural aspects of project implementation.

(c) Conducting review of technical feasibility of the project on the basis of the
report prepared by own experts or by outside consultants.

(d) Assisting in the preparation of project report from a financial angle, and
advising and acting on various procedural steps including obtaining government
consents for implementation of the project.

(e) Assisting in obtaining approvals/licenses/permissions/grants, etc from

government agencies in the form of letter of intent, industrial license, DGTD
registration, and government approval for foreign collaboration.

(f) Identification of potential investment avenues.

(g) Arranging and negotiating foreign collaborations, amalgamations, mergers,
and takeovers.

(h) Undertaking financial study of the project and preparation of viability reports
to advise on the framework of institutional guidelines and laws governing
corporate finance.

(i) Providing assistance in the preparation of project profiles and feasibility

studies based on preliminary project ideas, covering the technical, financial and
economic aspects of the project from the point of view of their acceptance by
financial institutions and banks.

(j) Advising and assisting clients in preparing applications for financial assistance
to various national financial institutions, state level institutions, banks, etc.

3. Pre-investment studies: Another function of a merchant banker is to guide the

entrepreneurs in conducting pre-investment studies. It involves detailed
feasibility study to evaluate investment avenues to enable to decide whether to
invest or not. The important activities involved in preinvestment studies are as
follows:

(a) Carrying out an in-depth investigation of environment and regulatory factors,

location of raw material supplies, demand projections and financial requirements
in order to assess thefinancial and economic viability of a given project.

(b) Helping the client in identifying and short-listing those projects which are
built upon the client’s inherent strength with a view to promote corporate
profitability and growth in the longrun.

(c) Offering a package of services, including advice on the extent of participation,

governmentregulatory factors and an environmental scan of certain industries in
India.

4. Loan syndication: A merchant banker may help to get term loans from banks
and financial institutions for projects. Such loans may be obtained from a single
financial institution or asyndicate or consortium. Merchant bankers help
corporate clients to raise syndicated loans from commercial banks. The following
activities are undertaken by merchant bankers under loan syndication:

(a) Estimating the total cost of the project to be undertaken.

(b) Drawing up a financing plan for the total project cost which conforms to the
requirements of the promoters and their collaborators, financial institutions and
banks, government agencies and underwriters.

(c) Preparing loan application for financial assistance from term lenders/financial
institutions/banks, and monitoring their progress, including pre-sanction
negotiations.

(d) Selecting institutions and banks for participation in financing.

(e) Follow-up of term loan application with the financial institutions and banks,
and obtaining the approval for their respective share of participation.

(f) Arranging bridge finance.

(g) Assisting in completion of formalities for drawing of term finance sanctioned

by institutions by expediting legal documentation formalities, drawing up
agreements etc. as prescribed by the participating financial institutions and banks.

(h) Assessing working capital requirements.

5. Issue management: Issue management involves marketing or corporate

securities by offering them to the public. The corporate securities include equity
shares, preference shares, bonds, debentures etc. Merchant bankers act as
financial intermediaries. They transfer capital from those who own it to those who
need it. The security issue function may be broadly classified into two – pre-issue
management and post-issue management. The pre-issue management involves
the following functions:

(a) Public issue through prospectus.

(b) Marketing and underwriting.

(c) Pricing of issues.

These may be briefly discussed as follows:

(a) Public issue through prospectus: To being out a public issue, merchant bankers
have to coordinate the activities relating to issue with different government and
public bodies, professionals and private agencies. First the prospectus should be
drafter. The copies of consent of experts, legal advisor, attorney, solicitor,
bankers, and bankers to the issue, brokers and underwriters are to be obtained
from the company making the issue. These copies are to be filed along with the
prospectus To the Registrar Companies. After the prospectus is ready, it has to be
sent to the SEBI for clearance. It is only after clearance by SEBI, the prospectus
can be filed with the Registrar. The brokers to the issue, principal agent and
bankers to issue are appointed by merchant bankers.

(b) Marketing and underwriting: After sending prospectus to SEBI, the merchant
bankers arrange a meeting with company representatives and advertising agents
to finalise arrangements relating to date of opening and closing of issue,
registration of prospectus, launching publicity campaigns and fixing date of board
meeting to approve and pass the necessary resolutions. The role of merchant
banker in publicity campaigns to help selecting the media, determining the size
and publications in which the advertisement should appear. The merchant bank
shall decide the number of copies to be printed, check accuracy of statements
made and ensure that the size of the application form and prospectus are as per
stock exchange regulations. The merchant banker has to ensure that he material
is delivered to the stock exchange at least 21 days before the issue opens and to
the brokers to the issue, and underwriters in time.

(c) Pricing of issues: Pricing of issues is done by companies themselves in

consultation with the merchant bankers. An existing listed company and a new
company set up by an existing company with 5 year track record and existing
private closely held company and existing unlisted company going in for public
issues for the first time with 2 ½ years track record of constant profitability can
freely price the issue. The premium can be determined after taking into
consideration net asset value, profit earning capacity and market price. The price
and premium has to be stated in the prospectus. Post-issue management consists
of collection of application forms and statement of amount received from bankers,
screening applications, deciding allotment procedures, mailing of allotment
letters, share certificates and refund orders. Merchant bankers help the company
by co-ordinating the above activities.

6. Underwriting of public issue: In underwriting of public issue the activities

performed by merchant bankers are as follows:

(a) Selection of institutional and broker underwriters for syndicating/

underwriting arrangements.

(b) Obtaining the approval of institutional underwriters and stock exchanges for
publication of the prospectus.
(c) Co-ordination with the underwriters, brokers and bankers to the issue, and the
Stock Exchanges.

7. Portfolio management: Merchant bankers provide portfolio management

service to their clients. Today every investor is interested in safety, liquidity and
profitability of his investment. But investors cannot study and choose the
appropriate securities. Merchant bankers help the investors in this regard. They
study the monetary and fiscal policies of the government. They study the financial
statements of companies in which the investments have to be made by investors.
They also keep a close watch on the price movements in the stock market. The
merchant bankers render the following services in connection with portfolio
management:

(a) Undertaking investment in securities.

(b) Collection of return on investment and re-investment of the same in profitable

avenues, investment advisory services to the investors and other related services.

(c) Providing advice on selection of investments.

(d) Carrying out a critical evaluation of investment portfolio.

(e) Securing approval from RBI for the purchase/sale of securities (for NRI
clients).

(f) Collecting and remitting interest and dividend on investment.

(g) Providing tax counselling and filing tax returns through tax consultants.

8. Merger and acquisition: A merger is a combination of two or more companies

into a single company where one survives and others lose their corporate
existence. A takeover refers to the purchase by one company acquiring
controlling interest in the share capital of another existing company. Merchant
bankers are the middlemen in setting negotiation between the offered and offer
or. Being a professional expert they are apt to safeguard the interest of the
shareholders in both the companies. Once the merger partner is proposed, the
merchant banker appraises merger/takeover proposal with respect to financial
viability and technical feasibility. He negotiates purchase consideration and mode
of payment. He gets approval from the government/RBI, drafts scheme of
amalgamation and obtains approval from financial institutions.
9. Foreign currency financing: The finance provided to fund foreign trade
transactions is called ‘Foreign Currency Finance’. The provision of foreign
currency finance takes the form of exportimport trade finance, euro currency
loans, Indian joint ventures abroad and foreign collaborations.

The main areas that are covered in this type of merchant activity are as follows:

(a) Providing assistance for carrying out the study of turnkey and construction
contract projects.

(b) Arranging for the syndication of various types of guarantees, letters of credit,
pre-shipment credit, deferred post-shipment credit, bridge loans, and other credit
facilities.

(c) Providing assistance in opening and operating bank accounts abroad.

(d) Arranging foreign currency loans under buyer’s credit scheme for importing
goods.

(e) Arranging deferred payment guarantees under suppliers credit scheme for
importing capital goods.

(f) Providing assistance in obtaining export credit facilities from the EXIM bank
for export of capital goods, and arranging for the necessary government approvals
and clearance.

(g) Undertaking negotiations for deferred payment, export finance, buyers credits,
documentary credits, and other foreign exchange services like packing credit, etc.

10. Working capital finance: The finance required for meeting the day-to-day
expenses of an enterprise is known as ‘Working Capital Finance’. Merchant
bankers undertake the following activities as part of providing this type of finance:

(a) Assessment of working capital requirements.

(b) Preparing the necessary application to negotiations for the sanction of

appropriate credit facilities.

11. Acceptance credit and bill discounting: Merchant banks accept and discount
bills of exchange on behalf of clients. Merchant bankers give loans to business
enterprises on the security of bill of exchange. For this purpose, merchant bankers
collect credit information relating to the clients and undertake rating their
creditworthiness.
12. Venture financing: Another function of a merchant banker is to provide
venture finance to projects. It refers to provision of equity finance for funding
high-risk and high-reward projects.

13. Lease financing: Leasing is another function of merchant bankers. It refers to

providing financial facilities to companies that undertake leasing. Leasing
involves letting out assets on lease for a particular period for use by the lessee.
The following services are provided by merchant bankers in connection with
lease finance:

(a) Providing advice on the viability of leasing as an alternative source for

financing capital investment projects.

(b) Providing advice on the choice of a favourable rental structure.

(c) Providing assistance in establishing lines of lease for acquiring capital

equipment, including preparation of proposals, documentations, etc.

14. Relief to sick industries: Merchant bankers render valuable services as a part
of providing relief to sick industries.

15. Project appraisal: Project appraisal refers to evaluation of projects from

various angles such as technology, input, location, production, marketing etc. It
involves financial appraisal, marketing appraisal, technical appraisal, economic
appraisal etc. Merchant bankers render valuable services in the above areas.

The functions of merchant banker can be summarized as follows:

(a) Issue management.

(b) Underwriting of issues.

(c) Project appraisal.

(d) Handling stock exchange business on behalf of clients.

(e) Dealing in foreign exchange.

(f) Floatation of commercial paper.

(g) Acting as trustees.

(h) Share registration.

(i) Helping in financial engineering activities of the firm.

(j) Undertaking cost audit.

(k) Providing venture capital.

(l) Arranging bridge finance.

(m) Advising business customers (i.e. mergers and takeovers).

(n) Undertaking management of NRI investments.

(o) Large scale term lending to corporate borrowers.

(p) Providing corporate counseling and advisory services.

(q) Managing investments on behalf of clients.

(r) Acting as a stock broker.

Objectives of Merchant Banking

The objectives of merchant banking are as follows:

1. To help for capital formation.

2. To create a secondary market in order to boost the industrial activities in the

country.

3. To assist and promote economic endeavour.

4. To prepare project reports, conduct market research and pre-investment

surveys.

5. To provide financial assistance to venture capital.

6. To build a data bank as human resources.

7. To provide housing finance.

8. To provide seed capital to new enterprises.

9. To involve in issue management.

10. To act as underwriters.

11. To identify new projects and render services for getting clearance from
government.
12. To provide financial clearance.

13. To help in mobilizing funds from public.

14. To divert the savings of the country towards productive channel.

15. To conduct investors conferences.

16. To obtain consent of stock exchange for listing.

17. To obtain the daily report of application money collected at various branches
of banks.

18. To appoint bankers, brokers, underwrites etc.

19. To supervise the process on behalf of NRIs for their ventures.

20. To provide service on fund based activities.

21. To assist in arrangement of loan syndication.

22. To act as an acceptance house.

23. To assist in and arrange mergers and acquisitions.

Role of Merchant Bankers in Managing Public Issue

In issue management, the main role of merchant bankers is to help the company
issuing securities in raising funds for the purpose of financing new projects,
expansion/ modernization/ diversification of existing units and augmenting long
term resources for working capital

requirements.

The most important aspect of merchant banking business is to function as lead

managers to the issue management. The role of the merchant banker as an issue
manager can be studied from the following points:

1. Easy fund raising: An issue manager acts as an indispensable pilot facilitating

a public/ rights issue. This is made possible with the help of special skills
possessed by him to execute the management of issues.

2. Financial consultant: An issue manager essentially acts as a financial architect,

by providing advice relating to capital structuring, capital gearing and financial
planning for the company.
3. Underwriting: An issue manager allows for underwriting the issues of
securities made by corporate enterprises. This ensures due subscription of the
issue.

4. Due diligence: The issue manager has to comply with SEBI guidelines. The
merchant banker will carry out activities with due diligence and furnish a Due
Diligence Certificate to SEBI.

The detailed diligence guidelines that are prescribed by the Association of

Merchant Bankers of India (AMBI) have to be strictly observed. SEBI has also
prescribed a code of conduct for merchant bankers.

5. Co-ordination: The issue manger is required to co-ordinate with a large number

of institutions and agencies while managing an issue in order to make it successful.

6. Liaison with SEBI: The issue manager, as a part of merchant banking activities,
should register with SEBI. While managing issues, constant interaction with the
SEBI is required by way of filing of offer documents, etc. In addition, they should
file a number of reports relating to the issues being managed.

❖ What is a Stockbroker?

A stockbroker is a regulated representative of the financial market who enables

the buying and selling of securities on behalf of financial institutions, investor
clients, and firms. A stockbroker is also called a registered representative or a
broker. The trading or purchase or sale of stocks on the national stock exchanges
are usually executed through a stockbroker.
Stockbrokers handle transactions for both institutional and retail customers. The
primary job of a stockbroker is to obtain buy and sell orders and execute them.
Many market participants depend on stockbrokers’ knowledge and expertise
regarding the dynamics of the market to invest in securities. A stockbroker can
work either individually or with a brokerage firm. Sometimes, broker-dealers and
brokerage firms are also called stockbrokers.
Types of Stockbrokers

The choice of a stockbroker should be related to the trading needs of the

traders. Traders should focus on their trading strategy and choose a
stockbroker who will help meet their trading needs. For example, for short-
selling stocks, traders would need to find stockbrokers with a deep list of
stocks available to short.

The following are the various types of stockbrokers:

1. Full-Service Stockbroker
A full-service stockbroker offers a variety of financial services to clients.
Usually, clients are assigned individual licensed stockbrokers. The
brokerage firms employ research departments providing analyst
recommendations and access to initial public offerings (IPOs).

Full-service stockbrokers also provide services like financial planning,

business and personal home loans, banking services, and asset
management. Clients can either contact their personal stockbroker for
trading options or use mobile and online platforms.

However, stockbrokers offering trading functions and online access charge

higher commissions. Moreover, as the online platforms of full-service
stockbrokers usually cater to long-term investors, the platforms provide
fewer indicators and tools for day trading investors.

2. Discount Stockbroker
Discount stockbrokers provide financial products, access to mutual funds,
banking products, and other services. A discount stockbroker offers many
products and services that are similar to a full-service stockbroker, but with
smaller commissions.

Hence, swing traders and day traders who are more active may find
discount stockbrokers appealing. Moreover, the platforms serve active day
traders and investors; hence, they provide more research tools and trading
options than full-service platforms.

3. Online Stockbroker
Also called a direct access stockbroker, an online stockbroker offers
services to active day traders with the smallest commission – usually priced
on a per-stock basis. Online stockbrokers offer direct access platforms with
capabilities of routing and charting, and access to multiple exchanges,
market makers, and electronic communication networks (ECN).

Also, online stockbrokers offer the advantages of access and speed,

allowing executions of orders on point-and-click. The platforms also
enable the placing of complex options and stock orders. The access to
heavy-duty platforms usually comes with a monthly fee consisting of
software and exchange fees; however, the software fees can be discounted
or waived depending on the actual number of shares traded monthly by the
client.
Qualifications of a Stockbroker

Education
An undergraduate degree in finance or business administration is required
if a stockbroker seeks to work with an institutional client. Additionally, an
understanding of accounting methods, financial forecasting and planning,
and related laws and regulations is preferred.

Experience
A stockbroker can start working with a brokerage firm in any role, even as
a college intern, and gain experience on the job. However, to be a
stockbroker, he/she must show a strong understanding of accounting
standards and regulations of the financial market.

Exams
A stockbroker must pass the General Securities Representative Exam,
controlled by the Financial Industry Regulatory Authority (FINRA). A
person needs to be financed by a member firm of FINRA or a Self-
Regulatory Organization (SRO).

Additional Resources
CFI is the official provider of the Capital Markets & Securities Analyst
(CMSA)™ certification program, designed to transform anyone into a
world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we

highly recommend the additional resources below:

Alternative Trading System (ATS)

Institutional Investor
Trade Order
Self-Regulatory Organization (SRO)
❖ Introduction to Derivatives
We move on to the world of derivatives – considered one of the most
complex financial instruments.

The derivative market in India, like its counterparts abroad, is increasingly

gaining significance. Since the time derivatives were introduced in the year
2000, their popularity has grown manifold. This can be seen from the fact
that the daily turnover in the derivatives segment on the National Stock
Exchange currently stands at Rs. crore, much higher than the turnover
clocked in the cash markets on the same exchange.
Here we decode it for you.

If you want to read up our latest reports on derivatives markets, you can
click here.

WHAT ARE DERIVATIVES:

Derivatives are financial contracts that derive their value from an
underlying asset. These could be stocks, indices, commodities, currencies,
exchange rates, or the rate of interest. These financial instruments help you
make profits by betting on the future value of the underlying asset. So, their
value is derived from that of the underlying asset. This is why they are
called ‘Derivatives’.

You can read about the advantages of trading in futures and options here.

Derivatives types

The value of the underlying assets changes every now and then.

For example, a stock’s value may rise or fall, the exchange rate of a pair of
currencies may change, indices may fluctuate, commodity prices may
increase or decrease. These changes can help an investor make profits.
They can also cause losses. This is where derivatives come handy. It could
help you make additional profits by correctly guessing the future price, or
it could act as a safety net from losses in the spot market, where the
underlying assets are traded.

To understand the RBI rules about futures, click here.

WHAT IS THE USE OF DERIVATIVES:

In the Indian markets, futures and options are standardized contracts, which
can be freely traded on exchanges. These could be employed to meet a
variety of needs.

USE OF DERIVATIVES |
Earn money on shares that are lying idle:

So you don’t want to sell the shares that you bought for long term, but want
to take advantage of price fluctuations in the short term. You can use
derivative instruments to do so. Derivatives market allows you to conduct
transactions without actually selling your shares – also called as physical
settlement.

Benefit from arbitrage:

When you buy low in one market and sell high in the other market, it called
arbitrage trading. Simply put, you are taking advantage of differences in
prices in the two markets.

Protect your securities against

fluctuations in prices The derivative market offers products that allow you
to hedge yourself against a fall in the price of shares that you possess. It
also offers products that protect you from a rise in the price of shares that
you plan to purchase. This is called hedging.

Transfer of risk:

By far, the most important use of these derivatives is the transfer of market
risk from risk-averse investors to those with an appetite for risk. Risk-
averse investors use derivatives to enhance safety, while risk-loving
investors like speculators conduct risky, contrarian trades to improve
profits. This way, the risk is transferred. There are a wide variety of
products available and strategies that can be constructed, which allow you
to pass on your risk.

If the benefits have intrigued you enough and you want to start trading right
away, here is how to buy and sell future contracts.

DERIVATIVE TRADING

WHO ARE THE PARTICIPANTS IN DERIVATIVES MARKETS:

On the basis of their trading motives, participants in the derivatives markets
can be segregated into four categories – hedgers, speculators, margin
traders and arbitrageurs. Let's take a look at why these participants trade in
derivatives and how their motives are driven by their risk profiles.

Hedgers: Traders, who wish to protect themselves from the risk involved
in price movements, participate in the derivatives market. They are called
hedgers. This is because they try to hedge the price of their assets by
undertaking an exact opposite trade in the derivatives market. Thus, they
pass on this risk to those who are willing to bear it. They are so keen to rid
themselves of the uncertainty associated with price movements that they
may even be ready to do so at a predetermined cost.

For example, let's say that you possess 200 shares of a company – ABC
Ltd., and the price of these shares is hovering at around Rs. 110 at present.
Your goal is to sell these shares in six months. However, you worry that
the price of these shares could fall considerably by then. At the same time,
you do not want to liquidate your investment today, as the stock has a
possibility of appreciation in the near-term.

You are very clear about the fact that you would like to receive a minimum
of Rs. 100 per share and no less. At the same time, in case the price rises
above Rs. 100, you would like to benefit by selling them at the higher price.
By paying a small price, you can purchase a derivative contract called an
'option' that incorporates all your above requirements. This way, you
reduce your losses, and benefit, whether or not the share price falls. You
are, thus, hedging your risks, and transferring them to someone who is
willing to take these risks.

If you’re a hedger looking to shield your portfolio against small-cap crash,

you might want to read up on 5 ways to hedge against a small-cap crash.

Speculators: As a hedger, you passed on your risk to someone who will

willingly take on risks from you. But why someone do that? There are all
kinds of participants in the market.

Some might be averse to risk, while some people embrace them. This is
because, the basic market idea is that risk and return always go hand in
hand. Higher the risk, greater is the chance of high returns. Then again,
while you believe that the market will go up, there will be people who feel
that it will fall. These differences in risk profile and market views
distinguish hedgers from speculators. Speculators, unlike hedgers, look for
opportunities to take on risk in the hope of making returns.

Let's go back to our example, wherein you were keen to sell the 200 shares
of company ABC Ltd. after one month, but feared that the price would fall
and eat your profits. In the derivative market, there will be a speculator
who expects the market to rise. Accordingly, he will enter into an
agreement with you stating that he will buy shares from you at Rs. 100 if
the price falls below that amount. In return for giving you relief from this
risk, he wants to be paid a small compensation. This way, he earns the
compensation even if the price does not fall and you wish to continue
holding your stock.
This is only one instance of how a speculator could gain from a derivative
product. For every opportunity that the derivative market offers a risk-
averse hedger, it offers a counter opportunity to a trader with a healthy
appetite for risk.

In the Indian markets, there are two types of speculators – day traders and
the position traders.

A day trader tries to take advantage of intra-day fluctuations in prices. All

their trades are settled by by undertaking an opposite trade by the end of
the day. They do not have any overnight exposure to the markets.
On the other hand, position traders greatly rely on news, tips and technical
analysis – the science of predicting trends and prices, and take a longer
view, say a few weeks or a month in order to realize better profits. They
take and carry position for overnight or a long term.
If you’re a beginner at intra-day trading, you might want to read up on what
Kotak Securities has to say here.

Margin traders: Many speculators trade using of the payment mechanism

unique to the derivative markets. This is called margin trading. When you
trade in derivative products, you are not required to pay the total value of
your position up front. . Instead, you are only required to deposit only a
fraction of the total sum called margin. This is why margin trading results
in a high leverage factor in derivative trades. With a small deposit, you are
able to maintain a large outstanding position. The leverage factor is fixed;
there is a limit to how much you can borrow. The speculator to buy three
to five times the quantity that his capital investment would otherwise have
allowed him to buy in the cash market. For this reason, the conclusion of a
trade is called ‘settlement’ – you either pay this outstanding position or
conduct an opposing trade that would nullify this amount.

For example, let's say a sum of Rs. 1.8 lakh fetches you 180 shares of ABC
Ltd. in the cash market at the rate of Rs. 1,000 per share. Suppose margin
trading in the derivatives market allows you to purchase shares with a
margin amount of 30% of the value of your outstanding position. Then,
you will be able to purchase 600 shares of the same company at the same
price with your capital of Rs. 1.8 lakh, even though your total position is
Rs. 6 lakh.

If the share price rises by Rs. 100, your 180 shares in the cash market will
deliver a profit of Rs. 18,000, which would mean a return of 10% on your
investment. However, your payoff in the derivatives market would be
much higher. The same rise of Rs. 100 in the derivative market would fetch
Rs. 60,000, which translates into a whopping return of over 33% on your
investment of Rs. 1.8 lakh. This is how a margin trader, who is basically a
speculator, benefits from trading in the derivative markets.

Arbitrageurs: Derivative instruments are valued on the basis of the

underlying asset’s value in the spot market. However, there are times when
the price of a stock in the cash market is lower or higher than it should be,
in comparison to its price in the derivatives market.

Arbitrageurs exploit these imperfections and inefficiencies to their

advantage. Arbitrage trade is a low-risk trade, where a simultaneous
purchase of securities is done in one market and a corresponding sale is
carried out in another market. These are done when the same securities are
being quoted at different prices in two markets.

In the earlier example, suppose the cash market price is Rs. 1000 per share,
but is quoting at Rs. 1010 in the futures market. An arbitrageur would
purchase 100 shares at Rs. 1000 in the cash market and simultaneously,
sell 100 shares at Rs. 1010 per share in the futures market, thereby making
a profit of Rs. 10 per share.

Speculators, margin traders and arbitrageurs are the lifeline of the capital
markets as they provide liquidity to the markets by taking long (purchase)
and short (sell) positions. They contribute to the overall efficiency of the
markets.

Whether you are an Arbitrageur, Speculator, Margin Trader or Hedger, you

stand to benefit from Kotak Securities extensive research reports. Click
here to read the latest research reports on derivatives market.

WHAT ARE THE DIFFERENT TYPES OF DERIVATIVE

CONTRACTS:
There are four types of derivative contracts – forwards, futures, options and
swaps. However, for the time being, let us concentrate on the first three.
Swaps are complex instruments that are not available for trade in the stock
markets.

Futures and forwards: Futures are contracts that represent an agreement to

buy or sell a set of assets at a specified time in the future for a specified
amount. Forwards are futures, which are not standardized. They are not
traded on a stock exchange.
For example, in the derivatives market, you cannot buy a contract for a
single share. It is always for a lot of specified shares and expiry date. This
does not hold true for forward contracts. They can be tailored to suit your
needs.

Options: These contracts are quite similar to futures and forwards.

However, there is one key difference. Once you buy an options contract,
you are not obligated to hold the terms of the agreement.

This means, even if you hold a contract to buy 100 shares by the expiry
date, you are not required to. Options contracts are traded on the stock
exchange.

Read more about what is options trading.

DERIVATIVES INSTRUMENT | Kotak Securities®

HOW ARE DERIVATIVE CONTRACTS LINKED TO STOCK

PRICES:
Suppose you buy a Futures contract of Infosys shares at Rs 3,000 – the
stock price of the IT company currently in the spot market. A month later,
the contract is slated to expire. At this time, the stock is trading at Rs 3,500.
This means, you make a profit of Rs. 500 per share, as you are getting the
stocks at a cheaper rate.

Had the price remained unchanged, you would have received nothing.
Similarly, if the stock price fell by Rs. 800, you would have lost Rs. 800.
As we can see, the above contract depends upon the price of the underlying
asset – Infosys shares. Similarly, derivatives trading can be conducted on
the indices also. Nifty Futures is a very commonly traded derivatives
contract in the stock markets. The underlying security in the case of a Nifty
Futures contract would be the 50-share Nifty index.

HOW TO TRADE IN DERIVATIVES MARKET:

Trading in the derivatives market is a lot similar to that in the cash segment
of the stock market.

First do your research. This is more important for the derivatives market.
However, remember that the strategies need to differ from that of the stock
market. For example, you may wish you buy stocks that are likely to rise
in the future. In this case, you conduct a buy transaction. In the derivatives
market, this would need you to enter into a sell transaction. So the strategy
would differ.
Arrange for the requisite margin amount. Stock market rules require you
to constantly maintain your margin amount. This means, you cannot
withdraw this amount from your trading account at any point in time until
the trade is settled. Also remember that the margin amount changes as the
price of the underlying stock rises or falls. So, always keep extra money in
your account.
Conduct the transaction through your trading account. You will have to
first make sure that your account allows you to trade in derivatives. If not,
consult your brokerage or stock broker and get the required services
activated. Once you do this, you can place an order online or on phone with
your broker.
Select your stocks and their contracts on the basis of the amount you have
in hand, the margin requirements, the price of the underlying shares, as
well as the price of the contracts. Yes, you do have to pay a small amount
to buy the contract. Ensure all this fits your budget.
You can wait until the contract is scheduled to expiry to settle the trade. In
such a case, you can pay the whole amount outstanding, or you can enter
into an opposing trade. For example, you placed a ‘buy trade’ for Infosys
futures at Rs 3,000 a week before expiry. To exit the trade before, you can
place a ‘sell trade’ future contract. If this amount is higher than Rs 3,000,
you book profits. If not, you will make losses.

HOW TO TRADE IN DERIVATIVES MARKET BY Kotak Securities®

Thus, buying stock futures and options contracts is similar to buying shares
of the same underlying stock, but without taking delivery of the same. In
the case of index futures, the change in the number of index points affects
your contract, thus replicating the movement of a stock price. So, you can
actually trade in index and stock contracts in just the same way as you
would trade in shares.

WHAT ARE THE PRE-REQUISITES TO INVEST

As said earlier, trading in the derivatives market is very similar to trading
in the cash segment of the stock markets.

If you want to read up more about derivatives expiry, you can visit here.

This has three key requisites:

Demat account: This is the account which stores your securities in

electronic format. It is unique to every investor and trader.
Trading account: This is the account through which you conduct trades.
The account number can be considered your identity in the markets. This
 makes the trade unique to you. It is linked to the demat account, and thus
ensures that YOUR shares go to your demat account. Click here if you
want to open a trinity account that relives you from the hassles of operating
different demat, trading and savings bank accounts.
Margin maintenance: This pre-requisite is unique to derivatives trading.
While many in the cash segment too use margins to conduct trades, this is
predominantly used in the derivatives segment.

❖ Securitization of Debt/Assets

Loans given to customers are assets for the bank. They are called loan assets.
Unlike investment assets, loan assets are not tradable and transferable. Thus loan
assets are not liquid. The problem is how to make the loan of a bank liquid. This
problem can be solved by transforming the loans into marketable securities. Now
loans become liquid. They get the characteristic of marketability. This is done
through the process of securitization. Securitization is a financial innovation. It is
conversion of existing or future cash flows into marketable securities that can be
sold to investors. It is the process by which financial assets such as loan
receivables, credit card balances, hire purchase debtors, lease receivables, trade
debtors etc. are transformed into securities. Thus, any asset with predictable cash
flows can be securitized.

Securitization is defined as a process of transformation of illiquid asset into

security which may be traded later in the opening market. In short,
securitization is the transformation of illiquid, nonmarketable assets into
securities which are liquid and marketable assets. It is a process of transformation
of assets of a lending institution into negotiable instruments. Securitization is
different from factoring. Factoring involves transfer of debts without
transforming debts into marketable securities. But securitization always involves
transformation of illiquid assets into liquid assets that can be sold to investors.

Parties to a Securitisation Transaction

There are primarily three parties to a securitisation deal, namely -

a. The Originator: This is the entity on whose books the assets to be securitised
exist. It is the prime mover of the deal i.e. it sets up the necessary structures to
execute the deal. It sells the assets on its books and receives the funds generated
from such sale. In a true sale, the Originator transfers both the legal and the
beneficial interest in the assets to the SPV.
b. The SPV: The issuer also known as the SPV is the entity, which would
typically buy the assets (to be securitised) from the Originator. The SPV is
typically a low-capitalised entity with narrowly defined purposes and activities,
and usually has independent trustees/directors. As one of the main objectives of
securitisation is to remove the assets from the balance sheet of the Originator, the
SPV plays a very important role is as much as it holds the assets in its books and
makes the upfront payment for them to the Originator.

c. The Investors: The investors may be in the form of individuals or institutional

investors like FIs, mutual funds, provident funds, pension funds, insurance
companies, etc. They buy a participating interest in the total pool of receivables
and receive their payment in the form of interest and principal as per agreed
pattern. Besides these three primary parties, the other parties involved in a
securitisation deal are given below:

a) The Obligor(s): The Obligor is the Originator's debtor (bor’ower of the

original loan). The amount outstanding from the Obligor is the asset that is
transferred to the SPV. The credit standing of the Obligor(s) is of paramount
importance in a securitisation transaction.

b) The Rating Agency: Since the investors take on the risk of the asset pool
rather than the Originator, an external credit rating plays an important role. The
rating process would assess the strength of the cash flow and the mechanism
designed to ensure full and timely payment by the process of selection of loans
of appropriate credit quality, the extent of credit and liquidity support provided
and the strength of the legal framework.

c) Administrator or Servicer: It collects the payment due from the Obligor/s

and passes it to the SPV, follows up with delinquent borrowers and pursues legal
remedies available against the defaulting borrowers. Since it receives the
instalments and pays it to the SPV, it is also called the Receiving and Paying
Agent.

d) Agent and Trustee: It accepts the responsibility for overseeing that all the
parties to the securitisation deal perform in accordance with the securitisation
trust agreement. Basically, it is appointed to look after the interest of the investors.

e) Structurer: Normally, an investment banker is responsible as structurer for

bringing together the Originator, credit enhancer/s, the investors and other
partners to a securitisation deal. It also works with the Originator and helps in
structuring deals. The different parties to a securitisation deal have very different
roles to play. In fact, firms specialise in those areas in which they enjoy
competitive advantage. The entire process is broken up into separate parts with
different parties specialising in origination of loans, raising funds from the capital
markets, servicing of loans etc. It is this kind of segmentation of market roles that
introduces several efficiencies securitisation is so often credited with.

The advantages of securitisation:

1. Additional source of fund – by converting illiquid assets to liquid and

marketable assets.

2. Greater profitability- securitisation leads to faster recycling of fund and thus

leads to higher business turn over and profitability.

3. Enhancement of CAR- Securitisation enables banks and financial institutions

to enhance their capital adequacy ratio(CAR) by reducing their risky assets.

4. Spreading Credit Risks- securitisation facilitates the spreading of credit risks

to different parties involved in the process of securitisation such as SPV,
insurance companies(credit enhancer) etc.

5. Lower cost of funding- originator can raise funds immediately without much
cost of borrowing.

6. Provision of multiple instruments – from investors point of view,

securitisation provides multiple instruments so as to meet the varying
requirements of the investing public.

7. Higher rate of return- when compared to traditional debt securities like bonds
and debentures, securitised assets provides higher rates of return along with better
liquidity.

8. Prevention of idle capital- in the absence of securitisation, capital would

remain idle in the form of illiquid assets like mortgages, term loans etc.
Housing Finance

HOUSING FINANCE—A DOMINANT RETAIL FINANCING

Today one can witness a paradigm shift to housing finance. Housing finance has
become a lucrative business to many banking and non-banking companies.
Almost all financial institutions seem to concentrate on ‘retail financing’ rather
than ‘wholesale financing’. Lending to corporates and big institutional
borrowers is called wholesale lending or financing. On the other hand, lending
to individuals and group of individuals come under the category of ‘retail
financing’. In retail financing, housing finance grows at an impressive rate due
to various reasons. Easy access at affordable rates has accelerated the tempo of
housing activities in recent times. Different financial products have been
introduced to cater to the vast housing requirements of varied people. Housing
loans are given not only for construction, but also for extension, improvements
etc. Loans are given for furnishing houses and also for paying stamp duties.
Banks have come forward to waive the processing fees. Housing loans are
sanctioned with flexible repayment schedule which can be decided by the
customers themselves. Housing loans are sanctioned for family planning clinics,
health centers, educational, social, and cultural and other institutions also.
Shopping centers in residential areas can also avail of housing loan facilities.

Housing / home loan products

Generally, the following financial products are available in the housing market.

(i) Housing loan for purchase of homes – This product is available purely for
the purchase of either new houses or flats or existing ones.

(ii)House construction loan –This product is available only for the construction
of new houses.

(iii) Home extension loan-This is available purely for expanding an already

existing home.

(iv) Home improvement loan – This is granted for renovating an existing home.

(v)Flexible repayment plan – This type of housing loan permits the borrower to
fix the repayment schedule as per his option.

(vi) Flexible loan installment plan – Under this type of housing loan, the
borrower can decide the amount of installment to be paid according to his
discretion on the basis of his future earnings.

(vii)Home transfer or conversion loan – This product is available to those who

have already availed of housing loans and want to move to another house for
which additional funds are required. Under this type, the existing housing loan
is transferred to the new housing loan amount without the necessity of settling
the previous loan account.

(viii)Home furnishing loan – This product is available to furnish a house fully.

(ix) Housing repayment or refinance loan – This loan is available to redeem the
prior debts incurred for the purchase of homes from friends, relatives and other
private sources.

(x) Housing loan transfer plan – This loan is available to pay off an existing
housing loan with a higher interest rate and enjoy a new loan with a lower rate
of interest.

(xi) Bridge loan for housing – This product is available to those who wish to
sell their old homes and purchase another. This loan is available for the new
home until a suitable buyer is found for the old home.

(xii) Stamp duty /Documenting Loan- this is the HL product meant for payment
of stamp duty and other documentation charges in connection with house
purchases.

Housing finance institutions

A number of institutions play a dominant role in the field of housing finance.

The most important ones are the following:

I. National Housing Bank (NHB)

II. Commercial Banks

III. Cooperative Banks

IV. Housing and Urban Development Corporation Ltd. (HUDCO)

V. Private Finance Companies

VI. Insurance companies.

National Housing Bank

The National Housing Bank was set up on July 9, 1988 as an apex institution to
mobilize resources for the housing sector and to promote housing finance
institutions, both on regional and local levels. It was established as a subsidiary
of the RBI with a view to coordinating and developing housing finance
schemes. Following are the main functions of the NHB:

(i) To promote and develop specialized housing finance institutions for

mobilizing resources and supplying credit for house construction.
(ii) To provide refinance facilities to housing finance institutions and scheduled
banks.

(iii) To provide guarantee and underwriting facilities to housing finance

institutions.

(iv)To promote schemes for mobilization of resources and extension of credit

for housing especially for economically weaker sections of the society.

(v) To co-ordinate the working of all agencies connected with housing.

HDFC and Other Private Housing Finance Companies

The Housing Development and Finance Corporation (HDFC) was set up in the
private sector in 1977 by institutions like ICICI, IFC (International Finance
Corporation) etc. Today it has become the largest provider of housing finance in
India. It has pioneered a variety of housing loans like group loans, housing
complexes, housing societies etc. It lends to companies employers and
institutions to finance their house construction requirements for their
employees, staff quarters etc. It also provides loans to individuals, groups and
societies. Apart from the HDFC, many housing finance corporations have come
into existence in the private sector. Some of these institutions are:

a. Birla Home Finance Ltd. (NHFL)

b. Sundaram Home Finance Ltd. (SHFL)

c. Global Housing Finance Corporation Ltd. (GHFCL)

d. Dewan Housing Finance Corporation Ltd. (DHFCL)

e. Maharishi Housing Finance Corporation Ltd. (MHFCL)

f. Home Trust Housing Finance Corporation Ltd. (HHFCL).

These institutions have designed some innovative housing finance products so

as to cater to the requirements of various types of borrowers.

❖ What is Asset and Liability Management (ALM)?

Asset and liability management (ALM) is a practice used by financial
institutions to mitigate financial risks resulting from a mismatch of assets and
liabilities. ALM strategies employ a combination of risk management and
financial planning and are often used by organizations to manage long-term
risks that can arise due to changing circumstances.
The practice of asset and liability management can include many factors,
including strategic allocation of assets, risk mitigation, and adjustment of
regulatory and capital frameworks. By successfully matching assets against
liabilities, financial institutions are left with a surplus that can be actively
managed to maximize their investment returns and increase profitability.
Asset and liability management (ALM) is a practice used by financial
institutions to mitigate financial risks resulting from a mismatch of assets and
liabilities.
By strategically matching of assets and liabilities, financial institutions can
achieve greater efficiency and profitability while also reducing risk.
Some of the most common risks addressed by ALM are interest rate risk and
liquidity risk.

Understanding Asset and Liability Management

At its core, asset and liability management is a way for financial institutions
to address risks resulting from a mismatch of assets and liabilities. Most often,
the mismatches are a result of changes to the financial landscape, such as
changing interest rates or liquidity requirements.
A full ALM framework focuses on long-term stability and profitability by
maintaining liquidity requirements, managing credit quality, and ensuring
enough operating capital. Unlike other risk management practices, ALM is a
coordinated process that uses frameworks to oversee an organization’s entire
balance sheet. it ensures that assets are invested most optimally, and liabilities
are mitigated over the long-term.
Traditionally, financial institutions managed risks separately based on the type
of risk involved. Yet, with the evolution of the financial landscape, it is now
seen as an outdated approach. ALM practices focus on asset management and
risk mitigation on a macro level, addressing areas such as market, liquidity,
and credit risks.
Unlike traditional risk management practices, ALM is an ongoing process that
continuously monitors risks to ensure that an organization is within its risk
tolerance and adhering to regulatory frameworks. The adoption of ALM
practices extends across the financial landscape and can be found in
organizations, such as banks, pension funds, asset managers, and insurance
companies.
Pros and Cons of Asset and Liability Management
Implementing ALM frameworks can provide benefits for many organizations,
as it is important for organizations to fully understand their assets and
liabilities. One of the benefits of implementing ALM is that an institution can
manage its liabilities strategically to better prepare itself for future
uncertainties.
Using ALM frameworks allows an institution to recognize and quantify the
risks present on its balance sheet and reduce risks resulting from a mismatch
of assets and liabilities. By strategically matching assets and liabilities,
financial institutions can achieve greater efficiency and profitability while
reducing risk.
The downsides of ALM involve the challenges associated with implementing
a proper framework. Due to the immense differences between different
organizations, there is no general framework that can apply to all
organizations. Therefore, companies would need to design a unique ALM
framework to capture specific objectives, risk levels, and regulatory
constraints.
Also, ALM is a long-term strategy that involves forward-looking projections
and datasets. The information may not be readily accessible to all
organizations, and even if available, it must be transformed into quantifiable
mathematical measures.
Finally, ALM is a coordinated process that oversees an organization’s entire
balance sheet. It involves coordination between many different departments,
which can be challenging and time-consuming.
Examples of ALM Risk Mitigation
Although ALM frameworks differ greatly among organizations, they typically
involve the mitigation of a wide range is risks. Some of the most common
risks addressed by ALM are interest rate risk and liquidity risk.
Interest Rate Risk
Interest rate risk refers to risks associated with changes to interest rates, and
how changing interest rates affect future cash flows. Financial institutions
typically hold assets and liabilities that are affected by changing interest rates.
Two of the most common examples are deposits (assets) and loans (liabilities).
As both are impacted by interest rates, an environment where rates are
changing can result in a mismatching of assets and liabilities.
Liquidity Risk
 Liquidity risk refers to risks associated with a financial institution’s ability to
facilitate it’s present and future cash-flow obligations, also known as liquidity.
When the financial institution is unable to meet its obligations due to a
shortage of liquidity, the risk is that it will adversely affect its financial
position.
To mitigate the liquidity risk, organizations may implement ALM procedures
to increase liquidity to fulfill cash-flow obligations resulting from their
liabilities.
Other Types of Risk
Aside from interest and liquidity risks, other types of risks are also mitigated
through ALM. One example is currency risk, which are risks associated with
changes to exchange rates. When assets and liabilities are held in different
currencies, a change in exchange rates can result in a mismatch.

Another example is capital market risk, which are risks associated with
changing equity prices. Such risks are often mitigated through futures,
options, or derivatives.
Additional Resources
Thank you for reading CFI’s guide to Asset and Liability Management
(ALM).To keep learning and developing your knowledge base, please explore
the additional relevant resources below:
Audit Risk Model
Net Working Capital
Risk Tolerance
Options: Calls and Puts

❖ LEASING

Meaning of leasing

Leasing is a process by which a firm can obtain the use of a certain fixed assets
for which it must pay a series of contractual, periodic, tax deductible payments.
The lessee is the receiver of the services or the assets under the lease contract and
the lessor is the owner of the assets. The relationship between the tenant and the
landlord is called a tenancy, and can be for a fixed or an indefinite period of time
(called the term of the lease). The consideration for the lease is called rent.
Lease can be defined as the following ways:

1. A contract by which one party (lessor) gives to another (lessee) the use and
possession of equipment for a specified time and for fixed payments.

2. The document in which this contract is written.

3. A great way companies can conserve capital.

4. An easy way vendors can increase sales.

A lease transaction is a commercial arrangement whereby an equipment owner

or Manufacturer conveys to the equipment user the right to use the equipment in
return for a rental. In other words, lease is a contract between the owner of an
asset (the lessor) and its user (the lessee) for the right to use the asset during a
specified period in return for a mutually agreed periodic payment (the lease
rentals). The important feature of a lease contract is separation of the ownership
of the asset from its usage.

Importance of Lease Financing

Lease financing is based on the observation made by Donald B. Grant:

“Why own a cow when the milk is so cheap? All you really need is milk and not
the cow.”

Leasing industry plays an important role in the economic development of a

country by providing money incentives to lessee. The lessee does not have to pay
the cost of asset at the time of signing the contract of leases. Leasing contracts
are more flexible so lessees can structure the leasing contracts according to their
needs for finance. The lessee can also pass on the risk of obsolescence to the
lessor by acquiring those appliances, which have high technological obsolescence.
Today, most of us are familiar with leases of houses, apartments, offices, etc.

The advantages of leasing include:

a. Leasing helps to possess and use a new piece of machinery or equipment

without huge investment..

b. Leasing enables businesses to preserve precious cash reserves.

c. The smaller, regular payments required by a lease agreement enable businesses
with limited capital to manage their cash flow more effectively and adapt quickly
to changing economic conditions.

d. Leasing also allows businesses to upgrade assets more frequently ensuring they
have the latest equipment without having to make further capital outlays.

e. It offers the flexibility of the repayment period being matched to the useful life
of the equipment.

f. It gives businesses certainty because asset finance agreements cannot be

cancelled by the lenders and repayments are generally fixed.

g. However, they can also be structured to include additional benefits such as

servicing of equipment or variable monthly payments depending on a business’s
needs.

h. It is easy to access because it is secured – largely or entirely – on the asset

being financed, rather than on other personal or business assets.

i. The rental, which sometimes exceeds the purchase price of the asset, can be
paid from revenue generated by its use, directly impacting the lessee's liquidity.

j. ’ease instalments are exclusively material costs.

k. Using the purchase option, the lessee can acquire the leased asset at a lower
price, as they pay the residual or non-depreciated value of the asset.

l. For the national economy, this way of financing allows access to state-of-the-
art technology otherwise unavailable, due to high prices, and often impossible to
acquire by loan arrangements.

Limitation of leasing

a. It is not a suitable mode of project financing because rental is payable soon

after entering into lease agreement while new project generate cash only after
long gestation period.

b. Certain tax benefits/ incentives/subsidies etc. may not be available to leased

equipments.

c. The value of real assets (land and building) may increase during lease period.
In this case
lessee may lose potential capital gain.

d. The cost of financing is generally higher than that of debt financing.

e. A manufacturer(lessee) who want to discontinue business need to pay huge

penalty to lessor for pre-closing lease agreement

f. There is no exclusive law for regulating leasing transaction.

eg. In undeveloped legal systems, lease arrangements can result in inequality

between the parties due to the lessor's economic do’inance, which may lead to the
lessee signing an unfavourable contract.

TYPES OF LEASE

(a) Financial lease

(b) Operating lease.

(c) Sale and lease back

(d) Leveraged leasing and

(e) Direct leasing.

1) Financial lease: Long-term, non-cancellable lease contracts are known as

financial leases. The essential point of financial lease agreement is that it contains
a condition whereby the lessor agrees to transfer the title for the asset at the end
of the lease period at a nominal cost. At lease it must give an option to the lessee
to purchase the asset he has used at the expiry of the lease. Under this lease the
lessor recovers 90% of the fair value of the asset as lease rentals and the lease
period is 75% of the economic life of the asset. The lease agreement is irrevocable.
Practically all the risks incidental to the asset ownership and all the benefits
arising there from are transferred to the lessee who bears the cost of maintenance,
insurance and repairs. Only title deeds remain with the lessor. Financial lease is
also known as 'capital lease‘. In India, f’nancial leases are very popular with high-
cost and high technology equipment.

2) Operational lease: An operating lease stands in contrast to the financial lease

in almost all aspects. This lease agreement gives to the lessee only a limited right
to use the asset. The lessor is responsible for the upkeep and maintenance of the
asset. The lessee is not given any uplift to purchase the asset at the end of the
lease period. Normally the lease is for a short period and even otherwise is
revocable at a short notice. Mines, Computers hardware, trucks and automobiles
are found suitable for operating lease because the rate of obsolescence is very
high in this kind of assets.

3) Sale and lease back: It is a sub-part of finance lease. Under this, the owner of
an asset sells the asset to a party (the buyer), who in turn leases back the same
asset to the owner in consideration of lease rentals.

However, under this arrangement, the assets are not physically exchanged but it
all happens in records only. This is nothing but a paper transaction. Sale and lease
back transaction is suitable for those assets, which are not subjected depreciation
but appreciation, say land. The advantage of this method is that the lessee can
satisfy himself completely regarding the quality of the asset and after possession
of the asset convert the sale into a lease arrangement.

4) Leveraged leasing: Under leveraged leasing arrangement, a third party is

involved beside lessor and lessee. The lessor borrows a part of the purchase cost
(say 80%) of the asset from the third party i.e., lender and the asset so purchased
is held as security against the loan. The lender is paid off from the lease rentals
directly by the lessee and the surplus after meeting the claims of the lender goes
to the lessor. The lessor, the owner of the asset is entitled to depreciation
allowance associated with the asset.

5) Direct leasing: Under direct leasing, a firm acquires the right to use an asset
from the manufacture directly. The ownership of the asset leased out remains with
the manufacturer itself. The major types of direct lessor include manufacturers,
finance companies, independent lease companies, special purpose leasing
companies etc
HIRE PURCHASE

Concept and Meaning of Hire Purchase

Hire purchase is a type of instalment credit under which the hire purchaser, called
the hirer, agrees to take the goods on hire at a stated rental, which is inclusive of
the repayment of principal as well as interest, with an option to purchase. Under
this transaction, the hire purchaser acquires the property (goods) immediately on
signing the hire purchase agreement but the ownership or title of the same is
transferred only when the last instalment is paid. The hire purchase system is
regulated by the Hire Purchase Act 1972. This Act defines a hire purchase as “An
agreement under which goods are let on hire and under which the hirer has an
option to purchase them in accordance with the terms of the agreement and
includes an agreement under which:

1) The owner delivers possession of goods thereof to a person on condition that

such person pays the agreed amount in periodic instalments.
2) The property in the goods is to pass to such person on the payment of the last
of such instalments, and

3) Such person has a right to terminate the agreement at any time before the
property so passes”.

AN OVERVIEW OF VENTURE CAPITAL, FACTORING,

VENTURE CAPITAL

There are some businesses that involve higher risks. In the case of newly started
business, the risk is more. The new businesses may be promoted by qualified
entrepreneurs. They lack necessary experience and funds to give shape to their
ideas. Such high risk, high return ventures are unable to raise funds from regular
channels like banks and capital markets.

Origin/History of Venture Capital

In the 1920’s and 1930’s, the wealthy families of individual investors provided
the start-up money for companies that would later become famous. Eastern
Airlines and Xerox are the more famous ventures they financed. Among the early
VC fund set-ups was the one by the Rockfeller family which started a special
fund called Venrock in 1950, to finance new technology companies.

General Georges Doriot (the father of venture capital), a professor at Harvard

Business School, in 1946 set up the American Research and Development
Corporation (ARD). ARD’s approach was a classic VC in the sense that it used
only equity, invested for long term. ARD’s investment in Digital Equipment
Corporation (DEC) in 1957 was a watershed in the history of VC financing.
While in its early years VC may have been associated with high technology, over
the years, the concept has undergone a change and, as it stands today, it implies
pooled investment to unlisted companies.

Characteristics/ Features of Venture Capital

The important characteristics of venture capital finance are outlined as bellow:

1. It is basically equity finance.

2. It is a long term investment in growth-oriented small or medium firms.

3. Investment is made only in high risk projects with the objective of earning a
high rate of return.
4. In addition to providing capital, venture capital funds take an active interest in
the management of the assisted firm. It is rightly said that, “venture capital
combines the qualities of banker, stock market investor and entrepreneur in one”.

5. The venture capital funds have a continuous involvement in business after

making the investment.

6. Once the venture has reached the full potential, the venture capitalist sells his
holdings at a high premium. Thus his main objective of investment is not to earn
profit but capital gain.

Types of Venture Capitalists

Generally, there are three types of venture capital funds. They are as follows:

1. Venture capital funds set up by angel investors (angels): They are individuals
who invest their personal capital in start up companies. They are about 50 years
old. They have high income and wealth. They are well educated. They have
succeeded as entrepreneurs. They are interested in the start up process.

2. Venture capital subsidiaries of Corporations: These are established by major

corporations, commercial banks, holding companies and other financial
institutions.

3. Private capital firms/funds: The primary source of venture capital is a venture

capital firm. It takes high risks by investing in an early stage company with high
growth potential.

Methods or Modes of Venture Financing (Funding Pattern)/Dimensions of

Venture Capital

Venture capital is typically available in four forms in India: equity, conditional

loan, income note and conventional loan.

Equity: All VCFs in India provide equity but generally their contribution does not
exceed 49 percent of the total equity capital. Thus, the effective control and
majority ownership of the firm remain with the entrepreneur. They buy shares of
an enterprise with an intention to ultimately sell them off to make capital gains.

Conditional loan: It is repayable in the form of a royalty after the venture is able
to generate sales. No interest is paid on such loans. In India, VCFs charge royalty
ranging between 2 and 15 per cent; actual rate depends on the other factors of the
venture, such as gestation period, cost-flow patterns and riskiness.

Income note: It is a hybrid security which combines the features of both

conventional loan and conditional loan. The entrepreneur has to pay both interest
and royalty on sales, but at substantially low rates.

Conventional loan: Under this form of assistance, the enterprise is assisted by

way of loans. On the loans, a lower fixed rate of interest is charged, till the unit
becomes commercially operational.

When the company starts earning profits, normal or higher rate of interest will be
charged on the loan. The loan has to be repaid as per the terms of loan agreement.

Other financing methods: A few venture capitalists, particularly in the private

sector, have started introducing innovative financial securities like participating
debentures introduced by TCFC.

Stages of Venture Capital Financing

Venture capital takes different forms at different stages of a project. The various
stages in the venture capital financing are as follows:

1. Early stage financing: This stage has three levels of financing. These three
levels are:

(a) Seed financing: This is the finance provided at the project development stage.
A small amount of capital is provided to the entrepreneurs for concept testing or
translating an idea into business.

(b) Start up finance/first stage financing: This is the stage of initiating commercial
production and marketing. At this stage, the venture capitalist provides capital to
manufacture a product.

(c) Second stage financing: This is the stage where product has already been
launched in the market but has not earned enough profits to attract new investors.
Additional funds are needed at this stage to meet the growing needs of business.
Venture capital firms provide larger funds at this stage.

2. Later stage financing: This stage of financing is required for expansion of an

enterprise that is already profitable but is in need of further financial support. This
stage has the following levels:
(a) Third stage/development financing: This refers to the financing of an
enterprise which has overcome the highly risky stage and has recorded profits but
cannot go for public issue. Hence it requires financial support. Funds are required
for further expansion.

(b) Turnarounds: This refers to finance to enable a company to resolve its

financial difficulties. Venture capital is provided to a company at a time of severe
financial problem for the purpose of turning the company around.

(c) Fourth stage financing/bridge financing: This stage is the last stage of the
venture capital financing process. The main goal of this stage is to achieve an exit
vehicle for the investors and for the venture to go public. At this stage the venture
achieves a certain amount of market share.

(d) Buy-outs: This refers to the purchase of a company or the controlling interest
of a company’s share. Buy-out financing involves investments that might assist
management or an outside party to acquire control of a company. This results in
the creation of a separate business by separating it from their existing owners.

Advantages of Venture Capital

Venture capital has a number of advantages over other forms of finance. Some of
them are:

1. It is long term equity finance. Hence, it provides a solid capital base for future
growth.

2. The venture capitalist is a business partner. He shares the risks and returns.

3. The venture capitalist is able to provide strategic operational and financial

advice to the company.

4. The venture capitalist has a network of contacts that can add value to the
company. He can help the company in recruiting key personnel, providing
contracts in international markets etc.

5. Venture capital fund helps in the industrialization of the country.

6. It helps in the technological development of the country.

7. It generates employment.

8. It helps in developing entrepreneurial skills.

9. It promotes entrepreneurship and entrepreneurism in the country.

❖ Consumer Finance:

The branch of banking which facilitate finance for purchasing consumer

durables is called ‘consumer finance’ or ‘consumer credit’. Today it has become
part of life of an average Indian as they need credit in large quantity to meet
their needs of various kinds. This emerging set of wants and consequent need
for funds multiplies the scope and role of consumer finance.

Meaning and Concept of Consumer Finance:

Consumer finance refers to the raising of finance by individuals for meeting

their personal expenditure or for the acquisition of durable consumer goods. It is
an important asset based financial service in India. This include credit
merchandising, deferred payments, installment buying, hire purchase, pay-out
of income scheme, pay-as-you earn scheme, easy payment, credit buying,
installment credit plan, credit cards, etc.

Consumer durables include Cars, Two Wheelers, LCD TVs, Refrigerators,

Washing Machines, Home Appliances, Personal Computers, Cooking Ranges,
and Food Processors etc. Under consumer finance scheme, the consumer or
buyer pays a part of the purchase price in cash at the time of the delivery of the
asset, the balance with interest over a pre-determined period of time.

The objective of consumer finance is to provide credit easily to the consumer at

his door steps. Both private and public sector finance companies provide
consumer finance to purchase ‘consumer goods and construction of such goods
(building materials, iron rods, cement etc.). Multinational finance companies are
also engaged in consumer finance in India. Usually the credit/finance is
extended for a period of 2 to 5 years.

Definitions:

According to E.R.A. Seligman, “The term consumer credit refers to a transfer of

wealth, the payment of which is deferred in whole or in part, to future, and is
liquidated piecemeal or in successive fractions under a plan agreed upon at the
time of the transfer”.

According to Reavis Cox, consumer credit is ‘”a business procedure through

which the consumers purchase semi-durables and durables other than real
estate, in order to obtain from them a series of payments extending over a
period of three months to five years, and obtain possession of them when only a
fraction of the total price has been paid”.

Features of Consumer Credit:

Following are the features of Consumer credit:

1. Consumer credit is a method of financing semi-durables and durables.

2. It assists consumers to acquire assets.

3. Consumers get possession of the assets immediately when a fraction of the

price is paid.

4. The balance payment is payable in installments over an agreed span of time.

5. The duration of the finance normally ranges between three months to five
years,

6. It is an agreement between parties to the contract.

7. When there are only two parties to the contract, it is called a Bipartite
Agreement (the customer and the dealer cum financier) and where there are
three parties, such agreements are called Tripartite Agreements (the customer,
the dealer and the financier.)

8. The structure of financing may by way of hire-purchase, conditional sale or

credit sale. In the case of both hire purchase and conditional sale, ownership of
the asset is transferred only on completion of all the terms of agreement. But in
the case of credit sale ownership is transferred immediately on payment of first
installment.

9. Generally advances are made on the security of the asset itself and

10. It involves down payment normally ranging from 20 to 25% of the asset
price.

Forms/Types of Consumer Credit:

Following are the different forms for financing consumers:

1. Revolving Credit:

It is an ongoing credit arrangement. It is similar to overdraft facility. Here a

credit limit will be sanctioned to the customer and the customer can avail credit
to the extent of credit limit sanctioned by the financier. Credit Card facility is an
excellent example of revolving credit.

2. Cash Loan:

In this form, the buyer consumer gets loan amount from bank or non- banking
financial institutions for purchasing the required goods from seller. Banker acts
as lender. Lender and seller are different. Lender does not have the
responsibilities of a seller
3. Secured Credit:

In this form, the financier advances money on the security of appropriate

collateral. The collateral may be in the form of personal or real assets. If the
customer makes default in payments, the financier has the right to appropriate
the collateral. This kind of consumer credit is called secured consumer credit.

4. Unsecured Credit:
When financier advances fund without any security, such advances are called
unsecured consumer credit. This type of credit is granted only to reputed
customers.

5. Fixed Credit:

In this form of financing, finance is made available to the customer as term loan
for a fixed period of time i.e., for a period of one to five years. Monthly
installment loan, hire purchase etc. are the examples.

Advantages of Consumer Finance:

1. Compulsory Savings:

Consumer credit promotes compulsory savings habit among the people. To

make periodical installments knowingly or unknowingly, people cut short their
other expenditures and save. These savings ultimately fetch them ownership of
an asset in course of time. Thus consumer credit adds to the savings habit of
people.

2. Convenience:

Considering the nature and type of customers, consumer credit facility offers
schemes to the convenience and satisfaction of the customers. Walk in and drive
out, pay as you earn, everything at the door step, one time processing etc. are
examples.

3. Emergencies:
Consumer credit facility is available to meet personal requirements like family
requirements, festival requirements, emergencies etc. The credit facility is not
strictly restricted to purchasing of consumer durables alone. In ordinary course
of life people come across number of urgent financial requirements, for which
consumer credit offers a better solution.

4. Assists to Meet Targets:

In all business activities, there will be targets to be achieved by the executives.

Most people abstain/ postpone purchasing for want of sufficient fund. When the
dealer themselves arrange for fund people get attracted and purchase take place
in large quantity. Thus it assists to meet sales targets and profit targets.

5. Assists to Make Dreams to Reality:

A car, a TV, a washing machine, a computer, a laptop, a mobile phone, etc. is

undoubtedly a dream of an average human being. But people may not purchase
because of fund problem. In those cases consumer credit facilitates an
opportunity to possess and own those dreams on convenient terms.

6. Enhances Living Standard:

Consumer credit enhances living standard of the people by providing latest

articles and amenities at reasonable and affordable terms.

7. Accelerates Industrial Investments:

Demand for consumer durables enhances further investment in the consumer

durables industry. Thus provides more and more employment opportunities in
the country.

8. Promotes Economic Development:

Demand for consumer durables, further investments in consumer durables

industry, increased living standard of people, improved employment
opportunities and income etc. improves economic development of the country.

9. Economies of Large Scale Production:

Increased demand leads to large scale production. Large scale operations lead to
the economies of large scale operation. This in turn leads to lower prices.

10. National Importance:

Consumer credit is of national importance in India. Unless there is such a
convenient mode of financing, total demand for consumer durables will be far
lesser. Poor demand lead to lower production, which in turn lead to poor
employment opportunity and lower income level. All these finally land the
economy in trouble.

Disadvantages of Consumer Finance:

Following are the disadvantages of consumer finance:

1. Promotes Blind Buying:

Facility to purchase at somebody else’s money tempts people to buy and buy
goods blindly. This may land these people to debt trap within a short while.

2. Leads to Insolvency:

Blind buying of goods make these people insolvent/bankrupt within a shorter

span of time. This ultimately spoils their life in the long run.

3. Consumer Credit is Costlier:

Along with the convenience that it offers it charge the customer for all these
conveniences offered. Thus it becomes costlier when compared to other forms
of finance.

4. Artificial Boom:

The economic development posed by the impact of consumer credit is not real
but artificial. Economy will take years to stabilize the artificial boom claimed
by the proponents of consumer credit.

5. Bad Debts Risk:

By whatever name called credit is always risky so is the case with consumer
credit as well. Defaults are a major threat to consumer credit. Once there is a
default, repossession and other legal formalities are difficult.

6. Causes Economic Instability:

Artificial boom and depression leads to economic instability and causes chaos
in the economic progress. It will be difficult for the real ordinary business man
to identify real progress and artificial progress.
Individual Credit Rating:

Always the financier should assess the repaying capacity of the customer before
advancing money. To assess the credibility and repayment capacity of a
customer several methods are made use of. Those methods which are used to
assess the credit worthiness and repaying capacity of a customer are called
consumer credit scoring methods or credit rating methods.

These methods provide standards for accepting or rejecting a customer and

assess the credit worthiness of a customer. Some of the commonly used
methods are Dunham Greenberg Formula, Specific Fixed Formula and
Machinery Risk Formula. In India, the largest credit rating agency for
individual consumer finance is Credit Bureau of Information India Ltd. (CBIL)

A. Dunham Greenberg Formula:

This method is based the customer’s i) Employment Record, ii) income level,
iii) Financial Position, iv) Type of Security Offered and v) Past Payment
Record. It gives more importance to the customer’s income level and past
records. Under this method points are allotted to the various aspects/parameters
of the customer. It is ranked out of a total of 100. An applicant scoring more
than 70 points is considered as one with good credit standing.

The points allotted to various aspects are:

B. Specific Fixed Formula:

This method is another credit rating formula. It give emphasis to i) Age, ii)
Gender, iii) Stability of Residence, iv) Occupation, v) Type of Industry, vi)
Stability of Employment and vii) Assets of the Customer in assessing the credit
worthiness of a customer. Specific scores are allotted to each of these
parameters. The borrowers getting a score more than 3.5, is ranked as ‘excellent
borrower’ and those getting more than 2.5 but less than 3.5 is ranked as
‘marginal borrower’.

The method of scoring is as follows:

C. Machinery Risk Formula:

This method is based upon the amount of down payment, monthly income and
length of service. Basically this method is based upon the present financial
position and future income earning capacity of the customer. Generally this
method is used in government Departments to advance loans to its employees.
The loan amount to be sanctioned is calculated using the following formula.

Loan amount = Down payment + (0.124 x monthly income) + (6.45 x length of

service in months)

Recent Trends in Consumer Finance:

i. Rapid Growth:

Consumer finance market is growing rapidly in India. The last decade witnessed
steady growth of consumer credit market in India. Growing consumer appetite
for consumer durable goods like appliances and other convenience needs,
developed and competitive market for such consumer goods, expectations of
future income, potential for increase in future income, The tendency of people
to borrow early in life and enjoy etc. are increasingly evident in emerging
Indian consumer credit market.

ii. Reduced Rate of Interest:

Recently the reduction in the rate of interest and flexibility in the purchase
schemes fueled the rapid growth of consumer credit industry. There are number
of schemes with alternative payment schedules and rate of interest placed before
the customer for selection. It is up to the customer which one to select.

iii. Increased Income Level:

Another change in the Indian economy is the increase in the startup salary
scales and pay structure. The pay structure has been increased considerably
when compared with what it was ten years back. This has changed the
purchasing preferences of middle class families. Increased pay structure
together with the DINK factor (Double Income No Kids), made a category of
people more and more extravagant. People have started tasting the fruits of
modern life which lands them to more and more needs.

iv. Changes in Life Concepts:

Changes in the life style, living standard and life perspective of Indian middle
class families were another important recent change in the consumer durables
industry. People have started dreaming and trying to convert their dreams to
realism. Many have started visualizing a kingly life and wish to live with as
many facilities possible. All these will land consumer durables industry and its
financing industry to further heights within a short while.

v. Competition among Financiers:

Modern life has made people more and more mechanical and busy. People
hardly have any time to spend on negotiation and settlement. They need
everything to be settled right at their door step. Today everything has become
customer centered/ oriented. So unless schemes are framed in accordance with
customer requirements, it will be difficult even for financiers to survive. Today
there is tough competition among financiers also. It is observed that financiers
also compete with competitive schemes to attract potential customers.

vi. Tie-Ups and Collaborations:

Today is a period of tie ups and collaborations. Manufacturers make tie ups with
financiers to market/finance their product and services. Similarly financiers
arrange tie ups with dealers and manufacturers to market their services. It has
become so that without appropriate tie ups and collaborations nobody could
survive in the long run.

vii. Credit Cards:

The introduction of credit cards is another land mark in the consumer finance
industry in India. Credit cards provide short term credit at no cost. Large
numbers of credit cards with varied features to suit the individual requirements
of customers are available in the market. The convenience and the economy of
large scale purchases added to the popularity and use of credit cards even by
ordinary customers.

viii. A Period of Schemes and Offers:

Luring schemes and tempting advertisements are other peculiar features

emerged these days. Zero interest schemes, walk in and drive out, free test
drive, exchange schemes, exchange bonus offers, festival offers, special
schemes, yearend schemes, free packages, lucky draws, etc. offers brighter
future for consumer credit market in India and thereby the market for consumer
finance also.

ix. Development of Used Cars Market:

Another trend currently gained momentum in India is the market for used cars.
Across the country large dealer network for used cars has been established.
Most of them have financial backing also. It is interesting to note that financiers
have come forward to finance used cars purchase also.

This shows the paradigm shift that took place in the consumer finance market.
Practically this facility multiplied the market for consumer durables in India. It
has gained much popularity among the common folk. It is felt that this second
hand market is going to go beyond the first hand market in terms of number of
transactions within no time.

The high-growth emerging market in India represents a significant opportunity

for retail banks to seize market share as the growing middle-class seeks
financing for durable goods. These emerging markets, also present significant
challenges as credit history and data on the credit worthiness of most of the
customers are not available.

Moreover mass availability of credit is new to the Indian financial culture with
limited history on the consequences of non-payment of consumer credit.
However use of controlled testing of different market segments and products to
learn about consumer propensity, systematic approach over judgmental
decisions, systems to track lending and pricing decisions, developing a
‘performance data reserve’ for individual consumers to establish customers’
credit profile etc. will make the role of consumer credit market in India
imperative.

❖ Plastic Money

Plastic money is a term that is used predominantly in reference to the hard

plastic cards we use everyday in place of actual bank notes.

They can come in many different forms such as

Cash Cards

Credit Cards

Debit Cards

Pre-paid Cash Cards

In-store cards
Cash Card or ATM Card

A card that will allow you to withdraw money directly from your

bank via an Automated Teller Machine (ATM) but it will not allow the holder
to purchase anything directly with it. Unlike a debit card, in-store purchases or
refunds with an ATM card can generally be made in person only, as they
require authentication through a personal identification number or PIN. In other
words, ATM cards cannot be used at merchants that only accept credit cards.

In some countries, the two functions of ATM cards and debit cardsare combined
into a single card called a debit card or alsocommonly called a bank card. These
are able to perform bankingtasks at ATMs and also make point-of-sale
transactions, bothfunctions using a PIN.

Credit Cards

Again this card will permit the card holder to withdraw cash from an ATM, and
a credit card will allow the user to purchase goods andservices directly, but
unlike a Cash Card the money is basically a high interest loan to the card holder,
although the card holder can avoid any interest charges by paying the balance
off in full each month.

A credit card is a small plastic card issued to users as a system of payment. It

allows its holder to buy goods and services based on the holder's promise to pay
for these goods and services. The issuer of the card creates a revolving account
and grants a line of credit to the consumer (or the user) from which the user can
borrow money for payment to a merchant or as a cash advance to the user.

Parties involved

Cardholder: The holder of the card used to make a purchase; the consumer.

Card-issuing bank: The financial institution or other organization that issued the
credit card to the cardholder.

Acquiring bank: The financial institution accepting payment for the products or
services on behalf of the merchant.

Merchant account: This could refer to the acquiring bank or the independent
sales organization, but in general is the organization that the merchant deals
with.
Credit Card association: An association of card-issuing banks such as Discover,
Visa, MasterCard, American Express, etc. that set transaction terms for
merchants, card-issuing banks, and acquiring banks.

Transaction network: The system that implements the mechanics of the

electronic transactions. May be operated by an independent company, and one
company may operate multiple networks.

Affinity partner: Some institutions lend their names to an issuer to attract

customers that have a strong relationship with that institution, and get paid a fee
or a percentage of the balance for each card issued using their name

Insurance providers: Insurers underwriting various insurance protections offered

as credit card perks

Transaction steps

1.Authorization: The cardholder presents the card as payment to the merchant

and the merchant submits the transaction to the acquirer (acquiring bank). The
acquirer verifies the credit card number, the transaction type and the amount
with the issuer (Card-issuing bank) and reserves that amount of the cardholder's
credit limit for the merchant. An authorization will generate an approval code,
which the merchant stores with the transaction.

2.Batching: Authorized transactions are stored in "batches", which are sent to

the acquirer. Batches are typically submitted once per day at the end of the
business day. If a transaction is not submitted in the batch, the authorization will
stay valid for a period determined by the issuer, after which the held amount
will be returned to the cardholder's available credit Transaction steps contd…

3.Clearing and Settlement: The acquirer sends the batch transactions through
the credit card association, which debits the issuers for payment and credits the
acquirer. Essentially, the issuer pays the acquirer for the transaction.

4.Funding: Once the acquirer has been paid, the acquirer pays the merchant.
The merchant receives the amount totaling the funds in the batch minus either
the "discount rate," "mid-qualified rate", or "non-qualified rate" which are tiers
of fees the merchant pays the acquirer for processing the transactions.

5.Chargebacks: A chargeback is an event in which money in a merchant

account is held dueto a dispute relating to the transaction. Chargebacks are
typically initiated by the cardholder. In the event of a chargeback, the issuer
returns the transaction to the acquirer for resolution. The acquirer then forwards
the chargeback to the merchant, who must either accept the chargeback or
contest it.

Credit card issuers (banks) have several types of costs:

Interest expenses

Operating costs

Charge offs or Bad Debts

Rewards

Fraud

Promotion

Revenues

Offsetting the costs are the following revenues:

Interchange fee

Interest on outstanding balances

Over limit charges

Fees charged to customers

Late payments or overdue payments

Charges that result in exceeding the credit limit on the card (whether done
deliberately or by mistake), called over limit fees

Returned cheque fees or payment processing fees (e.g. phone payment fee)

Cash advances and convenience cheques

Transactions in a foreign currency. A few financial institutions do not charge a

fee for this.

Membership fees (annual or monthly), sometimes a percentage of the credit

limit.

Exchange rate loading fees.

Merits and Demerits to Customer

Merits

Convenience

Allows a short term credit to customer

Provide more fraud protection than debit cards.

Many credit cards offer rewards and benefits packages

Demerits

High interest and bankruptcy

Inflated pricing for all consumers

Weakens self regulation

Debit Card

This type of card will directly debit money from your bank account, and can
directly be used to purchase goods and services. While there is no official credit
facility with debit cards, as it is linked to the bank account the limit is the limit
of what is in the account, for instance if an overdraft facility is available then
the limit will be the extent of the overdraft.

A debit card (also known as a bank card or check card) is a plastic card that
provides the cardholder electronic access to his or her bank account(s) at a
financial institution. Some cards have a stored value with which a payment is
made, while most relay a message to the cardholder's bank to withdraw funds
from a designated account in favor of the payee's designated bank account. The
card can be used as an alternative payment method to cash when making
purchases.

Types of debit card systems

Online Debit System :Online debit cards require electronic authorization of

every transaction and the debits are reflected in the user’s account immediately.

Offline Debit System : This type of debit card may be subject to a daily limit,
and/or a maximum limit equal to the current/checking account balance from
which it draws funds. Transactions conducted with offline debit cards require 2–
3 days to be reflected on users’ account balances.

Electronic Purse Card System : Smart-card-based electronic purse systems (in

which value is stored on the card chip, not in an externally recorded account, so
that machines accepting the card need no network connectivity)

Advantages

Customer having poor credit worthiness can opt for debit card.

Instant finalization of accounts

Less identification and scrutiny than personal checks, thereby making

transactions quicker and less intrusive.

A debit card may be used to obtain cash from an ATM or a PIN-based

transaction at no extra charge

Disadvantages

Limited to the existing funds in the account to which it is linked Banks charging
over-limit fees or non-sufficient funds fees based upon pre-authorizations, and
even attempted but refused transactions by the merchant

Lower levels of security protection than credit cards

More prone to frauds

Credit Card Vs Debit Card

Credit Card Debit Card

1. Transactions are of Credit 1. Transactions are of Debit
2. Nature 2. Nature
3. Risk of overspending 3. No or less risk of over spending
4. Interest is charged to the 4. Only Fees are charged on
holder of card in case of yearly basis for card usage
overdrawing
5. Source of additional funds 5. Eliminates need to carry hard Cash

In-store cards

These are used by the departmental stores mainly as marketing tools to retain
customers and increases turnover.
The main features of in-store cards are as below:

Issued by big department stores or retailers.

Can be used only in retailers outlet or for purchasing the company’s products.

Little or no cost to retailers

Usually developed by the traders in partnership with banks or financing

companies who undertake the administration and sometimes the financing
involved.

Types on In-store card

Budget Card: This card requires monthly payment on behalf of the holders.
The cost of goods purchased is spread over a certain period.

Option Card: Here, payment can be either be made in full or at the

cardholder’s discretion. However, option available is subject to a minimum
repayment and interest charged on the balance outstanding amount.

Monthly Card: The card holder is required to make the payment every month.
No extension of credit is given beyond a month. This card differs for budget
card, where outstanding credit can be settled in 30 monthly statements.

Pre-paid Cash Cards:

As the name suggests the user will add credit to the card themselves, and will
not exceed that amount. These are usually re-useable in that they can be 'topped
up' however some cards, usually marketed as Gift Cards are not re-useable and
once the credit hasbeen spent they are disposed of. They provide some specials
benefits or discounts to the holder of the card.

Pre-paid Cash Cards Examples: DMRC Smart Cards. Pantaloons Green card.
Cards used in Food courts of Malls.

❖ Credit Rating Agencies

Meaning: A credit rating is a quantified assessment of the creditworthiness of

a borrower in general terms or with respect to a particular debt or financial
obligation.

Definition of 'Credit Rating'

Credit rating is an analysis of the credit risks associated with a financial
instrument or a financial entity. It is a rating given to a particular entity based on
the credentials and the extent to which the financial statements of the entity are
sound, in terms of borrowing and lending that has been done in the past.

Credit Rating Agency

Meaning of a credit rating agency: A credit rating agency is a private company

that looks at the credit worthiness of a large-scale borrower, such as a company
or country. It effectively ranks the borrower on their ability to pay off their loan.

CHARACTERISTICS OF CREDIT RATING

1. Assessment of issuer's capacity to repay. It assesses issuer's capacity to meet

its financial obligations i.e., its capacity to pay interest and repay the principal
amount borrowed.

2. Based on data. A credit rating agency assesses financial strength of the

borrower on the financial data.

3. Expressed in symbols. Ratings are expressed in symbols e.g. AAA, BBB

which can be understood by a layman too.

4. Done by expert. Credit rating is done by expert of reputed, accredited

institutions.

5. Guidance about investment-not recommendation. Credit rating is only a

guidance to investors and not recommendation to invest in any particular
instrument.

FUNCTIONS/IMPORTANCE OF CREDIT RATING

1. It provides unbiased opinion to investors. Opinion of good credit rating

agency is unbiased because it has no vested interest in the rated company.

2. Provide quality and dependable information. Credit rating agencies employ

highly qualified, trained and experienced staff to assess risks and they have
access to vital and important information and therefore can provide accurate
information about creditworthiness of the borrowing company.

3. Provide information in easy to understand language. Credit rating agencies

gather information, analyse and interpret it and present their findings in easy to
understand language that is in symbols like AAA, BB, C and not in technical
language or in the form of lengthy reports.

4. Provide information free of cost or at nominal cost. Credit ratings of

instruments are published in financial newspapers and advertisements of the
rated companies.

The public has not to pay for them. Even otherwise, anybody can get them from
credit rating agency on payment of nominal fee. It is beyond the capacity of
individual investors to gather such information at their own cost.

5. Helps investors in taking investment decisions. Credit ratings help investors

in assessing risks and taking investment decision.

6. Disciplines corporate borrowers. When a borrower gets higher credit rating, it

increases its goodwill and other companies also do not want to lag behind in
ratings and inculcate financial discipline in their working and follow ethical
practice to become eligible for good ratings, this tendency promotes healthy
discipline among companies.

7. Formation of public policy on investment. When the debt instruments have

been rated by credit rating agencies, policies can be laid down by regulatory
authorities (SEBI, RBI) about eligibility of securities in which funds can be
invested by various institutions like mutual funds, provident funds trust etc. For
example, it can be prescribed that a mutual fund cannot invest in debentures of a
company unless it has got the rating of AAA.

BENEFITS OF CREDIT RATING

Credit rating offers many advantages which can be classified into:

A. Benefits to investors.

B. Benefits to the rated company.

C. Benefits to intermediaries.

D. Benefits to the business world.

BENEFITS TO INVESTORS

1. Assessment of risk. The investor through credit rating can assess risk
involved in an investment. A small individual investor does not have the skills,
time and resources to undertake detailed risk evaluation himself. Credit rating
agencies who have expert knowledge, skills and manpower to study these
matters can do this job for him. Moreover, the ratings which are expressed in
symbols like AAA, BB etc. can be understood easily by investors.

2. Information at low cost. Credit ratings are published in financial newspapers

and are available from rating agencies at nominal fees. This way the investors
get credit information about borrowers at no or little cost.

3. Advantage of continuous monitoring. Credit rating agencies do not normally

undertake rating of securities only once. They continuously monitor them and
upgrade and downgrade the ratings depending upon changed circumstances.

4. Provides the investors a choice of Investment. Credit ratings agencies helps

the investors to gather information about creditworthiness of different
companies. So, investors have a choice to invest in one company or the other.

5. Ratings by credit rating agencies is dependable. A rating agency has no

vested interest in a security to be rated and has no business links with the
management of the issuer company. Hence ratings by them are unbiased and
credible.

BENEFITS TO THE RATED COMPANY

1. Ease in borrowings. If a company gets high credit rating for its securities, it
can raise funds with more ease in the capital market.

2. Borrowing at cheaper rates. A favorably rated company enjoys the

confidence of investors and therefore, could borrow at lower rate of interest.

3. Facilitates growth. Encouraged by favorable rating, promoters are motivated

to go in for plans of expansion, diversification and growth. Moreover, highly
rated companies find it easy to raise funds from public through issue of
ownership or credit securities in future. They find it easy to borrow from banks.

4. Recognition of lesser known companies. Favorable credit rating of

instruments of lesser known or unknown companies provides them credibility
and recognition in the eyes of the investing public.

5. Adds to the goodwill of the rated company. If a company is rated high by

rating agencies it will automatically increase its goodwill in the market.
6. Imposes financial discipline on borrowers. Borrowing companies know that
they will get high credit rating only when they manage their finances in a
disciplined manner i.e., they maintain good operating efficiency, appropriate
liquidity, good quality assets etc. This develops a sense of financial discipline
among companies who want to borrow.

7. Greater information disclosure. To get credit rating from an accredited

agency, companies have to disclose a lot of information about their operations
to them. It encourages greater information disclosures, better accounting
standards and improved financial information which in turn help in the
protection of the investors.

BENEFITS TO INTERMEDIARIES

1. Merchant bankers' and brokers' job made easy. In the absence of credit rating,

merchant bankers or brokers have to convince the investors about financial

position of

the borrowing company. If a borrowing company's credit rating is done by a

reputed

credit agency, the task of merchant bankers and brokers becomes much easy.

BENEFITS TO THE BUSINESS WORLD

1. Increase in investor population. If investors get good guidance about

investing the money in debt instruments through credit ratings, more and more
people are encouraged to invest their savings in corporate debts.

2. Guidance to foreign investors. Foreign collaborators or foreign financial

institutions will invest in those companies only whose credit rating is high.
Credit rating will enable them to instantly identify the position of the company.

What CREDIT RATING is not?

1. Not for company as a whole. Credit rating is done for a particular instrument
i.e., for a particular class of debentures and not for the company as a whole, it is
quite possible that two instruments issued by the same company may carry
different rating.
2. Does not create a fiduciary relationship. Credit rating does not create a
fiduciary relationship (relationship of trust) between the credit rating agency
and the investor.

3. Not attestation of truthfulness of information provided by rated company.

Rating does not imply that the credit rating agency attests the truthfulness of
information provided by the rated company.

4. Rating not forever. Credit rating is not a one-time evaluation of risk. Which
remains valid for the entire life of a security. It can change from time to time.

COMPULSORY CREDIT RATING:

Obtaining credit rating is compulsory in the following cases:

1. For debt securities. The Reserve Bank of India and SEBI have made credit
rating compulsory in respect of all non-government debt securities where the
maturities exceed 18 months

2. Public deposits. Rating of deposits in companies has also been made

compulsory.

3. For commercial papers (CPs). Credit rating has also been made compulsory
for commercial papers. As per Reserve Bank of India guidelines rating of P2 by
CRISIL or A2 by ICRA or PP2 by CARE is necessary for commercial papers.

4. For fixed deposits with non-banking financial institutions (NBFCs). Under

the Companies Act, credit rating has been made compulsory for fixed deposits
with NBFs.

FACTORS CONSIDERED IN CREDIT RATING

1. Issuer’s ability to service its debt. For this credit rating agencies calculate

a) Issuer Company’s past and future cash flows.

b) Assess how much money the company will have to pay as interest on
borrowed funds and how much will be its earnings.

c) How much are the outstanding debts?

d) Company's short term solvency through calculation of current ratio.

e) Value of assets pledged as collateral security by the company.

f) Availability and quality of raw material used, favorable location, cost
advantage.

g) Track record of promoters, directors and expertise of the staff.

2. Market positon of the company. What is the market share of various products
of the company, whether it will be stable, does the company possess
competitive advantage due to distribution net- work, customer base research and
development facilities etc.

3. Quality of management. Credit rating agency will also take into consideration
track record, strategies, competency and philosophy of senior management.

4. Legal position of the instrument. It means whether the issued instrument is

legally valid, what are the terms and conditions of issue and redemption; how
much the instrument is protected from frauds, what are the terms of debenture
trust deed etc.

5. Industry risks. Industry risks are studied in relation to position of demand and
supply for the products of that industry (e.g. cars or electronics) how much is
the international competition, what are the future prospects of that industry, is it
going to die or expand?

6. Regulatory environment. Whether that industry is being regulated by

government (like liquor industry), whether there is a price control on it, whether
there is government support for it, can it take advantage of tax concessions etc.

7. Other factors. In addition to the above, the other factors to be noted for credit
rating of a company are its cost structure, insurance cover undertaken,
accounting quality,

market reputation, working capital management, human resource quality,

funding policy, leverage, flexibility, exchange rate risks etc.
CREDIT RATING PROCESS

In India credit rating is done mostly at the request of the borrowers or issuer
companies. The borrower or issuer company requests the credit rating agency
for assigning a ranking to the proposed instrument. The process followed by
most of the credit rating agencies is as follows:

1. Agreement. An agreement is entered into between the rating agency and the
issuer company. It covers details about terms and conditions for doing the
rating.

2. Appointment of analytical team. The rating agency assigns the job to a team
of experts. The team usually comprises of two analysts who have expert
knowledge in the relevant business area and is responsible for carrying out
rating.

3. Obtaining information. The analytical team obtains the required information

from the client company and studies company's financial position, cash flows,
nature and basis of competition, market share, operating efficiency
arrangements, managements track cost structure, selling and distribution record,
power (electricity) and labour situation etc.

4. Meeting the officials. To obtain clarifications and understanding the client's

business the analytical team visits and interacts with the executives of the client.

5. Discussion about findings. After completion of study of facts and their

analysis by the analytical team the matter is placed before the internal
committee (which comprises of senior analysts) an opinion about the rating is
taken.

6. Meeting of the rating committee. The findings of internal committee are

referred to the “rating committee" which generally comprises of a few directors
and is the final authority for assigning ratings.

7. Communication of decision. The rating decided by the rating committee is

communicated to the requesting company.

8. Information to the public. The rating company publishes the rating through
reports and the press.

9. Revision of the rating. Once the issuer company has accepted the rating, the
rating agency is under an obligation to monitor the assigned rating. The rating
agency monitors all ratings during the life of the instrument.

TYPES OF CREDIT RATING

1. Rating of bonds and debentures. Rating is popular in certain cases for bonds
and debentures. Practically, all credit rating agencies are doing rating for
debentures and bonds.

2. Rating of equity shares. Rating of equity shares is not mandatory in India but
credit rating agency ICRA has formulated a system for equity rating. Even
SEBI has no immediate plans for compulsory credit rating of initial public
offerings (IPOs).

3. Rating of preference shares. In India preference shares are not being rated,
however Moody's Investor Service has been rating preference shares since 1973
and ICRA has provision for it.

4. Rating of medium term loans (Public deposits, CDs etc.). Fixed deposits
taken by companies are rated on regular scale in India.
5. Rating of short-term instruments [Commercial Papers (CPs). Credit rating of
short term instruments like commercial papers has been started from 1990.
Credit rating for CPs is mandatory which is being done by CRISIL, ICRA and
CARE.

6. Rating of borrowers. Rating of borrowers, may be an individual or a company

is known as borrower’s rating.

7. Rating of real estate builders and developers. A lot of private colonisers and
flat builders are operating in big cities. Rating about them is done to ensure that
they will properly develop a colony or build flats. CRISIL has started rating of
builders and developers.

8. Rating of chit funds. Chit funds collect monthly contributions from savers
and give loans to those participants who offer highest rate of interest. Chit funds
are rated on the basis of their ability to make timely payment of prize money to
subscribers.

CRISIL does credit rating of chit funds.

9. Ratings of insurance companies. With the entry of private sector insurance

companies, credit rating of insurance companies is also gaining ground.
Insurance companies are rated on the basis of their claim paying ability
(whether it has high, adequate, moderate or weak claim-paying capacity). ICRA
is doing the work of rating insurance companies.

10. Rating of collective investment schemes. When funds of a large number of

investors are collectively invested in schemes, these are called collective
investment schemes. Credit rating about them means (assessing) whether the
scheme will be successful or not. ICRA is doing credit rating of such schemes.

11. Rating of banks. Private and cooperative banks have been failing quite
regularly in India. People like to deposit money in banks which are financially
sound and capable of repaying back the deposits. CRISIL and ICRA are now
doing rating of banks.

12. Rating of states. States in India are now being also rated whether they are fit
for investment or not. States with good credit ratings are able to attract investors
from within the country and from abroad.
13. Rating of countries. Foreign investors and lenders are interested in knowing
the repaying capacity and willingness of the country to repay loans taken by it.
They want to make sure that investment in that country is profitable or not.
While rating a country the factors considered are its industrial and agricultural
production, gross domestic product, government policies, rate of inflation,
extent of deficit financing etc. Moody’s, and Morgan Stanley are doing rating of
countries.

CREDIT RATING AGENCIES IN INDIA

There are 6 credit rating agencies which are registered with SEBI. These are
CRISIL, ICRA, CARE, Fitch India, Brickwork Ratings, and SMERA.

1. Credit Rating and Information Services of India Limited (CRISIL)

• It is India’s first credit rating agency which was incorporated and promoted by
the erstwhile ICICI Ltd, along with UTI and other financial institutions in 1987.

• After 1 year, i.e. in 1988 it commenced its operations

• It has its head office in Mumbai.

• It is India’s foremost provider of ratings, data and research, analytics and

solutions, with a strong track record of growth and innovation.

• It delivers independent opinions and efficient solutions.

• CRISIL’s businesses operate from 8 countries including USA, Argentina,

Poland, UK, India, China, Hong Kong and Singapore.

• CRISIL’s majority shareholder is Standard & Poor’s.

• It also works with governments and policy-makers in India and other emerging
markets in the infrastructure domain.

2. Investment Information and Credit rating agency (ICRA)

• The second credit rating agency incorporated in India was ICRA in 1991.

• It was set up by leading financial/investment institutions, commercial banks

and financial services companies as an independent and professional investment
Information and Credit Rating Agency.

• It is a public limited company.

• It has its head office in New Delhi.

• ICRA’s majority shareholder is Moody’s.

3. Credit Analysis & Research Ltd. (CARE)

• The next credit rating agency to be set up was CARE in 1993.

• It is the second-largest credit rating agency in India.

• It has its head office in Mumbai.

• CARE Ratings is one of the 5 partners of an international rating agency called

ARC Ratings.

4. ONICRA

• It is a private sector agency set up by Onida Finance.

• It has its head office in Gurgaon.

• It provides ratings, risk assessment and analytical solutions to Individuals,

MSMEs and Corporates.

• It is one of only 7 agencies licensed by NSIC (National Small Industries

Corporation) to rate SMEs.

• They have Pan India Presence with offices over 125 locations.