Consolidated Q&a

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Topic Bond Basic Valuing Debt Interest Rate Arbitrage Hedge Funds Futures Mergers & Acquisitions Understanding Financial Statements Mutual Funds Banking Cost of Capital Financing Decisions Interest rate Swaps Working Capital Mmgt. Infrastructure projects Cash Flow Capital A/c Convertibility Credit Risk Technical Analysis Mutual Funds Securitisation Strategic Cost Mgmt. Microfinance Investment Decisions Risk & Return Credit Default Swaps Infrastructure Project(IDFC) Capital Budgeting Securitization Credit Derivatives Synthetic CDOs Business Valuation

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Submitted by Divya Sampath Falguni Bavishi Neha Karve Abhishek Singh Craig Rodrigues Praveen Kumar Upasana Rana Yuvraj Singh Sushil Gautam Mahyar Ravi Arijit Kartik Anjan Vivek Rishabh Pallavi Priya Omkar Divyesh Janavi Anand Pramath Nikhil Puncham Shiv Angad Kalra Rachita Maheshwari Shraddha Chhabria Ebrahim Mukadam Yogesh Chandorkar

TOPIC 1: BOND BASICS (Divya Sampath) 1. What Makes a Bond a Bond? First and foremost, a bond is a loan that the bond purchaser, or bondholder, makes to the bond issuer. Governments, corporations and municipalities issue bonds when they need capital. If you buy a government bond, you’re lending the government money. If you buy a corporate bond, you’re lending the corporation money. Like a loan, a bond pays interest periodically and repays the principal at a stated time. Suppose a corporation wants to build a new manufacturing plant for $1 million and decides to issue a bond to help pay for the plant. The corporation might decide to sell 1,000 bonds to investors for $1,000 each. In this case, the “face value” of each bond is $1,000. The corporation—now referred to as the bond “issuer”—determines an annual interest rate, known as the “coupon,” and a timeframe within which it will repay the principal, or the $1 million. To set the coupon, the issuer takes into account the prevailing interest-rate environment to ensure that the coupon is competitive with those on comparable bonds and attractive to investors. Our hypothetical corporation may decide to sell five-year bonds with an annual coupon of 5%. At the end of five years, the bond reaches “maturity” and the corporation repays the $1,000 face value to each bondholder. How long it takes for a bond to reach maturity can play an important role in the amount of risk as well as the potential return an investor can expect. A $1 million dollar bond repaid in five years is typically regarded as less risky than the same bond repaid over 30

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years because many factors can have a negative impact on the issuer’s ability to pay bondholders over a 30-year period. The additional risk incurred by a longer maturity bond has a direct relation to the interest rate, or coupon, the issuer must pay on the bond. In other words, an issuer will pay a higher interest rate for a long-term bond. An investor therefore will potentially earn greater returns on longer-term bonds, but in exchange for that return, the investor incurs additional risk. Every bond also carries some risk that the issuer will “default,” or fail to fully repay the loan. Independent credit rating services assess the default risk of most bond issuers and publish credit ratings in major financial newspapers. These ratings not only help investors evaluate risk but also help determine the interest rates on individual bonds. An issuer with a high credit rating will pay a lower interest rate than one with a low credit rating. Again, investors who purchase bonds with low credit ratings can potentially earn higher returns, but they must bear the additional risk of default by the bond issuer. 2. What Determines the Price of a Bond in the Open Market? Bonds can be traded in the open market after they are issued. When listed on the open market, a bond’s price and yield determine its value. Obviously, a bond must have a price at which it can be bought and sold (see “Understanding Bond Market Prices” below for more). A bond’s yield is the actual annual return an investor can expect if the bond is held to maturity. Yield is therefore based on the purchase price of the bond as well as the coupon. A bond’s price always moves in the opposite direction of its yield, as illustrated above. The key to understanding this critical feature of the bond market is to recognize that a bond’s price reflects the value of the income that it provides through its regular coupon interest payments. When prevailing interest rates fall—notably rates on government bonds—older bonds of all types become more valuable because they were sold in a higher interest-rate environment and therefore have higher coupons. Investors holding older bonds can charge a “premium” to sell them in the open market. On the other hand, if interest rates rise, older bonds may become less valuable because their coupons are relatively low, and older bonds therefore trade at a “discount.”

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3. How to measure bond risk: What Is Duration? Now that we’ve established that bond prices and yields move in opposite directions, let’s explore the price-yield relationship in more detail. How do we know how much a bond’s price will move when interest rates change? This is a key question because some bonds are more sensitive to changes in interest rates than others. To estimate how much a specific bond’s price will move when interest rates change, the bond market uses a measure known as duration. Duration is a weighted average of a bond’s cash flows, which include a series of regular coupon payments followed by a much larger payment at the end when the bond matures and the face value is repaid. In the illustration below, the small dollar signs represent the coupon payments and the large dollar sign on the right represents the repayment of the bond’s face value at maturity. Duration is the point at which the cash flows balance out—in other words, the point when payments already made to bondholders equal the payments yet to come, or put yet another way, the point when bondholders have received half of the money they are owed, as illustrated below. Duration is less than the maturity. Duration will also be affected by the size of the regular coupon payments and the bond’s face value. For a zero coupon bond, maturity and duration are equal since there are no regular coupon payments and all cash flows occur at maturity. Because of this feature, zero coupon bonds tend to provide the most price movement for a given change in interest rates, which can make zero coupon bonds attractive to investors expecting a decline in rates. The end result of the duration calculation, which is unique to each bond, is a risk measure that allows us to compare bonds with different maturities, coupons and face values on an apples-to-apples basis. Duration tells us the approximate change in price that any given bond will experience in the event of a 100 basis point (1/100 of a percent, causing yields on every bond in the market to fall by the same amount). In that event, the price of a bond with a duration of two years will rise two percent and the price of a five-year duration bond will rise five percent. 4. What is the role of bonds in a portfolio?

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Investors have traditionally held bonds in their portfolio for three reasons: income, diversification, and protection against economic weakness or deflation. Let’s look at each of these in more detail. Income: Most bonds provide the investor with “fixed” income. On a set schedule, perhaps quarterly, twice a year or annually, the bond issuer sends the bondholder an interest payment—a check that can be spent or reinvested in other bonds. Stocks might also provide income through dividend payments, but dividends tend to be much smaller than bond coupon payments, and companies make dividend payments at their discretion, while bond issuers are obligated to make coupon payments. Diversification: Diversification means not “putting all of your eggs in one basket.” A stock market investor faces the risk that the stock market will decline and take the portfolio along for the ride. To offset this risk, investors have long turned to the bond market because the performance of stocks and bonds is often non-correlated: market factors that are likely to have a negative impact on the performance of stocks historically have little to no impact on bonds and in some cases can actually improve bond performance. For example, an investor who purchases a blue-chip stock and a government bond may offset a downward market cycle in either asset class because a drop in a particular company’s share price and a government’s ability to repay a bond are usually unrelated. Although diversification does not ensure against loss, an investor can diversify a portfolio across different asset classes that perform independently in market cycles to reduce the risk of low, or even negative, returns. Protection Against Economic Slowdown or Deflation: Bonds can help protect investors against an economic slowdown for several reasons. Recall that the price of a bond depends on how much investors value the income that bonds provide. Most bonds pay a fixed income that doesn’t change. When the prices of goods and services are rising, an economic condition known as “inflation,” a bond’s fixed income becomes less attractive because that income buys fewer goods and services. Inflation is usually caused by faster economic growth, which increases demand for goods and services. On the other hand, slower economic growth usually leads to lower inflation, which makes bond income more attractive. An economic slowdown is also typically bad for corporate profits and stock returns, adding to the attractiveness of bond income as a source of return. If the slowdown becomes bad enough that consumers stop buying things and prices in the economy begin to fall—a dire economic condition known as “deflation”—then bond income becomes even more attractive because you can buy more goods and services (due to their deflated prices) with the same bond income. As demand for bonds increases, so do bond prices and bondholder returns. 5. What are the variations (types) in bonds? Now that we’ve highlighted the main features common to virtually all bonds, let’s move on to the bond market’s evolution and the many different types of bonds available in the global market. In its early days, the bond market was primarily a place for governments and large companies to borrow money. The main investors in bonds were insurance

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companies, pension funds and individual investors seeking a high quality investment for money that would be needed for some specific future purpose. In the 1970s, the bond market began to evolve as investors learned there was money to be made by trading bonds in the open market. As investor interest in bonds grew (and faster computers made bond math easier), finance professionals created innovative ways for borrowers to tap the bond market for funds and new ways for investors to tailor their exposure to risk and return potential. Broadly speaking, government bonds and corporate bonds remain the largest sectors of the bond market, but there are a growing number of subcategories within these broad groups. There are also large segments of the market, such as mortgage-backed and assetbacked securities, which do not fall easily into either category. Here’s what you need to know about the major sectors of the bond market: Government Bonds The government bond sector is a broad category that includes “sovereign” debt, which is issued and backed by a central government. U.S. Treasuries, German Bunds, Japanese Government Bonds (JGBs), French OATs and U.K. Gilts are all examples of sovereign government bonds. The U.S., Japan and European Union countries (primarily Germany, France, Italy and Spain) dominate the government bond market, accounting for about 84% of all government bonds outstanding.2 Sovereign bonds issued by these major industrialized countries are generally considered to have very low default risk and are among the safest investments available. However, we should note that guarantees on government bonds tend to relate to the timely repayment of interest and do not eliminate market risk. Also, shares of a portfolio of government bonds are not guaranteed. A number of governments also issue sovereign bonds that are linked to inflation, also known as “linkers” in Europe or “TIPS” in the U.S. On an inflation-linked bond, the interest and/or principal is adjusted on a regular basis to reflect changes in the rate of inflation, thus providing a “real,” or inflation-adjusted, return. In addition to sovereign bonds, the government bond sector also includes a number of subcomponents, such as: • Agency and “Quasi-Government” Bonds: Central governments pursue various goals— supporting affordable housing or the development of small businesses, for example— through agencies, a number of which issue bonds to support their operations. Some agency bonds are guaranteed by the central government while others are not. For example, the German government guarantees bonds issued by the agency KfW, which makes housing and small businesses loans. On the other hand, the U.S. government does not guarantee bonds issued by agencies Fannie Mae and Freddie Mac, both of which buy mortgages from banks, but does guarantee bonds issued by Ginnie Mae, another mortgage agency. Supranational organizations, like the World Bank and the European Investment Bank also borrow in the bond market to finance public projects and/or development. • Emerging Market Bonds: Emerging market bonds are sovereign bonds issued by countries with developing economies, including most of Africa, Eastern Europe, Latin America, Russia, the Middle East and Asia excluding Japan. The emerging market sector has grown and matured significantly in recent years, attracting many new investors. While emerging market bonds can offer very attractive yields, they also pose special

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risks, including but not limited to currency fluctuation and political risk. An emerging market portfolio would usually be more volatile than that of a U.S.-only portfolio. • Local Government Bonds: Local governments borrow to finance a variety of projects, from bridges to schools, as well as general operations. The market for local government bonds is well established in the U.S., where these bonds are known as “municipal bonds,” and European local government bond issuance has grown significantly in recent years. Municipal bonds (munis) may enjoy a tax advantage over other bonds because interest on municipal bonds is exempt from federal taxes. However, capital gains on munis are not tax exempt and income from portfolios that invest in munis is subject to state and local taxes and, possibly, the alternative minimum tax. Corporate Bonds After the government sector, the next largest segment of the bond market is corporate bonds, accounting for nearly 30% of outstanding bonds in the global market, according to Merrill Lynch. Corporations borrow money in the bond market to expand operations or fund new business ventures. The corporate sector is evolving rapidly and is one of the fastest growing segments of the bond market, particularly in Europe. From the end of 2000 to the end of 2003, the outstanding amount of bonds issued by non-financial euro area corporations grew nearly 60%, according to the European Central Bank. Corporate bonds fall into two broad categories: investment-grade and speculative-grade (also known as high-yield or “junk”) bonds. Speculative-grade bonds are issued by companies perceived to have a lower level of credit quality and higher default risk compared to more highly rated, investment-grade, companies. Within these two broad categories, corporate bonds have a wide range of ratings, reflecting the fact that the financial health of issuers can vary significantly. Speculative-grade bonds tend to be issued by newer companies, companies that are in a particularly competitive or volatile sector, or companies with troubling fundamentals. While a speculative-grade credit rating indicates a higher default probability, higher coupons on these bonds often compensate for the higher risk. Ratings can be downgraded if the credit quality of the issuer deteriorates or upgraded if fundamentals improve. In recent years, new securities have emerged that provide investors with additional options for gaining exposure to corporate credit. For example, investors can buy credit default swaps that provide insurance against a default by the corporate bond issuer. Credit default swaps can also be used to gain exposure to corporate credit without buying actual corporate bonds, or to “sell short” corporate exposure, which was previously not possible. Credit default swaps and other corporate credit derivatives have also been bundled into index products that allow for diversified, and in some cases leveraged, exposure to a broad array of corporate credit. Derivatives carry their own distinct risks and portfolios investing in derivatives could potentially lose more than the principal amount invested. Derivatives may involve certain costs and risks such as liquidity risk, interest rate risk, market risk, credit risk, management risk and the risk that a portfolio could not close out a position when it would be most advantageous to do so. - Mortgage-Backed and Asset-Backed Securities Another major growth area in the global bond market comes from a process known as “securitization,” in which the cash flows from various types of loans (mortgage

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payments, car payments or credit card payments, for example) are bundled together and resold to investors as securities. Mortgage-backed securities and asset-backed securities are the largest examples of securitization, but there are many other variations. Here’s what you need to know about the major types of securitized loans: • Mortgage-Backed Securities: These bonds are securities created from the monthly mortgage payments of many residential homeowners. Mortgage lenders sell individual mortgage loans to another entity that bundles those loans into a security that pays an interest rate similar to the mortgage rate being paid by the homeowners. As with other bonds, mortgage-backed securities may be sensitive to changes in prevailing interest rates and could decline in value when interest rates rise. And while most mortgage-backed securities are backed by a private guarantor, there is no assurance that the private guarantors or insurers will meet their obligations. • Asset-Backed Securities: These bonds are securities created from car payments, credit card payments or other loans. As with mortgage-backed securities, similar loans are bundled together and packaged as a security that is then sold to investors. Special entities are created to administer asset-backed securities, allowing credit card companies and other lenders to move loans off of their balance sheet. Asset-backed securities are usually “tranched,” meaning that loans are bundled together into high-quality and lower-quality classes of securities. • Pfandbriefe and Covered Bonds: German securities secured by mortgages are known as Pfandbriefe or, depending on the size of the offering, “Jumbo” Pfandbriefe. The Jumbo Pfandbrief market is one of the largest sectors of the European bond market. The key difference between Pfandbriefe and mortgage-backed or asset-backed securities is that banks that make loans and package them into Pfandbriefe keep those loans on their books. Because of this feature, Pfandbriefe are sometimes classified as corporate bonds. Other nations in Europe are increasingly issuing Pfandbrief-like securities known as covered bonds. The non-government bonds described above tend to be priced relative to a rate with little or no risk, rates such as government bond yields or the London Interbank Offered Rate (LIBOR). The difference between the yield on a lower-rated bond and the government or LIBOR rate is known as the “credit spread.” Credit spreads adjust based on investor perceptions of credit quality and economic growth, as well as investor demand for risk and higher returns. 6. What are the different bond investment strategies? Investors have several options for adding bonds to their portfolio. One option is to invest with an “active” bond manager that will employ various strategies in an effort to maximize the return on a bond portfolio and outperform the market’s return as measured by a selected benchmark. A second option is to invest with a “passive” manager whose goal is to replicate (rather than outperform) the returns of the bond market or a specific sector of the bond market. A third option is to invest in a “laddered” bond strategy, in which maturing bonds are passively reinvested in new bonds without any attempt to maximize returns.

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Investors have long debated the merits of active management versus passive management and laddered strategies. The key contention in this debate is whether the bond market is too efficient to allow active managers to consistently outperform the market itself. An active bond manager, would counter this argument by noting that both size and flexibility enable active managers to optimize short- and long-term trends in order to outperform the market. Active bond managers commonly adjust a bond portfolio’s duration (the weighted average duration of all the bonds in the portfolio) based on an economic forecast. For example, in anticipation of declining interest rates an active manager may lengthen a portfolio’s duration because the longer the duration, the more price appreciation the portfolio will experience if rates decline. To lengthen duration, the bond manager might sell shorter-term bonds and buy longer-term bonds. On the other hand, a bond manager expecting interest rates to rise would normally shorten the bond portfolio’s duration by buying shorter-term bonds and selling longer-term bonds. As rates fall, the price of a shorter-duration portfolio should fall less than that of a longer-duration portfolio in the event of rising interest rates. Another active bond investment strategy is to adjust the credit quality of the portfolio. For example, when economic growth is accelerating, an active manager might add bonds with lower credit quality in hopes that the bond issuers will experience credit improvement with the positive change in the economy and the bond prices will rise. In some cases, active managers take advantage of strong credit analysis capabilities to identify sectors of the market that seem likely to improve, therein potentially increasing a portfolio’s return. A third active bond strategy is to adjust the maturity structure of the portfolio based on expected changes in the relationship between bonds with different maturities, a relationship illustrated by the yield curve. While yields normally rise with maturity, this relationship can change, creating opportunities for active bond managers to position a portfolio in the area of the yield curve that is likely to perform the best in a given economic environment. 7. What Determines the Shape of the Yield Curve? Most economists agree that two major factors affect the slope of the yield curve: investors’ expectations for future interest rates and certain “risk premiums” that investors require to hold long-term bonds. Three widely followed theories have evolved that attempt to explain these factors in detail: • The Pure Expectations Theory holds that the slope of the yield curve reflects only investors’ expectations for future short-term interest rates. Much of the time, investors expect interest rates to rise in the future, which accounts for the usual upward slope of the yield curve. • The Liquidity Preference Theory, an offshoot of the Pure Expectations Theory, asserts that long-term interest rates not only reflect investors’ assumptions about future interest rates but also include a premium for holding long-term bonds, called the term premium or the liquidity premium. This premium compensates investors for the added risk of having their money tied up for a longer period, including the greater price uncertainty. Because

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of the term premium, long-term bond yields tend to be higher than short-term yields, and the yield curve slopes upward. • The Preferred Habitat Theory, another variation on the Pure Expectations Theory, states that in addition to interest rate expectations, investors have distinct investment horizons and require a meaningful premium to buy bonds with maturities outside their “preferred” maturity, or habitat. Proponents of this theory believe that short-term investors are more prevalent in the fixed-income market and therefore, longer-term rates tend to be higher than short-term rates. Because the yield curve can reflect both investors’ expectations for interest rates and the impact of risk premiums for longer-term bonds, interpreting the yield curve can be complicated. Economists and fixed-income portfolio managers put great effort into trying to understand exactly what forces are driving yields at any given time and at any given point on the yield curve. 8. When Does the Slope of the Yield Curve Change? Historically, the slope of the yield curve has been a good leading indicator of economic activity. Because the curve can summarize where investors think interest rates are headed in the future, it can indicate their expectations for the economy. A sharply upward sloping, or steep yield curve, has often preceded an economic upturn. The assumption behind a steep yield curve is interest rates will begin to rise significantly in the future. Investors demand more yield as maturity extends if they expect rapid economic growth because of the associated risks of higher inflation and higher interest rates, which can both hurt bond returns. When inflation is rising, the Federal Reserve will often raise interest rates to fight inflation. The graph below shows the steep U.S. Treasury yield curve in early 1992 as the U.S. economy began to recover from the recession of 1990-91.

A flat yield curve frequently signals an economic slowdown. The curve typically flattens when the Federal Reserve raises interest rates to restrain a rapidly growing economy; short-term yields rise to reflect the rate hikes, while long-term rates fall as expectations of inflation moderate. A flat yield curve is unusual and typically indicates a transition to either an upward or downward slope. The flat U.S. Treasury yield curve below signaled an economic slowdown prior to the recession of 1990-91.

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An inverted yield curve can be a harbinger of recession. When yields on short-term bonds are higher than those on long-term bonds, it suggests that investors expect interest rates to decline in the future, usually in conjunction with a slowing economy and lower inflation. Historically, the yield curve has become inverted 12 to 18 months before a recession. The graph below depicts an inverted yield curve in early 2000, almost a year before the economy fell into recession in 2001.

9. What are the Different Uses of the Yield Curve? The yield curve provides a reference tool for comparing bond yields and maturities that can be used for several purposes. First, the yield curve has an impressive record as a leading indicator of economic conditions, alerting investors to an imminent recession or signaling an economic upturn, as noted above. Second, the yield curve can be used as a benchmark for pricing many other fixed income securities. Because U.S. Treasury bonds have no perceived credit risk, most fixed-income securities, which do entail credit risk, are priced to yield more than Treasury bonds. For example, a three-year, high-quality corporate bond could be priced to yield 0.50%, or 50 basis points, more than the three-year Treasury bond. A three-year, high-yield bond could 11

be valued 3% more than the comparable Treasury bond, or 300 basis points “over the curve.” Third, by anticipating movements in the yield curve, fixed-income managers can attempt to earn above-average returns on their bond portfolios. Several yield curve strategies have been developed in an attempt to boost returns in different interest-rate environments. Three yield curve strategies focus on spacing the maturity of bonds in a portfolio. In a bullet strategy, a portfolio is structured so that the maturities of the securities are highly concentrated at one point on the yield curve. For example, most of the bonds in a portfolio may mature in 10 years. In a barbell strategy, the maturities of the securities in a portfolio are concentrated at two extremes, such as five years and 20 years. In a ladder strategy, the portfolio has equal amounts of securities maturing periodically, usually every year. In general, a bullet strategy outperforms when the yield curve steepness’, while a barbell outperforms when the curve flattens. Investors typically use the laddered approach to match a steady liability stream and to reduce the risk of having to reinvest a significant portion of their money in a low interest-rate environment. Using the yield curve, investors may also attempt to identify bonds that appear cheap or expensive at any given time. The price of a bond is based on the present value of its expected cash flows, or the value of its future interest and principal payments discounted to the present at a specified interest rate or rates. If investors apply different interest-rate forecasts, they will arrive at different values for a given bond. In this way, investors judge whether particular bonds appear cheap or expensive in the marketplace and attempt to buy and sell those bonds to earn extra profits. Fixed-income managers can also seek extra return with a bond investment strategy known as riding the yield curve, or rolling down the yield curve. When the yield curve slopes upward, as a bond approaches maturity or “rolls down the yield curve,” it is valued at successively lower yields and higher prices. Using this strategy, a bond is held for a period of time as it appreciates in price and is sold before maturity to realize the gain. As long as the yield curve remains normal, or in an upward slope, this strategy can continuously add to total return on a bond portfolio. 10. What is duration? And what are the types of duration and its uses? Duration is the most commonly used measure of risk in bond investing. Duration incorporates a bond's yield, coupon, final maturity and call features into one number, expressed in years, that indicates how price-sensitive a bond or portfolio is to changes in interest rates. There are a number of ways to calculate duration, but the generic term generally refers to effective duration, defined as the approximate percentage change in price for a 100-basispoint change in yield. For example, the price of a bond with an effective duration of two years will rise (fall) two percent for every one percent decrease (increase) in yield, and the price of a five-year duration bond will rise (fall) five percent for a one percent decrease (increase) in rates. The longer the duration, the more sensitive a bond is to changes in interest rates. Different Duration Measures :

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Other methods of calculating duration are applicable in different situations, - which are used to enhance our understanding of how bond portfolios will react in different interestrate scenarios. • Bear Duration: Bear Duration estimates the price change in a security or portfolio in the event of a rapid, 50-basis-point rise in interest rates over the entire yield curve. This tool measures the effect that mortgages and callable bonds will have on the lengthening (or extension) of the portfolio's duration. • Bull Duration: Bull Duration estimates the price change in a security or portfolio in the event of a rapid, 50-basis-point drop in interest rates over the entire yield curve. This tool measures the effect that mortgages and callable bonds will have on shortening (or contracting) the portfolio's duration. • Curve Duration: This measures a portfolio's price sensitivity to changes in the shape of the yield curve (i.e., steepening or flattening). A portfolio's curve duration is considered positive if it has more exposure to the 2- to 10-year part of the curve. A portfolio with positive curve duration will perform well as the yield curve steepens, but will perform poorly as the yield curve flattens. A portfolio with negative curve duration has greater exposure to the 10- to 30-year portion of the curve. It will be a poor performer as the yield curve steepens and a strong performer as the yield curve flattens. • Spread Duration: This estimates the price sensitivity of a specific sector or asset class to a 100 basis-point movement (either widening or narrowing) in its spread relative to Treasuries. For example, corporate spread duration considers the widening or narrowing of the spread over LIBOR in floating-rate notes. The spread duration for fixed-rate corporates is the same as standard duration. Mortgage spread duration considers the widening or narrowing of the option-adjusted spread (OAS) that takes into account the prepayment risk of mortgage-backed securities. • Total Curve Duration: This indicates a portfolio's price sensitivity to changes in the shape of the yield curve relative to its benchmark's sensitivity to those same changes (see Curve Duration above for characteristics of positive vs. negative portfolios).

Uses: Duration can be used in response to expected changes in the economic environment. If the outlook on bonds is "bullish," i.e., we expect interest rates to fall, duration is then extended. If the outlook on bonds is "bearish," i.e., we expect interest rates to rise, duration is then reduced. Moreover, fund managers use duration in an attempt to construct the most appropriate portfolio for a given investor. Low-duration portfolios, which maintain average portfolio duration of one to three years under normal market conditions, should be less volatile than longer-duration strategies and are often used as an alternative for traditional cash vehicles such as money market funds. In a low interest rate environment a low-duration portfolio can be a higher yielding alternative to money market funds that is used by investors willing to accept additional risk in pursuit of greater return. Moderate-duration portfolios, which maintain average portfolio durations ranging from two to five years, could be appropriate for investors seeking the potential for higher

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returns than money market or short-term investments, but that are averse to a higher level of interest rate risk as measured by duration. Long-duration portfolios, which maintain average portfolio durations ranging from six to 25 years under normal market conditions, offer a relatively stable alternative to equities. In addition, they may be suitable for an investor looking for a closer match between the duration of its portfolio and its liabilities. Longer-duration strategies tend to benefit from uncertainty in the financial markets that might result in, for example, equity-market volatility or a flight to quality into Treasuries. Although duration is an important tool in constructing portfolios, portfolios with the same duration do not necessarily provide equal returns. For example, a hypothetical portfolio of 10-year Treasuries returned 15.4% from October 2000 to October 2001. During the same period, a portfolio of two-year and 30-year Treasuries with the same duration as the portfolio of 10-year Treasuries produced a return of 11.8% (a difference of 360 basis points). Why did the two hypothetical portfolios with equal duration have such different returns? Because yields on Treasuries of different maturities rarely move in unison. In general, the yield curve tends to steepen when interest rates are declining and flatten as interest rates rise. In the example above, the yield on the 10-year Treasury dropped from 5.80% to 4.59% from October 2000 to October 2001, a 121-basis-point decline. The portfolio consisting of two-year and 30-year Treasuries was affected by the movement in the yield curve, which steepened massively over the period in question: the 30-year bond went from yielding 14 basis points less than the two-year note in October 2000 (an inverted yield curve) to yielding 265 basis points more in October 2001, a 279-basis-point steepening.

Glossary: Face Value: The value of a bond as stated on the actual security. Also the amount that will be returned to the bondholder when the bond reaches “maturity.” Typical face values are $1,000, $5,000 and $10,000. Coupon: The stated interest rate on a bond when it is issued. In the U.S., most coupons are paid twice a year while annual payments are more common in Europe. Maturity: The amount of time before the bond repayment is due. A bond with a “10-year maturity is repaid by the issuer in the tenth year. Default:

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Default occurs when a bond issuer fails to make full payments on the bond (either the coupon or the face value). Default is usually the result of bankruptcy. Price: The market price of a bond is the present value of its future cash flows, including coupon payments and principal. Bond prices are usually quoted as a percentage of the bond’s face value. Yield: The term “yield” usually refers to yield-to-maturity, which is the average annual return on a bond if held to maturity. Another term, current yield, refers to a bond’s annual interest income. Duration: Duration measures a bond’s interest rate risk and is expressed in years. The longer the duration of a bond, the more sensitive the bond’s price is to changes in interest rates Basis Point: A basis point is 1/100 of a percent, i.e., 100 basis points equals one percent. Changes in bond yields are often quoted in basis points. For example, a drop in bond yields from 5% to 4.5% would be a 50 basis point decline. Returns can also be quoted in basis points. Credit Ratings: The table below shows credit ratings by Moody’s and Standard & Poor’s in descending order, from the highest rating to the lowest:

LIBOR: LIBOR stands for the London Interbank Offered Rate. This is the rate at which very large banks with high credit ratings lend to each other. If LIBR is 2% and a bond is quoted at 100 basis points over LIBOR, the bond is trading at 3%. Credit Spread: Credit spreads reflect the additional return investors to take on more credit risk. Bonds with lower credit ratings have larger credit spreads. For example, a corporate bond quoted at a credit spread of 100 basis points means investors are requiring 100 basis points of additional yield to buy that bond rather than a risk-free alternative such as a government bond. Yield Curve: The yield curve is a line graph that plots the relationship between yields to maturity and time to maturity for bonds of the same asset class and credit quality. The plotted line

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begins with the spot interest rate, which is the rate for the shortest maturity, and extends out in time, typically to 30 years.

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TOPIC 2: VALUING DEBT (Falguni Bavishi) 1

WHY DOES THE GENERAL LEVEL OF INTEREST RATES CHANGE OVER TIME?

Ans

Most bond promise a fixed nominal rate of interest. The real interest rate depends on the inflation rates. e.g. If one year bond promises a return of 10% Expected inflation rate 4% Therefore, the expected real return on the bond 1.10 -1 =0.058 or 5.8% 1.04 Since the future inflation rate is uncertain, the real return is also uncertain. Indexed bonds payments are linked to inflation . Treasury began to issue inflation-indexed bonds known as TIPs (Treasury Inflation-protected Securities) Real cash flow on TIPs are fixed but the nominal cash flow are increased as the Consumer Price Index increases. The real interest rate, according to Fisher, is the price which equates the supply and demand for the capital. The supply depends on people’s willingness to save. The demand depends on the opportunities for productive investment. Fisher’s theory states that, changes in anticipated inflation produce corresponding changes in the rate of interest. According to Fisher’s theory, A change in the expected inflation rate will cause the same nominal interest rate; it has no effect on the required real interest rate.

         2

HOW INTEREST RATE CHANGE AFFECT THE BOND PRICES?

Ans

Important factors are bond volatility and duration  Price of a longer-term bond is more sensitive to interest rate fluctuations than that of a shorter bond  E.g -Present value of bond - 108.57 percent of face value -Yielded 4.9%

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Year 1 2 3 4 5

Ct

PV(Ct)at 4.9% [PV(Ct)/V] Total value*Time 68.75 65.54 0.060 0.060 68.75 62.48 0.058 0.115 68.75 59.56 0.055 0.165 68.75 56.78 0.052 0.209 1068.75 841.39 0.775 3.875 V=1085.74 1.000 4.424yrs

Here, duration =[1*PV(C1)] + V where, PV =

[2*PV(C2)] V

+

[3*PV(C3)] V

C1 C2 1,000 + C N + + ... + 1 2 (1 + r ) (1 + r ) (1 + r ) N

Now, if the interest rates change, Suppose, the change is of 1 Percent-point variation in yield causes: say its 1.049 change then, Volatility (percent)= Duration 1 + Yield = 4.424 1.049 in

3 Ans

= 4.22

Note: 1 percentage-point change in interest rates leads to 4.22 percent change bond price. Change in bond price = 4.22 * Change in interest rates Its called as one factor model of bond returns. WHAT ARE STEPS IN VALUING THE BOND? When a firm defaults, its stockholders are in effect exercising their put. The put’s value is the value of liability – the value of the stock holders’ right to walk away from their firms debt in exchange for handling over the firm’s assets to its creditors. Thus, two steps involved in the process: 1) Calculate the bond’s value assuming no default risk 2) Calculate the value of put written on the firm’s assets where, the maturity of the put equals the maturity of the bond and the exercise price of the put equals the promised payments to bond holders

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BOND VALUE = ASSUMING NO CHANCE OF DEFAULT

BOND VALUE

VALUE OF PUT OPTION

NOTE:\ Owing a corporate bond is also equivalent to owing the firm’s asset but giving a call option on these assets to the firm’s stockholders BOND VALUE 4) Ans

=

ASSET VALUE

VALUE OF CALL OPTION ON ASSETS

Example of valuing a bond Example  If today is October 2002, what is the value of the following bond? An IBM Bond pays $115 every Sept for 5 years. In Sept 2007 it pays an additional $1000 and retires the bond. The bond is rated AAA (WSJ AAA YTM is 7.5%) Cash Flows Sept 03 115

PV =

04 115

05 115

06 115

07 1115

115 115 115 115 1,115 + + + + 2 3 4 1.075 (1.075) (1.075) (1.075) (1.075) 5

= $1,161.84 1600 1400 1200 1000 800 600 400 200 0 0

2

4

5 Year 9% Bond

6

8

10

12

1 Year 9% Bond

19

14

5)

HOW TO CALCULATE THE PROBABILITY OF DEFAULT?

Ans

Banks and other institution not only tries to know the value of the loan that they have made but also need to know the risk that they are incurring.

E.g Suppose ABC company have a current market value - $100 Its debt has a face value of - $60  Due to be repaid at the end of 5 years  The expected value of the assets is $120, but its not certain.  There is a probability of 20% that the asset value could fall below $60, in which case the company will default on its debt. To calculate the probability,  The growth in assets in the market value of its assets,  The face value maturity of debt and  Variability of the future asset values 6) Ans

Example of debt and risk. Calculate the duration of the bonds. Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM: Year CF 1 90 2 90 3 90 4 90 5 1090

PV@YTM 82.95 76.45 70.46 64.94 724.90 1019.70

% of Total PV % x Year .081 0.081 .075 0.150 .069 0.207 .064 0.256 .711 3.555 1.00 Duration= 4.249

7)

A FIRM HAS A CHOICE OF TAKING ON BANK DEBT OT ISSUING BONDS, WHAT ARE THE ADVANTAGE THAT IT WILL TAKE ON BANK DEBT?

Ans

Bank debt provides the borrower with several advantages : 1) It can be used for borrowing relatively small amounts of money; in contrast, the bond issue thrives on economies of scale with larger issues

having 2)

lower costs If the company is neither well known nor widely followed by analyst. firm can convey proprietary information to the lending bank that will help both pricing

and 3)

evaluating the loan. While in corporate bonds issue, the information will be widely disseminated. In order to issue bonds. firms usually have to submit to being rated which is not 20

required in the bank debts.

8) Ans

WHAT IS YEILD TO MATURITY? EXPLAIN WITH EXAMPLE. Rather than discounting each of the payments at a different rate of interest, one could find a single rate of discount that would produce the same present value, such a rate is called YTM. Example We have a 9% 1 year bond. The built in price is $1000. But, there is a 20% chance the company will go into bankruptcy and not be able to pay. What is the bond’s value? Bond Value 1090 0 0.20

Prob 0.80 =

=

872.00 0

. 872.00 (expected CF )

872 = $800 1.09 1090 YTM = = 36.3% 800

Value =

Conversly - If on top of default risk, investors require an additional 2 percent market risk premium, the price and YTM is as follows: 872 = $785.59 1.11 1090 YTM = = 38.8% 785.59

Value =

9)

WHAT IS TERM STRUCTURE OF INTEREST RATES AND WHAT DETERMINES THE SHAPE OF THE TS (TERM STRUCTURE).

Ans

Long rates of interest are higher than the short rates but sometimes shorter rates are higher than the longer rates. Its basically relationship of interest rates on loans of different maturities The follwing determines the shape of TS: 1 - Unbiased Expectations Theory-

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2 - Liquidity Premium Theory 3 - Market Segmentation Hypothesis Term Structure & Capital Budgeting  CF should be discounted using Term Structure info  Since the spot rate incorporates all forward rates, then one should use the spot rate that equals the term of ones project.  If one believe in other theories one should take advantage of the arbitrage.

10) Ans

SOME BOND TERMINOLOGY  Foreign bonds - Bonds that are sold to local investors in another country's bond market  Yankee bond- a bond sold publicly by a foreign company in the United States  Sumari - a bond sold by a foreign firm in Japan  Indenture or trust deed - the bond agreement between the borrower and a trust company  Registered bond - a bond in which the Company's records show ownership and interest and principal are paid directly to each owner  Bearer bonds - the bond holder must send in coupons to claim interest and must send a certificate to claim the final payment of principal  Mortgage bonds - long-term secured debt often containing a claim against a specific building or property  Asset-backed securities - the sale of cash flows derived directly from a specific set of bundled assets  Sinking fund - a fund established to retired debt before maturity  Callable bond - a bond that may be repurchased by a the firm before maturity at a specified call price  Defeasance - a method of retiring corporate debt involving the creation of a trust funded with treasury bonds

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•

Straight Bond vs. Callable Bond

Value of bond

Straight bond

100 bond callable at 100

75

50 25

25

50

75

100

23

125

150

Value of straight bond

TOPIC 3: INTEREST RATE ARBITRAGE (Neha Karve) 1. We have the following rates: GBP/USD spot: 1.5625/35 Euro$ deposits: 8-1/4 – 8-1/2 Euro₤ deposits: 12 ⅝ – 13 Work out the limits on forward quotes such that there are no covered interest arbitrage opportunities. Solution: Option 1: Borrow Sterling, convert spot to dollars, invest dollars and sell the maturing dollar deposit forward. Each sterling borrowed will give $1.5625 in the spot market. This is deposited at the rate of 8.25% p.a. The maturity value of the deposit is $(1.5625 * 1.0825) = $1.6914 This is sold forward at a forward as rate Fa. The sterling inflow would be ₤(1.6914/ Fa). The repayment of the sterling loan would require ₤1.13. If there is to be no arbitrage, we must have: (1.6914/ Fa) ≤ 1.13 or Fa ≥ (1.6914/1.13) = 1.4968 Option 2: Borrow dollars, convert spot to sterling, invest sterling and sell the sterling deposit forward. One dollar sold spot would get us (1/1.5635) sterling. This amount deposited at an interest rate of 12 ⅝ or 12.625% will grow to (1/1.5635)(1.2625) sterling a year later. This would be sold forward at the forward bid rate Fb to fetch Fb[(1/1.5635)(1.2625)] dollars a year later. The repayment of the dollar loan would require $1.0850. To prevent riskless profit we must have Fb[(1/1.5635)(1.2625)] ≤ 1.0850 Or Fb ≤ (1.0850 x 1.5635)/1.2625 = 1.5062 Fb < F a The limits are 1.4968/1.5062 2. The following rates are available in the market: Spot USD/CHF: 1.6010/20 3- months Forward: 1.5710/25 CHF 3-month rates: 4 – 4¼

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EuroUSD 3-month rates: 12⅛ - 12 ⅜ Examine if there are covered interest arbitrage possibilities. Solution: Option 1: Borrow 1 CHF to make a covered investment in 3-month Euro$. At the end of 3 months you must repay: CHF[1 + (0.25)(0.0425)] = CHF 1.0106 Covered investment in Euro$ yields, after conversion back to CHF: CHF(1.5710/1.6020) [1 + (0.25)(0.12125)] = CHF 1.0104 This is a losing proposition Option 2: Borrow $1 to make a covered investment in CHF. You have to repay: $[1 + (0.25)(0.12375)] = $1.0309 Covered CHF investment yields, after conversion to USD: $(1.6010/1.5725) [1 + (0.25)(0.04)] = $1.0283 This is also a loss. Thus there is no riskless profit to be had by way of interest arbitrage. 3. A Swiss firm needs $10 million 3 months from now. The firm has access to the Eurodeposit market. Solution: If the firm buys dollars forward, each dollar will cost CHF1.57253 3 months later. As an alternative, it can borrow CHF, convert spot to dollars, place dollars in a euro$ deposit and use these to make the payment. The cost per dollar in terms of CHF outflow 3 months later is CHF (1.6020) {[1 + 0.25(0.0425)]/[1 + 0.25(0.12125)]} = CHF 1.5714 4. The market rates are as follows: USD/CHF spot: 1.6450 6 month forward: 1.6580 Euro$ 6-month interest rate: 4.50% per annum EuroCHF 6-month interest rate: 6.50% per annum What is the forward discount on CHF? Solution: The forward discount on CHF is: [(1.6580 – 1.6450)/1.6450] * 100 * 2 = 1.58% Which is less than 2% as required by the covered interest parity condition. Forward CHF is overvalued relative to spot CHF. 5. A Swiss firm needs $1 million right now to settle an import bill.

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The market rates are as follows: USD/CHF spot: 1.6450 6 month forward: 1.6580 Euro$ 6-month interest rate: 4.50% per annum EuroCHF 6-month interest rate: 6.50% per annum Solution: Option 1: It can acquire dollars in the spot market at a cost of CHF 1.6450 million. Option 2: It can take a 6-month $1 million loan in the Eurodollar market to settle the import bill and set aside enough CHF on deposit to buy the dollar loan principal and interest 6 months forward. It has to repay $1,000,000 [1 + (0.045/2)] = $1.0225 million To acquire this in the forward market, it will need CHF (1.0225 * 1.6580) million = CHF 1.695305 million To have this amount ready 6 months later, it must deposit now CHF (1.695305/1.0325) million = CHF 1,641,941.9 Thus, it saves over CHF 3000 by following the second option. 6. A firm needs CHF 1 million 6 months from now to pay off a maturing payable. How should it acquire it? The market rates are as follows: USD/CHF spot: 1.6450 6 month forward: 1.6580 Euro$ 6-month interest rate: 4.50% per annum EuroCHF 6-month interest rate: 6.50% per annum Solution: Option 1: It can directly buy it in the forward market. For a forward purchase it will need $(1,000,000/1.6580) = $603136.31, 6 months hence. Option 2: It can indirectly acquire it via the spot and money markets. It can borrow dollars, convert spot to CHF and depost CHF in the Euromarket. To have CHF 1 million 6 months hence, it must deposit CHF (1,000,000/1.0325) = CHF 968523 now. To acquire this in the spot market, it will need to borrow: $(968523/1.6450) = $588767.78 now. The repayment of this loan will require $(588767.78 * 1.0225) = $602015.06, six month hence. Thus, the US firm saves by avoiding the forward market.

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7. What is the Covered Interest Parity Theorem. Solution: In the absence of restrictions on capital flows and transaction costs, for any pair of currencies A and B the following relation must hold: (1+niA) = Fn(B/A) (1+niB) S(B/A) Here, iA and iB are annual Eurodeposit rates, Fn is the n-year forward rate and S is the spot rate. 8. Discuss the various reasons for departures from covered interest parity in practice. Solution: a) Transaction costs. Covered interest parity does not imply a unique pair of forward bid-ask rates. b) Political risk. c) Taxes. d) Interest rates accessible to a particular firm may differ from Eurorates because of government restrictions or the firm’s own creditworthiness. 9. Does covered interest arbitrage work in reality? Empirical studies of forward markets in major convertible currencies confirm that the interest parity relationship doe is fact hold within the limits imposed by transaction costs. 10. An American company needs SEK 10 million 3 months from now to pay a Swedish supplier. The forex and Eurodeposit rates are as under Spot (USD/SEK) = 9.3065 3 month forward = 9.2155 EuroSEK 3 month deposit 5% Euro$ 3 month deposit 9% The company can borrow in the US at a prime rate of 8% while it can earn 4.75% on EuroSEK deposits. Should it purchase the SEK in the forward market or acquire them indirectly? Solution: Option 1: $ (10/9.1244) = $1085130.33 Option 2: Borrow dollars for 3 months @ 8%. Convert spot to SEK, deposit SEK @ 4.75% $ [(1/9.3065)(1.02)(10)]/[1+0.25(0.0475)*1,000,000] = $1083145.81

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TOPIC 4: HEDGE FUNDS (Abhishek Singh) Q.1 What are hedge funds? A. The concept of hedge funds has been around now for over 50 years, dating back at least to sociologist Alfred Winslow Jones. The term “hedge fund” referred to Jones’ original innovation, where long positions in undervalued equities were offset (or “hedged”) with other short positions. Today, hedge funds are defined more by their structure than by their method of investing. These investments are commonly set up as a limited partnership with the manager acting as the general partner while the investors act as the limited partners. Hedge funds are able to invest using several different strategies, which may include one or more of short-selling, leverage, arbitrage, and of course, hedging. Today, these strategies are applied across a diverse array of asset classes, including stocks, bonds, commodities, and currencies. Q. 2 Who typically invests in hedge funds? A. Hedge funds are designed for sophisticated, high net worth investors including qualified individuals, institutions, endowments, fund of funds, family offices, and pensions. Q.3 Are there special risks associated with hedge funds? A. Yes. In addition to the general risks described for all alternative investments, investing in hedge funds may involve a high degree of risk, often engage in leveraging and other speculative investment practices that may increase the risk of investment loss, can be highly illiquid, are not required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are not subject to the same regulatory requirements as mutual funds, often charge high fees which may offset any trading profits, and in many cases the underlying investments are not transparent and are known only to the investment manager. All hedge funds are unique and any investor should carefully consider all risks prior to placing money with a particular fund. Specific risks can be found in the hedge fund’s offering memorandum. Q.4 What is the minimum investment in a hedge fund? A. There is no standard as to hedge fund minimum investments. Minimums are set by the General Partner, and although typically hedge funds may have a $250,000 or $500,000 minimum investment, there are also funds with minimums well over $1 million.

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Q. 5 What types of fees do most hedge funds charge? A. Hedge funds typically charge a fee based on the amount of invested assets (a “management fee”), and a profit based fee (an “incentive fee”). Typically the management fee may be set at 1%-2% of assets annually, and an incentive fee may be set at 20%-25% of yearly profits. There are many variations to the basic fee structure, some fairly common. Many funds observe a “high-water mark." Under this structure, if an investor loses money with a fund during a given period, no incentive fees will be charged in later periods until these losses are recovered. Another common variation is the "preferred return" or "benchmark." This means that a fund will not collect an incentive fee until a certain return is achieved. Q. 6: Can I use third parties to sell the fund? A: Yes, you can use third parties to sell the fund, but typically substantial investors will not consent to the use of their own money to pay commissions. Furthermore, anyone who sells your units must be licensed as a broker/dealer Q. 7: Can a fund manager simultaneously operate both a Private Investment Company and a Qualified Purchaser Fund which are substantially similar to each other? A: Yes. Legislation passed in 1996 eliminates the application of the "integration" doctrine in this context. (The "integration" doctrine was developed by the SEC staff to police the 100 securityholder restriction on Private Investment Companies. In broad terms, this doctrine requires two substantially identical funds to be treated as if they were a single fund for purposes of testing whether the Private Investment Company Exclusion is available.) Q. 8: What about trading commodities? A: If a Hedge Fund trades in futures contracts or options thereon, the fund would likely be considered a commodity pool under the Commodity Exchange Act and the general partner of the fund would have to register with the Commodity Futures Trading Commission as a commodity pool operator and would have to take a test administered by the CFTC. Q. 9: What is the typical compensation to the general partner? A: The general partner typically gets a special allocation equal to 20% of the net profits allocated at the end of the year to each partner. This allocation is based on realized and unrealized gains and losses. It is made on a partner by partner basis. The general partner or an affiliate also receives a management fee which is typically 1% of the net asset value and the fee is paid quarterly in advance. Q.10: Do I need to take a test to be a general partner of a fund?

29

A: The answer varies depending upon the state in which an investment manager is domiciled. In Texas, managers generally need to have taken a general securities law exam (usually Series 7) and the exam on state law (usually the Series 65 exam).

TOPIC 5: FUTURES (Craig Rodrigues) 1.

What is a future contract?

Agreement to buy or sell a set number of shares of a specific stock in a designated future month at a price agreed upon by the buyer and seller. The contracts themselves are often traded on the futures market. A futures contract differs from an option because an option is the right to buy or sell, whereas a futures contract is the promise to actually make a transaction. A future is part of a class of securities called derivatives, so named because such securities derive their value from the worth of an underlying investment. 2.

What is “price–time priority”?

A market has price–time priority if it gives a guarantee that every order will be matched against the best available price in the country, and that if two orders are equal in price, the one which came first will be matched first. Forward markets, which involve dealers talking to each other on phone, do not have price–time priority. Floor–based trading with open–outcry does not have price–time priority. Electronic exchanges with order matching, or markets with a monopoly market maker, have price–time priority. On markets without price–time priority, users suffer greater search costs, and there is a greater risk of fraud. 3.

How does the futures market solve the problems of forward markets?

Futures markets feature a series of innovations in how trading is organised:  Futures contracts trade at an exchange with price–time priority - All buyers and sellers come to one exchange. This reduces search costs and improves liquidity. This harnesses the gains that are commonly obtained in going from a non– transparent club market to an anonymous, electronic exchange which is open to participation. The anonymity of the exchange environment largely eliminates cartel formation.  Futures contracts are standardised – all buyers or sellers are constrained to only choose from a small list of tradable contracts defined by the exchange. This

30

avoids the illiquidity that goes along with the unlimited customisation of forward contracts.  A new credit enhancement institution, the clearing corporation, eliminates counterparty risk on futures markets. The clearing corporation interposes itself into every transaction, buying from the seller and selling to the buyer. This is called novation. This insulates each from the credit risk of the other. In futures markets, unlike in forward markets, increasing the time to expiration does not increase the counterparty risk. Novation at the clearing corporation makes it possible to have safe trading between strangers. This is what enables large–scale participation into the futures market –in contrast with small clubs which trade by telephone – and makes futures markets liquid.

4.

What is cash settlement?

In practice, settlement involves high transactions costs. This is particularly the case for products such as the equity index, or an inter–bank deposit, where effecting settlement is extremely difficult or impossible. In these cases, futures markets use “cash settlement”. Here, the terminal value of the product is deemed to be equal to the price seen on the spot market. This is used to determine cash transfers from the counterparties of the futures contract. The cash transfer is treated as settlement. Example: - Suppose L has purchased 30 units of Nifty from S at a price of 1500 on 31 Dec 2000. Suppose we come to the expiration date, i.e. 31 Dec 2000, and the Nifty spot is actually at 1600. In this case, L has made a profit of Rs.100 per Nifty and S has made a loss of Rs.100 per Nifty. A profit/loss of Rs.100 per nifty applied to a transaction of 30 Nifties translates into a profit/loss of Rs.3,000. Hence, the clearing corporation organises a payment of Rs.3, 000 from S and a payment of Rs.3,000 to L. This is called cash settlement. Cash settlement was an important advance, which extended the reach of derivatives into many products where physical settlement was unviable. 5.

What determines the fair price of a derivative?

The fair price of a derivative is the price at which profitable arbitrage is infeasible. In this sense, arbitrage determines the fair price of a derivative. This is the price at which there are no profitable arbitrage opportunities. 6.

What determines the fair price of an index futures product?

31

The pricing of index futures depends upon the spot index, the cost of carry, and expected dividends. For simplicity, suppose no dividends are expected, suppose the spot Nifty is at 1000 and suppose the one–month interest rate is 1.5%. Then the fair price of an index futures contract that expires in a month is 1015. 7.

What happens if the futures are trading at Rs.1025 instead of Rs.1015?

This is an error in the futures price of Rs.10. An arbitrageur can, in principle, capture the mispricing of Rs.10 using a series of transactions. He would (a) buy the spot Nifty, (b) sell the futures, and (c) hold till expiration. This strategy is equivalent to riskless lending money to the market at 2.5% per month. As long as a person can borrow at 1.5%/month, he would be turning a profit of 1% per month by doing this arbitrage, without bearing any risk. 8.

What happens if the futures are trading at Rs.1005 instead of Rs.1015?

This is an error in the futures price of Rs.10. An arbitrageur can, in principle, capture the mispricing of Rs.10 using a series of transactions. He would (a) sell the spot Nifty, (b) buy the futures, and (c) hold till expiration. This is equivalent to borrowing money from the market, using (Nifty) shares as collateral, at 0.5% per month. As long as a person can lend at 1.5%/month, he would be turning a profit of 1% per month by doing this arbitrage, without bearing any risk.

9.

Are these pricing errors really captured by arbitrageurs?

In practice, arbitrageurs will suffer transactions costs in doing Nifty program trades. The arbitrageur suffers one market impact cost in entering into a position on the Nifty spot, and another market impact cost when exiting. As a thumb rule, transactions of a million rupees suffer a one–way market impact cost of 0.1%, so the arbitrageur suffers a cost of 0.2% or so on the roundtrip. Hence, the actual return is lower than the apparent return by a factor of 0.2 percentage points or so. 10.

What kinds of arbitrage opportunities will be found in this fashion?

The international experience is that in the first six months of a new index futures market, there are greater arbitrage opportunities that lie unexploited for relatively longer. After that, the increasing size and sophistication of the arbitrageurs ensures that arbitrage opportunities vanish very quickly. However, the international experience is that the glaring arbitrage opportunities only go away when extremely large amounts of capital are deployed into index arbitrage.

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TOPIC 6: MERGERS AND ACQUISITIONS (Praveen Kumar) Q1.) When one firm takes another over, or merges with another, what are the things which can happen to the firm's shares? Answer. It depends. In some cases, the shares of one company are converted to shares of the other company. For instance, 3Com announced in early 1997 that it was going to purchase US Robotics. Every US robotics shareholder will receive 1.75 shares of 3Com stock. In other cases, one company simply buys all of the other company's shares. It pays cash for these shares. Another possibility, not very common for large transactions, is for one company to purchase all the assets of another company. Company X buys all of Company Y's assets for cash, which means that Company Y will have only cash (and debt, if they had debt before). Of course, then company Y is merely a shell, and will eventually move into other businesses or liquidate. Q2.) What's the difference between a Merger and an Acquisition? A)An Acquisition is the generic term used to describe a transfer of ownership. Merger is a distinctive, technical term of a particular legal procedure occurring after an acquisition. Q3.) What is a Leveraged Buyout? A)A Leveraged Buyout (LBO) is a transaction whereby a company's stock or assets are purchased largely with borrowed money, resulting in a new capital structure consisting of a high percentage of debt secured by the assets of the acquired entity. Q4.) Who is in the best position to evaluate the challenges and risks of a merger? A) Nonprofits considering the opportunities presented by a merger should put together a team of professionals in this area – attorney, accountant and consultant with nonprofit merger expertise – to ensure that they are fully apprised of the challenges and risks involved. Q5.) I own a September call option for company XYZ. News has come out stating that XYZ is the subject of a cash buyout that is expected to close in May. Assuming that the merger is approved, what can I expect to happen to the call option I own. A) When an underlying security is converted into a right to receive a fixed amount of cash, options on that security will generally be adjusted to require the delivery upon exercise of a fixed amount of cash, and trading in the options will ordinarily cease when the merger becomes effective. As a result, after such an adjustment is made all options on

33

that security that are not in the money will become worthless and all that are in the money will have no time value. Q6.) How options are typically adjusted in the case of a merger where an election is involved? A) The option's deliverable in the case of an election merger is usually adjusted based on the merger consideration which accrues to non-electing shareholders. If call option holders do not wish to receive the non-electing consideration upon exercise after the contract adjustment, they must exercise in advance of the election deadline and submit elections pursuant to the election procedures described in the proxy statement/prospectus. Q7.) 11 What are the legal issues concerning restricted funds when there is a merger? A) To ensure that gifts or grants can be legally transferred to the surviving or newly created nonprofit post-merger, grantors of funds restricted for specific programs or endowments may need to be contacted about the merger to secure their consent to the transfer of funds at issue. Additionally, the actual and potential liabilities of the nonprofits, lawsuits, contract disputes and/ or judicial decrees and such, will need to be fully disclosed and investigated during the due diligence phase of the merger transaction to make sure that the newly structured organization’s operations and resources are not immediately threatened. Q8.) Why should a nonprofit consider a merger? A) A weak nonprofit struggling with cash flow problems and revenue losses may want to consider a merger to help sustain an organization’s work, services and mission; achieve or handle growth; and/or improve service delivery. Q9.) When considering a merger, what should be taken into account? A) Nonprofit boards and administrators should answer the following five questions: 1) Will the contemplated new organizational structure enhance the nonprofit’s ability to fulfill its mission and strategic goals? 2) Will the new structure allow the nonprofit to expand its scope of services or constituency base? 3)

Will the services offered to the nonprofit’s constituents be improved?

4)

Will the nonprofit’s operations be made more cost-effective and efficient?

5)

Will the nonprofit’s overall financial position be improved?

If the answer to a majority of these questions is “yes”, a merger might be the way for the organization to survive and thrive in the current economy. Q10.) What are the legal issues involved with a merger?

34

A) The legal framework for mergers that need to be considered are largely areas of state law and require consultation with a lawyer experienced in nonprofit mergers, but essentially require the merging nonprofits to do the following: 1) receive the approval of the majority of each nonprofit’s board of directors; 2) clarify the purpose and mission of surviving nonprofit; 3) decide on the terms and conditions of merger; 4) make necessary revisions to the surviving corporation’s articles of incorporation and bylaws; 5) restructure the board; 6) decide on the effective date of the transaction; 7) receive any approval required by state law (i.e. secretary of state and/or attorney general).

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TOPIC 7: UNDERSTANDING FINANCIAL STATEMENTS (Upasana Rana) 1. Valuation of assets For a resource to be an asset, a firm has to have acquired it in a prior transaction and be able to quantify future benefits from it. The accounting view of asset value is grounded in the notion of historical cost, which is the original cost of the asset, adjusted upwards for improvements made to the asset since purchase and downwards for the loss in value associated with the aging of the asset. This historical cost is called the book value. There are three principles that underlie the way assets are valued in accounting statements. a) Book value: Valuing an asset begins with the book value unless a substantial reason is given, they view the historical cost as the best estimate. b) Market or estimated value: When a current market value exists for an asset that is different from the book value, accounting conventions view this market value with suspicion. The MP of an asset is much too volatile and too easily manipulated to be used as an estimate. This suspicions increases more when the values are estimated for an asset based on expected future cash flows. c) Market value or book value: When there is more than one approach to value an asset, accounting conventions views the more conservative estimate of the value rather than the less conservative estimate of the value. Therefore, when both the market value and book value are available for an asset, the value which is lower is viewed. 2. Measures of profitability a) ROA = EBIT / Total Assets b) ROC = EBIT / BV of debt + BV of equity c) ROE = Net Income / BV of common equity 3. Ratio Analysis

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It is a systematic use of ratios to interpret or assess the performance and status of the firms. It is used to compare the risk and return relationships of firms of different sizes. Some of the ratios used to analyze the financial statements are: a) Current ratio b) Quick ratio c) Turnover ratio d) Debt equity ratio 4. Measuring risk a) b) c) d) e) f) g)

Current Ratio = Current Assets / Current Liabilities Quick Ratio = Cash + Marketable Securities / Current Liabilities Account Receivable Turnover = Sales / Avg Account Receivables Inventory Turnover = Cost of Goods Sold / Avg Inventory Account Payable Turnover = Purchases / Avg Account Payables Total Assets Turnover = Cost of goods Sold / Avg Total Assets Capital Turnover = Cost of goods Sold / Avg Capital Employed

5. Working capital turnover ratios a) Interest Coverage Ratio = EBIT / Interest Expenses b) Operating CF to Capital Expenditure = CF from Operations / Capital Exp c) Working Capital Turnover = Cost of Goods Sold / Net Working Capital 6. Debt/ Equity Ratios a) Debt to Capital Ratio = Debt / Debt + Equity b) Debt to Equity Ratio = Debt / Equity 7. Profitability Ratios The management of the firm is also eager to measure the firm’s operating efficiency. The operating efficiency of the firm and its ability to ensure adequate returns to its shareholders depends on the profits of the firm. The profitability of the firm can be measured by its profitability ratios. a) b) c) d)

Gross profit margin = (Gross Profit / Sales)*100 Operating Profit Ratio = EBIT / Net Sales Net Profit Ratio = EAIT / Net Sales EPS = Net Profit available to equity holders / No. of Ordinary share o/s

8. Importance of Ratio Analysis

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The importance of ratio analysis lies in the fact that it presents facts on a comparative basis and enables the drawing of inferences regarding the performance of a firm. It is relevant in assessing the performance of a firm in respect of the following aspects: a) Liquidity Position: The liquidity position of the firm would be satisfactory if it is able to meet its current obligations when they become due. A firm can be said to have the ability to meet its short term liabilities if it has sufficient liquid funds to pay the interest on its short term maturing debt usually within a year as well as to pay the principal. b) Long term Solvency: The long term solvency is measured by the leverage and profitability ratios which focus on earning power and operating efficiency. c) Operating Efficiency: It throws light on the degree of efficiency in the management and utilization of its assets. d) Overall Profitability: The management is concerned about the ability of the firm to meet its short term as well as long term obligations to its creditors, to ensure a reasonable return to its owners and secure optimum utilization of the assets of the firm. This is possible only if the ratios are considered together. e) Trend Analysis: Ratio analysis enables the firm to take the time dimension in to account. The significance of trend analysis of ratios lies in the fact that the analysts can know the direction of movements, whether the movement is favorable or not. 9. Limitations of Ratio Analysis a) Difficulty in Comparison: Different firms may have different accounting procedures, different accounting periods, and implying differences in the composition of the assets. So the ratios of two firms may not be comparable. b) Impact of Inflation: The tool of financial analysis is associated with price level changes. So this is a weakness of the traditional financial statements which are based on historical costs. c) Conceptual diversity: There may be difference of opinion regarding the various concepts used to compute the ratios.

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10. Du Pont Chart Rate of return on assets

EAT as percentage of sales

EAT

Multiplied by

Sales

/

Assets Turnover

Sales

Gross Profit = Sales – Cost of goods sold

/

Total Assets

Fixed Assets

+

minus

Expenses: selling administrative interest

Current Assets

minus

Income tax

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TOPIC 8: MUTUAL FUNDS (Yuvraj Singh) 1. What are Mutual Funds? Mutual Funds are a method of investing in various underlying investments such as stocks, bonds, mortgages, treasury bills and real estate. Mutual funds provide the advantages of professional investment management, liquidity, investment record keeping and diversification. Investing through mutual funds is the indirect ownership of the underlying investment vehicles.

A mutual fund enables investors to pool their money and place it under professional investment management. The portfolio manager trades the fund's underlying securities, realizing a gain or loss, and collects the dividend or interest income. The investment proceeds are then passed along to the individual investors. There are more mutual funds than there are individual stocks.

2. What is an Asset Management Company (AMC)?

The company that manages a mutual fund is called an AMC. For all practical purposes, it is an organized form of a "money portfolio manager". An AMC may have several mutual fund schemes with similar or varied investment objectives. The AMC hires a professional money manager, who buys and sells securities in line with the fund's stated objective. 3. What is the role of a Fund Manager?

Fund managers are responsible for implementing a consistent investment strategy that reflects the goals and objectives of the fund. Normally, fund managers monitor market and economic trends and analyse securities in order to make informed investment decisions. 4. How are mutual funds regulated?

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All Asset Management Companies (AMCs) are regulated by SEBI and/or the RBI (in case the AMC is promoted by a bank). In addition, every mutual fund has a board of directors that represents the unit holders' interests in the mutual fund. 5. Do mutual funds offer a periodic investment plan?

Most private sector funds provide you the convenience of periodic purchase plans (through a Systematic Investment Plan), automatic withdrawal plans and the automatic reinvestment of dividends. You would basically need to give post-dated cheques (monthly or quarterly, periodic date of the cheque is fixed by the Asset Management Company). Most funds allow a monthly investment of as little as Rs500 with a provision of giving 46 post-dated cheques and follow up later with more. Regular monthly investments are a good way to build a long-term portfolio and add discipline to your investment process. 6. Do any mutual funds invest in both stocks and bonds?

Yes, balanced funds invest in a combination of stocks and bonds, a typical mix is 60:40 in favour of stocks. Returns from balanced funds are normally lower than pure equity mutual funds when markets are rising, however if the market declines, the losses are also normally lower. Balanced funds are best suited for investors who do not plan their asset allocation and yet want to invest in equities. Buying separate equity and income funds for your portfolio also achieves the same results as buying a balanced fund. The advantage with the former option is that you can choose your own split (between stocks and bonds i.e fixed income) rather than let the fund manager decide the same. What are the different types of Mutual Funds? Mutual Funds are classified by structure in to: •

Open - Ended Schemes

•

Close-Ended Schemes

•

Interval Schemes

7. and by objective in to •

Equity (Growth) Schemes

•

Income Schemes

•

Money Market Schemes

•

Tax Saving Schemes

•

Balanced Schemes

•

Offshore funds

8. How significant are fund costs while choosing a scheme?

The cost of investing through a mutual fund is not insignificant and deserves due consideration, especially when it comes to fixed income funds. Management fees, annual expenses of the fund and sales loads can take away a significant portion of 41

your returns. As a general rule, 1% towards management fees and 0.6% towards other annual expenses should be acceptable. Carefully examine the fee a fund charges for getting in and out of the fund. Again, you can query on entry and exit loads under our Find-A-Fund query module or get a pre-defined shortlist of funds on the load specification structure through the Mutual Fund Directory section. 9. Ideally how many different schemes should one invest in?

10. Don't just zero in on one mutual fund (to avoid the risk of being overly dependent on any one fund). Pick two, preferably three mutual funds that would match you investment objective in each asset allocation category and spread your investment. We recommend a 60:40 split if you have shortlisted 2 funds and a 40:30:30 split if you have short-listed 3 funds for investment. 11. 12. How do you select a mutual fund scheme?

What's strategy got to do with selecting a mutual fund? Shouldn't you just go and invest in the best performing fund? The answer is no. Mutual fund investing requires as much strategic input as any other investment option. But the advantage is that the strategy here is a natural extension of your asset allocation plan (use our Asset Allocator to understand what your optimum asset allocation plan should be, based on your personal risk profile). Moneycontrol recommends the following process: 13. Identify funds whose investment objectives match your asset allocation needs Just as you would buy a computer that fits your needs and budget, you should choose a mutual fund that meets your risk tolerance (need) and your risk capacity (budget) levels (i.e. has similar investment objectives as your own). Typical investment objectives of mutual funds include fixed income or equity, general equity or sector-focused, high risk or low risk, blue-chips or turnarounds, longterm or short-term liquidity focus. You can use Moneycontrol's Find-A-Fund query module to find funds whose investment objectives match yours. 14. Evaluate past performance, look for consistency Although past performance is no guarantee of future performance, it is a useful way of assessing how well or badly a fund has performed in comparison to its stated objectives and peer group. A good way to do this would be to identify the five best performing funds (within your selected investment objectives) over various periods, say 3 months, 6 months, one year, two years and three years. Shortlist funds that appear in the top 5 in each of these time horizons as they would have thus demonstrated their ability to be not only good but also, consistent performers. 15. Why should you invest through Mutual Funds?

Firstly, we are not all investment professionals. We go to a doctor when we need medical advice or a lawyer for legal guidance, similarly mutual funds are investment vehicles managed by professional fund managers. And unless you rate highly on the Investment IQ Quiz, we recommend you use this option for 42

investing. Mutual funds are like professional money managers, however a key factor in their favour is that they are more regulated and hence offer investors the ability to analyse and evaluate their track record. Secondly, investing is becoming more complex. There was a time when things were quite simple - the market went up with the arrival of the first monsoon showers and every year around Diwali. Since India started integrating with the world (with the start of the liberalisation process), complex factors such as an increase in short-term US interest rates, the collapse of the Brazilian currency or default on its debt by the Russian government, have started having an impact on the Indian stock market. Although it is possible for an individual investor to understand Indian companies (and investing) in such an environment, the process can become fairly time consuming. Mutual funds (whose fund managers are paid to understand these issues and whose asset management company invests in research) provide an option of investing without getting lost in the complexities. Lastly, and most importantly, mutual funds provide risk diversification: Diversification of a portfolio is amongst the primary tenets of portfolio structuring (see The Need to Diversify). And a necessary one to reduce the level of risk assumed by the portfolio holder. Most of us are not necessarily well qualified to apply the theories of portfolio structuring to our holdings and hence would be better off leaving that to a professional. Mutual funds represent one such option.

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TOPIC 10: BANKING (Sushil Gautam)

What do you mean by Repayment holiday ? Whenever a loan is taken especially for acquiring fixed assets, the repayment does not start immediately. It starts after the fixed asset starts giving a return especially in the case of business enterprises. This is not so in the case of personal loans. The period during which there is no repayment is known as “repayment holiday period”. This is also known as “Moratorium period”. This period is longer in the case of industrial loans and minimum or absent in the case of personal loans. It should be noted that during this period, interest is charged and there is no period for non-levy of interest, although there may be a period of non-recovery of interest, i.e., interest, although levied not recovered for a specific period. Again if this is the case, interest on interest is recovered. What is Syndication ? Making arrangement for loans for borrowers. Should not be confused with granting of loans. The bank may or may not participate in the loan process, but would assume responsibility for getting “in principle” sanction from all the participating banks and financial institutions. It is more common internationally and syndication fees are quite substantial abroad. For example an Indian company wants a Foreign Currency Loan of 100 M. Rs. Making arrangement for this is called syndication. Even if the arranging bank participates in the loan by granting a portion of it, syndication is different from it. It gets paid separately for this activity.

What are CD’s?

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Certificates of deposit (CD): These are issued by banks in denominations of Rs 0.5mn and have maturity ranging from 30 days to 3 years. Banks are allowed to issue CDs with a maturity of less than one year while financial institutions are allowed to issue CDs with a maturity of at least one year. Usually, this means 366 day CDs. The market is most active for the one year maturity bracket, while longer dated securities are not much in demand. One of the main reasons for an active market in CDs is that their issuance does not attract reserve requirements since they are obligations issued by a bank. What are Non-performing assets? An asset, including a leased asset, becomes non-performing when it ceases to generate income for the bank. A ‘non-performing asset’ (NPA) was defined as a credit facility in respect of which the interest and/ or installment of principal has remained ‘past due’ for a specified period of time. The specified period was reduced in a phased manner as under: Year ending March 31 1993 1994 1995 onwards

Specified period four quarters Three quarters two quarters

An amount due under any credit facility is treated as “past due” when it has not been paid within 30 days from the due date. Due to the improvements in the payment and settlement systems, recovery climate, up gradation of technology in the banking system, etc., it was decided to dispense with ‘past due’ concept, with effect from March 31, 2001. Accordingly, as from that date, a Non-performing Asset (NPA) shall be an advance where Interest and/or installment of principal remain overdue for a period of more than 180 days in respect of a Term Loan,

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The bill remains overdue for a period of more than 180 days in the case of bills purchased and discounted, interest and/or instalment of principal remains overdue for two harvest seasons but for a period not exceeding two half years in the case of an advance granted for agricultural purposes, and any amount to be received remains overdue for a period of more than 180 days in respect of other accounts. With a view to moving towards international best practices and to ensure greater transparency, it has been decided to adopt the ‘90 days’ overdue’ norm for identification of NPAs, from the year ending March 31, 2004. Accordingly, with effect from March 31, 2004, a nonperforming asset (NPA) shall be a loan or an advance where; interest and/ or instalment of principal remain overdue for a period of more than 90 days in respect of a term loan, the account remains ‘out of order’ as indicated at paragraph 2.2 below, in respect of an Overdraft/Cash Credit (OD/CC), the bill remains overdue for a period of more than 90 days in the case of bills purchased and discounted, interest and/or instalment of principal remains overdue for two harvest seasons but for a period not exceeding two half years in the case of an advance granted for agricultural purposes, and any amount to be received remains overdue for a period of more than 90 days in respect of other accounts. As a facilitating measure for smooth transition to 90 days norm, banks have been advised to move over to charging of interest at monthly rests, by April 1, 2002. However, the date of classification of an advance as NPA should not be changed on account of charging of interest at monthly rests. Banks should, therefore, continue to 46

classify an account as NPA only if the interest charged during any quarter is not serviced fully within 180 days from the end of the quarter with effect from April 1, 2002 and 90 days from the end of the quarter with effect from March 31, 2004. 'Out of Order' status An account should be treated as 'out of order' if the outstanding balance remains continuously in excess of the sanctioned limit/drawing power. In cases where the outstanding balance in the principal operating account is less than the sanctioned limit/drawing power, but there are no credits continuously for 180 days (to be reduced to 90 days, with effect from March 31, 2004) as on the date of Balance Sheet or credits are not enough to cover the interest debited during the same period, these accounts should be treated as 'out of order'. Show the Regulatory Structure of Financial Institutions

Discuss the ALM of Banking Industry ? Mismatch between assets and liabilities, i.e. more liabilities accruing due at a time and demanding payment against meagre assets readily realisable into cash for satisfying these liabilities. This we call "asset/liability risk". In a business firm receivables may go overdue and get blocked. Similar problem in Banking is credit risk. Fluctuations in foreign exchange rate affects both industry and banks.

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ALM comprises both timely detection of mismatches between assets & liabilities maturing over a time and effecting appropriate steps to remedy the situation. While most of the banks in other economies began with strategic planning for asset liability management as early as 1970, the Indian banks remained unconcerned about the same. Till eighties, the Indian banks continued to operate in a protected environment. In fact, the deregulation that began in international markets during the 1970s almost coincided with the nationalization of banks in India during 1969. Nationalization brought a structural change in the Indian banking sector. Wholesale banking paved the way for retail banking and there has been an all-round growth in branch network, deposit mobilization and credit disbursement. The Indian banks did meet the objectives of nationalization, as there was overall growth in savings, deposits and advances. But all this was at the cost of profitability of the banks. Quality was subjugated by quantity, as loan sanctioning became a mechanical process rather than a serious credit assessment decision. Political interference has been an additional malady. Externally directed and over-controlled banking operations (like directed credit, directed pricing of all products both assets & liabilities, directed investment etc.) in a captive market insulated them from risk-exposure, since inter-bank competition was non-existent and free market forces were not operating. But the reforms of 1991-92 set a new phase in As all transactions of the banks revolve around raising and deploying the funds, AssetLiability Management gains more significance for them. Asset-liability management is concerned with the strategic management of balance sheet involving the management of risks caused by changes in the interest rates, exchange rates and the liquidity position of the bank. While managing these three risks, forms the crux of the ALM, credit risk and contingency risk also form a part of the ALM. Due to the presence of a host of risks and due to their inter-linkage, the risk management approaches for ALM should always be multi-dimensional. To manage the risks collectively, the ALM technique should aim to manage the volume, mix, maturity, rate sensitivity, quality and liquidity of the assets and liabilities as a whole so as to attain a predetermined acceptable risk/reward ratio. The purpose of ALM is thus, to enhance the asset quality, quantify the risks associated. Parameters Indicating Stability of ALM Composition The various risks that banks are exposed to will affect the short-term profits, the longterm earnings and the long-run sustenance capacity of the bank and hence the ALM model should primarily aim to stabilize the adverse impact of the risks on the same. Depending on the primary objective of the model, the appropriate parameter should be selected. The most common parameters for ALM in banks are: 1. Net Interest Margin (NIM - The impact of volatility on the short-term profits is measured by NIM, which is the ratio of the net interest income to total assets. Hence, if a bank has to stabilize its short-term profits, it will have to minimize the fluctuations in the NIM. 2. Market Value of Equity (MVE) - The market value of equity represents the long-term profits of the bank. The bank will have to minimize adverse movement

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in this value due to interest rate fluctuations. The target account will thus be MVE. In the case of unlisted banks, the difference between the market value of assets and liabilities will be the target account. 3. Economic Equity Ratio - The ratio of the shareholders funds to the total assets measures the shifts in the ratio of owned funds to total funds. This in fact assesses the sustenance capacity of the bank. Stabilizing this account will generally come as a statutory requirement. While targeting any one parameter, it is essential to observe the impact on the other parameters also. It is not possible to simultaneously eliminate completely the volatility in both income and market value. If the bank lays exclusive focus on the short-term profits, it may have an adverse impact on the long-term profits of the bank and vice-versa. Thus, ALM is a critical exercise of balancing the risk profile with the long/short term profits as well as its long-run sustenance Asset Liability Management is strategic balance sheet management of risks caused by changes in the interest rates, exchange rates and the liquidity position of the bank. To manage these risks, banks will have to develop suitable models based on its product profile and operational style. Several techniques are followed by banks in advanced countries for managing ALM.

Discuss Stress Testing ? Stress Testing "Stress testing" has been adopted as a generic term describing various techniques used by banks to gauge their potential vulnerability to exceptional, but plausible, events. Stress testing addresses the large moves in key market variables of that kind that lie beyond dayto-day risk monitoring but that could potentially occur. The process of stress testing, therefore, involves first identifying these potential movements, including which market variables to stress, how much to stress them by, and what time frame to run the stress analysis over. Once these market movements and underlying assumptions are decided upon, shocks are applied to the portfolio. Revaluing the portfolios allows one to see what the effect of a particular market movement has on the value of the portfolio and the overall Profit and Loss. Stress test reports can be constructed that summarise the effects of different shocks of different magnitudes. Normally, then there is some kind of reporting procedure and follow up with traders and management to determine whether any action needs to be taken in response. What are the guidelines of RBI to Commercial Banks for Adoption of ALM System? ALM model recommended by RBI to commercial banks is based on three pillars. 1. ALM Information Systems o

Management Information Systems 49

Information availability, accuracy, adequacy and expediency 2. ALM Organisation o Structure and responsibilities o Level of top management involvement 3. 3. ALM Process o Risk parameters o Risk identification o Risk measurement o Risk management o Risk policies and tolerance levels. o

TOPIC 11: COST OF CAPITAL (Mahyar Niroumand) Q1. What is cost of capital and what are the components of it? The cost of capital is expected return over the historical portfolio of company. For calculating the cost of capital we just calculate the weighted average cost of capital. Cost of capital = (debt/debt+equity)*cost of debt +(equity/debt+equity)*cost of equity And we know that the value of equity and debt is the market value of them, so the summation of them is the market value of the firm. Example: The equity of company A is 30 and the value of debt is 70, if investors expect a return of 7.5 percent on the debt and 15% on the equity, then what is the cost of capital( expected return on assets) COC= (30% X 7.5%)+(70% X 15%) = 12.75% Q2. How the change in the capital structure will affect the beta of company? As we know that the debtors and shareholders of company will build up the portfolio of company and this portfolio will bearing the risk regarding to their expectation. But as the rule, the debtors will bearing lesser risk toward the equity holders of company, because company must pay the debt either has profit or not, it can just avoid paying for dividends. So always as thumb rule the debt holders, they have beta between .1 to .3. Which in the Large Corporation, we can ignore it, but the most risk, which will affect the portfolio of company, is the risk of shareholder and according to the CAPM model: Cost of equity = Rf + beta(Risk premium)

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As the whole we can sum up the conclusion as: Beta of assets = Beta of portfolio = D/V * Beta of Debt + E/V * Beta of Equity So as we see any increase in risk of debt will carry the risk components for equity share holders, so that’s why borrowing it has financial leverage over the equity, with increase the beta of debt, the risk of portfolio will increase and the expectation of investors will increase, so the portfolio become more risky. With any change in beta of debt, the beta of assets and company will remain constant, but the beta of equity will change with it. We should consider that the cost of debt is the after tax, cost of debt. Q3. How to calculate the cost of debt and cost of equity of company? Cost of equity, according to CAPM model is the: Risk free rate + Beta (market return – Risk free rate) And as we know the market return is equal to: Market return = (Price of today – Price of yesterday+ dividend)/price of yesterday And cost of debt is equal to: Risk free rate + spread The amount of spread will indicate by credit rating of company. So by increasing the amount of debt the amount of spread will increase but simultaneously the probability of default of bond also will increase, and that will cause increase in probability of bankruptcy of company. Q4. What is the risk premium and risk free rate? Risk premium is the difference between the market return and risk free rate. Free risk rate is the interest rate over the government bonds. It will estimate annually by RBI. Q5. What is the relation between Cost of Capital and Firm’s value? With discounting the expected cash flow to the firm at the rate of WACC, we can define the value of firm. The cash flow at the firm can be estimated as cash flow after operating

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expenses, taxes, and any capital investments needed to create future growth on both fixed assets and working capital, but before financing expenses. Cash flow to firm = EBIT(1-Tax) – (capital expenditure – Depreciation) – Change in working capital So value of the firm can be estimated as: Value of firm =Σ Cash flows to firm / (1+WACC)^t So with increase or decrease in WACC and it can be the change in financing mix, we can change the value of firm, accordingly with decreasing the cost of capital, we can increase the firm value.

Q6. What are the steps for finding the optimum financing mix? 1. we assume the amount of debt and equity as the percentage of firm’s value 2. so for different financing mix, we have different beta and different cost of equity 3. According to that with increase in percentage of equity, we have different percentage of debt. 4. regarding to percentage of debt, we will estimate the interest rate 5. with increasing in interest rate, the tax rate will change, so we can find the effective tax rate 6. Now regarding to these components, we have the cost of debt and according to that we can find the after tax cost of debt. 7. With applying formula for WACC, we will have range of cost of capital, but in this range in one certain point we have least amount of cost of capital, that point is the optimum cost of capital. Q7. How can we estimate cost of capital in the bank and insurance companies, and what are the problems which we will face with it? First, bond rating for this industry is totally different from the manufacturing company, because the relation between interest coverage ratio and rating is very weak in this industry, so estimation of spread sounds difficult. Secondly is a measurement problem that arises partly from difficulty in estimating debt on the financial services company’s balance sheet. Because lots of components of short term debt, repurchasing agreements and other liabilities can arise on their balance sheet, so the only solution for that is just focusing on long term liabilities that may appear on a financial and use the interest coverage ratio for long term debt rather than short term debts.

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Third problem which can be occur, is this kind of companies have to meet capital ratios that are defined in terms of book value, if in the process of moving to an optimal market value of debt ratio, these firms violate the book capital ratios, they could put themselves in jeopardy.

FINANCING DECISIONS What are warrants and why would a firm issue warrants than common stock to raise equity? Warrant holders receive the right to buy shares in the company at a fixed price in the future, in return for paying for the warrants today. Following are the reasons for a firm to issue warrants 1) Warrants are priced according to the variance of the underlying stock’s price; the greater the variance, the greater the value. To the degree that the market overestimates a firm’s risk, the firm may gain by using warrants and other equity options because they will be overpriced relative to their true value 2) Warrants themselves create no financial obligations (such as dividends ) at the time of the issue 3) Warrants do not create any new additional shares currently while they raise equity capital for current use and hence there is no dilution effect. What are contingent value rights? Contingent value rights provide investors with the right to sell stocks for a fixed price and thus derive their value from the volatility of the stock and the investors’ desire to protect themselves against losses. Contingent value rights are similar to put option except that the proceeds from the contingent value rights sales go to the firm whereas those from the sale of listed puts go to the seller of the put and contingent value rights tend to be much long term than typical listed puts. The reasons for a firm to issue contingent value rights is because the firm believes it is significantly undervalued by the market, market is overestimating volatility and the put price reflects the mismatched volatility and the presence of contingent value rights as insurance may attract new investors to the market for the common stock. What are the advantages for a firm to raise money through bank debt? 1) Debt can be used for borrowing relatively small amounts of money. 2) If the company is neither well known nor widely followed by analysts, it can provide proprietary information to the lending bank that will help in both pricing

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and evaluating the loan, without worrying about the information getting out to its competitors. 3) To avail a bank loan, the firm is not required to be rated as in the case of issuing bonds. Why do firms issue convertible debt? 1) Convertible debt provides an attractive alternative to straight debt for high-growth companies that do not currently have high operating cash flows. The high growth and risk combine to increase the value of the conversion option, which in turn, pushes down the interest rate and reduces the coupon payment and cash outflow for the firm. 2) It is one of the ways of reducing the conflict between equity and debt holders in a firm. Equity investors, by taking riskier projects and new debt, can make existing bondholders worse off. If they do so with convertible debt, debt holders can always exercise their conversion options and become equity investors, thus removing themselves as a target for such actions. Why do firms issue preferred stock? 1) Many analysts and ratings agencies treat preferred stock as equity for the purposes of calculating leverage. For firms that are concerned about being viewed as having too much debt, it offers a way of raising money without giving up control and without increasing their debt ratios. 2) Firms do not have to pay taxes on 70% of the preferred dividends they receive on preferred stock investments they might have made in other firms. 3) Preferred stock offers a way of raising money for firms that have no other options – debt or equity – available to them. What is the difference between seed-money venture capital and start-up venture capital? Seed-money venture capital is provided to start-up firms that want to test a concept or develop a new product. Start-up venture capital allows firm that have established products and concepts to develop and market them What are the benefits of a firm using debt over equity? 1) Firms obtain a tax benefit because interest on debt is tax deductible, whereas dividends paid to stock holders are not. 2) Debt allows firms to impose discipline on managers. Firms have to make regular payments to debt holders, and managers who choose to invest in poor investments increase the likelihood that they will be unable to make these payments. How do firms choose a financing mix? Firms choose the mix of debt and equity by trading off the benefit of borrowing against the costs. There are, however, three alternative views of how firms choose a financing mix.

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1) The choice between debt and equity is determined by where a firm is in the growth life cycle. 2) Firms choose their financing mix by looking at other firms in their business. 3) Firms have strong preferences as to the kind of financing they will use, that is, a financing hierarchy, and they deviate from these preferences only when they have no choice. What is recapitalization? How does a firm do it? When a firm changes its current financing mix, either by using new equity to retire debt or new debt to reduce equity is called recapitalization. 1) Borrowing money and buying back stock 2) Debt-for-equity swap 3) Divestiture and use of proceeds 4) Financing new instruments disproportionately with debt or equity 5) Changing dividend payout INTEREST RATE SWAPS What is a swap? A swap is a agreement between two companies to exchange cash flows in the future. The agreement defines the dates when the cash flows are to be paid and the way in which they are to be calculated. Usually the calculation of the cash flows involves the future value of an interest rate, an exchange rate, or other market variable. What do you mean by plain vanilla interest rate swap and the term libor? Plain vanilla is the most common type of interest rate swap. With this swap the company agrees to pay cash flows equal to interest at a predetermined fixed rate on a notional principal for a number of years. In return, it receives interest at a floating rate on the same notional principal for the same period of time. The floating in most interest rate swap agreements is the London interbank offer rate (LIBOR). It is the rate of interest at which a bank is prepared to deposit money with other banks in the Eurocurrency market. Typically 1month, 3months, 6months, and 12 months LIBOR is quoted in all major currencies. How can you use a swap to transform a liability? The swap can be used to transform a floating rate loan to a fixed rate loan and vice-versa. Suppose a company ABC has arranged to borrow $100 million at LIBOR plus 10 basis points. It has a agreement with a company XYZ to pay fixed rate of interest at 5% and receive at a LIBOR rate. Now the three sets of cash flow for ABC would be: • It pays LIBOR plus 0.1% to its outside lenders. • It receives LIBOR under the terms of the swap. • It pays 5% under the terms of swap. Thus for ABC company , the could have the effect of transforming borrowings at a floating rate of LIBOR plus 10 basis points into borrowings at a fixed rate of 5.1%

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Now suppose XYZ has a liability of $100 million on which it pays fixed at 5.2%. After he has entered the swap the three sets of cash flows for XYZ would be: • It pays 5.1 % to its outside lenders. • It pays LIBOR under the terms of swap. • It receives 5% under the terms of swaps. Thus, for XYZ swap could have the effect of transforming borrowings into fixed rate of 5.2% into borrowings at a floating rate of LIBOR plus 20 basis points.

How can you use a swap to transform an asset? Swaps can b used to transform the nature of the assets. Suppose ABC owns $100 million in bonds that provide an interest at 4.7% per annum. After it enters into a swap, it has three sets of cash flows: • It receives 4.7% on the bonds. • It receives LIBOR under the terms of swap. • It pays 5% under the terms of swap. Now use of swap for ABC is to transform an asset earning 4.7% into an asset earning LIBOR minus 30 basis points. Now in the same case XYZ is getting returns on its bonds as LIBOR minus 20 basis points. It will have the following sets of cash flows: • It receives LIBOR minus 20 basis points. • It pays LIBOR under the terms of the swap. • It receives 5% under the terms of swap. Now use of swap for XYZ is to transform an asset earning LIBOR minus 20 basis points into an asset earning 4.8 %. What is the role of financial intermediary? Usually two non financial companies do not get in touch directly to arrange a swap. They each deal with a financial intermediary such as a bank or other financial institution. Plain vanilla fixed-for-floating swaps on US interest rates are usually structured so that the financial institution earns about 3 or 4 basis points on a pair of offsetting transactions. Who are the market makers? In practice it is unlikely that two companies contact a financial institution at the same time and want to take opposite position in exactly the same swap. For this reason many financial institution act as market makers for swap. This means that they are prepared to enter into a swap without having an offsetting swap with counterparty. What are confirmations?

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A confirmation is a legal agreement underlying a swap and is signed by representative of the two parties. The drafting of conformations has been facilitated by the work of the International Swaps and Derivatives Association (ISDA) in New York. The confirmation specifies that the following business day convention is to be used and the US calendar determines which days are business days which days are holidays. What is Comparative Advantage Argument? This states that popularity of swaps concerns comparative advantages. Consider the use of an interest rate swap to transform a liability. Some companies, it is argued, have a comparative advantage when borrowing in fixed rate markets, whereas some companies have comparative advantages in floating rate markets. As a result company may borrow floating when it wants and vice-versa. What are currency swaps? In its simplest form, this involves exchanging principal and interest payments in one currency for principal and interest payments in another. The principal amounts in each currency are usually exchanged at the beginning and at the end of the life of the swap. Usually the principal amounts are chosen to be approximately equivalent using the exchange rate at the swaps initiation. When they are exchanged at the end of the life the swap, their values may be quite different. What do you mean by coupon swap and basis swap? A coupon swap means when in an agreement a company X pays cash flows equal to the interest at predetermined fixed rate to company Z. And in return Y pays cash flows equal to the interest at LIBOR rate basis called as floating rate basis on the same notional principal. Basis swap means when a company receives interest on floating rate basis and pays also on floating rate basis. Company A pays to company B interest on a floating rate of return, lets say on 3 months LIBOR basis or 3 month T-bill and in return B also pays on a floating basis but lets on a 6 month LIBOR rate. Working Capital Management Q1. What is working capital management? What are the important factors affecting it? Ans. Working Capital management involves short-term financing which helps in running the day- to –day operations of the business. It is different from long term financing, in the sense it provides benefits in the short term. It is used to earn the revenues for the current financial year, whereas long-term financing which is used for the purchase of capital equipment provides benefits over several years. There are two key concepts:

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Gross working capital: is the total of all current assets Net working capital: is the difference between current assets and current liabilities. The factors influencing working capital management are: Nature of business Seasonality of business Production policy Market conditions Conditions of supply It varies from sector to sector and changing economic conditions. Q2. What is operating and cash cycle? Ans. Operating cycle is the time elapse between the purchase of raw materials and the collection of cash from sales. Cash cycle is the time elapse between purchase of raw materials and collection of cash from sales. Operating cycle = Inventory days + Accounts receivable days. Cash cycle = Operating cycle – accounts payable period Q3. What are the options available for a firm to manage Surplus funds? Ans. There are six strategies for handling excess cash balance: 1. Do Nothing- allow surplus liquidity to accumulate in the current account. 2. Make Ad Hoc investments: Such a strategy would make some contribution to the earnings but not optimal. 3. Ride the yield curve: this strategy is to increase the yield from a portfolio of marketable securities, if the interest rates are going to fall in the near future, one would buy long term securities as they appreciate more. On the other hand if the interest rates are expected to rise, one would sell long term securities. 4. Guidelines: Each firm would have different guidelines such as policies of anti speculation, minimizing transaction costs, holding investments to maturity. 5. Utilizing control limits: Setting the upper and lower limits of cash balances. 6. Managing with a portfolio perspective: Defining the efficient frontier and slecting the optimal portfolio. Q4. Discuss the features of the Economic Order Quantity model? Ans. The economic order quantity (EOQ) is the order quantity that minimizes the total costs of new orders and the carrying costs of inventory. To select the optimal level of inventory we have to balance out costs and the benefits. On one hand too high an

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investment in inventory can increase carrying costs while too low an investment can cause lost sales.

EOQ =

2*Annual Demand in units*Ordering Cost per order Carrying cost per unit

Note: the carrying cost also includes the interest that could have otherwise been earned. •

The model assumes that the demand is constant over time. If there is uncertainty associated with demand, the Eoq in that case is more difficult to estimate.

•

It assumes that the inventory can be replenished instantaneously which is unrealistic.

•

It assumes that the ordering costs are constant which is not true since economies of scale can reduce the ordering costs.

Q5. What are the determinants of optimal cash balances? The answer depends on a number of factors such as size of the firm, the sophistication of the banking system in which the firm operates. As we came up with the optimal inventory model, there is a Baumol Model which calculates the optimal cash balance in a very similar manner.

Opt cash Balance =

2*Annual Cash usage rate* Cost per sale of securities Annual interest rate

Q6. Discuss the Miller and Orr model? An alternative model to the Baumol model is the Miller and Orr model for those firms whose cash flows are uncertain. It allows firms to develop lower and upper limits for cash balances. The spread between the upper and lower limits is that which minimizes the sum of transaction costs and interest costs. The firm buys securities when it reaches the upper limit, and reduces its cash balances to the return point and sells securities when it reaches the lower limit. Q7. Explain the various terminologies under Managing Float?

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Ans. When businesses make or receive payments in the form of checks, there is usually a lag between when the check is written and the time it is cleared. This period is referred to as float. This time period is referred to as float, and it can have either a positive or negative impact on the firm. When a firm makes a payment it benefits for the time period until the check is cleared since it can access the funds, and when it is on the receiving end, it is referred to as processing float. The difference between the disbursements and the processing float is the net float. 1. Q.) What is Project Financing ? A.) It is a method of financing very large capital intensive projects, with long gestation period, where the lenders rely on the assets created for the project as security and the cash flow generated by the project as source of funds for repaying their dues. This is also called Non-recourse financing. Project finance is not a new financing technique. The earliest known project finance transaction took place in 1299, when the English Crown negotiated a loan from a leading Italian merchant bank of that period to develop the Devon silver mines. Under the loan contract, the lender would be able to control the operations of the mines for one year. He was entitled to all the unrefined ore extracted during the contract period, but had to pay all the operating costs associated with the extraction. There was no provision for interest, nor did the Crown guarantee the quantity or quality of silver that could be extracted. In current parlance, this transaction would be known as a "production payment loan". Project financing has been increasingly emerging as the preferred alternative to conventional methods of financing infrastructure worldwide. New financing structures, access to private equity and innovative credit enhancements make project finance the preferred alternative in large-scale infrastructure projects. According to World Bank estimates, the demand for infrastructure investment is staggering. Asian countries alone, which historically have accounted for about only 15% of the Project Finance market, need to invest USD 2 trillion in infrastructure in this decade to maintain their current rate of development. Most studies on economic development find that large-scale infrastructure investment is associated with one-for-one growth in the country's GDP. Similar country studies of economic development find that inadequate or absent infrastructure severely impede economic growth. Benjamin Esty mentions three primary motivations for using project finance: (1) reduced agency costs and conflicts, (2) reduced debt overhang problem, and (3) enhanced risk management 2. Q.) What are the features of limited recourse/ non-recourse financing?

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A.) Some of the features are * Financing through Special Purpose Vehicles (SPV) * Sponsor support obligation for SPV * Use of Trust and Retention Arrangement to capture the cash Flow * Govt. guarantee may be available

3. Q.) What is an SPV? A.) SPV is a "bankruptcy-remote entity" whose operations are limited to the acquisition and financing of specific assets. The SPV is usually a subsidiary company with an asset/liability structure and legal status that makes its obligations secure even if the parent company goes bankrupt. A corporation can use such a vehicle to finance a large project without putting the entire firm at risk. Problem is, due to accounting loopholes, these vehicles became a way for CFOs to hide debt. Essentially, it looks like the company doesn't have a liability when they really do. As we saw with the Enron bankruptcy, if things go wrong, the results can be devastating. Thanks to Enron, SPVs/SPEs are household words. These entities aren't all bad though. They were originally (and still are) used to isolate financial risk. 4. Q.) What are the typical characteristics of Infrastructure Projects? A.) Some of the typical characteristics are * Large capital costs * Large, lumpy investments * Uncertainty of cash flows * Negative cash flows in initial years * Cash flow financing may also be used, not necessarily asset based financing * Absence of full recourse financing * Limited or non-recourse financing employed * Lenders must rely on long term contracts underlying the project structure * Lenders must rely on government support including guarantees. * “Infrastructure” as defined in income-tax act. * Many “project participants” involved. * Risk allocation to all participants is done through ‘contracts’ * Long gestation periods * Assets are not easily transferable * Services provided are not tradable * Revenues only in local currency; borrowing may be in foreign currency

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* Tariffs are politically sensitive * Social aspects involved * Vulnerable to regulatory policies * entire global/National economy is the background context

5. Q.) why and how does government support infrastructure projects? A.) the higher risk perception makes private players demand a higher return on Investments. As a result, the tariffs charged would have to be higher than that charged before private players were allowed in, because the government did not take the real cost of capital into account. These higher prices are politically unacceptable to the government due to the universality of demand for infrastructure services and due to Infrastructure services being considered essential by consumers. Hence the government enhances the projects financability and reduces the degree of risk, this brings the return expected by the private players down and in-turn the tariff charged to the end-user also comes down to politically acceptable levels. These enhancements take the form of preferential tax treatment, contributions to equity or contribution to subordinated debt, and guarantees. 6. Q.) what are the different Types of Government Guarantees to Private Infrastructure Projects A.) Some of the guarantees typically given are: I. Contractual Obligations of Government Entities Guarantee of off-take in power projects Guarantee of fuel supply in power projects II. Policy/Political Risk Protection Guarantee of currency convertibility and transferability Guarantee in case of changes of law or regulatory regime III. Financial Market Disruption/Fluctuations Guarantee of interest rate Guarantee of exchange rate Debt Guarantee IV. Market Risk Guarantee of tariff rate / Sales risk guarantee Revenue guarantee

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7. Q.) what are the various types of project participants in Infrastructure Projects?  Government – The policies and regulatory rules are set by this participant. It also provides risk reducing features to the project. It is the “Public” part of the “public-private partnership”. It may also contribute to capital.  Sponsors – the private sector player which is the “Private” part of the “publicprivate partnership”. Brings in equity and limited or non-recourse debt from banks  Lenders – they supply limited or non-recourse financing. They are taking more risk and so will be depending on the contracts with the other participants to diversify the risks.  R.M Suppliers – The risk of non-supply of raw materials for production is reduced by entering into long-term supply contracts with penalty clauses with this participant.  Construction contractor – The Turnkey contract which this party enters into, is used to mitigate risk of delay and cost over-runs.  Equipment vendors – they provide performance warranties for the duration of the project life.  O&M Contractor (Operations and Maintenance) – they run the project after it has been completed and started. They guarantee efficient desired performance of the project by way of a contract.  Agent/Trustee – handles escrow account.  Insurer – provides all sorts of risk protection as needed.  Buyers/Off takers – they enter into long term buying contracts to mitigate selling risk. 8. Q.) What are the various options available for private participation? Increasingly governments are seeking to transform their roles – from being the exclusive financiers, managers, and operators of infrastructure to being the facilitators and regulators of services provided primarily by private firms .When a decision is made to involve the private sector in the provision of infrastructure, there are various options or procurement routes that can be followed. It is important to consider these various options for private sector participation because the procurement route followed defines which party (public vs. private) will be responsible for various crucial aspects such as the financing and risk burden aspects of the project.  Service contract

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









Under this option, the private sector performs a specific operational service for a fee, for example meter reading, billing and collection. Management contract With this option, the private sector is paid a fee for operating and maintaining a government - owned business and making management decisions. Lease Under the lease option, the private sector leases facilities and is responsible for operation and maintenance. Concession Under concessions, the private sector finances the project and also has full responsibility for operations and maintenance. The government owns the asset and all full use rights must revert to the government after the specified period of time. Build own transfer (BOT) / Build own operate (BOO) These are similar to concessions but they are normally used for new greenfield projects. The private sector receives a fee for the service from the users. Divestiture This option can take two forms – partial or complete divestiture. A complete divestiture, like a concession, gives the private sector full responsibility for operations, maintenance and investment, but unlike a concession, a divestiture transfers ownership of the assets to the private sector .

9. Q.) What are the essential conditions for the success of project financing? For project finance transactions to be successful, there are several essential conditions that need to be in place within the overall country and policy framework of the project: There must be a supportive policy environment which creates a conducive macroeconomic environment; The country in which the project is being undertaken must have a sound economic base. Policy frameworks can play an important role in ensuring that the economic environment is stable; Project finance techniques are most successful in an economic and country environment where business dealings are transparent, contracts are respected (particularly contracts between state and private sector entities), and a framework exists for resolving disputes fairly Government can do a great deal to facilitate private financing for projects by providing a legal and judicial framework that is conducive to private contractual activity

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 Above all, the regulatory framework should be clear and consistent, and policy should aim to keep the macroeconomic environment stable. 10. Q.) what are the barriers to private sector involvement? Despite the advantages of involving the private sector in infrastructure provision, there are still certain blockages preventing effective private sector participation, including : I) Policy and regulatory concerns. The policy and regulatory framework must be supportive. In many countries, private sector involvement in infrastructure is a new concept and as a result the policies should be adapted in a way that promotes these innovations. II) Weak domestic capital markets, unable to provide long-term financing for infrastructure projects that have long pay -back times and earn little or no foreign exchange III) High transaction and bidding costs. Infrastructure projects involving private sector involvement typically have high transactions costs. In a review of transaction costs in infrastructure, these costs amount on average to some 5 to 10 percent of total project costs. This is a prohibitive factor and since the burden of these high transaction and bidding costs will eventually trickle down to the taxpayers, the onus is on the various institutions responsible for awarding these projects to keep these costs down.

11. Q.) what are the risks involved in project financing?  Completion risk – includes Delay, cost-over-run, failure to meet performance standards, Abandonment  Operational risk – includes Demand risk, supply risk, Associated Infrastructure development risk.  Promoter risk – includes Expertise & Capability risk, commitment & resourcefulness risk, Conflict of interest risk, Insolvency risk. Insolvency risk can be mitigated using a SPV and therefore increasing the ‘Bankruptcy remoteness’  Financial risk – Interest rate and exchange rate risks, Inflation risk, Currency inconvertibility risk.

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 Political, Legal and Regulatory risk – includes changes in laws/taxes/duties risk, Environmental risks, failure of government to honor commitments, failure to obtain/renew permits, licenses or concessions, tariff revision and nationalization.  Force Majeure – this risk is mitigated using insurance.

12. Q.) what are the various completion risk mitigants in Project financing? Three main groups of instruments are used to mitigate risk during the construction period: (1)Contractual arrangements and associated guarantees, (2) contingency funds and lines of credit, and (3) private insurance. Contractual arrangements:: They offer a broad range of possibilities for allocating risks among project participants. The construction contract, for example, assigns responsibilities to the project sponsor and the construction companies for engineering, procurement, performance testing, obtaining permits and insurance, provision of required services (water, electricity, fuel), and relief under force majeure events. The contractor may be responsible only for bringing a project to mechanical completion according to the owner’s design and specifications, transferring to the sponsors responsibility for start-up and testing. Under an engineering, procurement, and construction (EPC) contract, however, the contractor accepts full responsibility for delivering a fully operational facility on a date-certain, fixed-price basis. If the contractor fails to meet its obligations, it may be required to pay compensation to the project sponsors, often in the form of liquidated damages(LD). Material, workmanship, and equipment warranties cover defects discovered following a project’s final completion. Contingency funds: they can be used to cover all types of cost overruns or earmarked for specific contingencies such as environmental cleanup.. Construction budgets often include a 5 to 15 percent line item to cover unexpected cost increases. This financing may be provided pro-rata between debt and equity or under some other sharing arrangement (for example, 100 percent equity for the first 5 percent of cost overruns and pro rata thereafter). Insurance: A project is generally covered by several types of insurance. Construction All Risk insurance protects against property damage and is effective from the commencement of procurement to transportation to the project site through completion of construction and performance testing. Risks covered include acts of God and standard perils (fire, lightning). Adjunct liability coverage insures against bodily injury or property damage to third parties resulting from project work. Advance Loss of Profits insurance covers income losses due to delays resulting from the same risks covered under Construction All Risk insurance. Miscellaneous coverage may include employer’s liability, architect errors and omissions, and force

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majeure insurance, which can cover losses due to strikes, contractor insolvency, and delays in obtaining permits.

13. Q.) what are the various operational risks and risk mitigants in Project financing? The instruments most commonly used to mitigate risk during the operating period are (1)contractual arrangements, (2)contingency reserves, (3)cash traps, (4)insurance, and (5)risk compensation devices. Contractual Arrangements: Of the many contractual structures that can allocate risks during the operating period, take-or-pay, put-or-pay, and pass-through structures are perhaps the most commonly applied. Take-or-pay arrangements require the offtaker to pay for the good or service regardless of whether it is needed. Put-or-pay contracts provide for a secure supply of project feed stocks or raw materials. If the supplier is unable to provide the inputs, it agrees to indemnify the project company for excess costs incurred in securing the inputs from third parties or, if third-party supply is unavailable, for revenue losses due to the project’s resulting inability to comply with its offtake arrangements. Pass-through structures often link the offtake and input agreements to shield investors from adverse changes in the prices of project inputs or outputs Contingency reserves: To cover cash flow shortages, a debt service reserve fund can be established through sponsor equity contributions, excess cash flow (available cash flow after debt service payments but before dividend distributions), standby letters of credit, or sponsor guarantees. A separate fund to cover extraordinary 67

maintenance can also be created to ensure proper operation and maintenance in the future. Cash Traps: Sometimes a project can meet its debt service obligations, but not with the cash flow margins that lenders had expected. Cash traps can be used to ensure that lenders continue to receive timely payments. For example, if a project is unable to maintain a required DSCR (typically defined on a pretax basis as gross revenues minus operating expenses divided by interest and principal payments), no dividend distributions would be permitted. Until the project achieves the required DSCR, “trapped” cash flow could be escrowed or applied in inverse order of maturity to prepay debt (often referred to as a “clawback”). Insurance: Coverage for the operating period typically includes property insurance with extensions available for loss of revenue from machinery breakdown and for business interruption from property damage. Third-party general liability insurance might include coverage for workers’ compensation, automobiles, and pollution cleanup. Risk Compensation Devices: Sometimes investors and contractual participants assume certain risks in return for an opportunity to share in the project’s upside potential. Tracking accounts are often used to compensate input suppliers or offtakers for offering fixed price agreements, which shield project sponsors from market risk. Under an offtake agreement that provides for tracking, if the contract price exceeds spot market prices, the difference between the two would be tracked. Amounts tracked may be 100 percent of the price difference or a lower proportion, with payments owed only if the difference exceeds a certain threshold. Equity kickers, such as convertible debentures, stock warrants, and contingent interest payments, allow investors to share in the upside potential of the project while still providing them priority over common equity investors with regard to claims on project assets and cash flow if the project is unable to generate sufficient cash flow to meet its financial obligations.

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Additional Questions: 14. What is the risk allocation and hedging mechanish in Infrastructure financing? Answers in pg 2/104 15. who are the project participants and what are their risk allocations? Answers in Pg 6/37 16. what are the cdr mechanisms? Answers in Pg 6/51 17. what is cdr? Answers in 6/265 18. what are the innovations in project financing? Answers in Pg 2/107 19. what is the structure of a Infrastructure project contract? Answers in Pg 2/106 20. what are the sectors for which infrastructure financing is done? Answers in Pg 2/171 21. what are the legal issues in Infrastructure financing? 69

Answers in Pg 2/175 22. what are the issues in infrastructure finance? Answers in 2/207 23. what are the characteristics of bankruptcy remoteness? what is an SPV, why is it used? 24. write a note on Social Cost Benefit Analysis? Answers in Pg 2/39 25. UNIDO methor for project evaluation? Answers in Pg 2/39

CASH FLOW 1) What Is Cash Flow? Business is all about trade, the exchange of value between two or more parties, and cash is the asset needed for participation in the economic system. For this reason - while some industries are more cash intensive than others - no business can survive in the long run without generating positive cash flow per share for its shareholders. To have a positive cash flow, the company's long-term cash inflows need to exceed its long-term cash outflows. An outflow of cash occurs when a company transfers funds to another party (either physically or electronically). Such a transfer could be made to pay for employees, suppliers and creditors, or to purchase long-term assets and investments, or even pay for legal expenses and lawsuit settlements. It is important to note that legal transfers of value through debt - a purchase made on credit - is not recorded as a cash outflow until the money actually leaves the company's hands. A cash inflow is of course the exact opposite; it is any transfer of money that comes into the company's possession. Typically, the majority of a company's cash inflows are from customers, lenders (such as banks or bondholders) and investors who purchase company equity from the company. Occasionally cash flows come from sources like legal settlements or the sale of company real estate or equipment.

2) What Is the Cash Flow Statement?

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There are three important parts of a company's financial statements: the balance sheet, the income statement and the cash flow statement. The balance sheet gives a one-time snapshot of a company's assets and liabilities. And the income statement indicates the business's profitability during a certain period. The cash flow statement differs from these other financial statements because it acts as a kind of corporate checkbook that reconciles the other two statements. Simply put, the cash flow statement records the company's cash transactions (the inflows and outflows) during the given period. It shows whether all those lovely revenues booked on the income statement have actually been collected. At the same time, however, remember that the cash flow does not necessarily show all the company's expenses: not all expenses the company accrues have to be paid right away. So even though the company may have incurred liabilities it must eventually pay, expenses are not recorded as a cash outflow until they are paid The following is a list of the various areas of the cash flow statement and what they mean: Cash flow from operating activities - This section measures the cash used or provided by a company's normal operations. It shows the company's ability to generate consistently positive cash flow from operations. Think of "normal operations" as the core business of the company. For example, Microsoft's normal operating activity is selling software. Cash flows from investing activities - This area lists all the cash used or provided by the purchase and sale of income-producing assets. If Microsoft, again our example, bought or sold companies for a profit or loss, the resulting figures would be included in this section of the cash flow statement. Cash flows from financing activities - This section measures the flow of cash between a firm and its owners and creditors. Negative numbers can mean the company is servicing debt but can also mean the company is making dividend payments and stock repurchases, which investors might be glad to see. When you look at a cash flow statement, the first thing you should look at is the bottom line item that says something like "net increase/decrease in cash and cash equivalents", since this line reports the overall change in the company's cash and its equivalents (the assets that can be immediately converted into cash) over the last period. If you check under current assets on the balance sheet, you will find cash and cash equivalents (CCE or CC&E). If you take the difference between the current CCE and last year's or last quarter's, you'll get this same number found at the bottom of the statement of cash flows.

3) What is discounted cash flow?

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Valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one. Calculated as:

There are many variations when it comes to what you can use for your cash flows and discount rate in a DCF analysis. Despite the complexity of the calculations involved, the purpose of DCF analysis is just to estimate the money you'd receive from an investment and to adjust for the time value of money. DCF models are powerful, but they do have shortcomings. DCF is merely a mechanical valuation tool, which makes it subject to the axiom "garbage in, garbage out". Small changes in inputs can result in large changes in the value of a company. Instead of trying to project the cash flows to infinity, a terminal value approach is often used. A simple annuity is used to estimate the terminal value past 10 years, for example. This is done because it is harder to come to a realistic estimate of the cash flows as time goes on.

4) What is free cash flow, what is free cash flow for the firm and what is free cash flow per share? A measure of financial performance calculated as operating cash flow, minus capital expenditures. In other words, free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain/expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it's tough to develop new products, make acquisitions, pay dividends and reduce debt.

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Some believe that Wall Street focuses myopically on earnings while ignoring the "real" cash that a firm generates. Earnings often can be clouded by accounting gimmicks, but it's tougher to fake cash flow. For this reason, some investors believe that FCF gives a much clearer view of the ability to generate cash (and thus profits). It is important to note that negative free cash flow is not bad in itself. If free cash flow is negative, it could be a sign that a company is making large investments. If these investments earn a high return, the strategy has the potential to pay off in the long run. Free Cash Flow For The Firm - FCFF: A measure of financial performance that expresses the net amount of cash that is generated for the firm, consisting of expenses, taxes and changes in net working capital and investments. Calculated as:

This is a measurement of a company's profitability after all expenses and reinvestments. It's one of the many benchmarks used to compare and analyze financial health. A positive value would indicate that the firm has cash left after expenses. A negative value, on the other hand, would indicate that the firm has not generated enough revenue to cover its costs and investment activities. In that instance, an investor should dig deeper to assess why this is happening - it could be a sign that the company may have some deeper problems. Free Cash Flow per Share : A measure of a company's financial flexibility. It is calculated as net income plus all noncash expenses less dividends and capital expenditures. The total is then divided by the number of shares outstanding. This measure signals a company's ability to pay debt, pay dividends, buy back stock and facilitate the growth of business. When a firm's share price is low and free cash flow is on the rise, the odds are good that earnings and share value will soon be on the up.

5) What are Operating Cash Flow and Non-Operating Cash Flow? Operating Cash Flow– OCF: The cash generated from the operations of a company, generally defined as revenues less all operating expenses, but calculated through a series of adjustments to net income. The OCF can be found on the statement of cash flows.

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Also known as "cash flow provided by operations" or "cash flow from operating activities". Calculated as:

Operating cash flow is the cash that a company generates through running its business. It's arguably a better measure of a business's profits than earnings because a company can show positive net earnings (on the income statement) and still not be able to pay its debts. It's cash flow that pays the bills! You can also use OCF as a check on the quality of a company's earnings. If a firm reports record earnings but negative cash, it may be using aggressive accounting techniques. Non-Operating Cash Flows: Cash inflows and outflows related to non-current investments, financing, and dividends. This is looked at separately from the cash flows resulting from day-to-day operations 6) Why Operating Cash Flow: Better Than Net Income? Operating cash flow is the lifeblood of a company and the most important barometer that investors have. For two main reasons, operating cash flow is a better metric of a company's financial health than net income. First, cash flow is harder to manipulate under GAAP than net income (although it can be done to a certain degree). Second, 'cash is king' and a company that does not generate cash over the long term is on its deathbed. By operating cash flow I don't mean EBITDA (earnings before interest taxes depreciation and amortization). While EBITDA is sometimes called "cash flow", it is really earnings before the effects of financing and capital investment decisions. It does not capture the changes in working capital (inventories, receivables, etc.). The real operating cash flow is the number derived in the statement of cash flows.

7) Difference between Cash Flow & Income It is important to note the distinction between being profitable and having positive cash flow transactions: just because a company is bringing in cash does not mean it is making a profit (and vice versa). For example, say a manufacturing company is experiencing low product demand and therefore decides to sell off half its factory equipment at liquidation prices. It will receive cash from the buyer for the used equipment, but the manufacturing company is definitely losing money on the sale: it would prefer to use the equipment to manufacture products and earn an operating profit. But since it cannot, the next best option is to sell off the equipment at prices much lower than the company paid for it. In the year that it sold the equipment, the company would end up with a strong positive cash flow, but its current 74

and future earnings potential would be fairly bleak. Because cash flow can be positive while profitability is negative, investors should analyze income statements as well as cash flow statements, not just one or the other.

8) What Cash Flow Doesn't Tell Us? Cash is one of the major lubricants of business activity, but there are certain things that cash flow doesn't shed light on. For example, as we explained above, it doesn't tell us the profit earned or lost during a particular period: profitability is composed also of things that are not cash based. This is true even for numbers on the cash flow statement like "cash increase from sales minus expenses", which may sound like they are indication of profit but are not. As it doesn't tell the whole profitability story, cash flow doesn't do a very good job of indicating the overall financial well-being of the company. Sure, the statement of cash flow indicates what the company is doing with its cash and where cash is being generated, but these do not reflect the company's entire financial condition. The cash flow statement does not account for liabilities and assets, which are recorded on the balance sheet. Furthermore accounts receivable and accounts payable, each of which can be very large for a company, are also not reflected in the cash flow statement. In other words, the cash flow statement is a compressed version of the company's checkbook that includes a few other items that affect cash, like the financing section, which shows how much the company spent or collected from the repurchase or sale of stock, the amount of issuance or retirement of debt and the amount the company paid out in dividends.

9) How Some Companies Abuse Cash Flow? It seems that every year another top athlete is exposed in a doping scandal. But these are people who are trained since birth to believe that all that matters is their performance, so they naturally take a risk on anything likely to increase their chances of winning. Companies, similarly indoctrinated to perform well at all costs, also have a way to inflate or artificially "pump up" their earnings - it's called cash flow manipulation. Here we look at how it's done, so you are better prepared to identify it. The Reason for Cash Flow Manipulation: Cash flow is often considered to be one of the cleaner figures in the financial statements. (WorldCom, however, has proven that this isn't true.) Companies benefit from strong cash flow in the same way that an athlete benefits from stronger muscles - a strong cash flow means being more attractive and getting a stronger

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rating. After all, companies that have to use financing to raise capital, be it debt or equity, can't keep it up without exhausting themselves. The corporate muscle that would receive the cash flow accounting injection is operating cash flow (OCF). It is found in the cash flow statement, which comes after the income statement and balance sheet. (If you'd like a refresher, see What Is A Cash Flow Statement? and The Essentials Of Cash Flow.)

10) How the Manipulation Is Done? Dishonesty in Accounts Payable: Companies can bulk up their statements simply by changing the way they deal with the accounting recognition of their outstanding payments, or their accounts payable. When a company has written a check and sent it to make an outstanding payment, the company should deduct its accounts payable. While the "check is in the mail", however, a cashmanipulating company will not deduct the accounts payable with complete honesty and claim the amount in the OCF (operating cash flow) as cash on hand. Companies can also get a huge boost by writing all their checks late and using overdrafts. This boost, however, is a result of how generally accepted accounting principles (GAAP) treat overdrafts: they allow, among other things, for overdrafts to be lumped into accounts payable, which are then added to operating cash flow. This allowance has been seen as a weakness in the GAAP, but until the accounting rules change, you'd be wise to scrutinize the numbers and footnotes to catch any such manipulation. Selling Accounts Receivable: Another way a company might increase operating cash flow is by selling off its accounts receivable. This is also called securitizing. The agency buying the accounts receivable pays the company a certain amount of money, and the company passes off to this agency the entitlement to receive the money that customers owe. The company therefore secures the cash from their outstanding receivables sooner than the customers pay for it. The time between sales and collection is shortened, but the company actually receives less money than if it had just waited for the customers to pay. So, it really doesn't make sense for the company to sell its receivables just to receive the cash a little sooner - unless it is having cash troubles, and has a reason to cover up a negative performance in the operating cash flow column. Non-Operating Cash: A subtler steroid is the inclusion of cash raised from operations that are not related to the core operations of the company. Non-operating cash is usually money from securities trading, or money borrowed to finance securities trading, which have nothing to do with business. Short-term investments are usually made to protect the value of excess cash

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before the company is ready and able to put the cash to work in the business' operations. It may happen that these short-term investments make money, but it's not money generated from the power of the business's core operations. Therefore, since cash flow is a metric that measures a company's health, the cash from unrelated operations should be dealt with separately. Including it would only distort the true cash flow performance of the company's business activities. GAAP requires these non-operating cash flows to be disclosed explicitly. And you can analyze how well a company does simply by looking at the corporate cash flow numbers in the cash flow statement. Capital Account Convertibility 1. What is capital account convertibility? Capital account convertibility (CAC), or a floating exchange rate, has no discrete definition. General discussion assumes that the phrase signifies the ability to convert from one currency to another without any limit, control or regulation. Full convertibility is understood as the condition of being able to make that conversion at market rates. The rationale behind full capital account convertibility is efficient allocation of global capital which not only equalises the rates of return of capital across countries but also increases the level of output and equitable distribution of level of income. In India’s case the rupee is not yet fully convertible on the capital account. The Tarapore committee set up by the Reserve Bank of India (RBI) in 1997 to go into the issue of CAC defined it as the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange. In simple language, this means is that CAC allows anyone to freely move from local currency into foreign currency and back. 2. How is CAC different from current account convertibility? Current account convertibility allows free inflows and outflows for all purposes other than for capital purposes such as investments and loans. In other words, it allows residents to make and receive trade-related payments - receive dollars (or any other foreign currency) for export of goods and services and pay dollars for import of goods and services, make sundry remittances, access foreign currency for travel, studies abroad, medical treatment and gifts etc. In India, current account convertibility was established with the acceptance of the obligations under Article VIII of the IMF’s Articles of Agreement in August 1994. 3. Why is CAC an important issue?

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CAC is widely regarded as one of the hallmarks of a developed economy. It is also seen as a major comfort factor for overseas investors since they know that anytime they change their mind they will be able to re-convert local currency back into foreign currency and take out their money. In a bid to attract foreign investment, many developing countries went in for CAC in the 80s not realizing that free mobility of capital leaves countries open to both sudden and huge inflows as well as outflows, both of which can be potentially destabilizing. More important, that unless you have the institutions, particularly financial institutions, capable of dealing with such huge flows countries may just not be able to cope as was demonstrated by the East Asian crisis of the late nineties. Following the East Asian crisis, even the most ardent votaries of CAC in the World Bank and the IMF realized that the dangers of going in for CAC without adequate preparation could be catastrophic. Since then the received wisdom has been to move slowly but cautiously towards CAC with priority being accorded to fiscal consolidation and financial sector reform above all else. 4. What is the position in India today? Convertibility of capital for non-residents has been a basic tenet of India’s foreign investment policy all along, subject of course to fairly cumbersome administrative procedures. It is only residents - both individuals as well as corporate - who continue to be subject to capital controls. However, as part of the liberalizations process the government has over the years been relaxing these controls. It has been argued that for most business and personal transactions the rupee is practically fully convertible. Further, in cases where specific permission is required for transactions above a monetary ceiling, it is generally received easily. Thus, a few years ago, residents were allowed to invest through the mutual fund route and corporate to invest in companies abroad but within fairly conservative limits. However, it is not immediately possible to give unlimited access to short-term external borrowings, and allow unrestricted freedom to domestic residents to convert their domestic bank deposits and idle assets in response to market developments or exchange rate expectations because of the vulnerability of the financial system. Buoyed by the very comfortable build-up of forex reserves, the strong GDP growth figures for quite sometime now and the fact that progressive relaxations on current account transactions have not lead to any flight of capital, the government has been announcing further relaxations on the kind and quantum of investments that can be made by residents abroad. India’s movement towards full CAC necessitated the RBI to setup the two Tarapore Committee’s in 1997 & 2006, to ensure that the roadmap to a full CAC could be charted.

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5. Why was the Tarapore Committee setup in 1997, & what were its implications? The committee on capital account convertibility, setup by the Reserve Bank of India (RBI) under the chairmanship of former RBI deputy governor S.S. Tarapore in 1997, was to "lay the road map" to capital account convertibility. The five-member committee recommended a three-year time frame for complete convertibility by 1999-2000. A number of provisions of the report submitted by the company have not been met yet. A few have been met, but they were not good enough to ensure full CAC by 1999-2000. The second Tarapore Committee had been setup in 2006 as fallout of this. A large part of the inaction on the recommendations could be blamed on the East Asian crisis. It put Central Bankers of developing countries across the world on a back foot. 6. What were the recommendations of the first Tarapore committee? The highlights of the 1997 report including the preconditions to be achieved for the full float of money were as follows:PRE-CONDITIONS: • Gross fiscal deficit to GDP ratio has to come down from a budgeted 4.5 per cent in 1997-98 to 3.5% in 1999-2000 • A consolidated sinking fund has to be set up to meet government's debt repayment needs; to be financed by increased in RBI's profit transfer to the govt. and disinvestment proceeds • Inflation rate should remain between an average 3-5 per cent for the 3-year period 1997-2000 • Gross NPAs of the public sector banking system needs to be brought down from the present 13.7% to 5% by 2000. At the same time, average effective CRR needs to be brought down from the current 9.3% to 3% • RBI should have a Monitoring Exchange Rate Band of plus minus 5% around a neutral Real Effective Exchange Rate RBI should be transparent about the changes in REER • External sector policies should be designed to increase current receipts to GDP ratio and bring down the debt servicing ratio from 25% to 20% • Four indicators should be used for evaluating adequacy of foreign exchange reserves to safeguard against any contingency. Plus, a minimum net foreign asset to currency ratio of 40 per cent should be prescribed by law in the RBI Act. PHASED LIBERALIZATION OF CAPITAL CONTROLS The Committee's recommendations for a phased liberalization of controls on capital outflows over the three year period which have been set out in detail in a tabular form in Chapter 4 of the Report, inter alia, include:i) Indian Joint Venture/Wholly Owned Subsidiaries (JVs/WOSs) should be allowed to 79

invest up to US $ 50 million in ventures abroad at the level of the Authorised Dealers (ADs) in phase 1 with transparent and comprehensive guidelines set out by the RBI. The existing requirement of repatriation of the amount of investment by way of dividend etc., within a period of 5 years may be removed. Furthermore, JVs/WOs could be allowed to be set up by any party and not be restricted to only exporters/exchange earners. ii) Exporters/exchange earners may be allowed 100 per cent retention of earnings in Exchange Earners Foreign Currency (EEFC) accounts with complete flexibility in operation of these accounts including cheque writing facility in Phase I. iii) Individual residents may be allowed to invest in assets in financial market abroad up to $ 25,000 in Phase I with progressive increase to US $ 50,000 in Phase II and US$ 100,000 in Phase III. Similar limits may be allowed for non-residents out of their non repatriable assets in India. iv) SEBI registered Indian investors may be allowed to set funds for investments abroad subject to overall limits of $ 500 million in Phase I, $ 1 billion in Phase II and $ 2 billion in Phase III. v) Banks may be allowed much more liberal limits in regard to borrowings from abroad and deployment of funds outside India. Borrowings (short and long term) may be subject to an overall limit of 50 per cent of unimpaired Tier 1 capital in Phase 1, 75 per cent in Phase II and 100 per cent in Phase III with a sub-limit for short term borrowing. in case of deployment of funds abroad, the requirement of section 25 of Banking Regulation Act and the prudential norms for open position and gap limits would apply. vi) Foreign direct and portfolio investment and disinvestment should be governed by comprehensive and transparent guidelines, and prior RBI approval at various stages may be dispensed with subject to reporting by ADs. All non-residents may be treated on part purposes of such investments. vii) In order to develop and enable the integration of forex, money and securities market, all participants on the spot market should be permitted to operate in the forward markets; FIIs, non-residents and non-resident banks may be allowed forward cover to the extent of their assets in India; all India Financial Institutions (FIs) fulfilling requisite criteria should be allowed to become full-fledged ADs; currency futures may be introduced with screen based trading and efficient settlement system; participation in money markets may be widened, market segmentation removed and interest rates deregulated; the RBI should withdraw from the primary market in Government securities; the role of primary and satellite dealers should be increased; fiscal incentives should be provided for individuals investing in Government securities; the Government should set up its own office of public debt. viii) There is a strong case for liberalizing the overall policy regime on gold; Banks and FIs fulfilling well defined criteria may be allowed to participate in gold markets in India and abroad and deal in gold products.

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7. Why was the second Tarapore Committee setup? The RBI setup the new committee on full CAC with the following purposes in mind: (i) To review the experience of various measures of capital account liberalization in India, (ii) To examine implications of fuller capital account convertibility on monetary and exchange rate management, financial markets and financial system, (iii) To study the implications of dollarisation in India of domestic assets and liabilities and internationalization of the Indian rupee, (iv) To provide a comprehensive medium-term operational framework, with sequencing and timing, for fuller capital account convertibility taking into account the above implications and progress in revenue and fiscal deficit of both centre and states, (v) To survey regulatory framework in countries which have advanced towards fuller capital account convertibility (vi) To suggest appropriate policy measures and prudential safeguards to ensure monetary and financial stability, and (vii) To make such other recommendations as the Committee may deem relevant to the subject. 8. What were the major conditions & prerequisites which were suggested by the new report? The committee has charted a three phase plan towards fuller CAC by 2009-11. • Phase 1 – 2006-07 • Phase 2 – 2007-09 • Phase 3 – 2009-11 The following pre-conditions were suggested for imposition: A. Ban on participatory notes B. Removal of ‘tax haven’ anomalies (Ex: Mauritius) C. No tax exemptions on NRI deposits D. FIIs to setup up reserves to meet exigencies & volatility E. Consolidation in the banking industry F. Control on Government & PSU borrowings

9. What are the major recommendations of the Committee? The salient features of the recommendations are as follows: A. Gradually raising the ceiling of ECB which falls under automatic approval & no ceiling on long term & rupee denominated ECBs B. Companies to be able to invest four times their net worth in overseas subsidiaries

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C. Non resident corporate to be able to invest in stocks through Portfolio Management Schemes(PMS) & Mutual Funds D. Banks overseas borrowing to be linked to its capital & free reserves, the borrowing to be 100% of capital (not only unimpaired Tier-I capital) E. PMS like MFs to be allowed to invest abroad, while raising ceiling of this investment to $5 billion F. Indians allowed to freely remit up to $200,000 overseas G. Indians to be allowed to have foreign currency accounts in overseas banks H. Foreign companies allowed to raise rupee loans & bonds in India

10. Is there case against CAC in emerging countries like India? A number of academicians & experts have said that India & emerging countries should have a more calibrated approach towards fuller CAC and not jump into the bandwagon too early. For any country which adopts convertibility must ensure that it meets the following conditions: • Fiscal discipline to ensure capital inflows do not lead to an unsustainable, temporary momentum • Maintaining inflations at 3 to 5% levels so as to enable inflation targeting by the Central Bank • Strong banking infrastructure so as to ensure that the capital inflow is channeled to the most profitable & sustainable channel India has been improving on the last two parameters since the first Tarapore committee was setup. India’s fiscal discipline however leaves it behind and hence makes it vulnerable to volatilities of capital inflows & outflows. The possible postponing of the FRBM deadline too is cause for concern in this regard. Another school of thought suggests that India does not need more convertibility than it has now as it has been able to attract to attract both FDI & FII. Moreover Indian companies have been investing abroad substantially over the last few years. This essentially meets most of our needs. Also, the Indian markets today are among the fastest growing markets in the world. So, one would not see large capital outflow from India. Finally, India is does not need another crisis like the South Asian crisis to halt its other wise good run. CREDIT RISK 1) What is Credit Risk? Credit risk is risk due to uncertainty in a counterparty's (also called an obligor's ) ability to meet its obligations. There may be many types of counterparties, like individuals, business houses, sovereign governments, and many different types of obligations ranging from vehicle loans to company establishment, credit risk may take many forms. Institution manage it in different ways.

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In assessing credit risk from a single counterparty, an institution must consider three issues:

-default probability: What is the likelihood that the counterparty will default on its obligation either over the life of the obligation or over some specified horizon, such as a year? Calculated for a one-year horizon, this may be called the expected default frequency. -credit exposure: In the event of a default, how large will the outstanding obligation be when the default occurs? -recovery rate: In the event of a default, what fraction of the exposure may be recovered through bankruptcy proceedings or some other form of settlement? 2) What is Credit Scoring? For loans to individuals or small businesses, credit quality is typically assessed through a process of credit scoring. Prior to extending credit, a bank or other lender will obtain information about the party requesting a loan. In the case of a bank issuing credit cards, this might include the party's annual income, existing debts, whether they rent or own a home, etc. A standard formula is applied to the information to produce a number, which is called a credit score. Based upon the credit score, the lending institution will decide whether or not to extend credit. The process is formulaic and highly standardized. 3) What are the types of credit that can be offered by banks? Credits can be divided into two broad categories: Fund Based a) b) c) d) e) f)

Overdraft/ Cash Credit Trust Receipt Loans( Importer’s Loan) Bills payable Short term loan Long term loan Consumer Loans

Non Fund Based a) Letter of Credit b) Guarantee 4) How does the bank make credit assessment of its borrowers? Banks may do the assessment for providing credit to their customers , by going through the following steps:

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a)

Analysis of the customer’s background-Some general information about the customer may be gathered, such as in case of company, who is on the board?, who are the managers; Does the company have any associates/ sister concerns? Another thing that is considered here is, what kind of relationship has the company had with the bank in the past. b) Financial Analysis- The historical performance of the customer based on the following information is determined: -

Sales/Profitability Net Worth Liquidity Cash Flow Banking Transactions

Financial Projections may also be done by using sensitivity analysis and industry averages. c) Outlook- Credit assessment also involves analyzing various non financial issues such as the condition of the business environment in which the borrower is operating, the factor’s that may affect his business. d) Assessment of the facility needs- The borrower may be requiring a particular form of credit, so his reason for requirement should be assessed.

5) What are Credit Ratings? Credit analysts review information about the counterparty. This might include its balance sheet, income statement, recent trends in its industry, the current economic environment, etc. Based upon this analysis, the credit analysts assign the counterparty (or the specific obligation) a credit rating, which can be used for making credit decisions. Many banks, investment managers and insurance companies hire their own credit analysts who prepare credit ratings for internal use. Other firms—including Standard & Poor's, Moody's and Fitch—are in the business of developing credit ratings for use by investors or other third parties. Institutions that have publicly traded debt hire one or more of them to prepare credit ratings for their debt. Those credit ratings are then distributed for little or no charge to investors. Some regulators also develop credit ratings. This is the system of credit ratings Standard & Poor's applies to bonds. AAA- Best credit quality—Extremely reliable with regard to financial obligations. AA -Very good credit quality—Very reliable. A- More susceptible to economic conditions—still good credit quality.

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BBB- Lowest rating in investment grade. BB- Caution is necessary—Best sub-investment credit quality. B- Vulnerable to changes in economic conditions—Currently showing the ability to meet its financial obligations. CCC- Currently vulnerable to nonpayment—Dependent on favorable economic conditions. CC- Highly vulnerable to a payment default. C- Close to or already bankrupt—payment on the obligation currently continued. D- Payment default on some financial obligation has actually occurred. Ratings can be modified with + or – signs, so a AA– is a higher rating than is an A+ rating. With such modifications, BBB– is the lowest investment grade rating. 6) What is country risk exposure? It is the measure of risk that arises when incurring credit exposure to an obligor in a currency other than that of the obligor. Credit exposure includes the following amongst others. - Acceptances - Confirmation of Irrevocable Letters of Credit - Interest Bearing Deposits with Banks in other countries - Other Monetary Assets in Non- Rupee currencies 7) What is the most common type of rating system used by international banks for country risk rating?

Class of Rating I II III IV V VI

Basis of Judgement Best Risk. No significant political or economic problems No problem is expected with sovereign risk, but bond may trade at a discount Best developing country risk Significant political & economic risks, lending should be done only in special circumstances High Risk Restricted

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The risk represented by the ratings above may be further highlighted or emphasized by asterisks. The asterisks system is designed to convey signals about recent or current economic and/or political events in a concerned country. 8) What is Value at Risk? What are the parameters on which its measured? Value at risk (VaR) is a measure (a number) saying how the market value of an asset or of a portfolio of assets is likely to decrease over a certain time period (usually over 1 day or 10 days) under usual conditions. It is typically used by security houses or investment banks to measure the market risk of their asset portfolios (market value at risk). VaR has following parameters: -

The time horizon (period) we are going to analyze (i. e. the length of time over which we plan to hold the assets in the portfolio - the "holding period"). The typical holding period is 1 day, although 10 days are used, for example, to compute capital requirements under the European Capital Adequacy Directive (CAD). For some problems, even a holding period of 1 year is appropriate. - The confidence level at which we plan to make the estimate. Popular confidence levels usually are 99% and 95%. - The unit of the currency which will be used to denominate the value at risk(VaR). VaR, with the parameters: holding period x days; confidence level y%, defines the likelihood that a given portfolio's losses will exceed a certain amount on a normal market conditions over a given period. 9) What are the most common VaR calculation models? • (a) variance-covariance (VCV), assuming that risk factor returns are always (jointly) normally distributed and that the change in portfolio value is linearly dependent on all risk factor returns, • (b) the historical simulation, assuming that asset returns in the future will have the same distribution as they had in the past (historical market data), • (c) Monte Carlo simulation, where future asset returns are more or less randomly simulated TECHNICAL ANALYSIS 1) What is technical analysis? Technical analysis is the study of market action through the use of charts, for the purpose of forecasting future price trends. Technical analysis is a method of forecasting price movements by looking at purely market-generated data. Price data from a particular market is most commonly the type of information analyzed by a technician, though most will also keep a close watch on volume and open interest in futures contracts. Technical analysis is concerned with what has actually happened in the forex and stock market, rather than what should happen. A technical analyst will study the price and volume movements and from that data create charts (derived from the actions of the market

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players) to use as his primary tool. The technical analyst is not much concerned with any of the “bigger picture” factors affecting the market, as is the fundamental analyst, but concentrates on the activity of that instrument’s market. The market is typically composed of trends and is, therefore, a place where technical analysis can be effective. Traders are able to speculate on both up and down trends in the market. Technical analysis helps determine where the trends are and which way they are going, thus giving the trader a chance of profiting from the market, regardless of its direction. 2) What is the difference between fundamental and technical analysis? While technical analysis focuses on the study of market action, fundamental analysis focuses on the economic forces of supply and demand that cause the price to move higher, lower, or stay the same. The fundamental analysis examines all of the relevant factors affecting the price of the market in order to determine the intrinsic value of that market. The intrinsic value is what the fundamentals indicate something is actually worth based on the law of supply and demand. If this intrinsic value is under the current market price, then the market is overpriced and should be sold. If market price is under the intrinsic value then the market is undervalues and should be bought. Both of these approaches attempt to determine the direction the prices are likely to move, but from different directions. The fundamentalist studies the cause of market movement, whereas the technician studies the effect. The technician believes that the effects are important and the reasons or the causes are unnecessary. Technical analysis uses various tools like price charts, and trends and various indicators to determine the move of the market. Fundamentals takes into consideration only the economic factors like the GDP, inflation, unemployment rate, balance of payments, industry production, company financial reports, etc. political developments too cannot be ignored. Most traders classify themselves as either technicians or fundamentalists. Although in reality, there is a lot of overlap as technicians do have awareness of the fundamentals, and the fundamentalists have a working knowledge of the chart analysis. The problem is that the fundamentals and charts are often in conflict with each other. Market price acts as a leading indicator of the fundamentals. Fundamental analysis does not include a study of the price action. It is possible to trade financial markets using just the technical approach. It is doubtful that anyone could trade off the fundamentals alone with no consideration of the technical side of the market. 3) What are the various types of charts used by the technicians? Charts are the main tool that technical analysts use in order to plot data and predict prices.

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Technical analysts may use several different types of charts in order to conduct their tests and look for patterns in the data, including line charts, bar charts, and candlestick charts. a) Line charts The Line Chart connects single prices for a selected time period. In the line chart, only the closing price is plotted for each successive day. This is because many chartists believe that only the closing price is the most important and critical price of the trading day.

b) Bar charts Standard bar charts are commonly used to convey price activity into an easily readable chart. Usually four elements make up a bar chart, the Open, High, Low, and Close for the trading session/time period. A price bar can represent any time frame the user wishes, from 1 minute to 1 month. The total vertical length/height of the bar represents the entire trading range for the period. The top of the bar represents the highest price of the period, and the bottom of the bar represents the lowest price of the period. The Open is represented by a small dash to the left of the bar, and the Close for the session is a small dash to the right of the bar.

c) Point and figure chart It is a chart that plots day-to-day price movements without taking into consideration the passage of time. Point and figure charts are composed of a number of columns that either consist of a series of stacked Xs or Os. A column of Xs is used to illustrate a rising price, while Os represent a falling price.

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d) Candle stick charts The Japanese version of bar charting is known as the candle stick charting. As in the bar chart, a candlestick also records the open, close, high and low.

The thick part of the candle is called the real body, and the lines at the top and bottom are the shadows that represent the high and low for that particular period. A candle could sometimes have only the lower shadow, in which case it is known as a shaven head, or it could have only the upper shadow, in which case it is known as a shaven bottom. Sometimes a candle might not have a real body if the opening and closing are the same or very near. In this case, it is called a doji. A bullish candle is usually green in color which shows that the closing price is higher than the opening price. A bearish candle is usually red in color which shows that the closing price is lower than the opening price. 4) What is trend? The concept of trend is absolutely essential to the technical approach to market analysis. In general, the trend is simply the direction of the market, which way it is moving. Markets don’t generally move in a straight line in any direction. Market moves are characterized my zigzags, which resemble a series of successive waves with fairly obvious peaks and troughs. It is the direction of these peaks and troughs that constitute market trend. An uptrend is a series of successively higher peaks and troughs. A downtrend is a series of declining peaks and troughs. Horizontal peaks and troughs would identify a sideways price trend. An uptrend line has a positive slope and is formed by connecting two or more low points. The second low must be higher than the first for the line to have a positive slope. Uptrend lines act as support and indicate that net-demand (demand less supply) 89

is increasing even as the price rises. A rising price combined with increasing demand is very bullish and shows a strong determination on the part of the buyers. As long as prices remain above the trend line, the uptrend is considered solid and intact. A break below the uptrend line indicates that net-demand has weakened and a change in trend could be imminent. A downtrend line has a negative slope and is formed by connecting two or more high points. The second high must be lower than the first for the line to have a negative slope. Downtrend lines act as resistance, and indicate that net-supply (supply less demand) is increasing even as the price declines. A declining price combined with increasing supply is very bearish and shows the strong resolve of the sellers. As long as prices remain below the downtrend line, the downtrend is considered solid and intact. A break above the downtrend line indicates that net-supply is decreasing and a change of trend could be imminent. 5) What is the concept of support and resistance levels? The troughs, or reaction lows are known as support. This indicates that support is a level or area on the chart under the market where buying interest is sufficiently strong to overcome selling pressure. Hence, it is unlikely that prices fall below the support level. A decline is halted, and prices turn back up again. Usually a support level is identified beforehand by a previous reaction low. Resistance is the opposite of support and represents a price level or area over the market where selling pressure overcomes the buying pressure. Hence, it is unlikely that the prices go above the resistance level. Usually resistance level is identified by the previous peaks. In an uptrend, the resistance levels represent pauses in the uptrend and are usually exceeded at some point. In a downtrend, support levels are not sufficient enough to stop the decline permanently, but are able to check it at least temporarily. For an uptrend to continue, each successive low (support level) must be higher than the one preceding it. Each rally high (resistance level) must be higher than the one before it. 6) What are price patterns? How many types of patterns are there? Price patterns are pictures or formations which appear on price charts of stocks or commodities, that can be classified into different categories, and that have predictive value. There are two major categories of price patterns: reversal and continuation. Reversal patterns indicate that an important reversal in trend is taking place. The continuation pattern, indicate that the market is only pausing for a while, possibly to correct a near term overbought or oversold condition, after which the existing trend will be resumed. The trick is to recognize the patterns as early as possible during the formation of the pattern.

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The commonly used major reversal patterns are the head and shoulders, triple tops and bottoms, double tops and bottoms, spike tops and bottoms. The major continuation patterns are triangles, wedges, flags. Volume plays an important role in confirming all of these price patterns. In times of doubt, a study of the volume pattern accompanying the price data can be the deciding factor as to whether or not the pattern can be trusted. 7) What is MACD and how is it used? The Moving Average Convergence Divergence (MACD) is one of the oscillators used in technical analysis to find out the buying and selling points. The MACD shows the relationship between two moving averages of prices. The MACD is calculated by subtracting the 26-day exponential moving average (EMA) from the 12- day EMA. A nine-day EMA of the MACD, called the "signal line", is then plotted on top of the MACD, functioning as a trigger for buy and sell signals It is also important to watch for a move above or below the zero line because this signals the position of the short-term average relative to the long-term average. When the MACD is above zero, the short-term average is above the long-term average, which signals upward momentum. The opposite is true when the MACD is below zero. The zero line often acts as an area of support and resistance for the indicator. When the MACD line cuts the signal from below, it triggers a buy signal. When the MACD cuts the signal from above, it triggers a sell signal. When the MACD is above zero line, it indicates that the asset is overbought, hence, prices are most likely to fall. When MACD is below zero line, the asset is oversold, and will rise again. 8) What is stochastic? The stochastic states that with the increase in price, closing prices tend to be closer to the upper end of the price range. Similarly, in downtrends, closing price tends to be near the lower end of the range. There are two lines used in the stochastics, the %K line and the %D line. %K= 100 [(C – L14) / (H14 – L14)] Where, C is the latest close, L14 is the lowest for last 14 periods, H14 is the highest for last 14 periods. Periods can refer to days, weeks or months. Fourteen is the most commonly used period, and can be changed according to preference. %D is the 3 period moving average of the %K. Stochastic also ranges from 0 to 100. Anywhere near 80 level signifies that the asset is overbought. Hence at this level, when the %K line crosses the %D from above, it is

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a sell signal. Anywhere near the 20 level indicates that the asset is oversold. Hence at this level when the %K line cuts %D line from below, it triggers a sell signal. 9) What are Bollinger bands? Bollinger bands use two lines, the upper and the lower, which revolve around a simple moving average. The simple moving average is usually of 20 days, and the upper and lower bands are the standard deviations of the moving average. The standard deviations can range from 2 to 5%, depending on personal preference. Bollinger bands are one of the most commonly used indicators on the price charts and are normally used with other indicators rather than alone. It can be used with moving averages or RSI, etc. When the price line touches the upper band, the asset is considered as overbought. Hence, it is advisable to sell at the point when the price line touches the upper band. After this level, the prices will start to decline. The price line touching the lower band indicates that the asset is oversold. The point at which it touches the lower band signals a buying opportunity. After this level, since the asset is oversold, the prices will rise up again as buying activity increases. 10) Explain the head and shoulders pattern. A Head and Shoulders reversal pattern forms after an uptrend, and its completion marks a trend reversal. The pattern contains three successive peaks with the middle peak (head) being the highest and the two outside peaks (shoulders) being low and roughly equal. As its name implies, the head and shoulders reversal pattern is made up of a left shoulder, head, right shoulder, and neckline. While in an uptrend, the left shoulder forms a peak that marks the high point of the current trend. After making this peak, a decline ensues to complete the formation of the shoulder. The low of the decline usually remains above the trendline, keeping the uptrend intact. From the low of the left shoulder, an advance begins that exceeds the previous high and marks the top of the head. After peaking, the low of the subsequent decline marks the second point of the neckline. The low of the decline usually breaks the uptrend line, putting the uptrend in jeopardy. The advance from the low of the head forms the right shoulder. This peak is lower than the head (a lower high) and usually in line with the high of the left shoulder. While symmetry is preferred, sometimes the shoulders can be out of symmetry. The decline from the peak of the right shoulder should break the neckline. The neckline forms by connecting low points 1 and 2. Low point 1 marks the end of the left shoulder and the beginning of the head. Low point 2 marks the end of the head and the beginning of the right shoulder. Depending on the relationship between the two low points, the neckline can slope up, slope down or be horizontal. The slope of the neckline will affect the pattern's degree of bearishness: a downward slope is more bearish than an upward slope. Sometimes more than one low point can be used to form the neckline.

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The head and shoulders pattern is one of the most common reversal formations. It is important to remember that it occurs after an uptrend and usually marks a major trend reversal when complete. While it is preferable that the left and right shoulders be symmetrical, it is not an absolute requirement. They can be different widths as well as different heights. Identification of neckline support and volume confirmation on the break can be the most critical factors. The support break indicates a new willingness to sell at lower prices. Lower prices combined with an increase in volume indicate an increase in supply. The combination can be lethal, and sometimes, there is no second chance return to the support break. Measuring the expected length of the decline after the breakout can be helpful, but don't count on it for your ultimate target. As the pattern unfolds over time, other aspects of the technical picture are likely to take precedence. 1> What is a Mutual Fund? A mutual fund is simply a financial intermediary that allows a group of investors to pool their money together with a predetermined investment objective. The mutual fund will have a fund manager who is responsible for investing the pooled money into specific securities (usually stocks or bonds). When you invest in a mutual fund, you are buying shares (or portions) of the mutual fund and become a shareholder of the fund. Mutual funds are one of the best investments ever created because they are very cost efficient and very easy to invest in. By pooling money together in a mutual fund, investors can purchase stocks or bonds with much lower trading costs than if they tried to do it on their own. But the biggest advantage to mutual funds is diversification. 2> What are the advantages of investing in Mutual Funds? The principal advantages of mutual fund ownership are:

• • •

marketability and liquidity professional management diversification

The first advantage to mutual fund ownership, guaranteed marketability, is very important to investors. It is the ability to get out of an investment. Here, open-end investment companies shine. By statute, the investment company guarantees to redeem the current value of a client's investment within seven days. However, the investment company has the right to demand a written request for redemptions. The second important advantage to mutual fund ownership, professional management, stems from the fact that the investment advisor or management company is much more knowledgeable than the average investor. Professional advisors work full time managing portfolio assets -a luxury few investors can afford when investing on their own. The third advantage would be the fund's availability to diversify much better than an individual could. 3> What information must you receive before buying? A fund must provide a copy of the prospectus to investors before accepting their initial investment. Its purpose is to provide complete disclosure of information about the fund. Information listed in the prospectus includes the following: 93

The objective: This allows you to find a fund that matches your investing objective. Performance: This describes how the fund has performed in the past. Since the funds may change managers or limit choices to particular sectors of the economy, past performance does not guarantee future success. Risk: Each fund must list the level of risk involved in achieving its objectives

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4. How does a fund produce income for the investor? When a fund invests in debt, the IOU usually requires interest payments at specific times, such as semi-annually. Similarly, a fund investing in the stock of a corporation receives whatever cash dividends that company pays. Interest payments and dividend income by law must be passed through to the fund's shareholders - you. You can even have that income reinvested in more fund shares. Also, when a fund actually sells a stock or bond that has increased in value, the fund realizes a capital gain. Periodically, the fund will distribute such gains to its shareholders in the form of dividend checks unless you have instructed it to reinvest the gains. 5. Are Mutual Funds regulated by any agency of the Government? The main law governing mutual funds is the Investment Company Act of 1940, as amended by the U.S. Congress over the years. The U.S. Securities and Exchange Commission (S.E.C.) is responsible for regulating mutual funds as well as most publiclytraded securities. Off shore mutual funds are regulated by the laws of the country in which they are organized. 6. Is the principal protected? Unlike a bank deposit, the value of your principal can rise or fall. People invest in mutual funds because of the fact they want their principal to rise over time. The value of a fund depends on the value of the securities it owns. Stocks and bonds fluctuate in value and therefore so do mutual funds.

7. Can one lose principal in a Mutual Funds Investment? Because the value of a fund fluctuates, when you sell ("redeem") your shares, the price may be more or less than what you paid for it. Just as the value of your home doesn't always stay the same, neither does the value of a mutual fund. If you sell your home soon after you buy it, chances are greater you won't make a profit. The same is true for mutual funds. Most real estate and mutual funds are long-term investments. 8. How many investments does a typical fund have? A typical mutual fund will invest in 50 to 200 different securities. The very large number of investments gives most funds much more diversification than any individual could afford and, historically, greater diversification has meant greater safety.

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9. What type of investments are in the mutual funds? Most funds buy stocks or some form of debt. Stocks represent a share of ownership in a corporation. As an owner the mutual fund (and through it, you) shares in the profits (or losses) of the corporation. Debt is an IOU, such as a bond, that will be paid off at a stated date in the future; the mutual fund receives interest payments and after paying expenses, passes them along to you as dividends 10. What are open-end funds? The typical mutual fund is an open-end fund. Open-end means that the fund will sell as many shares as investors want. You can't trade shares of open-end funds in the stock market. You can only buy or sell them through the mutual fund company itself. Finding a buyer for your shares, however is not a problem; every fund is required to buy back your shares immediately upon your request.

1. What is securitization? Securitization is the process of pooling and repackaging of homogenous illiquid financial assets into marketable securities that can be sold to investors. Securitization has emerged as an important means of financing in recent times. 2. How is it done? A typical securitisation transaction consists of the following steps: • creation of a special purpose vehicle to hold the financial assets underlying the securities; • sale of the financial assets by the originator or holder of the assets to the special purpose vehicle, which will hold the assets and realize the assets; • issuance of securities by the SPV, to investors, against the financial assets held by it. This process leads to the financial asset being take off the balance sheet of the originator, thereby relieving pressures of capital adequacy, and provides immediate liquidity to the originator. 3. What is the legal framework for securitization in India? The legal framework for securitisation in India with the enactment of the “The Securitisation and Reconstruction of Financial Assets And Enforcement of Security Interest Ordinance, 2002” (The Act). Its purpose is to promote the setting up of asset reconstruction/securitisation companies to take over the Non Performing Assets (NPA) accumulated with the banks and public financial institutions. The Act provides special powers to lenders and securitisation/ asset reconstruction companies, to enable them to take over of assets of borrowers without first resorting to courts. The Reserve Bank of India (“RBI”) has recently

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notified the following guidelines under the Act for the regulation of securitisation companies: a. The Securitisation Companies and Reconstruction Companies (Reserve Bank) Guidelines and Directions, 2003. b. Guidelines to banks/FIs on sale of Financial Assets to Securitisation Company (SC)/ Reconstruction Company (RC) (created under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002) and related issues, 2003. 4.

Major types of securitized financial instruments in developed markets? There are various innovative financial instruments developed. Few major and most liquid of them are as follows. Mortgage Backed Securities (MBS) : A mortgage-backed security (MBS) is similar to a bond whose cash flows are backed by mortgage payments. Asset Backed Securities (ABS) : are a type of bond that is based on pools of assets. Assets are pooled to make otherwise minor and uneconomical investments worthwhile, while also reducing risk by diversifying the underlying assets. The securitization makes these assets available for investment to a broader set of investors. Typically, the securitised assets might be highly illiquid and private in nature. The financial assets in the pool backing the asset-backed securities range from mortgages and credit card debt to accounts receivables. Often the term asset-backed security is used in a narrower sense. As the mortgage-backed security market is so large, it is often seen as separate. In this case, asset-backed security means bonds backed by a pool of financial assets other than mortgages.

5.

How do you value a MBS? Pricing a vanilla corporate bond is based on two sources of uncertainty; default risk (credit risk), and interest rate (IR) exposure. The MBS adds a third risk; early redemption (prepayment). The number of homeowners, in residential MBS securitizations, that prepay goes up when interest rates go down, because they can refinance at a lower fixed interest rate (fixed rate). In commercial MBS, this risk is mitigated by call protection. Since these two sources of risk (IR and prepayment) are linked, solving mathematical models of MBS value is a difficult problem in finance. (The level of difficulty rises with the complexity of the IR model, and the sophistication of the prepayment IR dependence, to the point that no closed form solution exists.) In models of this type numerical methods provide approximate theoretical prices. (These are also required in most models which specify the credit risk as a stochastic function with an IR correlation. Practitioners typically use Monte Carlo method or Binomial Tree numerical solutions.)

6.

What are the types of MBS? Any bond ultimately backed by mortgages is classified as a MBS. This can be confusing, because securities derived from MBS are also called MBS(s). To distinguish the basic MBS bond from other mortgage-backed instruments the qualifier pass-through is used, in the same way that 'vanilla' designates an option with no special features.

Mortgage-backed security sub-types include:

•

•

Pass-through mortgage-backed security is the simplest MBS, as described in the sections above. Essentially, a securitization of the mortgage payments to the mortgage originators. These can be subdivided into: Residential mortgage-backed security (RMBS) - a pass-through MBS backed by mortgages on residential property 97

• • •

7.

What are reasons for issuing MBS? There are many reasons for mortgage originators to finance their activities by issuing mortgagebacked securities. Mortgage-backed securities

• • •

• • •

8.

Commercial mortgage-backed security (CMBS) - a pass-through MBS backed by mortgages on commercial property Collateralized mortgage obligation (CMO) - a more complex MBS in which the mortgages are ordered into tranches by some quality (such as repayment time), with each tranche sold as a separate security. Stripped mortgage-backed securities (SMBS): Each mortgage payment is partly used to pay down the loan's principal and partly used to pay the interest on it. These two components can be separated to create SMBS's, of which there are two subtypes: i. Interest-only stripped mortgage-backed securities (IO) - a bond with cash flows backed by the interest component of property owner's mortgage payments. ii. Principal-only stripped mortgage-backed securities (PO) - a bond with cash flows backed by the principal repayment component of property owner's mortgage payments.

transform relatively illiquid, individual financial assets into liquid and tradeable capital market instruments. allow mortgage originators to replenish their funds, which can then be used for additional origination activities. can be used by wall street banks to monetize an arbitrage between the originating credit spread of an underlying mortgage (private market transaction) and the yield demanded by bond investors through bond issuance (typically, a public market transaction). are frequently a more efficient and lower cost source of financing in comparison with other bank and capital markets financing alternatives. allow issuers to diversify their financing sources, by offering alternatives to more traditional forms of debt and equity financing. allow issuers to remove assets from their balance sheet, which can help to improve various financial ratios, utilize capital more efficiently and achieve compliance with risk-based capital standards.

How does the link between interest rates and loan prepayments affect MBS valuations? Mortgage prepayments are most often made because a home is sold or because the homeowner is refinancing to a new mortgage, presumably with a lower rate or shorter term. Prepayment is classified as a risk for the MBS investor despite the fact that they receive the money, because it tends to occur when floating rates drop and the fixed income of the bond would be more valuable (negative convexity). Hence the term: prepayment risk. To compensate investors for the prepayment risk associated with these bonds, they trade at a spread to government bonds. This is referred to as an Option Adjusted Spread. There are other drivers of the prepayment function (or prepayment risk), independent of the interest rate, for instance:

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• • • • •

Economic growth, which is correlated with a faster turn over in the housing market Home prices inflation Unemployment Regulatory risk; if borrowing requirements or tax laws in a country change this can change the market profoundly. Demographic trends, and a shifting risk aversion profile, which can make fixed rate mortgages relatively less attractive.

9. How are CMOs different from MBS? A CMO issuers will distribute cash flow to bondholders from a series of classes, called tranches. Each tranche holds mortgage-backed securities with similar maturity and cash flow patterns. Each tranche is different from the others within the CMO. For example, a CMO might have four tranches with mortgages that average two, five, seven and 20 years each. When the mortgage payments come in, the CMO issuer will first pay the stated coupon interest rate to the bondholders in each tranche. Scheduled and unscheduled principal payments will go first to the investors in the first tranches. Once they are paid off, investors in later tranches will receive principal payments. The concept is to transfer the prepayment risk from one tranche to another. Some CMOs may have 50 or more interdependent tranches. Therefore, you should understand the characteristics of the other tranches in the CMO before you invest. There are two types: Planned Amortization Class (PAC) Tranche PAC tranches use the sinking fund concept to help investors reduce prepayment risk and receive a more stable cash flow. A companion bond is established to absorb excess principal as mortgages are paid off early. Then, with income from two sources (the PAC and the companion bond) investors have a better chance of receiving payments over the original maturity schedule. Z-Tranche Z-tranches are also known as accrual bonds or accretion bond tranches. During the accrual period, interest is not paid to investors. Instead, the principal increases at a compound rate. This eliminates investors' risk of having to reinvest at lower yields if current market rates decline. After prior tranches are paid off, Z-tranche holders will receive coupon payments based on the bond's higher principal balance. Plus, they'll get any principal prepayments from the underlying mortgages.

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Because the interest credited during the accrual period is taxable - even though investors don't actually receive it - Z-tranches may be better suited for taxdeferred accounts. 10. Who issues these MBS? You can buy MBS from several different issuers: Independent Firms Investment banks, financial institutions and homebuilders issue private-label, mortgage-backed securities. Their creditworthiness and safety rating may be much lower than those of government agencies and government-sponsored enterprises. Federal Home Loan Mortgage Corporation (Freddie Mac) Freddie Mac is a federally-regulated, government-sponsored enterprise that purchases mortgages from lenders across the country. It then repackages them into securities that can be sold to investors in a wide variety of forms. Freddie Macs are not backed by the U.S government, but the corporation has special authority to borrow from the U.S. Treasury. (For more information, visit the Freddie Mac website.) Federal National Mortgage Association (Fannie Mae) Fannie Mae is a shareholder-owned company that is actively traded (symbol FNM) on the New York Stock Exchange and is part of the S&P 500 Index. It receives no government funding or backing. As far as safety goes, Fannie Maes are backed by the corporation's financial health and not by the U.S. government. (For more information, check out the Fannie Mae website.) Government National Mortgage Association (Ginnie Mae) Ginnie Maes are the only MBS that are backed by the full faith and credit of the U.S. government. They mainly consist of loans insured by the Federal Housing Administration or guaranteed by the Veterans Administration. (For more information, visit the Ginnie Mae website.)

Strategic Cost Management – Question Bank 1. What is Strategic Cost Management and how is it different from conventional cost analysis? Ans. Strategic Cost Management is the use of cost information for formulating, communicating, implementing & monitoring of strategies throughout organisation. No 1

Particulars Traditional Approach Most useful way  In terms of products, to analyze costs customers & functions  Strongly internal focus  Value added is a key concept

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S.C.M Analysis  In terms of various stages of overall value chain.  Strongly external focus  Value added is seen as dangerously narrow concept

2

Objective of cost analysis

 Score keeping, attention directing, problem solving with no regard to strategic concept.

 All 3 objectives present but cost management systems change depending upon strategic positioning i.e. cost leadership or product differentiation

3

Cost behavior

 Cost is function of output  Variable Cost  Fixed Cost  Step Cost  Mixed Cost

 Cost is a function of strategic choices in terms of structural & executional cost drivers.

2. Which are the 3 keys to Strategic Cost Management? Ans.

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S.C.M

Value Chain Analysis

Value Chain Vs. Value added perspective by management accounting Value Added concept has 2 big problems: (a) Starts too late (b) Stops too early

Strategic Position Analysis

Cost leadership (Target Costing) Product Differentiation (Marketing cost

Cost Driver Analysis Traditionally cost are related to output S.C.M- 2 types of cost drivers

analysis)

Structural Scale Scope Experience Technology Complexity

Executional

Commitment of workforce T.Q.M Capacity utilisation Product configuration Linkages with suppliers &/or customers

3. Briefly explain the Value Chain Methodology of SCM. Ans. Step I: Identify value chain - Define industry’s value chain - Assign costs, revenues & assets to value activities - For each activity the following points are to be considered. a. Can we reduce costs in activity holding revenues constant b. Can we increase revenue in activity holding cost constant c. Can we reduce assets in activity holding costs & revenues constant Step II: Diagnosis of Cost Drivers For each of the activities in the value chain as obtained in step I, diagnosis of cost drivers is important. Both the structural and executional costs in each activity are to be identified which helps in understanding the behaviour of costs in each of these activities Step III: Development of Sustainable Competitive Advantage This can be achieved by a. Controlling the cost drivers as identified above

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b. Rearranging the value chain

4. Explain the Strategic Position Analysis in SCM Ans. The strategic position analysis depends on a. Mission b. Competitive advantage in line with the mission The main features of the mission of an organization can be stated as follows: No

Mission

1

Build

2 Hold

3

Harvest

Features  Implies goal of increased market share even at the expense of short term earnings.  Pursued by business units with low market share in high-growth industries  E.g. Apple Computers’ Macintosh business, Monsanto’s biotechnology business  It is geared to protect market share of business & its competitive position.  For such units cash outflow is more or less equals cash inflow.  Business with high market share in high growth industries pursue this mission.  E.g: IBM in mainframe computers  Implies a goal of maximising short-term earnings & cash flow even at expense of market share. Such unit is supplier of cash.  Business with high market share in low-growth industries pursue this mission.

Various strategic planning processes would involve the build, hold or harvest strategy, depending on the factors as described below No

Particulars

Build

Harvest

1

Selling Price

Low

High

2

Capital expenditure decision Capital expenditure evaluation

Less formal Longer payback More emphasis on nonfinancial data such as market share, efficient use of R&D budget etc.

Formal Shorter payback More emphasis on financial data, cost efficiency, cash flows etc.

3

4

Capital investment analysis More subjective & qualitativeMore quantitative & financial

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The budgetary designing systems would also follow the build and harvest strategies as described below: No 1

Particulars Role of budget

Build Short term planning tool High

Harvest Control tool

2

Influence of unit manager in preparing annual budget Revision of budget

Easy

Difficult

Low

High

5

Role of standard costs in assessing performance Importance of flexible budget

Low

High

6 7

Frequency of feedback Budget Flexibility

Less More

More Less

8

Importance of achieving budgeted targets

Low

High

3 4

Low

The incentive compensation system is described as follow w.r.t. the build and harvest strategies No

Particulars

Build

Harvest

1

High

Low

2

Percentage Compensation as bonus Bonus Criteria

3

Bonus Determination

4

Frequency of bonus payment

More emphasis on More emphasis on non-financial financial criteria criteria More subjective More formula based Less frequent

5. What are Cost Drivers? Ans. The main parameters that influence costs are: a. Volume b. Structural choices c. Executional skills The important cost drivers used in SCM are:

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More frequent

a. Economies of scale b. Technology c. Strategic Positioning

6. Name and describe the techniques used in SCM Ans. The following techniques are used in SCM a. Activity Based Costing Involves • Costs collected according to activities • Jobs & processes loaded with these activities rationally Significance: • Correct position of overheads • Accurate product cost • Highlights inter-relation of activities • Locates more profitable customers • Promotes standards of excellence Implementation of ABC: Step I : Identify major activities in organization Step II : Create cost center or cost pool for each activity Step III : Identify cost drivers Step IV : Trace cost of activities to products using cost drivers b. Life Cycle Costing Meaning: • Technique which takes into account total cost of owning physical asset or making product during its economical life • Life cycle costs cover following stages: (1) Product design (2) Product development (3) Market launch (4) Production (5) Sale (6) Product withdrawal from market Significance: • Provides important information for pricing decisions • Useful for revenue planning which covers all 6 stages above • Manager’s perspective enlarged covering product life cycle • Highlights inter-relationship across cost categories • Useful in capital budgeting c. Target Costing Meaning:

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•

Cost management tool for reducing overall cost of product over its entire life cycle • Purpose is to identify cost for a proposed product such that product generates desired profit margin Steps involved: Step 1:Market research to assess (a) Sales quantity (b)Target price Step 2:Determine standard margin Target Cost = Target price (-) Standard margin Step 3:Value engineering if target cost cannot be achieved Step 4:Ensure that target costs are maintained

1) What is microfinance? Who are the clients of microfinance? Ans: Microfinance is the supply of loans, savings, and other basic financial services to the poor. People living in poverty, like everyone else, need a diverse range of financial instruments to run their businesses, build assets, stabilize consumption, and shield themselves against risks. Financial services needed by the poor include working capital loans, consumer credit, savings, pensions, insurance, and money transfer services. The poor rarely access services through the formal financial sector. They address their need for financial services through a variety of financial relationships, mostly informal. Credit is available from informal commercial and noncommerical money-lenders but usually at a very high cost to borrowers. Savings services are available through a variety of informal relationships like savings clubs, rotating savings and credit associations, and mutual insurance societies that have a tendency to be erratic and insecure. Providers of financial services to the poor include donor-supported, non-profit non-government organizations (NGOs), cooperatives; community-based development institutions like self-help groups and credit unions; commercial and state banks; insurance and credit card companies; wire services; post offices; and other points of sale. NGOs and other nonbank financial institutions have led the way in developing workable credit methodologies for the poor and reaching out to large numbers of the poor. Throughout the 1980s and 1990s, these programs improved upon the original methodologies and bucked conventional wisdom about financing the poor. They have shown that the poor repay their loans and are willing and able to pay interest rates that cover the costs of providing the loans. Financial services for the poor have proved to be a powerful instrument for poverty reduction that enables the poor to build assets, increase incomes, and reduce their vulnerability to economic stress.? However, with nearly one billion people still lacking access to basic financial services, especially the very poor, the challenge of providing financial services to them remains. Convenient, safe, and secure deposit services are a particularly crucial need. The clients of microfinance—female heads of households, pensioners, displaced persons, retrenched workers, small farmers, and micro-entrepreneurs—fall into four poverty levels: destitute, extreme poor, moderate poor, and vulnerable non-poor. While repayment capacity, collateral availability, and data availability vary across these categories, methodologies and operational structures have been developed that meet the financial needs of these client groups in a sustainable manner. More formal and mainstream financial services including collateral-based credit, payment services, and credit card accounts may suit the moderate poor. Financial services and delivery mechanisms for the extreme and moderate poor may utilize group structures or more flexible forms of collateral and loan analysis. The client group for a given financial service provider is primarily determined by its mission, institutional form, and methodology. Banks that scale down to serve the poor tend to reach only the moderate poor. Credit union clients range from the moderate poor to the vulnerable non-poor, although this varies by region and type of credit union. NGOs, informal savings and loan groups, and community savings and credit associations have a wide range of client profiles. 2)

what is a microfinance institution

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Ans: A microfinance institution (MFI) is an organization that provides financial services to the poor. This very broad definition includes a wide range of providers that vary in their legal structure, mission, methodology, and sustainability. However, all share the common characteristic of providing financial services to a clientele poorer and more vulnerable than traditional bank clients. Historical context can help explain how specialized MFIs developed over the last few decades. Between the 1950s and 1970s, governments and donors focused on providing subsidized agricultural credit to small and marginal farmers, in hopes of raising productivity and incomes. During the 1980s, microenterprise credit concentrated on providing loans to poor women to invest in tiny businesses, enabling them to accumulate assets and raise household income and welfare. These experiments resulted in the emergence of nongovernmental organizations (NGOs) that provided financial services for the poor. In the 1990s, many of these institutions transformed themselves into formal financial institutions in order to access and on-lend client savings, thus enhancing their outreach. An MFI can be broadly defined as any organization—credit union, down-scaled commercial bank, financial NGO, or credit cooperative—that provides financial services for the poor.

Characteristics of MFIs Formal providers are sometimes defined as those that are subject not only to general laws but also to specific banking regulation and supervision (development banks, savings and postal banks, commercial banks, and non-bank financial intermediaries). Formal providers may also be any registered legal organizations offering any kind of financial services. Semiformal providers are registered entities subject to general and commercial laws but are not usually under bank regulation and supervision (financial NGOs, credit unions and cooperatives). Informal providers are non-registered groups such as rotating savings and credit associations (ROSCAs) and self-help groups. Ownership structures of MFIs can be of almost any type imaginable. They can be government-owned, like the rural credit cooperatives in China; member-owned, like the credit unions in West Africa; socially minded shareholders, like many transformed NGOs in Latin America; and profit-maximizing shareholders, like the microfinance banks in Eastern Europe. Focus of some providers is exclusively on financial services to the poor. Others are focused on financial services in general, offering a wide range of financial services for different markets. Organizations providing financial services to the poor may also provide non-financial services. These services can include business-development services, like training and technical assistance, or social services, like health and empowerment training. Services that poor people need and demand the same types of financial services as everyone else. The most well-known service is non-collateralized "micro-loans," delivered through a range of group-based and individual methodologies. The menu of services offered also includes others adapted to the specific needs of the poor, such as savings, insurance, and remittances. The types of services offered are limited by what is allowed by the legal structure of the provider˜nonregulated institutions are not generally allowed to provide savings or insurance. 3)

Why do MFIs charge high interest rates

Ans: To maintain and increase its services over time, an MFI must charge interest rates high enough to cover the cost of its loans. Otherwise, the MFI will lose money. Its activities will shrink instead of growing unless it is continually infused with fresh money from private donors or governments. The problem is that donor and government money is not reliable, and there is not enough to meet the demand. Commercial investment fundings available, but MFIs must be sustainable, i.e., profitable enough to continue, in order to attract this investment. There are three kinds of costs the MFI has to cover when it makes microloans. The first two, the cost of the money that it lends and the cost of loan defaults, are proportional to the amount lent. For instance, if the cost paid by the MFI for the money it lends is 10%, and it experiences defaults of 1% of the amount lent, then these two costs will total $11 for a loan of $100, and $55 for a loan of $500. An interest rate of 11% of the loan amount thus covers both these costs for either loan. The third type of cost, transaction costs, is not proportional to the amount lent. The transaction cost of the $500 loan is not much different from the transaction cost of the $100 loan. Both loans require roughly the same amount of staff time for meeting with the borrower to appraise the loan, processing the loan disbursement and repayments, and follow-

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up monitoring. Suppose that the transaction cost is $25 per loan and that the loans are for one year. To break even on the $500 loan, the MFI would need to collect interest of $50 + 5 + $25 = $80, which represents an annual interest rate of 16%. To break even on the $100 loan, the MFI would need to collect interest of $10 + 1 + $25 = $36, which is an interest rate of 36%. At first glance, a rate this high looks abusive to many people, especially when the clients are poor. But in fact, this interest rate simply reflects the basic reality that when loan sizes get very small, transaction costs loom larger because these costs can‚t be cut below certain minimums. Lending programs that continually subsidize their borrowers will de-capitalize themselves unless they continue to receive new subsidies from donors or governments. By contrast, MFIs who charge their clients enough to cover all the loan costs can attract funding from commercial sources and are capable of exponential growth without relying on scarce and uncertain subsidies as funding sources. MFIs have to charge rates that are higher than normal banking rates to keep the service available, but even these rates are far below what poor people routinely pay to village moneylenders and other informal sources, whose percentage interest rates routinely rise into the hundreds and even the thousands. This does not mean that all high interest charges by MFIs are justifiable. Sometimes MFIs, especially ones that are funded by donors, are not aggressive enough in containing transaction costs. The results is that they pass on unnecessarily high transaction costs to their borrowers. Sustainability should be pursued by cutting costs as much as possible, not just by raising interest rates to whatever the market will bear.

4) What Is the Role of Regulation and Supervision in Microfinance? Ans: Banks are regulated to protect their depositors and to prevent risks to the financial system. Credit-only MFIs do not take deposits from the public and are too small to pose much risk for the financial system. Regulation by the financial authorities is needed for MFIs that do take deposits—for instance, savings-based financial cooperatives or creditbased MFIs that want to start taking deposits to finance their growth. In many countries, various factions are pushing for new laws to create a special, new type of financial license that is tailor-made for deposit-taking MFIs. Such laws need to be approached with care. New licensing windows for MFIs have been most successful in countries where a critical mass of profitable credit-only MFIs existed before the opening of the window. Drafters of new legislation typically fail to give enough attention to the practical feasibility of supervising compliance with the new regulations. In Indonesia, Ghana, and the Philippines, for example, dozens of new institutions took advantage of a newly created licensing window, but supervision proved grossly inadequate and a high proportion of them failed. MFIs that do not take deposits do not need intensive regulation and supervision, but they do need a certain minimum regulatory structure in order to operate. In the transition economies of former socialist countries, legislation is sometimes necessary to clarify the right of NGOs and other non-bank institutions to engage in the business of lending. In all countries, enforcement of unrealistically low interest-rate caps can make sustainable microlending impossible. MFIs need to charge interest rates that are considerably higher than normal bank rates because the administrative costs of making small loans are high in relation to the amount lent. The following questions are in context of India. 5)

Are there any restrictions on lending channel

Ans: There is no restriction on the MFIs as regards their lending methodology. MFIs may on-lend directly to SHGs / individuals or route their assistance through their partner NGOs and MFIs. 6)

What are the eligible activities for which SFMC provides credit ?

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Ans: The loans to ultimate borrowers would have to be utilized for financing micro enterprises and non-farm income generating activities including agri-allied activities. In view of the diverse needs of the poor, particularly in urban and semi-urban areas in service related activities where many of the NBFCs / new generation livelihood companies are working, the loan funds may be used for on-lending, inter alia, for activities such as purchase / lease of renewable energy equipment, tool kits for masons/ servicemen, 2/3 wheelers for self-employed persons (for extending business reach, procurement of raw material, distribution of finished goods etc.). Further, a part of the loan to ultimate borrowers could also be utilised for consumption purpose. Integrated / group projects involving animal husbandry, poultry etc. along with related processing would also be eligible for assistance. In view of the composite requirements of the poor, loans to partner MFIs may also be used for on-lending for construction of new / renovation / expansion of dwelling units / dwelling unit-cum-work sheds etc. 7)

What is the frequency and quantum of loan being provided to MFIs ? Are there any ceilings on individual loan amount per borrower ?

Ans: SFMC may provide annual / need based repeat assistance to its partner MFIs. Loan assistance per MFI for onlending is subject to a minimum of Rs.10 lakh. Variations in the minimum loan limit may also be considered depending upon the merits of the case. Normally, maximum amount lent by the MFIs to an individual borrower / SHG member must not exceed Rs.25,000/-. In exceptional and extremely deserving cases, particularly for enterprise and housing, the amount per borrower may be further increased. 8)

What is the repayment period of loans to MFIs ?

Ans: Repayment period (including moratorium) from 15 months to 4 years from the date of disbursement, depending upon the merits of case is considered in respect of loans to MFIs. The initial moratorium on the principal would range from 3-12 months from the date of first disbursement. However, in case of housing loans, MFIs would be required to repay the loan in 6 years excluding a moratorium, not exceeding, of 2 years from the date of first disbursement. Interest payments and principal repayments would continue to be made on quarterly basis on March 01, June 01, September 01 and December 01 of each year. 9)

What are the main legal requirements for the MFIs ?

Ans: The Memorandum of Association and bye-laws of the MFI should have explicit powers with regard to the following:• • •

Power to raise loans from banks and financial institutions. Power to offer security for loans raised from banks and financial institutions in such form as may be required by the lender. Power to carry on micro finance activities including on-lending to partner NGOs/MFIs / SHGs / individuals. Investment Decision

1) What is an Investment Decision Rule? A) The biggest challenge for a person is where to invest and whether the investments would be productive or not. Investment Decision rules allow us to formalize the process and specify what conditions need to be met for acceptance of the project. For instance an investment decision rule may specify that only projects that recover the amount invested in them in less than five years will be accepted or that only projects that earn a return on capital greater than their 109

cost of capital are good projects. It should not only consider incremental cash flows but also time weights them. The most widely used rules are the net present value and internal rate of return. 2) What are the characteristics of a good investment decision rule? A) The following are the characteristics of a good investment rule• A good investment decision rule has to maintain a fair balance between allowing a manager analyzing a project to bring in his or her subjective assessments into the decision and ensuring that different projects are judged consistently. Thus an investment decision rule that is too mechanical or (by not allowing for subjective inputs) or too malleable (bias) is not a good rule. • It must allow the firm to maximize its value. The projects that are acceptable by using the decision rule should maximize the value of the firm while if the projects that do not meet the requirements are invested in would destroy the firms value. • Lastly, a good investment decision rule should work across a variety of investments as it can be revenue generating investments or they can be cost saving investments too. Some projects have large costs up front and some have costs spread across time. A good investment decision rule will provide an answer on all of these different kinds of investments. 3) What are the different categories of investment decision rules? A) There are three categories of investment decision rules. They are as followsa) Accounting Income Based Decision Rules b) Cash Flow Based Decision Rules c) Discounted Cash Flow Measures •

Accounting Income Based Decision Rules-The conventional and most established investment rules have been drawn from the accounting statements and, in particular, from accounting measures of income. Some of these are based on income to equity investors ie net income, whereas others are based on operating income.

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Cash Flow Based Decision Rules – In this type of decision rule we measure returns based on cash earnings rather than accounting earnings. The second is the payback measure that looks at how quickly a project generates cash flow to cover the initial investment.

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Discounted Cash Flow Measures- Investment decision rules based on discounting cash flows not only replace accounting income with cash flows but explicitly consider time value and money. The two most widely used cash flows rules are net present value and the internal rate of return. Net Present value of a project is the sum of the present values of each project as well as negative that occurs over the life of the project. 4) What approaches do firms use in Investment Analysis? 110

A) The firms generally use more than one technique in analyzing projects. They are wide differences even within firms in usage of investment decision rules. Periodic surveys have been carried out to know which of the techniques are used. It states popularity of accounting return measures, such as return on equity and assets, in spite of the emphasis placed on cash flows over earnings on investment analysis. Secondly even when discounted cash flow measures were used, the internal rate of return was much more likely to be used as primary decision technique that was net present value. Notwithstanding the problems with multiple internal rates of return and faculty reinvestment rate assumption, managers preferred a scaled measure of investment performance to an unscaled one as primary decision rule. Thirdly surprisingly large no of respondents claimed to use Pay back period as the primary investment decision rule, despite of all its limitations and problems. Finally most respondents used more than one techniques of investment analysis on deciding the measure on the project. 5) How to deal with inflation in project analysis? A) When working with projects that generate cash flows over multiple periods we have to consider the effects of inflation on these cash flows. If inflation is higher than anticipated, the cash flows might not be worth as much as we thought they would be at the start of the analysis. To deal with this there are two parts to understand. That is expected inflation in which we refer to loss we anticipate in buying power over time. In this when the economy strengthens the expected inflation, at least in short term, and tends to increase reflecting the much greater demand for products and labour. In dealing with expected inflation we have two choices. The first is to incorporate expected inflation into the estimates of future cash flows, resulting in nominal cash flows for the project and to discount these cash flows at the nominal discount rate. The second is to estimate cash flows in real terms, without building inflationary effects, and to discount these cash flows with the real discount rate. A mismatch can cause significant errors in analysis. Unexpected inflation refers to the difference between actual inflation and expected inflation. It can affect project values to different degrees, depending on tax effects and the firm’s power to set prices on its products. 6) What do we consider while analyzing foreign projects? A) When we look at projects in foreign markets we must be very careful and must look at the exchange rate risk and political risk. We need to make two basic modifications when looking at such projects. They are as follows• We must consider whether the discount rate we will use for these projects needs to be adjusted to include the additional risk associated with foreign projects, and if so, how to make that adjustment. • We must decide whether to present the cash flows in domestic currency terms or foreign currency terms, and how to forecast exchange rates to make this conversion.

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7) What are the different kinds of Risks involved in foreign projects? A) They are two major risks involved. They are as follows• Exchange rate risk- In this there is the risk of movements in the exchange rates over time and some of these changes are unanticipated. Exchange rates can change because of the changes in inflation rates or changes in real interest rates in countries. They can also change as a result of speculation on the part of investors or intervention by countries in the market. • Political and regulatory risks- Firms that operate in politically stable domestic markets often fear overseas expansion because of the increased political and regulatory risks associated with operating in an environment that is politically less stable. It is generally the laws governed in a country. 8) How to estimate cash flows for a foreign project? A) There are two primary ways of estimating the cash flows. They are as follows• Local currency analysis- In this we analyze the cash flow in local currency and discount them back at a local currency discount rate. The advantage in this approach is that the cash flows are estimated in the currency in which they are likely to occur and that unrealistic assumptions about exchange rates cannot be used to make projects look better than they are. The limitation in this project is to compare the results in returns across the projects. • Domestic currency analysis- The cash flows from foreign projects will be in a foreign currency. We can use the expected exchange rates to convert these cash flows to domestic currency. In making these estimates of expected rates, firms should draw heavily on the purchasing power and interest rate parity. 9) Other issues of estimating cash flows on foreign projects are-; A) The basic problem is the estimated project cash flows is that the firm can withdraw the after tax cash flow and reinvest it elsewhere, presumably where returns are higher. Although this assumption is generally justified in regular projects, it may not hold in countries that restrict cash withdrawals from project. The second factor is in estimation of cash flow in taxes. Depending on the tax rates in the country and the taxes to be paid in the country may vary after tax cash flows and in the firm’s policy. 10) Should project risk be managed and how should it be managed? A) Any time a firm enters into a transaction that exposes it to cash flows in a foreign currency it is exposed to exchange rate risk. If the firm ventures into other countries, it creates additional political and regulatory risks. Therefore it is necessary to hedge the risk. They can use futures contracts, forward contracts, and options to manage interest rate risk, exchange rate risk and commodity price risk and insurance products to manage event risk. They can also manage the risk by choosing the financing the project wisely.

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RISK AND RETURN Q1. What is risk and return? Ans. The risk and return can be explained as follows: a) Return is the primary motivating force that drives investment. It represents the reward for undertaking investment. b) Risk refers to the possibility that the actual outcome of an investment will differ from its expected outcome. More specifically, most investors are concerned about the actual outcome being less than the expected outcome. The wider the range of possible outcomes, the greater the risk. Q2. What are the components of return? Ans. The return of an investment consists of 2 components. a) Current return: The first component that often comes to mind when one is thinking about the return is the periodic cash flow (income), such as dividend or interest, generated by investment. Current return is measured as the periodic income in relation to the beginning price of the investment. It can be zero or positive. b) Capital return: The second component of return is reflected in the price change called the capital return-it is simply the price appreciation (or depreciation) divided by the beginning price of the asset. For assets like equity stocks, the capital return predominates. It can be zero, positive and negative. Q3. What are the types of risk? Ans. Modern portfolio theory looks at risk from a different perspective. It divides total as follows: Total risk = Unique risk + Market risk The unique risk of security represents that portion of its total risk which stems from firm specific factors like the development of a new product, a labour strike, or the emergence of a new competitor. Events of this nature primarily affect the specific firm and not all the firms in general. Hence this risk can be washed away by combining it with other stocks. This risk can be called as unsystematic or diversifiable risk. The market risk of a stock represents that portion of its risk which is attributable to economy-wide factors like growth rate of GDP, the level of government spending, money supply, interest rate structure, and inflation rate. Since these factors affect all firms to a greater or lesser degree, investors cannot avoid the risk arising from them, however diversified their portfolios may be. Hence it is also referred to as systematic or non diversifiable risk.

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Q4. What are the sources of risk? Ans. Risk emanates from several sources. The three major ones are: a) Business risk: as a holder of corporate securities, you are exposed to the risk of poor business performance. This may be caused by a variety of factors like heightened competition, emergence of new technologies, development of substitute products, shifts in consumer preferences, inadequate supply of essential inputs, changes in government policies, and so on. Often, of course, the principal factor may be inept and incompetent management. Al these factors have an impact on the income and wealth of the firm. b) Interest rate risk: the changes in interest rate have a bearing on the welfare of investors. As the interest rate goes up, the market price of the existing fixed income securities falls and vice versa. This happens because the buyer of a fixed income security would not buy it at its par value or face value if its fixed interest rate is lower than the prevailing interest rate on a similar security. c) Market risk: even if the earning power of the corporate sector and the interest rate structure remain more or less unchanged, prices of securities, equity shares in particular, tend to fluctuate. While there can be several reasons for this fluctuation, a major cause appears to be the changing psychology of the investors. There are periods when the investors become bullish and there investment horizon lengthen. Investor optimism, which may border on euphoria, during such periods, drives share prices to great heights. The buoyancy created in the wake of this development is pervasive, affecting almost all the share. Q5. What is variance and standard deviation? Ans. The most commonly used measures of risk in finance are variance or its square root the standard deviation. The variance and the standards deviation of a historical return series are defined as follows: n

_ (S.d.)^2 = E (Ri – R)^2 i=1 ------------------N–1 (S.d)^2 = Variance of return Ri = return from the stock in period i _ R= arithmetic mean N= number of periods

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Q6. What is risk premium? Ans. Investors assume risk so that they are rewarded in the form of higher return. Hence risk premium may be defined as the additional return investor s expect to get, or investors earned in the past, for assuming additional risk. Risk, premium may be calculated between two classes of securities that differ in their risk level. Q7. What are the types of risk premiums? Ans. There are three well known risk premiums and they are as follows: a) Equity risk premium: this is the difference between the return on equity stocks as a class and the risk free rate represented commonly by the return on treasury bills. b) Bond horizon premium: This is the difference between the return on long term government bond and the return on treasury bills. c) Bond default premium: This is the difference between the return on long term corporate bonds (which has the probability of default) and the return on long term government bonds which are free from default risk. Q8. What is beta? Ans. Beta is the sensitivity of the change in stock price vis-à-vis the change in the most diversified market portfolio. It is calculated by dividing the covariance of market return and stock return to standard deviation of market return 1. What is Credit Risk? Credit risk is the possibility that a borrower will fail to service or repay a debt on time. The degree of risk is reflected in the borrower's credit rating, which defines the premium over the riskless borrowing rate it pays for funds and ultimately the market price of its debt. Credit risk has two variables: market risk and firm-specific risk. Credit derivatives allow users to isolate, price and trade firm-specific credit risk by unbundling a debt instrument or a basket of instruments into its component parts and transferring each risk to those best suited or most interested in managing it. There are various traditional mechanisms to reduce credit risk including refusal to make a loan, insurance products, guarantees and letters of credit, but these mechanisms are less effective during periods of economic downturn when risks that normally offset each other simultaneously default and financial institutions suffer substantial loan losses. 2. What are Credit Derivatives? Credit derivatives are derivative instruments that seek to trade in credit risks. All derivatives have some common features: they are related to some risk or volatility,

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typically do not require initial investment, and may be net settled. For example, the risk or volatility in an inter-rate swap is movements in interest rates. In a commodity derivative, it is commodity prices. Likewise, the subject matter of a credit derivative is the general credit risk of a reference entity. The general credit risk is indicated by the happening of certain events, called credit events, which include bankruptcy, failure to pay, restructuring etc. There is a party trying to transfer credit risk, called protection buyer, and the counterparty is trying to acquire credit risk, called protection seller. The primary purpose of credit derivatives must have been to hedge - a bank having exposure in a reference entity seeks to protect itself by buying protection from another. But over time, credit derivatives market has become a trading market. Trades in credit derivatives are taken to be proxies for trades in actual loans or bonds of the reference entity. For example, a bank willing to acquire exposure in a reference entity X would sell protection referenced to X; while a bank holding a bearish view on X will buy protection. Therefore, credit derivatives trades have become easy tools to replicate a funded cash bond or cash loan of a reference entity, minus all the inflexibilities, lack of availability or regulatory and geographical barriers. Credit derivatives are typically unfunded - the protection seller is not required to put in any money upfront. The protection buyer typically pays a periodic premium. However, the credit derivative may be funded as well - for example, the protection buyer may require the protection seller to pre-pay the entire notional value of the contract upfront. In return, the protection buyer may issue a note, called credit linked note. The credit linked note is similar to any other bond or note, with the difference that from the amount due for repayment, the protection buyer (issuer) may deduct the amount of payments, if any, required on account of credit events. A credit derivative being a derivative, does not require either of the parties - the protection seller or protection buyer - to actually hold the reference asset. Thus, a bank may buy protection for an exposure it has, or does not have, or irrespective of the amount or term for which it has actual exposure. Obviously, therefore, the amount of compensation that can be claimed under a credit derivative is not related to the actual losses suffered by the protection buyer. When a credit event takes place, there are two ways of settlement - cash and physical. Cash settlement means the reference asset will be valued, and the difference between its par and fair value will be paid by the protection seller. Physical settlement means the protection seller will acquire the defaulted asset, for its full par. 3. Who uses them? Credit derivatives are tools used mostly by institutional investors—mostly banks, but also broker-dealers, institutional investors, money managers, hedge funds, insurers, reinsurers and corporate treasurers—to efficiently repackage and transfer the credit risk they carry as lenders and bondholders. Credit risk, also known as default risk, is the risk that borrowers or bond issuers will not fulfill their promise of timely payments of interest and principal. 4. Why are they important?

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Credit derivatives allow intermediaries to strip out unwanted credit risk exposure and redistribute it among banks and institutional investors who find the risk attractive as a mechanism for diversifying investment portfolios. In addition to helping large investors gain exposure to the risks they want and avoid the ones they don’t, credit derivatives have also helped make the credit markets more liquid and efficient. Since its inception in the late 1990s, the market for credit derivatives has grown rapidly at rates as high as 50% a year. (Because these agreements are usually confidential, accurate measurements are difficult.) As an asset class and risk management tool, credit derivatives have revolutionized the way that credit risk is originated, distributed, measured and managed. 5. Evolution of credit derivatives Many people claim that credit derivatives evolved in 1995, but they are wrong. Credit derivatives emerged in early 1993 or even before that. In March 1993, Global Finance carried an article which said that three Wall Street firms - J. P. Morgan, Merrill Lynch, and Bankers Trust - were already then marketing some form of credit derivatives. Prophetically, this article also said that credit derivatives could, within a few years, rival the $4-trillion market for interest rate swaps. In retrospect, we know that this was right. Not only were credit derivatives already a topic frequently talked about in financial press in 1993, they initially faced a bit of resistance. In Nov. 1993, Investment Dealers Digest carried an article titled Derivatives pros snubbed on latest exotic product which claimed that a number of private credit derivative deals had been seen in the market but it was doubted if they were ever completed. The article also said that Standard and Poor's had refused to rate credit derivative products and this refusal may put a permanent damper on the fledgling market. S&P seems to have issued some kind of a document which said that in essence, these securities represent a bet by the investor that none of the corporate issuers in the reference group will default or go bankrupt. One commentator quoted in the said article said: "It (credit derivatives) is like Russian roulette. It doesn't make a difference if there's only one bullet: If you get it you die". Almost 3 years later, Euromoney reported [March 1996: Credit derivatives get cracking ] that a lot of credit derivatives deals were already happening. From a product that was branded as a "touted" product in 1993, the market perception had changed into one of unbridled optimism. The article said: "The potential of credit derivatives is immense. There are hundreds of possible applications: for commercial banks which want to change the risk profile of their loan books; for investment banks managing huge bond and derivatives portfolios; for manufacturing companies over-exposed to a single customer; for equity investors in project finance deals with unacceptable sovereign risk; for institutional investors that have unusual risk appetites (or just want to speculate); even for employees worried about the safety of their deferred remuneration. The potential uses are so widespread that some market participants argue that credit derivatives could eventually outstrip all other derivative products in size and importance."

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Here are some significant milestones in the development of credit derivatives: • • • • • • • •

1992 - Credit derivatives emerge. Isda first uses the term "credit derivatives" to describe a new, exotic type of over-the-counter contract. 1993 -KMV introduces the first version of its Portfolio Manager model, the first credit portfolio model. 1994 - Credit derivatives market begins to evolve. There are doubts expressed by some - as above. September 1996 - The first CLO of UK's National Westminster Bank. April 1997 - J P Morgan launches CreditMetrics October 1997 - Credit Suisse launches CreditRisk+ December 1997 - The first synthetic securitisation, JP Morgan's Bistro deal. July 1999 - Credit derivative definitions issued by Isda.

6. Types of Credit Derivatives Based on the type of risk being transferred, credit derivatives may be broadly classed in • credit default swaps • total rate of return swaps • equity default swaps In a credit default swap, the protection buyer continues to pay a certain premium to the protection seller, with the option to put the credit to the protection seller should there be a credit event. Unless there is a credit event, there is no exchange of the actual asset or the cashflows arising out of the actual asset. In a total rate of return swaps, the parties agree to exchange the actual cashflows from the asset (say a bond), including the appreciation and depreciation in its market value, periodically, with returns referenced to a certain reference rate. Say, the reference rate is LIBOR. The protection buyer will get LIBOR + x bps, and pay over to protection seller all he earns from the reference assets. Thus, he replaces the returns from the reference asset by a return calculated on a reference rate - thereby transferring both the credit risk as well as the price risk of the reference asset. Equity default swaps, relatively new in the marketplace, use a substantial and nontransient decline in the market value of equity as a trigger event - assuming that a deep decline in the market value of equity is either indicative of a default or preparatory for a default. Credit linked notes package a credit default swap into a tradable instrument - a note or a bond. The credit linked notes may be issued either by the protection buyer himself or by a special purpose vehicle. A credit derivative may be reference to a single reference entity, or a portfolio of reference entities - accordingly it is called single name credit derivative, or portfolio

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credit derivative. In a portfolio derivative, the protection seller is exposed to the risk of one or more constituents in the portfolio, to the extent of the notional value of the transaction. A variant of a portfolio trade is a basket default swap. In a basket default swap, there would be a bunch of names, usually equally weighted (say with a notional value of USD 10 million each). The swap might be, say, for first to default in the basket. The protection seller sells protection on the whole basket, but once there is one default in the basket, the transaction is settled and closed. If the names in the basket are uncorrelated, this allows the protection seller to leverage himself - his losses are limited to only one default but he actually takes exposure on all the names in the basket. And for the protection buyer, assuming the probability of the second default in a basket is quite low, he actually buys protection for the entire basket but paying a price which is much lower than the sum of individual prices in the basket. Likewise, there might be a second-to-default or n-th to default basket swaps. 7. What Triggers the Default Swap? The default swap is triggered by a Credit Event. The ISDA definitions provide for six credit events that are usually defined in relation to a reference entity. Typically, only four or five will be used, depending on whether the reference credit is a corporate or sovereign A Credit Event is most commonly defined as the occurrence of one or more of the following: i. Failure to meet payment obligations when due (after giving effect to the Grace Period, if any, and only if the failure to pay is above the payment requirement specified at inception), ii. Bankruptcy (for non-sovereign entities) or Moratorium (for sovereign entities only), iii. Repudiation, iv. Material adverse restructuring of debt, v. Obligation Acceleration or Obligation Default. While Obligations are generally defined as borrowed money, the spectrum of Obligations goes from one specific bond or loan to payment or repayment of money, depending on whether the counterparties want to mirror the risks of direct ownership of an asset or rather transfer macro exposure to the Reference entity. 8. What is an Obligation? The obligation used in the definition of a credit event needs itself to be defined. In order to get evidence of a credit event as it relates to an obligation, we need to specify the different categories of obligation. There are six possible categories: bond, bond or loan, borrowed money, loan, payment, and reference obligations only. Most trades will specify the obligations using bond, bond or loan, or borrowed money. A further eight obligation characteristics, listed in Figure 41, are used to refine the nature of the obligation.

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9. Pricing Considerations Predictive or theoretical pricing models of Credit Swaps A common question when considering the use of Credit Swaps as an investment or a risk management tool is how they should correctly be priced. Credit risk has for many years been thought of as a form of deep out-of-the-money put option on the assets of a firm. To the extent that this approach to pricing could be applied to a Credit Swap, it could also be applied to pricing of any traditional credit instrument. In fact, option pricing models have already been applied to credit derivatives for the purpose of proprietary “predictive” or “forecasting” modeling of the term structure of credit spreads.

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A model that prices default risk as an option will require, directly or implicitly, as parameter inputs both default probability and severity of loss given default, net of recovery rates, in each period in order to compute both an expected value and a standard deviation or “volatility” of value. These are the analogues of the forward price and implied volatility in a standard Black-Scholes model. However, in a practical environment, irrespective of the computational or theoretical characteristics of a pricing model, that model must be parameterized using either market data or proprietary assumptions. A predictive model using a sophisticated option-like approach might postulate that loss given default is 50% and default probability is 1% and derive that the Credit Swap price should be, say, 20 b.p. A less sophisticated model might value a credit derivative based on comparison with pricing observed in other credit markets (e.g., if the undrawn loan pays 20 b.p. and bonds trade at LIBOR + 15 b.p., then, adjusting for liquidity and balance sheet impact, the Credit Swap should trade at around 25 b.p.). Yet the more sophisticated model will be no more powerful than the simpler model if it uses as its source data the same market information. Ultimately, the only rigorous independent check of the assumptions made in the sophisticated predictive model can be market data. Yet, in a sense, market credit spread data presents a classic example of a joint observation problem. Credit spreads imply loss severity given default, but this can only be derived if one is prepared to make an assumption as to what they are simultaneously implying about default likelihoods (or vice versa). Thus, rather than encouraging more sophisticated theoretical analysis of credit risk, the most important contribution that credit derivatives will make to the pricing of credit will be in improving liquidity and transferability of credit risk and hence in making market pricing more transparent, more readily available, and more reliable. Mark-to-market and valuation methodologies for Credit Swaps Another question that often arises is whether Credit Swaps require the development of sophisticated risk modeling techniques in order to be marked-to-market. It is important in this context to stress the distinction between a user’s ability to mark a position to market (its “valuation” methodology) and its ability to formulate a proprietary view on the correct theoretical value of a position, based on a sophisticated risk model (its predictive” or “forecasting” methodology). Interestingly, this distinction is recognized in the existing bank regulatory capital framework: while eligibility for trading book treatment of, for example, interest rate swaps depends on a bank’s ability to demonstrate a credible valuation methodology, it does not require any predictive modeling expertise. Fortunately, given that today a number of institutions make markets in Credit Swaps, valuation may be directly derived from dealer bids, offers or mid market prices (as appropriate depending on the direction of the position and the purpose of the valuation). Absent the availability of dealer prices, valuation of Credit Swaps by proxy to other credit instruments is relatively straightforward, and related to an assessment of the market credit spreads prevailing for obligations of the Reference Entity that are pari passu with the Reference Obligation, or similar credits, with tenor matching that of the Credit Swap, rather than that of the Reference Obligation itself. For example, a five-year Credit Swap on XYZ Corp. in a predictive modeling framework might be evaluated on the basis of a postulated default probability and recovery rate, but should be marked-to-market based

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upon prevailing market credit spreads (which as discussed above provide a joint observation of implied market default probabilities and recovery rates) for five-year XYZ Corp. obligations substantially similar to the Reference Obligation (whose maturity could exceed five years). If there are no such five-year obligations, a market spread can be interpolated or extrapolated from longer and/or shorter term assets. If there is no prevailing market price for pari passu obligations to the Reference Obligation, adjustments for relative seniority can be made to market prices of assets with different priority in a liquidation. Even if there are no currently traded assets issued by the Reference Entity, then comparable instruments issued by similar credit types may be used, with appropriately conservative adjustments. Hence, it should be possible, based on available market data, to derive or bootstrap a credit curve for any reference entity. Constructing a Credit Curve from Bond Prices In order to price any financial instrument, it is important to model the underlying risks on the instrument in a realistic manner. In any credit linked product the primary risk lies in the potential default of the reference entity: absent any default in the reference entity, the expected cashflows will be received in full, whereas if a default event occurs the investor will receive some recovery amount. It is therefore natural to model a risky cashflow as a portfolio of contingent cashflows corresponding to these different default scenarios weighted by the probability of these scenarios. Example: Risky zero coupon bond with one year to maturity. At the end of the year there are two possible scenarios: 1. The bond redeems at par; or 2. The bond defaults, paying some recovery value, RV. The decomposition of the zero coupon bond into a portfolio of contingent cashflows is therefore clear

This approach was first presented by R. Jarrow and S. Turnbull (1992): “Pricing Options on Financial Securities Subject to Default Risk”, Working Paper, Graduate School of Management, Cornell University. This approach to pricing risky cashflows can be extended to give a consistent valuation framework for the pricing of many different risky products. The idea is the same as that applied in fixed income markets, i.e. to value the product by decomposing it into its

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component cashflows, price these individual cashflows using the method described above and then sum up the values to get a price for the product. This framework will be used to value more than just risky instruments. It enables the pricing of any combination of risky and risk free cashflows, such as capital guaranteed notes - we shall return to the capital guaranteed note later in this section, as an example of pricing a more complex product. This pricing framework can also be used to highlight relative value opportunities in the market. For a given set of probabilities, it is possible to see which products are trading above or below their theoretical value and hence use this framework for relative value position taking. Calibrating the Probability of Default The pricing approach described above hinges on us being able to provide a value for the probability of default on the reference credit. In theory, we could simply enter probabilities based on our appreciation of the reference name’s creditworthiness and price the product using these numbers. This would value the product based on our view of the credit and would give a good basis for proprietary positioning. However, this approach would give no guarantee that the price thus obtained could not be arbitraged against other traded instruments holding the same credit risk and it would make it impossible to risk manage the position using other credit instruments. In practice, the probability of default is backed out from the market prices of traded market instruments. The idea is simple: given a probability of default and recovery value, it is possible to price a risky cashflow. Therefore, the (risk neutral) probability of default for the reference credit can be derived from the price and recovery value of this risky cashflow. For example, suppose that a one year risky zero coupon bond trades at 92.46 and the risk free rate is 5%. This represents a multiplicative spread of 3% over the risk free rate, since:

So the implied probability of default on the bond is 2.91%. Notice that under the zero recovery assumption there is a direct link between the spread on the bond and the probability of default. Indeed, the two numbers are the same to the first order. If we have a non-zero recovery the equations are not as straightforward, but there is still a strong link between the spread and the default probability:

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This simple formula provides a “back-of-the-envelope” value for the probability of default on an asset given its spread over the risk free rate. Such approximation must, of course, be used with the appropriate caution, as there may be term structure effects or convexity effects causing inaccuracies, however it is still useful for rough calculations. This link between credit spread and probability of default is a fundamental one, and is analogous to the link between interest rates and discount factors in fixed income markets. Indeed, most credit market participants think in terms of spreads rather than in terms of default probabilities, and analyze the shape and movements of the spread curve rather than the change in default probabilities. However, it is important to remember that the spreads quoted in the market need to be adjusted for the effects of recovery before default probabilities can be computed. Extra care must be taken when dealing with Emerging Market debt where bonds often have guaranteed principals or rolling guaranteed coupons. The effect of these features needs to be stripped out before the spread is computed as otherwise, an artificially low spread will be derived. So the implied probability of default on the bond is 2.91%. Notice that under the zero recovery assumption there is a direct link between the spread on the bond and the probability of default. Indeed, the two numbers are the same to the first order. If we have a non-zero recovery the equations are not as straightforward, but there is still a strong link between the spread and the default probability:

This simple formula provides a “back-of-the-envelope” value for the probability of default on an asset given its spread over the risk free rate. Such approximation must, of course, be used with the appropriate caution, as there may be term structure effects or convexity effects causing inaccuracies, however it is still useful for rough calculations. This link between credit spread and probability of default is a fundamental one, and is analogous to the link between interest rates and discount factors in fixed income markets. Indeed, most credit market participants think in terms of spreads rather than in terms of default probabilities, and analyze the shape and movements of the spread curve rather than the change in default probabilities. However, it is important to remember that the spreads quoted in the market need to be adjusted for the effects of recovery before default probabilities can be computed. Extra care must be taken when dealing with Emerging Market debt where bonds often have guaranteed principals or rolling guaranteed coupons.

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The effect of these features needs to be stripped out before the spread is computed as otherwise, an artificially low spread will be derived. Problems Encountered in Practice In practice it is rare to find risky zero coupon bonds from which to extract default probabilities and so one has to work with coupon bonds. Also the bonds linked to a particular name will typically not have evenly spaced maturities. As a result, it becomes necessary to make interpolation assumptions for the spread curve, in the same manner as zero rates are bootstrapped from bond prices. Naturally, the spread curve and hence the default probabilities will be sensitive to the interpolation method selected and this will affect the pricing of any subsequent products. Assumptions need to be made with respect to the recovery value as it is impossible, in practice, to have an accurate recovery value for the assets. It is clear from the equations above that the default probability will depend substantially on the assumed recovery value, and so this parameter will also affect any future prices taken from our spread curve.

Using Default Swaps to make a Credit Curve

For many credits, an active credit default swap (CDS) market has been established. The spreads quoted in the CDS market make it possible to construct a credit curve in the same way that swap rates make it possible to construct a zero coupon curve. Like swap rates, CDS spreads have the advantage that quotes are available at evenly spaced maturities, thus avoiding many of the concerns about interpolation. The recovery rate remains the unknown and has to be estimated based on experience and market knowledge. Strictly speaking, in order to extract a credit curve from CDS spreads, the cashflows in the default and nodefault states should be diligently modeled and bootstrapped to obtain the credit spreads. However, for relatively flat spread curves, approximations exist. To convert market CDS spreads into default probabilities, the first step is to strip out the effect of recovery. A standard CDS will pay out par minus recovery on the occurrence of a default event. This effectively means that the protection seller is only risking (100-recovery). So the real question is how much does an investor risking 100 expect to be paid. To compute this, the following approximation can be used:

(1 - RV/100) ≈ SMarket SRV = O

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Notice the similarity between this equation and the earlier one derived for risky zero coupon bonds. Here the resulting zero recovery CDS spread is still a running spread. However, as an approximation it can be treated as a credit spread, and therefore:

This approximation is analogous to using a swap rate as a proxy for a zero coupon rate. Although it is really only suitable for flat curves, it is still useful for providing a quick indication of what the default probability is. Combining the two equations above:

Linking the Credit Default Swap and Cash markets

An interesting area for discussion is that of the link between the bond market and the CDS market. To the extent that both markets are trading the same credit risk we should expect the prices of assets in the two markets to be related. This idea is re-enforced by the observation that selling protection via a CDS exactly replicates the cash position of being long a risky floater paying libor plus spread and being short a riskless floater paying libor flat1 . Because of this it would be natural to expect a CDS to trade at the same level as an asset swap of similar maturity on the same credit. However, in practice we observe a basis between the CDS market and the asset swap market, with the CDS market typically – but not always - trading at a higher spread than the equivalent asset swap. The normal explanations given for this basis are liquidity premia and market segmentation. Currently the bond market holds more liquidity than the CDS market and investors are prepared to pay a premium for this liquidity and accept a lower spread. Market segmentation often occurs because of regulatory constraints which prevent certain institutions from participating in the default swap market even though they are allowed to source similar risk via bonds. However, there are also participants who are more inclined to use the CDS market. For example, banks with high funding costs can effectively achieve Libor funding by sourcing risk through a CDS when they may pay above Libor to use their own balance sheet. Another more technical reason for a difference in the spreads on bonds and default swaps lies in the definition of the CDS contract. In a default swap contract there is a list of obligations which may trigger a credit event and a list of deliverable obligations which can be delivered against the swap in the case of such an event. In Latin American markets the obligations are typically all public external debt, whereas outside of Latin America the obligations are normally all borrowed money. If the obligations are all borrowed money this means that if the reference entity defaults on any outstanding bond or loan a

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default event is triggered. In this case the CDS spread will be based on the spread of the widest obligation. Since less liquid deliverable instruments will often trade at a different level to the bond market this can result in a CDS spread that differs from the spreads in the bond market. For contracts where the obligations are public external debt there is an arbitrage relation which ties the two markets and ought to keep the basis within certain limits. Unfortunately it is not a cheap arbitrage to perform which explains why the basis can sometimes be substantial. Arbitraging a high CDS spread involves selling protection via the CDS and then selling short the bond in the cash market. Locking in the difference in spreads involves running this short position until the maturity of the bond. If this is done through the repo market the cost of funding this position is uncertain and so the position has risk, including the risk of a short squeeze if the cash paper is in short supply. However, obtaining funding for term at a good rate is not always easy. Even if the funding is achieved, the counterparty on the CDS still has a credit exposure to the arbitrageur. It will clearly cost money to hedge out this risk and so the basis has to be big enough to cover this additional cost. Once both of these things are done the arbitrage is complete and the basis has been locked in. However, even then, on a mark-to-market basis the position could still lose money over the short term if the basis widens further. So ideally, it is better to account for this position on an accrual basis if possible. Using the Credit Curve As an example of pricing a more complex structure off the credit curve, we shall now work through the pricing of a 5 year fixed coupon capital guaranteed credit-linked note. This is a structure where the notional on the note is guaranteed to be repaid at maturity (i.e. is not subject to credit risk) but all coupon payments will terminate in the event of a default of the reference credit. The note is typically issued at par and the unknown is the coupon paid to the investor. For our example we shall assume that the credit default spreads and risk free rates are as given in Table 1:

The capital guaranteed note can be decomposed into a risk-free zero coupon bond and a zero recovery risky annuity, with the zero coupon bond representing the notional on the note and the annuity representing the coupon stream. As the zero coupon bond carries no credit risk it is priced off the risk free curve. In our case:

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So all that remains is to price the risky annuity. As the note is to be issued at par, the annuity component must be worth 100 - 78.35 = 21.65. But what coupon rate does this correspond to? Suppose the fixed payment on the annuity is some amount, C. Each coupon payment can be thought of as a risky zero coupon bond with zero recovery. So we can value each payment as a probability-weighted average of its value in the default and no default states as illustrated in Table 2:

So the payment on the annuity should be: C = 21.65 / (0.8837 + 0.7808 + 0.6900 + 0.6097 + 0.5388) C = 6.18

8. BIS II proposals on credit derivatives The BIS has issued the 3rd (and possibly the final) consultative paper on 29th April 2003 which made elaborate provisions on risk mitigations in general including credit derivatives. Most of these changes have been retained in the final draft. The essential approach of the Basle II on credit derivatives is substitution approach - that is, the risk weight of the protection seller substitutes the risk weight of the underlying asset. The new guidelines put in extensive eligibility conditions for the protection seller, have dropped restructuring to be a credit event in certain circumstances, have allowed asset mismatches in certain circumstances, etc.

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By way of a general qualification, a credit derivative must be a direct claim on the protection seller and must be unconditional and irrevocable. The following are the further specific requirements in case of credit derivatives: •

•

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The credit events specified must at least include the following: o Failure to pay and analogous events with a grace period that is consistent with the grace period allowed as for the underlying credit o bankruptcy, insolvecy or inability to pay the amount, or admission in writing of its inability to pay, and analogous events o adverse restructuring of the terms, that is, forgiveness or postponement of principal, interest or fees that results in a credit loss event (i.e. charge-off, specific provision or other similar debit to the profit and loss account). o In cases where restructuring is not included as a credit event, the amount of hedge is limited to 60%. In other words, 40% of the underlying exposure will be deemed as if it is unprotected. Asset mismatches, that is, the reference obligation and the underlying asset being different, are allowed only if it is of the same obligor, and the underlying obligation ranks at par, or is senior to the reference obligation. The credit derivative must not expire before the grace period to be given in an event of default. In case of cash settlements, there must be robust valuation process in place. The determination of a credit event having happened must be defintive and objective; in particular, the protection seller must not have the right to notify such event.

Asset mismatches Asset mismatches, that is, the referece obligation in the credit derivative being diferent from hedged asset, the hedged asset and the reference obligation must be with the same obligor, and the reference obligation must be either ranking at par or junior to the hedged obligation. Eligible protection sellers The list of eligible protection providers is greatly expanded to include: • •

sovereign entities, PSEs, banks and securities firms with a lower risk weight than the counterparty; other entities rated A- or better. This would include credit protection provided by parent, subsidiary and affiliate companies when they have a lower risk weight than the obligor.

Capital charge The capital charge is computed as usual by assigning the risk weight of the protection seller to the obligor.Materiality thresholds are equivalent to the first loss, and are a

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deduction from capital straightaway. The w factor contained in the initial drafts is not found in the April 2003 draft. In case of tranched cover, that is, first loss, second loss or subsequent loss tranched out to different parties, the rules relating to securitisation framework will be applicable. 10. Merger and Acquisitions Transactions Credit derivatives are currently actively used for leveraged mergers and acquisitions (M&A) transactions. Lenders who finance such transactions can use credit protection to manage exposure to the acquirer of a target company. The funding exposure can be in terms of bridge financing or a permanent syndicated loan used to finance the transaction. For example, Company A, the acquirer of the target Company B, intends to finance this acquisition through a syndicated loan of $5 billion. Before a permanent financing could be arranged, Bank C may provide bridge financing for the transaction and possess the credit exposure to Company A. Bank C can enter into a default swap with a Dealer D, or a combination of dealers, to protect itself against the credit of A. Since the transaction size is enormous, no one dealer will buy the whole credit exposure and a combination of dealers is needed. Another arena where credit derivatives can be used in an M&A transaction is the merger of a stronger credit with a weaker one that will potentially downgrade the credit of the combined firm. A lender that is exposed to stronger credit can buy credit protection or buy a put option on the credit spread of Company A to protect itself from any downgrading of the referenced credit. Another application of credit derivatives in an M&A transaction is to free credit constraints. For example, Bank C may not be able to provide bridge or permanent financing to the acquirer company A since it has reached the maximum credit limit with A. To free this lending constraint, it can transfer the risk of the existing credit lines by entering into a default swap with other credit dealers. By doing so, it will expand the bank's capacity to assume additional lending and provide the needed M&A financing to Company A. To hedge the risk of a credit derivative in a large M&A transaction, one can diversify the credit risk by entering into syndication or repackaging the credit risk and sell it off in the credit markets. The pricing of these products is generally done using the benchmarks in the cash markets. If such cash market benchmarks are not available for any particular market, then default probability and recovery rate models are used to price credit derivatives. As per one dealer, option-pricing models have been used to price credit options.

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Infrastructure Project Finance Q1) What is Infrastructure Project Finance? India has a large and fairly well developed infrastructure framework extending to all parts of the country. However, certain areas like power, telecommunications, transport etc. need further expansion and modernization. And, the public sector alone can no longer fully finance the requirements. Q2) What is the Budget announced on 1998-99 on Infrastructure Project Finance? The 1998-99 Budget announced by the BJP government has given a major thrust to infrastructure development, particularly in energy and power, transport and communications, by stepping up public expenditure in these sectors. This increased government spending on infrastructure is expected to boost India's sluggish economy. The lack of a clear policy frame work for private sector participation has hampered the badly-needed infrastructure development, particularly in telecommunications, power, roads and ports. The public sector, which led the investment in infrastructure development until recently, has reduced its investments considerably, due primarily to its poor fiscal position. Q3) What IDFC Do? The Infrastructure Development Finance Corporation (IDFC), established in 1997, is a specialized financial institution, set up to provide credit enhancement to infrastructure projects, and to extend long term loans and guarantees that existing institutions may not be able to provide. IDFC provides loans and guarantees worth dols 17million to five projects.

The Asian Development Bank and the International Finance Corporation are shareholders in the IDFC. A comprehensive funding package for infrastructure projects has been developed by the IDFC and the Power Finance Corporation (PFC). At the state level, the PFC is primarily focussed on public sector projects, while the IDFC concentrates on the private sector. In the recent budget, the government proposed giving IDFC incentives and benefits available to other public financial institutions. Q4) What is Infrastructure Project Finance – Airports? India currently has 5 international and 88 domestic airports. The annual growth rate in airline passenger traffic for the period 1997-2000 is expected to be about 7% for international travelers and 10% for domestic, reaching a total of around 60 million passengers per year by the turn of the century. Along with this, air cargo is expected to grow at least 12% annually to close to 5.6 million tons by 2000. The Air Corporation Act, 1953, repealed on March 1, 1994, ended the monopoly of Indian Airlines and Air India over scheduled air transport services. Private operators who were operating as air taxis, have been granted the scheduled airlines status. In addition, 21 air taxi operators have been given the permit for charter/non- schedule air transport services. India’s airports are in urgent need of modernization in equipment and services, terminal technologies and transport facilities. Specific investment opportunities include:

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building of common user domestic terminals at all international airports introduction of elevating transfer vehicles with stacker systems introduction of electronic data interchange at all airports to enable handling of international cargo

Q5) What is Infrastructure Project Finance – Ports? India has 11 major ports in the country apart from 139 minor working ports along the coastline of 5,550 km. India's 11 major ports, which account for over 90 percent of the country's port traffic, handled a record 251.44 million tons of cargo during IFY 1997-98, an increase of 10 percent over IFY 1996-97. Port traffic has been growing by 9-10 percent annually, and is expected to reach 424 million tons by 2002. To decongest the ports a plan, with an outlay of Rs. 17,000 crores, has been drawn in the Ninth Plan. It also aims to increase the major ports capacity to 424 million tonnes per annum from the existing 215.3 million tonnes. To meet the huge gap between demand and availability of port capacity, private and foreign investment in ports is being encouraged by the government, which issued guidelines liberalizing the sector in October 1996. As part of its port revival plan, the government has decided to lease out port assets to private companies at attractive terms to generate more revenue. Ministry of Surface Transport is also planning to incorporate the eleven major ports, and has announced a port investment plan of dols 7.6 billion for 21 projects in those major ports. Port capacity is to be increased from the current level of 215 million tons to 850 million tons by 2012. The guidelines for foreign investment have been liberalized to allow:

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Automatic approval for foreign equity participation up to 74% in construction of ports and harbors. Automatic approval for foreign equity participation up to 51% for support services such as operation and maintenance of piers, loading and discharging of vessels.

Q6) What is Infrastructure Project Finance – Power? The power sector is high on India’s priority as it offers tremendous potential for investing companies based on the sheer size of the market and the returns available on investment capital. Since independence in 1947, the power generating capacity in India has increased over 59-fold, from 1,362 megawatts (MW) to 81,000 MW in 1995. Presently thermal plants account for 74% of total power generation, hydroelectric plants for 24% and nuclear plants generate the remaining 2%. Currently approximately 85% of India's 560,000 villages have electricity and there is a nationwide network for the transfer and distribution of power to all parts of the country. The Central Government has identified a number of new initiatives to give a new thrust to the power sector. The government has agreed to set up a power trading corporation, which would be a centralized agency to trade in power. The proposed corporation could purchase power from large projects and trade in it at the inter-state level. In view of the paucity of resources and the need to bridge the gap between the rapidly growing demand and supply, the Government has undertaken a policy to encourage greater investments by private enterprises in this sector. Incentives include:

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Generation and distribution power projects of any type and size are allowed.

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Foreign equity participation can be as high as 100%.

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Return on equity of up to 16% is assured at 68.5% PLF for thermal power plants (with the possibility of earning higher returns for higher PLF). Similar incentives are provided for hydroelectric power projects.

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A renewable license period of 30 years has been set.

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Import duty at the concessional rate of 20% has been set for import of equipment.

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The Government allows a 5-year tax holiday for power generating projects with an additional 5 years in which a deduction of 30% of taxable profits is allowed.

Q7) What is Infrastructure Project Finance – Railways? Indian Railways is the second largest system in the world under a single management, with an extensive network of 62,725 kilometers, 21.5 percent of which is electrified. Indian Railways operates an extensive network. It ranks second in the world (after China) in terms of freight intensity, track to land ratio, wagons to track ratios, passengers and cargo. Freight traffic carried in IFY 1997-98 was 430 million tons, up 5.5 percent over the previous year. The target for IFY 1998-99 is 450 million tons and an annual growth rate of 7.4 percent has been projected for the next five years. Indian Railways has launched a program to reduce terminal delays and turn around time of its rolling stock. The program aims at increasing freight carrying capacity by 50 percent through continual usage of wagons. Indian Railways is also soliciting private sector participation in freight movement through a Build-Own-OperateTransfer (BOOT) scheme and a Own-Your-Wagon-Scheme (OYWS). Thrust areas identified for improvements and expansion include:

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replacement and renewal of over-aged assets, augmentation of terminal and rolling stock capacities, gauge conversion and electrification, introduction of new routes and long distance special parcel services

Q8) What is Infrastructure Project Finance – Roads? India’s road networking covers 2.9 million kilometers, the third largest in the world, with only 34,298 km of National Highways suitable for speedy transportation. Though it constitutes less than 2% of the total road network, it carries more than 40% of the traffic. According to Government estimates, by the year 2000 road traffic will account for 87% and 65 % of passenger and goods traffic, respectively, compared with 80% and 60 % at present. About 20% of the NH need widening from single to double lanes, and about 70% of two lane roads have to be strengthened. Selected corridors on NH need conversion into Expressway.

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The Government is looking for both private investment and foreign to build national highways and their maintenance. The National Highway Authority of India (NHAI) received a budgetary allocation of $ 56 million in the Indian financial year 1997-98. Private parties investing funds in identified projects will be permitted to recover their investment by way of collection of tolls for specified periods. At the end of the agreed period, the facilities will revert to the Government. Provisions relating to foreign investment in the road sector have also been considerably liberalized and include:

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Automatic approval for foreign equity participation up to 74% in the construction of roads and bridges. Automatic approval for foreign equity participation up to 51% in land transport support services such as operation of highway bridges, toll roads and vehicles. Land required for construction and operation of facilities will be made available by the Government free from encumbrances. Five-year tax holiday with subsequent deductions of 30% for the next five years.

Duty-free imports of road-building machinery are now permitted in order to attract more private investment. Banks and FIs have cleared a draft model concession agreement for road projects, which incorporates project-specific traffic guarantees. It also envisages safeguards for both investors and the National Highway Authority of India (NHAI). The government has decided to offer sovereign guarantees on all new multilateral loans in the road sector which are routed through NHAI, which will aid NHAI in securing additional funding

Q9) What is Infrastructure Project Finance – Shipping? Overseas shipping has an extremely important role to play in India’s international trade. The country has the largest merchant shipping fleet among developing countries and ranks 15th in the world in shipping tonnage. The fleet strength at the end of Dec 1996 was 484 vessels of 7.05 Gross Registered Tonnage. A new shipping policy was initiated in 1990-91 to promote the development of Indian shipping. Since then several policy reforms have been made inn conformity with the liberalization of the economy, including: automatic approval for the acquisition of ships, permission to retain sale proceeds for re-investment, relaxation of Cabotage Laws for container ships and lash barges, and decontrol of freight and passenger fares to promote coastal shipping Several incentives for investors introduced are easing of controls on the acquisition and sale of vessels, foreign investment is permitted, and facilities at part with 100% Export Oriented Units (EOUs) are available for the ship repair industry. Foreign investment is permitted and facilities at part with 100% Export Oriented Units (EOUs) are available for the ship repair industry.

Q10) What is Telecommunication?

Infrastructure

Project

Finance

–

India operates one of the largest telecom networks in Asia, comprising over 21,328 telephone exchanges with a capacity of over 15 million lines and 12 million working connections. The network has been growing at an annual rate of 21.6% and is expected to expand to over 24 million lines by the turn of the century. However, there is scope for much improvement as even

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today three of every four villages have no telephone service, and only 5% of India's villages have long-distance service. The entire telecom equipment manufacturing industry has been de-licensed and de-reserved, with the deregulation of the economy in July 1991. The National Telecom Policy of 1994 opened up the area of basic telephone services to private sector participation. The tremendous response of global telecom giants, in joint ventures with Indian companies, resulted in perhaps the most competitive bidding for telecom services witnessed anywhere in the world. In August 1995, the Lok Sabha passed a bill amending the Indian Telegraph Act 1885, paving the way for setting up a Telecom Regulatory Authority of India. The TRAI has well defined functions, responsibilities and powers to function as the watchdog of the telecom sector. The terms of reference inter alia include standard setting, price regulation, ensuring technical compatibility among different service providers, facilitating revenue sharing arrangement between the DOT and private operators and fixation of access charges. Specific Government reforms include:

•

•

•

Value-added services (VAS), including cellular mobile telephones, radio paging, electronic mail, voice mail/audiotex services, videotex services, data services, video-conference and credit card authorization services, were opened for private sector participation in 1992. Maximum foreign equity of 49% has been permitted in the case of basic services, cellular mobile, radio paging, VSAT and other wireless services. 51% foreign equity is allowable in other Value Added Services, including e-mail, voice mail, on-line information, database retrieval and data processing, enhanced / value added facsimile services

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TOPIC 12: CAPITAL BUDGETING (Angad Kalra) 1. 2. 3. 4. 5. 6. 7. 8. 9.

Explain NPV. What are properties of the NPV rule and its limitations? Explain IRR with its limitations. What is NPV profile and what does it show? Explain MIRR. Explain Pay Back period method with its limitations. What is Discounted Payback method? What is ARR method? give its features and limitations. What are different approaches to calculate cost of capital?

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1. The net present value of a project is the sum of the present values of all cash flows positive as well as negative that are expected to occur over the life of the project.the general formula for NPV is: NPV of project = ∑ Ct (1+r)t

- Initial Investment

2. Properties of the NPV rule: 

Net present values are additive in nature, NPV(A) + NPV (B) = NPV (A+B)

 

The NPV rule assumes that intermediate cash flows are invested at cost of capital. NPV calculations permit time varying discount rates.

Limitations of the NPV rule:  

The NPV is expressed in absolute terms rather than relative terms and hence does not factor the scale of investment. The NPV rule does not consider the life of the project. Hence when mutually exclusive projects with different lives are being considered, the NPV rule is biased in favour of the longer term project.

3. The internal rate of return (IRR) of a project is the discount rate which makes its NPV equal to zero. It is the discount rate which equates the present value of future cash flows with the initial investment. It is the value of ‘r’ in the following equation: Initial Investment = ∑ Ct (1+r)t Limitations of the IRR method: 

 

Often firms have to choose from 2 mutually exclusive projects. In this case IRR can be misleading. In such a case incremental cash flows are to be considered to compare the 2 projects. The IRR rule does not distinguish between lending and borrowing, hence a high IRR need not be always desirable. If the discounting rates are different for different years, it is difficult to compare the IRR and take a decision on the project.

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IRR

4. NPV profile is the plot of different values of NPV for different discounting rates.

0

1

2

3

4

5

6

7

8

9

10

NPV

The IRR is the point where the NPV profile intersects the x-axis. The slope of the NPV profile shows how sensitive the project is to discount rate changes.

 

5. Modified Internal Rate of Return is a percentage measure which overcomes the limitations of the regular IRR.   

Calculate the present value (PV) of the costs associated with the project, using the cost of capital as the discount rate. Calculate the terminal value (TV) of the cash inflows expected from the project. Obtain MIRR by solving the following equation: PVC =

TV (1+MIRR)n

Comparison between IRR and MIRR 



MIRR assumes that the project cash flows are reinvested at the cost of capital whereas the regular IRR assumes that the project cash flows are reinvested at the projects own IRR. The problem of Multiple rates does not exist in MIRR.

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6. The payback period gives the length of time required to recover the initial cost of the project. As per the payback criterion, the shorter the payback period, the more desirable the project. Firms using this criteria often specify the maximum acceptable payback period. Limitations:   

It fails to consider the time value of money. Cash flows are added without suitable discounting. It ignores cash flows after the payback period. This discriminates against the projects which have longer gestation period. It is a measure of the project’s capital recovery not profitability.

7. The discounted payback method has been suggested to overcome a major shortcoming of the conventional payback method that it does not take into account the time value of money. In this the cash flows are converted into their present values and then added to ascertain the period of time required to recover the initial outlay on the project. 8. The accounting rate of return also called as the average rate of return is defined as: Profit after Tax Book Value of Investment Shortcomings:   

It is based on accounting profit not cash flow. It does not take into account the time value of money. The measure is internally inconsistent, while the numerator represents profits belonging to equity and preference shareholders the denominator represents fixed investment which is rarely equal to the contribution of equity and preference shareholders.

9. The various modes of raising capital are as follows:  Cost of Debt instrument  Cost of Debt  Cost of Preference share  Cost of Equity Cost of Debentures: Conceptually, the cost of debt instrument is the yield to maturity of tat instrument. This concept is applicable to instruments such as debentures, bank loans and commercial papers. The cost of debt instrument is the value of ‘r’ in the following equation. Current Market price of the debt instrument = ∑

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I + F (1+r)t (1+r)n

TOPIC 13: SECURITIZATION (Rachita Maheshwari) Securitization 1. Concept & Process of Securitization -

Securitization is the process of pooling and repackaging of homogenous illiquid financial assets (mortgage loans, consumer loans, hire purchase receivables etc) in to marketable securities that can be sold to the investors.

-

The process leads to the creation of financial instruments that represent ownership interest in, or are secured by a segregated income producing asset or pool, of assets

Figure 1: Sample CLO (Collateralized Loan Obligation) structure.

In the above CLO transaction, the originator packages a pool of loans and assigns his interest therein, including the underlying security, to a bankruptcy remote & tax

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neutral entity which, in turn, issues securities to investors. The idea of such an exercise is to completely transfer the interest in pool of loans to the investors (a “true sale”) and achieve a rating higher than that of the Originator. With the help of securitization transaction, an originator can transfer the credit and other risks associated with the pool of assets securitized. Securitization can provide much needed liquidity to an Originator’s balance sheet; help the originator churn its portfolio and make room for fresh asset creation; obtain better pricing than through a debt-financing route; and help the originator in proactively managing its asset portfolio. Securitization allows investors to improve their yields while keeping intact or even improving the quality of investment. 2. Parties to the securitization process The parties to the securitization deals are (i) Primary (ii) others

a. Originator -

This is the entity on whose books the assets to be securitized exist.

-

Prime mover of the deal, i.e. sets up the necessary structures to execute the deal.

-

Sells the assets on its books & receives the funds generated from such sale.

b. SPV (Special Purpose vehicle)

-

An issuer, also known as SPV, which would buy the assets to be typically securitized from the originator

-

Low capitalized entity with narrowly defined objectives usually has independent set of directors/ trustees.

When a corporation, call it the sponsor of the SPV, wants to achieve a particular purpose, for example, funding, by isolating an activity, asset or operation from the rest of the sponsor's business, it hives off such asset, activity or operation into the vehicle by forming it as a special purpose vehicle. This isolation is important for external investors whose interest is backed by such hived-off assets, etc., but who are not affected by the generic business risks of the entity of the originating entity. Thus SPVs are housing devices - they house the assets etc transferred by the originating entity in a legal outfit, which is legally distanced from the originator, and yet self- sub stained as not to be treated as the baby of the originator

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c. Investors -

They buy a participating interest in the total pool of receivables and receive their payment in form of interest and principal as per agreed term.

d. Obligors -

The obligors are the originator debtors(borrowers of the original loan)

-

The amount outstanding from an obligor is the asset that is transferred to an SPV

e. Rating agency -

Assess the strength of the cash flow and the mechanism designed to ensure full and timely payment by the process of credit quality, the extent of credit and liquidity support and the strength of legal framework.

f. Administrator -

It collects the payment due from the obligors and passes it SPV, follows up with delinquent borrowers and pursues legal remedies available against the defaulting borrowers.

g. Agent and Trustee -

Accepts the responsibility for overseeing all the parties to the securitization deal performs in accordance with the agreement.

3. Credit Enhancement: •

The originator or some other agency may enhance the credit quality of the pool of assets to be securitized by providing insurance, often of a limited kind, to the investors.

•

It refers to the various means that attempt to buffer investors against losses on the asset collateralizing their investment.

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•

The credit enhancements are often essential to secure a high level of credit rating and for low cost of funding. By shifting the credit risk from a less known borrower to a well known, strong, and large credit enhancer, credit enhancement corrects the imbalance of information between the lender(s) and borrowers. They are either external (third party) or internal (structural or cash flow driven).

External Credit Enhancements They include - Insurance -

Third party guarantee and

-

Letter of credit.

Internal Credit Enhancements Such forms of credit enhancement compromise the following: - Credit trenching (senior/ sub ordinate structure) -

Over collateralization

-

Cash collateral

-

Spread account

-

Triggered amortization

4.

What are the benefits of securitization?

Economic benefits: Securitization benefits the economy as a whole by bringing financial markets and capital markets together. Financial assets are created in the financial markets, e.g., banks or mortgage financing companies. These assets are traditionally refinanced on on-balance sheet means of funding of the respective banks. Securitization connects the capital markets and financial markets by converting these financial assets into capital market commodities. The agency and intermediation costs are thereby reduced Securitization and cost of funding It is a clear proposition that the stronger the security rights of the creditor, the lesser is the risk he faces, and the lower, therefore, is the risk premium he

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translates into cost of lending. If securitization means lesser credit risks for the originator, obviously this should lead to lower funding costs. Benefits to investors Investor experience of investing in securitized paper has internationally been quite good, for primarily 3 reasons: •

•

• •

Securitization being a structured finance instrument can be more closely aligned to investor needs. Investors can invest in exactly what suits their investment policy the best. Securitization asset classes have shown much higher rating resilience. Rating transition histories have been published by both Moody's and Standard and Poor's depicting this. Recently, Fitch also came out with a rating transition history of ABS to prove this point. Default history of securitization tranches is much safer - there have been very few defaults over the past 16 years. Default recovery rate of securitization tranches has been significantly higher than in case of defaulted corporate bonds.

Need for Securitization in India • The generic benefits of securitization for Originators and investors have been discussed above. In the Indian context, securitization is the only ray of hope for funding resource starved infrastructure sectors like Power. For power utilities burdened with delinquent receivables from state electricity boards (SEBs), securitization seems to be the only hope of meeting resource requirements. • Securitization can help Indian borrowers with international assets in piercing the sovereign rating and placing an investment grade structure. An example, albeit failed, is that of Air India’s aborted attempt to securitize its North American ticket receivables. Such structured transactions can help premier corporate to obtain a superior pricing than a borrowing based on their non-investment grade corporate rating. • A market for Mortgage backed Securities (MBS) in India can help large Indian housing finance companies (HFCs) in churning their portfolios and focus on what they know best – fresh asset origination. Indian HFCs have traditionally relied on bond finance and loans from the National Housing Bank (NHB). 5. Instruments of securitization

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There are three kinds of instruments differing mainly on their maturity characteristics. They are: a. Pass through certificates: Cash flows from the underlying collateral are passed through to the holders of the securities in the form of monthly payment of interest, principal and pre payments. I.e. the cash flows are distributed on a pro – rata basis to the holders of the securities. Features of PTC’s - Reflect ownership rights in the assets backing the securities - Prepayment precisely reflects the payment on the underlying mortgage. If it is a home loan with monthly payments, the payments on securities would be monthly but at a slightly less coupon rate than a loan. - Pre payment occurs when the debtor makes a payment, which exceeds the minimum scheduled amount. It shortens the life of the instrument and skews the cash flows towards the earlier years.

-

-

-

b. Pay through security (PTS) The PTS structure overcomes the single maturity limitations of PTC. Its structure permits the issuer to restructure the receivables flow to offer a range of investment maturities to the investors associated with different yields and risks.\ The issuers of asset backed debt are freed from the limitations imposed by the pass through structure which simply provides a conduit for sale of ownership interest in receivables. By contrast in a PTS structure, the issuer typically owns the receivables and simply sells the debt that is backed by the assets. As a result, the issuer of debt is free to restructure the cash flow from receivable into payments on several debt tranches with varying maturities c. Stripped securities Under this instrument securities are classified as interest only (IO) or Principal only (PO) securities. The IO holders are paid back out the interest income only while the PO holders are paid out the principal repayments only. These securities are highly volatile by nature and are least preferred by the investors. Normally PO securities increase in value when interest goes down because it becomes lucrative to prepay existing mortgagor and undertake fresh loans at lower interest rates.

6. Types of securitization market in India Asset backed securities The investor relies on the performance of the assets that collateralize the securities. 145

Asset backed Securities are the most general class of securitization transactions. The asset in question could vary from Auto Loan/Lease/Hire Purchase, Credit Card, consumer Loan, student loan, healthcare receivables and ticket receivables to even future asset receivables. In the Indian context, there has been moderate amount of activity on the Auto Loan securitization front. Companies like TELCO, Ashok Leyland Finance, Kotak Mahindra and Magma Leasing have been securitizing their portfolio of auto loans to buyers like ICICI and Citibank over the past 2-3 years, with several of the recent transactions rated by rating agencies like CRISIL and ICRA. Mortgage backed securities The securities are backed by the mortgage loans that are the loan secured by the specified real estate property, wherein the lender has the right to sell the property if the burrower defaults. Collateralized Debt Obligations (CDO, CLO, CBO) In this era of bank consolidations, CDOs can help banks to proactively manage their portfolio. CDOs can also help banks in restructuring their stressed assets. Asset Backed Commercial Paper (ABCP) Asset Backed Commercial Paper (ABCP) is usually issued by Special Purpose Entities (ABCP Conduits) set up and administered by banks to raise cheaper finances for their clients. ABCP conduits are usually ongoing concerns with new CP issuances taking out the previous ones. 7. Legal structure: In 2002, India enacted a law that reads Securitization and Reconstruction of Financial Assets and Enforcement of Security Interests Act, 2002 (SARFAESI) Though masquerading as a securitization-related law, this law does very little for securitization transactions and has been viewed as a law relating to enforcement of security interests. Most securitizations in India adopt a trust structure – with the underlying assets being transferred by way of a sale to a trustee, who holds it in trust for the investors. A trust is not a legal entity in law – but a trustee is entitled to hold property that is distinct from the property of the trustee or other trust properties held by him. Thus, there is a isolation, both from the property of the seller, as also from the property of the trustee. Therefore, the trust is the special purpose vehicle. Most transactions to date use discrete SPVs – master trusts are still not seen. The trustee typically issues PTCs. *A PTC is a certificate of proportional beneficial interest. Beneficial property and legal property is distinct in law – the issuance of the PTCs does not imply transfer of property by the SPV but certification of beneficial interest.

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8. Regulatory compliances: Among the regulatory costs, stamp duty is a major hurdle. The instrument of transfer of financial assets is, by law, a conveyance, which is a stampable instrument. Many states do not distinguish between conveyances of real estate and that of receivables, and levy the same rate of stamp duty on the two. The rates would therefore be weird – going up to 10% of the value of the receivables. Some 5 states have announced concessional rates of stamp duty on actionable claims, limiting the burden to 0.1%, but there is an un clarity as to whether this concession can be availed for assets situated in multiple locations. The stamp duty un clarity and illogicality has in a way shaped the market – players have limited transactions to such receivables as may be transferred without unbearable stamp duty costs. The SARFAESI law intended to resolve the stamp duty problem, but owing to its flawed language, did not succeed. Amendment of the definition of “securities” under the Securities Act: The Securities Contracts (Regulation) Amendment Bill, 2005 was introduced in the Lok Sabha on 16.12.2005 pursuant to the announcement in Budget 2005-06 regarding provision of a legal framework for trading of securitized debt including mortgage backed debt. The Bill stands referred to the Standing Committee on Finance. 9. Taxation: The tax laws have no specific provision dealing with securitization. Hence, the market practice is entirely based on generic tax principles, and since these were never crafted for securitizations, experts’ opinions differ. The generic tax rule is that a trustee is liable to tax in a representative capacity on behalf of the beneficiaries – therefore, there is a prima facie taxation of the SPV as a representative of all end investors. However, the representative tax is not applicable in case of non-discretionary trusts where the share of the beneficiaries is ascertainable. The share of the beneficiaries is ascertainable in all securitizations – through the amount of PTCs held by the investors. Though the PTCs might be multi-class, and a large part might be residual income certificates in effect, the market believes, though with no reliable precedent, that there will be no tax at the SPV level and the investors will be taxed on their share of income. 10. Developments in Indian structured finance market & Obstacles to securitization in India - Issuance volume in the structured finance market 121% to Rs. 308 Billion during FY 2005 over the previous year. -

Assets backed securitization issuances grew strong by a 176% to Rs 223 Billion during FY 2005 accounting for 72% in the SF market.

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-

Also during FY 2005 ABS market witnessed an average increase in the deal size, the entry of newer loan asset categories such as two and three wheeler and used cars and incorporation of prepayment option features in some tranches of pass through certificates

-

ABS asset based securitization market sees growing preference of par transactions, earlier Indian ABS issues typically had premium pricing

-

Mortgage based securitization (MBS) grows 13 % during FY 2005

Obstacles: Lack of appropriate legislation As we discussed earlier, there are no laws specially governing securitization transactions in India. The following are the key areas where legislation is required: a. Tax neutral bankruptcy remote SPE The special purpose entity that buys assets from the Originator should be a bankruptcy remote conduit for distributing the income from the assets to the

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investors. While banks have experimented with company revocable trust and mutual fund structures, no clear vehicle has emerged for performing securitization. b. Stamp Duties Stamp Duty is a state subject in India. Stamp Duties on transfer of assets in securitization can often make a transaction unviable. While five Indian states have recognized the special nature of securitization transactions and have reduced the stamp duties for them, other states still operate at stamp duties as high as 10% for transfer of secured receivables. c. Taxation & Accounting At present there are no special laws governing recognition of income of various entities in a securitization transaction. Certain trust SPE structures actually can result in double taxation and make a transaction unviable. d. The weak foreclosure laws in India donot provide adequate comfort to the investors in assets based securities.

Debt market Lack of a sophisticated debt market is always a drawback for securitization for lack of benchmark yield curve for pricing. The appetite for long ended exposures (above 10 years) is very low in the Indian debt market requiring the Originator to subscribe to the bulk of the long ended portion of the financial flows. The development of the Indian debt market would naturally increase the securitization activity in India. Lack of Investor Appetite Investor awareness and understanding of securitization is very low. RBI, key drivers of securitization in India like ICICI and Citibank and rating agencies like CRISIL and ICRA should actively educate corporate investors about securitization. Mandatory rating of all structured obligations would also give investors much needed assurance about transactions. Once the private placement market for securitized paper gathers momentum, public retail securitization issuances would become a possibility.

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TOPIC 14: CREDIT DERIVATIVES (Shraddha Chhabria) Q1. What are credit derivatives? A credit derivative is an OTC derivative designed to transfer credit risk from one party to another. By synthetically creating or eliminating credit exposures, they allow institutions to more effectively manage credit risks. Credit derivatives take many forms. buying a credit derivative usually means buying credit protection, which is economically equivalent to shorting the credit risk. Equally, selling the credit derivative usually means selling credit protection, which is economically equivalent to going long the credit risk. One must be careful to state whether it is credit protection or credit risk that is being bought or sold. Q2. What is the purpose of credit derivatives? Ans:- The primary purpose of credit derivatives is to enable the efficient transfer and repackaging of credit risk. Credit risk encompasses all credit related events ranging from a spread widening, through a ratings downgrade, all the way to default. Banks in particular are using credit derivatives to hedge credit risk, reduce risk concentrations on their balance sheets, and free up regulatory capital in the process. In their simplest form, credit derivatives provide a more efficient way to replicate in a derivative form the credit risks that would otherwise exist in a standard cash instrument. In their more exotic form, credit derivatives enable the credit profile of a particular asset or group of assets to be split up and redistributed into a more concentrated or diluted form that appeals to the various risk appetites of investors. The best example of this is the tranched portfolio default swap. With this instrument, yieldseeking investors can leverage their credit risk and return by buying first-loss products. More risk-averse investors can then buy lowerrisk, lower-return second- loss products. With the introduction of unfunded products, credit derivatives have for the first time separated the issue of funding from credit. This has made the credit markets more accessible to those with high funding costs and made it cheaper to leverage credit risk. Recognized as the most widely used and flexible

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framework for over-the-counter derivatives, the documentation used in most credit derivative transactions is based on the documents and definitions provided by the International Swaps and Derivatives Association (ISDA). Q3. Who are the participants in the credit derivatives market? The wide variety of applications of credit derivatives attracts a broad range of market participants. Historically, banks have dominated the market as the biggest hedgers, buyers, and traders of credit risk. Over time, we are finding that other types of player are entering the market. This observation was echoed by the results of the BBA survey, which produced a breakdown of the market by the type of participant. The results are shown in Figure below. .

A Breakdown of Who Buys and Sells Protection by Market Share at the Start of 2000

As in its earlier 1998 survey, the BBA found that banks easily dominate the credit derivatives market as both buyers and sellers of credit protection. Since banks are in the business of lending and thereby taking on credit exposure to borrowers, it is not surprising that they use the credit derivatives market to buy credit protection to reduce their exposure. Though the precise details may vary between different regulatory jurisdictions, banks can use credit derivatives to offset and reduce regulatory capital requirements. On a single asset level, this may be achieved using a standard default swap. More commonly, banks are now using credit derivatives to securitize whole portfolios of bonds and loans. This technology, known as the synthetic CLO can be used by banks with the purpose of reducing regulatory capital, reducing credit risk concentrations, and enhancing return on capital. The 2001 Risk Magazine survey finds that banks as counterparties in synthetic securitizations account for 18% of the market. At the same time, banks are also seeking to maximize return on equity, and credit derivatives provide an unfunded way for banks to earn yield from their underused credit lines and to diversify 151

concentrations of credit risk. As a consequence, we see that banks are the largest sellers of credit protection. Securities firms are the second-most dominant player in the market. With their market making and risk-taking activities, securities firms are a major provider of liquidity to the market. As they tend to run a flat trading book, we see that they are buyers and sellers of protection in approximately equal proportions. An interesting development in the credit derivatives market has been the increased activity of insurance and re-insurance companies, on both the asset and liability side. For insurance companies, selling protection using credit derivatives presents a new asset class that can be used to earn income and diversify revenue away from their core business of insurance. The credit derivatives market is ideal for this since through the structuring of second loss products, it creates the very highly rated securities that insurance companies require in order to maintain their high ratings. As compensation for their novelty and lower liquidity compared with Treasury bonds, these securities can return a substantially higher yield for a similar credit rating. On the liability side, re-insurance companies are also prepared to take leveraged credit risks, such as retaining the most subordinate piece on tranched credit portfolios. This is seen as just another way to write insurance contracts. As protection buyers, this growth in usage by insurance companies has been driven by their desire to hedge various insurance risks. For instance, in the area of insuring project financing within developing economies, the sovereign credit derivatives market provides a good, though imperfect, hedge against any sovereign risk to which they may be exposed. Re-insurance companies who typically develop concentrations of credit risk can use credit derivatives to reduce this exposure and so enable them to take on new more diversified business without an overall increase in risk. Over the next few years, we expect to see re-insurance companies account for an even larger share of the credit derivatives market. Hedge funds are another growing particpant. Some focus on exploiting the arbitrage opportunities that can arise between the cash and default swap markets. Others focus on portfolio trades such as investing in CDOs. Equity hedge funds are especially involved in the callable asset swap market in which convertible bonds have their equity and credit components stripped. These all add risk-taking capacity and so add to market liquidity. Q4. Explain the concept of asset swaps? An asset swap is a synthetic floating-rate note. By this we mean that it is a specially created package that enables an investor to buy a fixed-rate bond and then hedge out almost all of the interest rate risk by swapping the fixed payments to floating. The investor takes on a credit risk that is economically equivalent to buying a floating-rate note issued by the issuer of the fixed-rate bond. For assuming this credit risk, the investor earns a corresponding excess spread known as the asset swap spread. While the interest rate swap market was born in the 1980s, the asset swap market was born in the early 1990s. It continues to be most widely used by banks, which use asset swaps to convert their long-term fixed-rate assets, typically balance sheet loans and bonds, to floating rate in order to match their short term liabilities, i.e., depositor accounts. During the mid-

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1990s, there was also a significant amount of asset swapping of government debt, especially Italian Government Bonds. There are several variations on the asset swap structure, with the most widely traded being the par asset swap. In its simplest form, it can be treated as consisting of two separate trades. In return for an up-front payment of par, the asset swap buyer: _ Receives a fixed rate bond from the asset swap seller. Typically the bond is trading away from par. _ Enters into an interest rate swap to pay to the asset swap seller a fixed coupon equal to that of the asset. In return, the asset swap buyer receives regular floating rate payments of LIBOR plus (or minus) an agreed fixed spread. The maturity of this swap is the same as the maturity of the asset. The fixed spread to LIBOR paid by the asset swap seller is known as the asset swap spread and is set at a breakeven value such that the net present value of the transaction is zero at inception. The most important thing about an asset swap is that the asset swap buyer takes on the credit risk of the bond. If the bond defaults, the asset swap buyer has to continue paying the fixed side on the interest rate swap that can no longer be funded with the coupons from the bond. The asset swap buyer also loses the redemption of the bond that was due to be paid at maturity and is compensated with whatever recovery rate is paid by the issuer. As a result, the asset swap buyer has a default contingent exposure to the mark-to-market on the interest rate swap and to the redemption on the asset. In economic terms, the purpose of the asset swap spread is to compensate the asset swap buyer for taking on these risks. The main reason for doing an asset swap is to enable a credit investor to take exposure to the credit quality of a fixed-rate bond without having to take interest rate risk. For banks, this has enabled them to match their assets to their liabilities. As such, they are a useful tool for banks, which are mostly floating rate based. Asset swaps can be used to take advantage of mispricings in the floating rate note market. Tax and accounting reasons may also make it advantageous for investors to buy and sell nonpar assets at par through an asset swap. TYPES OF ASSET SWAPS:FORWARD ASSET SWAPS-it is to go long a credit at some future date at a spread fixed today. If the bond defaults before the forward date is reached, the forward asset swap trade terminates at no cost. The investor does not take on the default risk until the forward date. Since credit curves are generally upward sloping, a forward asset swap can often make it cheaper for an investor to go long a credit on a forward basis than to buy the credit today. CROSS-CURRENCY ASSET SWAP-This enables investors to buy a bond denominated in a foreign currency, paying for it in their base currency, pay on the swap in the foreign currency, and receive the floating-rate payments in their base currency. The cash flows are converted at some predefined exchange rate. In this case, there is an exchange of principal at the end of the swap. This structure enables the investors to gain exposure to a foreign currency denominated credit with minimal interest rate and

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currency risk provided the asset does not default. However, for assets with very wide spreads, these residual risks can be material. CANCELLABLE ASSET SWAP- For callable bonds, where the bond issuer has the right to call back the bond at a pre-specified price, asset swap buyers will need to be hedged against any loss on the swap since they will no longer be receiving the coupon from the asset. In this case, the asset swap buyers will want to be able to cancel the swap on any of the call dates by buying a Bermudan-style receiver swaption. This package is known as a cancellable asset swap. Most U.S. agency callable bonds are swapped in this way. CALLABLE ASSET SWAPS- these are used to strip out the credit and equity components of convertible bonds. The investor buys the convertible bond on asset swap from the asset swap seller and receives a floating rate coupon consisting of LIBOR plus a spread. The embedded equity call option is also sold separately to an equity investor. So that the equity conversion option can be exercised, the asset swap must be callable by the asset swap seller with a strike set at some fixed spread to LIBOR. This enables the asset swap seller to retrieve the convertible bond and convert it into the underlying stock in the event that the equity option holder wishes to exercise. This example demonstrates how credit derivatives make it possible to split up a MECHANICS OF A PAR ASSET SWAP

Q5.what is a credit default swap? The default swap has become the standard credit derivative. For many, it is the basic building block of the credit derivatives market. Its appeal is its simplicity and the fact that 154

it presents to hedgers and investors a wide range of possibilities. A default swap is a bilateral contract that enables an investor to buy protection against the risk of default of an asset issued by a specified reference entity. Following a defined credit event, the buyer of protection receives a payment intended to compensate against the loss on the investment. In return, the protection buyer pays a fee. For short-dated transactions, this fee may be paid up front. More often, the fee is paid over the life of the transaction in the form of a regular accruing cash flow. The contract is typically specified using the confirmation document and legal definitions produced by the International Swap and Derivatives Association (ISDA). The reference entity is typically a corporate, bank or sovereign issuer. There can be significant difference between the legal documentation for corporate, bank, and sovereign linked default swaps. The credit event is closely linked to the choice of the reference entity and may include the following events: _ Bankruptcy (not relevant for sovereigns) _ Failure to pay _ Obligation acceleration/default _ Repudiation/Moratorium _ Restructuring Some default swaps define the triggering of a credit event using a reference asset. The main purpose of the reference asset is to specify exactly the capital structure seniority of the debt that is covered. The reference asset is also important in the determination of the recovery value should the default swap be cash settled. However, in many cases the credit event is defined with respect to a seniority of debt issued by a reference entity, and the only role of the reference asset is in the determination of the cash settled payment. Also, the maturity of the default swap need not be the same as the maturity of the reference asset. It is common to specify a reference asset with a longer maturity than the default swap. The contract must specify the payoff that is made following the credit event. Typically, this will compensate the protection buyer for the difference between par and the recovery value of the reference asset following the credit event. This payoff may be made in a physical or cash settled form, i.e. the protection buyer will usually agree to do one of the following: _ Physically deliver a defaulted security to the protection seller in return for par in cash. Note that the contract usually specifies a basket of obligations that are ranked pari passu that may be delivered in place of the reference asset. In theory, all pari passu assets should have the same value on liquidation, as they have an equal claim on the assets of the firm. In practice, this is not always reflected in the price of the asset following default. As a result, the protection buyer who has chosen physical delivery is effectively long a “cheapest to deliver” option. _ Receive par minus the default price of the reference asset settled in cash. The price of the defaulted asset is typically determined via a dealer poll conducted within 14-30 days of the credit event, the purpose of the delay being to let the recovery value stabilize. In certain cases, the asset may not be possible to price, in which case there may be

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provisions in the documentation to allow the price of another asset of the same credit quality and similar maturity to be substituted. _Fixed cash settlement. This applies to fixed recovery default swaps, in which, If the protection seller has the view that either by waiting or by entering into the work-out process with the issuer of the reference asset he may be able to receive more than the default price, he will prefer to specify physical delivery of the asset. Unless already holding the deliverable asset, the protection buyer may prefer cash settlement in order to avoid any potential squeeze that could occur on default. Cash settlement will also be the choice of a protection buyer who is simply using a default swap to create a synthetic short position in a credit. This choice has to be made at trade initiation. The protection buyer stops paying the premium once the credit event has occurred, and this property has to be factored into the cost of the default swap premium payments. It has the benefit of enabling both parties to close out their positions soon after the credit event and so eliminates the ongoing administrative costs that would otherwise occur. Current market standards for banks and corporates require that the protection buyer pay the accrued premium to the credit event; sovereign default swaps do not require a payment of accrued premium. A default swap is a par product: it does totally not hedge the loss on an asset that is currently trading away from par. If the asset is trading at a discount, a default swap overhedges the credit risk and vice-versa. This becomes especially important if the asset falls in price significantly without a credit event. To hedge this the investor can purchase protection in a smaller face value or can use an amortizing default swap in which the size of the hedge amortizes to the face value of the bond as maturity is approached. MECHANICS OF A DEFAULT SWAP

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Q6. What are the uses of a default swap? AnsThere are many applications for default swaps, which we now summarise: Hedging _ Default swaps can be used to hedge concentrations of credit risk. This is especially useful for banks that wish to hedge the large exposures that may exist on their balance sheet. _ Buying protection with a default swap is a private transaction between two counterparties, whereas assigning a loan may require customer consent and/or notification. Banks may therefore prefer to hedge loans through the default swap market, as this confidentiality may help to maintain good client relations. _ Default swaps can be used to hedge credit exposures where no publicly traded debt exists. Investing _ Default swaps are an unfunded way to take a credit risk. This makes leverage possible and helps those with high funding costs. _ Since default swaps are customisable over-the-counter contracts, investors can tailor the credit exposure to match their precise requirements in terms of maturity and seniority. _ Default swaps can be used to take a view on both the deterioration or improvement in credit quality of an reference credit. _ Investors may not be allowed to sell short an asset but may be allowed to buy protection with a default swap. _ Fixed recovery default swaps make it possible for investors to leverage their credit exposure and remove recovery rate uncertainty. _ Dislocations between the cash and derivatives markets can make the default swap a higher yielding investment than the equivalent cash instrument. Arbitrage/Trading _ For most credit names, buying protection in the default swap market is easier than shorting the asset. _ Traders can take advantage of the price dislocations between the cash and default swap market either by buying the cash and protection or by shorting the cash and selling protection, earning a net positive spread if the default swap market is trading respectively inside or outside where the cash trades. Q7.what are total return swaps? A total return swap is a contract that allows investors to receive all of the cash flow benefits of owning an asset without actually holding the physical asset on their balance sheet. As such, a total return swap is more a tool for balance sheet arbitrage than a credit derivative. However, as a derivative contract with a credit dimension—the asset can default—it usually falls within the remit of the credit derivatives trading desk of investment banks and so becomes classified as a credit derivative. At trade inception, one party, the total return receiver, agrees to make payments of LIBOR plus a fixed spread to the other party, the total return payer, in return for the coupons paid by some specified asset. At the end of the term of the total return swap, the total return payer pays the

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difference between the final market price of the asset and the initial price of the asset. If default occurs, this means that the total return receiver must then shoulder the loss. The asset is delivered or sold and the price shortfall paid by the receiver. In some instances, the total return swap may continue with the total return receiver posting the necessary collateral. The static hedge for the payer in a total return swap is to buy the asset at trade inception, fund it on balance sheet, and then sell the asset at trade maturity. Indeed, one way the holder of an asset can hedge oneself against changes in the price of the asset is to become the payer in a total return swap. This means that the cost of the trade will depend mainly on the funding cost of the total return payer and any regulatory capital charge incurred. We can break out the total cost of a TRS into a number of components. First, there is the actual funding cost of the position. This depends on the credit rating of the total return payer that holds the bond on its balance sheet. If the asset can be repo’d, it depends on the corresponding repo rate. If the total return payer is a bank, it also depends on the BIS risk weight of the asset, with 20% for OECD bank debt and 100% for corporate debt. If the total return payer is holding the asset, then the total return receiver has very little counterparty exposure to the total return seller. However, the total return payer has a real and potentially significant counterparty exposure to the total return receiver. This can be reduced using collateral agreements or may be factored into the LIBOR spread coupon paid. There are several reasons why an investor would wish to use such a total return structure: Funding/Leverage _ Total return swaps make it possible to take a leveraged exposure to a credit. _ They enable investors to obtain off-balance-sheet exposure to assets to which they might otherwise be precluded for tax, political, or other reasons. Trading/Investing _ Total return swaps make it possible to short an asset without actually selling the asset. This may be useful from a point of view of temporarily hedging the risk of the credit, deferring a payment of capital gains tax, or simply gaining confidentiality regarding investment decisions. _ Total return swaps can be used to create a new synthetic asset with the required maturity. Credit maturity gaps in a portfolio may, therefore, be filled.

MECHANICS OF A TOTAL RETURN SWAP

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Q8.What are cdos? A collateralized debt obligation (CDO) is a structure of fixed income securities whose cash flows are linked to the incidence of default in a pool of debt instruments. These debts may include loans, revolving lines of credit, other asset-backed securities, emerging market corporate and sovereign debt, and subordinate debt from structured transactions. When the collateral is mainly made up of loans, the structure is called a Collateralised Loan Obligation (CLO), and when it is mainly bonds, the structure is called a Collateralised Bond Obligation (CBO). The fundamental idea behind a CDO is that one can take a pool of defaultable bonds or loans and issue securities whose cash flows are backed by the payments due on the loans or bonds. Using a rule for prioritizing the cash flow payments to the issued securities, it is possible to redistribute the credit risk of the pool of assets to create securities with a variety of risk profiles. In doing so, assets that individually had a limited appeal to investors because of their lack of liquidity or low credit quality can be transformed into securities with a range of different risks that match the risk-return appetites of a larger investor base.The bond or loan collateral is placed in a special purpose vehicle (SPV), which then issues several tranches of notes. These notes have different levels of seniority in the sense that the senior tranche has coupon and principal payment priority over the mezzanine and equity tranches. This means that the income from the collateral is paid to the most senior tranches first as interest on the notes. The remaining income from the collateral is then paid as interest on the mezzanine tranche notes. Finally, the remaining income is paid as a coupon on the notes in the equity tranche. The rules governing the priority of payments are known as the waterfall structure and may be quite complicated. For example, they may contain interest coverage tests. As a consequence, defaults in the underlying collateral will first affect the coupon and principal payments on the equity tranche. As a result, this first-loss tranche is typically unrated and may be retained by the sponsor of the deal. The mezzanine tranche typically achieves an investment-grade rating, and the senior tranche may even achieve a 159

AAA rating. These tranches will typically pay floating-rate coupons to investors. If the payments from the collateral are fixed rate, interest rate risk will be hedged through interest rate swap agreements with a highly rated counterparty. While the equity tranche is the most subordinated tranche and so is the first to absorb losses following default, it is also the note that pays the highest spread. It receives the excess spread—the difference between the interest received on the collateral and the interest paid to the senior tranches after losses. The pricing of CDOs is typically determined by the rating.The determination of the rating category of CDOs is undertaken by the rating agencies, which have full access to data about the structure of the underlying collateral pool and use this to model the credit quality of the various tranches. Their approach must take into account the role of default correlation in the riskiness of the issued securities. For example, Moody's applies its Binomial Expansion Technique, which combines a measure of default correlation across the collateral pool, a knowledge of the average credit quality of the different assets in the pool, and the details of the waterfall structure to determine an expected loss for each tranche. The default correlation is measured using the Diversity Score. This is calculated using a methodology that takes into account how many of the assets are in the same industry and is intended to represent the number of independent assets that would have the same loss distribution as the actual portfolio of correlated assets. For example, a porfolio of 50 assets might have a diversity score of 30 meaning, that 50 correlated assets have the same loss distribution as 30 independent assets. The output of the model is an expected loss for the portfolio tranche being rated. This must be less than the target expected loss that Moody’s specifies for the required rating. The actual pricing of a CDO tranche is then determined by examining where similarly rated CDO tranches trade in the secondary market. Standard and Poor's does not use a Diversity Score approach. Instead, it sets concentration limits for the maximum number of obligors in the same industry. Typically, it is comfortable with an 8% concentration limit on a single industry. Default correlation is also taken into account implicitly by stressing the default probabilities of the assets in the portfolio. The portfolio loss distribution is computed using a multinomial probability distribution. STRUCTURE OF A CDO

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Q9. What are arbitrage cdos, cash flow clos and synthetic clos? ARBITRAGE CDOs- Insurance companies, commercial banks, and money managers issue a CDO to leverage their high-yield portfolios. Its purpose is to exploit the differences in credit spreads between high-yield sub-investment-grade securities and less risky investment-grade securities. They are thus termed "arbitrage" CDO's. For money managers, these structures create a high return asset, create stable fee income, increase assets under management, and lock in funding for a 3- to 7-year term. Arbitrage CDO's can have either cash flow or market value structures. With the former, the principal on tranches is repaid using cash generated from repayments on the underlying loans. The primary risk in cash flow CDO's is, therefore, to the default of the underlying collateral. In market value CDOs, the principal is paid by selling the collateral. As a result, investors are exposed to the market value of the underlying collateral that must be marked to market weekly or bi-weekly. The debt ratings are, therefore, a function of price volatility, as well as the diversity and credit quality of collateral. Cash flow CDOs are more common than market value CDOs. The composition of a typical arbitrage CDO contains 30-50 loans or securities. The credit of the pool in arbitrage CDOs tends to be lower quality than a balance sheet CDO, typically BB to B. Transaction sizes also tend to be smaller, e.g., $200 million-$1 billion, compared with $1-$5 billion for a balance sheet CDO. CASH FLOW CLOs- In general, the purpose of a cash flow CLO is to move a portfolio of loans off the balance sheet of a commercial bank. This is done in order to free up the regulatory and/or economic capital that the bank would otherwise be obliged to hold against these loans. This allows banks to use this capital to fund other highermargin business, new product lines, or share repurchase plans. It furthermore transfers the credit risk of these loans to the investor, thereby reducing the bank's concentrations of credit risk. For example, a bank has a loan book worth $500 million and is required to hold 8%,

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i.e., $40 million, as regulatory capital. By doing a CLO transaction, the bank sells 98% of its loan book, retaining an equity piece worth 2% of the $500 million. It is required to hold 100% of the equity piece, i.e., $10 million, for regulatory capital purposes. The bank has therefore reduced its regulatory capital charge from $40 million to $10 million, a saving of $30 million. In general, these pools of loans are very large and consist of mostly commercial and industrial loans with short maturities, which are rated between BB and BBB. Being of investment grade but usually trading with tight spreads, these loans are an inefficient use of regulatory capital. They are often revolving lines of credit where the members of the pool are anonymous, but investors are provided with a set of statistics about the distribution of credit quality to enable them to analyse the default and prepayment risks of the pool. Furthermore, banks have the ability to add or take away collateral from the pool as the loans repay. Balance sheet CLOs tend to trade tighter to LIBOR than other CBOs/CLOs since the pools of assets tend to be better quality than arbitrage CDOs due to their shorter average life and early amortization triggers. Moving the loans off the balance sheet can be difficult: the bank may need to obtain permission from the borrower to transfer the ownership of its loans, and this can be expensive, timeconsuming, and potentially harmful to customer relationships. For this reason, banks are increasingly turning to the synthetic CLO structure. SYNTHETIC CLOs- The synthetic CLO is also used to transfer the credit risk from the balance sheet of a bank. As in a cash flow CLO, the motivations are regulatory capital relief, freeing up capital to grow other businesses, and the reduction of credit risk. In the case of a synthetic CLO, this is achieved synthetically using a credit derivative. It therefore avoids the need to transfer the loans, which can be problematic. Instead, the bank retains the loans on balance sheet and uses a portfolio default swap structure to transfer out the credit risk to an SPV, which issues notes into the capital markets. Another factor in favor of the synthetic CLO is the flexibility of default swaps, which can be tailored to create the required risk-return profile for the bank. One main objective has to be achieved when structuring a synthetic CLO: the protection provided by the portfolio default swap needs to be purchased by the bank in a way that satisfies the bank’s regulator that the credit risk of the underlying loans has been removed from the bank and so is granted the desired reduction in regulatory capital. The credit risk of the portfolio of loans held by the sponsoring bank is tranched up. The riskiest tranche, which may comprise up to 2%-3% of the first losses in the portfolio, is usually retained for reasons including the facts that its high risk may make it difficult to sell, the bank may also believe that it is best able to judge the risk due to its close relationship with the borrower, and investors in other tranches may require the bank to hold the first loss for reasons of moral hazard. Under bank regulatory capital rules, the first-loss tranche is classified as equity and incurs a one-for-one capital charge. The second tranche assumes the credit risk of the portfolio usually starting after the first 2%-3% of losses with a maximum loss of about 10%. This risk is moved off the bank’s balance sheet through the use of a portfolio default swap. The counterparty to this portfolio default swap is an SPV, which then transfers this risk into the capital markets by issuing notes to the face value of the portfolio default swap. These notes can be tranched into several levels. The proceeds from selling these notes and used to borrow AAA-rated OECD government securities

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from a repo counterparty. Because of the high credit quality of this collateral and the fact that it is OECD government issued with a 0% BIS risk-weight , the counterparty risk in the portfolio default swap is negligible and, subject to the regulator’s approval, may obtain a 0% percent risk-weighting. The remaining credit risk of the portfolio is hedged throught the use of a second (senior) credit default swap with an OECD bank as the counterparty. This portion obtains a 20% risk-weighting. the total regulatory capital charge falls from 8% of the portfolio notional to 3.4%. Given that these trades typically have a notional of $3 billion-$5 billionn, this can be a substantial savings. Use of the synthetic CLO structure has grown substantially. As a synthetic CLO only requires about 10% of the balance sheet to be securitized, the notional of the issued securities is much less than the size of the collateral pool for which regulatory capital has been obtained. the main advantage of using a synthetic structure is that the bank is not required to transfer each loan into the SPV. Such a transfer is often difficult from a legal and relationship perpective. It also enables the bank to fund the assets more cheaply on balance sheet than by issuing a cash flow CLO. In conclusion, synthetic CLOs are a huge growth area and a perfect example of what is now possible using the credit derivative technology developed over the past few years.

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TOPIC 15: SYNTHETIC CDO’s

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(Ebrahim Mukadam)

What is a synthetic CDO?

Synthetic collateralised debt obligations (Synthetic CDOs) were conceived in 1997 as a flexible and low-cost mechanism for transferring credit risk off bank balance sheets The primary motivation was the banks’ reduction of regulatory capital. More recently, however, the fusion of credit derivatives modelling techniques and derivatives trading have led to the creation of a new type of synthetic CDO, which we call a customised CDO, which can be tailored to the exact risk appetites of different classes of investors. As a result, the synthetic CDO has become an investor-driven product. Overall, these different types of synthetic CDO have a total market size estimated by the Risk 2003 survey to be close to $500 billion. What is also of interest is that the dealerhedging of these products in the CDO market has generated a substantial demand to sell protection, balancing the traditional protection-buying demand coming from bank loan book managers. The performance of a synthetic CDO is linked to the incidence of default in a portfolio of CDS. The CDO redistributes this risk by allowing different tranches to take these default losses in a specific order. To see this, consider the synthetic CDO shown in Figure 8. It is based on a reference pool of 100 CDS, each with a €10m notional. This risk is redistributed into three tranches; (i) an equity tranche, which assumes the first €50m of losses (ii) a mezzanine tranche, which take the next €100m of losses, and (iii) the senior tranche with a notional of €850m takes all remaining losses. The equity tranche has the greatest risk and is paid the widest spread. It is typically unrated. Next is the mezzanine tranche which is lower risk and so is paid a lower spread. Finally we have the senior tranche which is protected by €150m of subordination. To get a sense of the risk of the senior tranche, note that it would require more than 25 of the assets in the 100 credit portfolio to default with a recovery rate of 40% before the senior tranche would take a principal loss. Consequently the senior tranche is typically paid a very low spread.

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The advantage of CDOs is that by changing the details of the tranche in terms of its attachment point (this is the amount of sub subordination below the tranche) and width, it is possible to customise the risk profile of a tranche to the investor’s specific profile.

What are the capital structure synthetics of a synthetic CDO In the typical synthetic CDO structured using securitization technology, the sponsoring institution, typically a bank, enters into a portfolio default swap with a Special Purpose Vehicle (SPV). The SPV typically provides credit protection for 10% or less of the losses on the reference portfolio. The SPV in turn issues notes in the capital markets to cash collateralize the portfolio default swap with the originating entity. The notes issued can include a non-rated ‘equity’ piece, mezzanine debt and senior debt, creating cash liabilities. The remainder of the risk, 90% or more, is generally distributed via a senior swap to a highly rated counterparty in an unfunded format. Reinsurers, who typically have AAA/AA ratings, have traditionally had a healthy appetite for this type of senior risk, and are the largest participants in this part of the capital structure – often referred to as super-senior AAAs or super-senior swaps. The initial proceeds from the sale of the equity and notes are invested in highly rated, liquid assets. If an obligor in the reference pool defaults, the trust liquidates investments in the trust and makes payments to the originating entity to cover default losses. This payment is offset by a successive reduction in the equity tranche, then the mezzanine and finally the super-seniors are called to make up losses.

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What are the “Mechanics” of a synthetic CDO? When nothing defaults in the reference portfolio of the CDO, the investor simply receives the Libor spread until maturity and CDO described earlier and shown in Figure 8, consider what happens if one of the reference entities in the reference portfolio undergoes the first credit event with a 30% recovery, causing a €7m loss. The equity investor takes the first loss of €7m, which is immediately paid to the originator. The tranche notional falls from €50m to €43m and the equity coupon, set at 1500bp, is now paid on this smaller notional. These coupon payments therefore fall from €7.5m to 15% times €43m = €6.45m. If traded in a funded format, the €3m recovered on the defaulted asset is either reinvested in the portfolio or used to reduce the exposure of the senior-most tranche (similar to early amortization of senior tranches in cash flow CDOs). The senior tranche notional is decreased by €3m to €847m, so that the sum of protected notional equals the sum of the collateral notionals which is now €990m. This has no effect on the other tranches. This process repeats following each credit event. If the losses exceed €50m then the mezzanine investor must bear the subsequent losses with the corresponding reduction in the mezzanine notional. If the losses exceed €150m, then it is the senior investor who takes the principal losses. The mechanics of a standard synthetic CDO are therefore very simple, especially compared with traditional cash flow CDO waterfalls. This also makes them more easily modelled and priced.

What are the factors the CDO tranche spread depends on? The synthetic CDO spread depends on a number of factors. We list the main ones and describe their effects on the tranche spread. ■ Attachment point: This is the amount of subordination below the tranche. The higher the attachment point, the more defaults are required to cause tranche principal losses and the lower the tranche spread. ■ Tranche width: The wider the tranche for a fixed attachment point, the more losses to which the tranche is exposed. However, the incremental risk ascending the capital structure is usually declining and so the spread falls. ■ Portfolio credit quality: The lower the quality of the asset portfolio, measured by spread or rating, the greater the risk of all tranches due to the higher default probability and the higher the spread. ■ Portfolio recovery rates: The expected recovery rate assumptions have only a secondary effect on tranche pricing. This is because higher recovery rates imply higher default probabilities if we keep the spread fixed. These effects offset each other to first order. ■ Swap maturity: This depends on the shapes of the credit curves. For upward sloping credit curves, the tranche curve will generally be upward sloping and so the longer the maturity, the higher the tranche spread. ■ Default correlation: If default correlation is high, assets tend to default together and this makes senior tranches more risky. Assets also tend to survive together making the equity

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safer. To understand this more fully we need to better understand the portfolio loss distribution.

Explain “Portfolio loss distribution”

No matter what approach we use to generate it, the loss distribution of the reference portfolio is crucial for understanding the risk and value of correlation products. The portfolio loss is clearly not symmetrically distributed: it is therefore informative to look at the entire loss distribution, rather than summarizing it in terms of expected value and standard deviation. We can expect to observe one of the two shapes shown in Figure 10. They are (i) a skewed bell curve; (ii) a monotonically decreasing curve. The skewed bell curve applies to the case when the correlation is at or close to zero. In this limit the distribution is binomial and the peak is at a loss only slightly less than the expected loss. As correlation increases, the peak of the distribution falls and the high quantiles increase: the curves become monotonically decreasing. We see that the probability of larger losses increases and, at the same time, the probability of smaller losses also increases, thereby preserving the expected loss which is correlation independent For very high levels of asset correlations (hardly ever observed in practice), the distribution becomes U-shaped. At maximum default correlation all the probability mass is located at the two ends of the distribution. The portfolio either all survives or it all defaults. It resembles the loss distribution of a single asset.

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How then does the shape of the portfolio loss distribution affect the pricing of tranches? To see this we must study the tranche loss distribution. The tranche loss distribution We have plotted in Figures 11–13 the loss distributions for a CDO with a 5% equity, 10% mezzanine and 85% senior tranche for correlation values of 20% and 50%. At 20% correlation, we see that most of the portfolio loss distribution is inside the equity tranche, with about 14% beyond, as represented by the peak at 100% loss. As correlation goes to 50% the probability of small losses increases while the probability of 100% losses increases only marginally. Clearly equity investors benefit from increasing correlation. The mezzanine tranche becomes more risky at 50% correlation. As we see in Figure 12, the 100% loss probability jumps from 0.50% to 3.5%. In most cases mezzanine investors benefit from falling correlation – they are short correlation. However, the correlation directionality of a mezzanine tranche depends upon the collateral and the tranche. In certain cases a mezzanine tranche with a very low attachment point may be a long correlation position. Senior investors also see the risk of their tranche increase with correlation as more joint defaults push out the loss tail. This is clear in Figure 13. Senior investors are short correlation.

In Figure 14 we plot the dependence of the value of different CDO tranches on correlation. As expected, we clearly see that: ■Senior investors are short correlation. If correlation increases, senior tranches fall in value. ■ Mezzanine investors are typically short correlation, although this very much depends upon the details of the tranche and the collateral.

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■ Equity investors are long correlation. When correlations go up, equity tranches go up in value. In the process of rating CDO tranches, rating agencies need to consider all of these risk parameters and so have adopted model based approaches.

What are “Customised” synthetic CDO tranches? Customisation of synthetic tranches has become possible with the fusion of derivatives technology and credit derivatives. Unlike full capital structure synthetics, which issue the equity, mezzanine and senior parts of the capital structure, customised synthetics may issue only one tranche. There are a number of other names for customised CDO tranches, including bespoke tranches, and single tranche CDOs.

The advantage of customised tranches is that they can be designed to match exactly the risk appetite and credit expertise of the investor. The investor can choose the credits in the collateral, the trade maturity, the attachment point, the tranche width, the rating, the rating agency and the format (funded or unfunded). Execution of the trade can take days rather than the months that full capital structure CDOs require. The basic paradigm has already been discussed in the context of default baskets. It is to use CDS to dynamically delta-hedge the first order risks of a synthetic tranche and to use a trading book approach to hedge the higher order risks. This is shown in Figure 15. For example, consider an investor who buys a customised mezzanine tranche from Lehman Brothers. We will then hedge it by selling protection in an amount equal to the delta of each credit in the portfolio via the CDS market. The delta is the amount of protection to be sold in order to immunize the portfolio against small changes in the CDS spread curve for that credit. Each credit in the portfolio will have its own delta.

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Understanding delta for CDOs For a specific credit in a CDO portfolio, the delta is defined as the notional of CDS for that credit which has the same mark-to-market change as the tranche for a small movement in the credit’s CDS spread curve. Although the definition may be straightforward, the behaviour of the delta is less so. One way to start thinking about delta is to imagine a queue of all of the credits sorted in the order in which they should default. This ordering will depend mostly on the spread of the asset relative to the other credits in the portfolio and its correlation relative to the other assets in the portfolio. If the asset whose delta you are calculating is at the front of this queue, it will be most likely to cause losses to the equity tranche and so will have a high delta for the equity tranche. If it is at the back of the queue then its equity delta will be low. As it is most likely to default after all the other asset, it will be most likely to hit the senior tranche. As a result the senior tranche delta will rise. This framework helps us understand the directionality of delta. The actual magnitude of delta is more difficult to quantify because it depends on the tranche notional and the contractual tranche spread, as well as the features of the asset whose delta we are examining. For example the delta for a senior tranche a credit whose CDS spread has widened will fall due to the fact that it is more likely to default early and hit the equity tranche, and also because the CDS will have a higher spread sensitivity and so require a smaller notional. To show this we take an example CDO with 100 credits, each $10m notional. It has three tranches: 5% equity, a 10% mezzanine and an 85% senior tranche. The asset spreads are all 150bp and the correlation between all the assets is the same. The sensitivity of the delta to changing the spread of the asset whose delta we are calculating is shown in Figure 16.

If the single asset spread is less than the portfolio average of 150bp, then it is the least risky asset. As a result, it would be expected to be the last to default and so most likely to impact the senior-most tranche. As the spread of the asset increases above 150bp, it becomes more likely to default before the others and so impacts the equity or mezzanine tranche. The senior delta drops and the equity delta increases.

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In Figure 17 we plot the delta of the asset versus its correlation with all of the other assets in the portfolio. These all have a correlation of 20% with each other. If the asset is highly correlated with the other assets it is more likely to default or survive with the other assets. As a result, it is more likely to default en masse, and so senior and mezzanine tranches are more exposed. For low correlations, if it defaults it will tend to do so by itself while the rest of the portfolio tends to default together. As a result, the equity tranche is most exposed. There is also a time effect. Through time, senior and mezzanine tranches become safer relative to equity tranches since less time remains during which the subordination can be reduced resulting in principal losses. This causes the equity tranche delta to rise through time while the mezzanine and senior tranche deltas fall to zero. Building intuition about the delta is not trivial.

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Types of Risks Higher order risks If properly hedged, the dealer should be insensitive to small spread movements. However, this is not a completely risk-free position for the dealer since there are a number of other risk dimensions that have not been immunised. These include correlation sensitivity, recovery rate sensitivity, time decay and spread gamma. There is also a risk to a sudden default which we call the value-on-default risk (VOD). For this reason, dealers are motivated to do trades that reduce these higher order risks. The goal is to flatten the risk of the correlation book with respect to these higher order risks either by doing the offsetting trade or by placing different parts of the capital structure with other buyers of customised tranches. Idiosyncratic versus systemic risk In terms of how they are exposed to credit, there is a fundamental difference between equity and senior tranches. Equity tranches are more exposed to idiosyncratic risk – they incur a loss as soon as one asset defaults. The portfolio effect of the CDO is only expressed through the fact that it may take several defaults to completely reduce the equity notional. This implies that equity investors should focus less on the overall properties of the collateral, and more on trying to choose assets which they believe will not default. As a result we would expect equity tranche buyers to be skilled credit investors, able to pick the right credits for the portfolio, or at least be able to hedge the credits they do not like. On the other hand, the senior investor has a significant cushion of subordination to insulate them from principal losses until maybe 20 or more of the assets in the collateral have defaulted. As a consequence, the senior investor is truly taking a portfolio view and so should be more concerned about the average properties of the collateral than the quality of any specific asset. The senior tranche is really a deleveraged macro credit trade.

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How did Synthetic structures evolve? Initially full capital structure synthetic CDOs had almost none of the structural features typically found in other securitised asset classes and cash flow CDOs. It was only in 1999 that features that diverted cash flows from equity to debt holders in case of certain covenant failures began entering the landscape. The intention was to provide some defensive mechanism for mezzanine holders fearing that the credit cycle would affect tranche performance. Broadly, these features fit into two categories – ones that build extra subordination using excess spread, and others that use excess spread to provide upside participation to mezzanine debt holders. The most common example of structural ways to build additional subordination is the reserve account funding feature. Excess spread (the difference between premium received from the CDS portfolio and the tranche liabilities) is paid into a reserve account. This may continue throughout the life of the deal or until the balance reaches a predetermined amount. If structured to accumulate to maturity, the equity tranche will usually receive a fixed coupon throughout the life of the transaction and any upside or remainder in the reserve account at maturity. If structured to build to a predetermined level, the equity tranche will usually receive excess interest only after the reserve account is fully funded. Other structures incorporated features to share some of the excess spread with mezzanine holders or to provide a step up coupon to mezzanines if losses exceeded a certain level or if the tranche was downgraded. Finally, over-collateralisation trigger concepts were adopted from cash flow CDOs. What are Principal protected structures? Investors who prefer to hold highly rated assets can do so by purchasing CDO tranches within a principal protected structure. This is designed to guarantee to return the investor’s initial investment of par. One particular variation on this theme is the Lehman Brothers High Interest Principal Protection with Extendible Redemption (HIPER). This is typically a 10-year note which pays a fixed coupon to the investor linked to the risk of a CDO equity tranche. This risk is embedded within the coupons of the note such that each default causes a reduction in the coupon size. However the investor is only exposed to this credit risk for a first period, typically five years, and the coupon paid for the remaining period is frozen at the end of year five. The coupon is typically of the form:

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In Figure 18 we show the cash flows assuming two credit events over the lifetime of the trade. The realised return is dependent on the timing of credit events. For a given number of defaults over the trade maturity, the later they occur, the higher the final return.

Managed synthetics The standard synthetic has been based on a static CDO, i.e., the reference assets in the portfolio do not change. However, recently, Lehman Brothers and a number of other dealers have managed to combine the customised tranche with the ability for an asset manager or the issuer of the tranche to manage the portfolio of reference entities. This enables investors to enjoy all the benefits of customised tranches and the benefits of a skilled asset manager. The customizable characteristics include rating, rating agency, spread, subordination, issuance format plus others. The problem with this type of structure is that the originator of the tranche has to factor into the spread the cost of substituting assets in the collateral. Initially this was based on the asset manager being told the cost of substituting an asset using some black-box approach. More recently the format has evolved to one where the manager can change the portfolio subject to some constraints. One example of such technology is Lehman Brothers’ DYNAMO structure. The advantage of this approach is that it frees the manager to focus on the credits without having to worry about the cost of substitution. The other advantages of such a structure for the asset manager are fees earned and an increase in assets under management. For investors the incentive is to leverage the management capabilities of a credit asset manager in order to avoid blow-ups in the portfolio and so better manage downturns in the credit cycle.

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What are “CDO of CDOs”? A recent extension of the CDO paradigm has been the CDO of CDOs, also known as ‘CDO squared’. Typically this is a mezzanine ‘super’ tranche CDO in which the collateral is made up of a mixture of asset-backed securities and several ‘sub’ tranches of synthetic CDOs. Principal losses are incurred if the sum of the principal losses on the underlying portfolio of synthetic tranches exceeds the attachment point of the super-tranche. Looking forward, we see growing interest in synthetic-only portfolios.

What is a Spread premium? Market spreads paid on securities bearing credit risk are typically larger than the levels implied by the historical default rates for the same rating. This difference, which we call the spread premium, arises because investors demand compensation for being exposed to default uncertainty, as well as other sources of risk, such as spread movements, lack of liquidity or ratings downgrades. Portfolio credit derivatives, such as basket default swaps and synthetic CDO tranches, offer a way for investors to take advantage of this spread premium. When an investor sells protection via a default basket or a CDO tranche, the note issuer passes this on by selling protection in the CDS market. This hedging activity makes it possible to pass this spread premium to the buyer of the structured credit asset. For buy and hold credit investors the spread premium paid can be significant and it is possible to show, for details of the method, that under certain criteria, these assets may be superior to single-name credit investments.

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Our results show that an FTD basket leverages the spread premium such that the size of the spread premium is much higher for an FTD basket than it is for a single-credit asset paying a comparable spread. This is shown in Figure 19 where we see that an FTD basket paying a spread of 350bp has around 290bp of spread premium. Compare this with a single-credit Ba3 asset also paying a spread close to 340bp. This has only 70bp of spread premium. For an STD basket we find that the spread premium is not leveraged. Instead, it is the ratio of spread premium to the whole spread which goes up. There are therefore two conclusions: 1. FTD baskets leverage spread premium. This makes them suitable for buy and hold yield-hungry investors who wish to be paid a high spread but also wish to minimise their default risk. 2. STD baskets leverage the ratio of spread premium to the market spread. This is suitable for more risk-averse investors who wish to maximise return per unit of default risk. We therefore see that default baskets can appeal to a range of investor risk preferences. CDO tranches exhibit a similar leveraging of the premium embedded in CDS spreads. The advantage of CDO of CDOs is that they provide an additional layer of leverage to the traditional CDO. This can make leveraging the spread premium arguments even more compelling. The conclusion is that buy-and-hold correlation investors are overcompensated for their default risk compared with single name investors.

Elaborate some CDO strategies. Investors in correlation products should primarily view them as buy and hold investments which allow them to enjoy the spread premium. This is a very straightforward strategy for mezzanine and senior investors. However, for equity investors, there are a number of strategies that can be employed in order to dynamically manage the idiosyncratic risk. We list some strategies below. 1. The investor buys CDO equity and hedges the full notional of the 10 or so worst names. The investor enjoys a significant positive carry and at the same time reduces his idiosyncratic default risk. The investor may also sell CDS protection on the tightest names, using the income to offset some of the cost of protection on the widest names. 2. The investor may buy CDO equity and delta hedge. The net positive gamma makes this trade perform well in high spread volatility scenarios. By dynamically re-hedging, the investor can lock in this convexity. The low liquidity of CDOs means that this hedging must continue to maturity. 3. The investor may use the carry from CDO equity to over-hedge the whole portfolio, creating a cheap macro short position. While this is a negative carry trade, it can be very profitable if the market widens dramatically or if a large number of defaults occur.

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TOPIC 16: BUSINESS VALUATION (Yogesh Chandorkar) Q1. What is valuation? The term ‘valuation’ implies the task of estimating the worth/value of a asset, a security or a business. The price an investor or a firm (buyer) is willing to pay to purchase a specific asset/security would be related to this value. Q2. What is book value, market value, intrinsic/economic value? The book value of an asset refers to the amount at which an asset is shown in the balance sheet of a firm. Generally, the sum is equal to the initial acquisition cost of an asset less accumulated depreciation. Market value refers to the price at which a asset can be sold in the market. It can be applied wit respect to tangible assets only. The intrinsic value of an asset is equal to the present value of incremental future cash inflows using an appropriate discount rate. Q3. What is liquidation value, replacement value, salvage value, value of goodwill, fair value? Liquidation value represents the price at which each individual asset can be sold if business operations are discounted in the wake of liquidation of the firm. Replacement value is the cost of acquiring a new asset of equal utility and usefulness. Salvage value represents realizable/scrap value on the disposal of assets after the expiry of their economic useful life. The value of goodwill is equivalent to the present value of super profits (likely to accrue, say for ‘n’ number of years in future), the discount rate being the required rate of return applicable to such business firms. Fair value is the average of book value, market value and intrinsic value. Q4. What are the different approaches to valuation? The different approaches to valuation are: (i) Asset based approach to valuation (ii) Earnings based approach to valuation

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(iii) (iv)

Market value based approach to valuation Fair value method approach to valuation

Q5. What is asset based approach to valuation? Asset based approach focuses on determining the value of net assets from the perspective of equity share valuation. Net assets = Total assets – Total external liabilities Q6. What are the two types of earnings based approach? The two types of earnings based approach are: (i) Accounting basis: It is based on two major parameters, that is, the earnings of the firm and the capitalization rate applicable to such earnings (given the level of risk) in the market. (ii) Cashflow basis: The cashflow basis method also uses the discounted value of the firm’s future cashflows. Q7. What is the market based approach to valuation? The market value, as reflected in the stock market quotations, is another method for estimating the value of a business. The market value of securities used for the purpose can be either (i) twelve months average of the stock exchange prices or (ii) the average of the high and low values of securities during a year. Alternatively, some other fair and equitable method of averaging (on the basis of the number of months/years) can be worked out. The justification of the market value as an approximation of the true worth of a firm is derived from the fact that market quotations by and large indicate the consensus of investors as to the firm’s earning potentials and the corresponding risk. The major problem with this method is that it is influenced not only by financial fundamentals but also by speculative factors. Q8. What is the fair value method? This method uses the average/weightage average or one or more methods mentioned earlier. Since this method uses the average concept, its virtue is that it helps in smoothening out wide variations in estimated valuations as per different methods. In other words, this approach provides, in a way, the balanced figure of valuation. Q9. What is EVA?

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The Economic Value Added (EVA) method is based on the past performance of the corporate enterprise. The underlying economic principle in this method is to determine whether the firm is earning a higher rate of return on the entire invested funds than the cost of such funds than the cost of such funds (measured in terms of the weighted average cost of capital, WACC). If the answer is positive, the firm’s management is adding to the shareholders value by earning extra for them. On the contrary, if the WACC is higher than the corporate earning rate, the firm’s operations have eroded the existing wealth of its equity shareholders. In the operational terms, the method attempts to measure economic value added (or destroyed) for equity shareholders, by the firm’s operations, in a given year. EVA = (Net operating profits after taxes – (Total capital * WACC)) Q10. What is market value added approach? The market value approach measures the change in the market value of the firm’s equity vis-à-vis equity investment (consisting of equity share capital and retained profits). MVA = Market value of firm’s equity – Equity capital investment/funds Though the concept of MVA is normally used in the context of equity investment (and, hence, is of greater relevance for equity shareholders), it can also be adapted (like other previous approaches) to measure value from the perspective of providers of all invested funds (i.e., including preference share capital and debt).

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