IGNOU MBA MS- 46 Free Solved Assignments 2010

MS- 46: Management of Financial Services

ASSIGNMENT 2010

Course Code : MS-46

Course Title : Management of Financial

Services

Assignment Code : 46/TMA/SEM-II/2010

Coverage : All Blocks

Attempt All the Questions.

1. List & explain the nature of risk associated with financial

services companies.

Solution: When we think of large risks, we often think in terms of

natural hazards such as hurricanes, earthquakes, or tornados.
Perhaps man-made disasters come to mind—such as the terrorist
attacks that occurred in the United States on September 11,
2001. We typically have overlooked financial crises, such as the
credit crisis of 2008. However, these types of man-made disasters
have the potential to devastate the global marketplace. Losses in
multiple trillions of dollars and in much human suffering and
insecurity are already being totaled as the U.S. Congress fights
over a $700 billion bailout. The financial markets are collapsing as
never before seen.

Many observers consider this credit crunch, brought on by

subprime mortgage lending and deregulation of the credit
industry, to be the worst global financial calamity ever. Its
unprecedented worldwide consequences have hit country after
country—in many cases even harder than they hit the United
States.[2] The world is now a global village; we’re so
fundamentally connected that past regional disasters can no
longer be contained locally.

We can attribute the 2008 collapse to financially risky behavior of

a magnitude never before experienced. Its implications dwarf any
other disastrous events. The 2008 U.S. credit markets were a
financial house of cards with a faulty foundation built by unethical
behavior in the financial markets:

1.Lenders gave home mortgages without prudent risk

management to under qualified home buyers, starting the so-
called subprime mortgage crisis.

2.Many mortgages, including subprime mortgages, were bundled

into new instruments called mortgage-backed securities, which
were guaranteed by U.S. government agencies such as Fannie
Mae and Freddie Mac.
3. These new bundled instruments were sold to financial
institutions around the world. Bundling the investments gave
these institutions the impression that the diversification effect
would in some way protect them from risk.

4. Guarantees that were supposed to safeguard these

instruments, called credit default swaps, were designed to take
care of an assumed few defaults on loans, but they needed to
safeguard against a systemic failure of many loans.

5. Home prices started to decline simultaneously as many of the

unqualified subprime mortgage holders had to begin paying
larger monthly payments. They could not refinance at lower
interest rates as rates rose after the 9/11 attacks.

6. These subprime mortgage holders started to default on their

loans. This dramatically increased the number of foreclosures,
causing nonperformance on some mortgage-backed securities.

7. Financial institutions guaranteeing the mortgage loans did not

have the appropriate backing to sustain the large number of
defaults. These firms thus lost ground, including one of the largest
global insurers, AIG (American International Group).

8.Many large global financial institutions became insolvent,

bringing the whole financial world to the brink of collapse and
halting the credit markets.
9. Individuals and institutions such as banks lost confidence in
the ability of other parties to repay loans, causing credit to freeze
up.

10.Governments had to get into the action and bail many of these
institutions out as a last resort. This unfroze the credit mechanism
that propels economic activity by enabling lenders to lend again.

As we can see, a basic lack of risk management (and regulators’

inattention or inability to control these overt failures) lay at the
heart of the global credit crisis. This crisis started with a lack of
improperly underwritten mortgages and excessive debt.
Companies depend on loans and lines of credit to conduct their
routine business. If such credit lines dry up, production slows
down and brings the global economy to the brink of deep
recession—or even depression. The snowballing effect of this
failure to manage the risk associated with providing mortgage
loans to unqualified home buyers has been profound, indeed. The
world is in a global crisis due to the prevailing (in)action by
companies and regulators who ignored and thereby increased
some of the major risks associated with mortgage defaults. When
the stock markets were going up and homeowners were paying
their mortgages, everything looked fine and profit opportunities
abounded. But what goes up must come down, as Flannery
O’Conner once wrote. When interest rates rose and home prices
declined, mortgage defaults became more common. This caused
the expected bundled mortgage-backed securities to fail. When
the mortgages failed because of greater risk taking on Wall
Street, the entire house of cards collapsed.
Additional financial instruments (called credit derivatives)[3] gave
the illusion of insuring the financial risk of the bundled
collateralized mortgages without actually having a true
foundation—claims, that underlie all of risk management.[4]
Lehman Brothers represented the largest bankruptcy in history,
which meant that the U.S. government (in essence) nationalized
banks and insurance giant AIG. This, in turn, killed Wall Street as
we previously knew it and brought about the restructuring of
government’s role in society. We can lay all of this at the feet of
the investment banking industry and their inadequate risk
recognition and management. Probably no other risk-related
event has had, and will continue to have, as profound an impact
worldwide as this risk management failure (and this includes the
terrorist attacks of 9/11). Ramifications of this risk management
failure will echo for decades. It will affect all voters and taxpayers
throughout the world and potentially change the very structure of
American government.

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2. Explain the various types of debt instruments that are trade

in Indian Debt Market. Discuss how the settlement of trades in
debt securities is done ?

Solution: Debt Instruments are obligations of issuer of such

instrument as regards certain future cash flow representing
Interest & Principal, which the issuer would pay to the legal owner
of the Instrument. They can also be said to be tradable form of
loans.
Debt Instruments are of various types like Bonds, Debentures,
Commercial Papers, Certificates of Deposit, Government
Securities (G secs) etc. The Government Securities (G-Secs)
market is the oldest and the largest component of the Indian debt
market in terms of market capitalization, trading volumes and
outstanding securities. The G-Secs market plays a vital role in the
Indian economy as it provides the benchmark for determining the
level of interest rates in the country through the yields on the
government securities which are treated as the risk-free rate of
return in any economy. The reserve Bank of India has permitted
Primary Dealers, Banks and Financial Institutions in India to do
transactions in debt instruments among themselves or with non-
bank clients. Debt instruments provide fixed return declared as
coupon rate. Retail investors would have a natural preference for
fixed income returns and especially so in the current situation of
increasing volatility in the financial markets. Now, retail investors
are also showing keen interest in Debt Instruments particularly in
the Central Government Securities (G-secs).For an individual
investor G-secs are one of the best investment options as there is
zero default risk and lower volatility in case of G-secs.SBI DFHI is
a major player in G-Secs market and widely deals in other debt
instruments also.

The distinguishing factors of the Debt Instruments are as follows:

-

1. Issuer class

2. Coupon bearing / Discounted

3. Interest Terms

4. Repayment Terms (Including Call / put etc.)

5. Security / Collateral / Guarantee

SBI DFHI Ltd. has several options like SBI DFHI Invest, SBI DFHI
Trade and SBI DFHI Invest Plus (details available on website)
through which investors can participate in the G-Sec and
Corporate Debt Market.

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3. What are depositories? Explain the functioning of a

depository.

Solution: An Depository otherwise referred to as a custodian is a

commercial bank or a financial institution, approved by the
Authority to hold in custody funds, securities, financial
instruments or documents of title to assets registered in the name
of local investors, East African investors, or foreign investors or an
investment portfolio.

Other Depositories include Barclays Bank of Kenya, National Bank

of Kenya, Stanbic Bank, Kenya Commercial Bank, National
Industrial Credit Bank, Co-operative Bank of Kenya, Investment &
Mortgage Bank, CFC Bank, Equity Bank, Dubai Bank and African
Banking Corporation.
A licensed custodian also acts as a Central Depository Agent
(CDA) for the Central Depository and Settlement Corporation Ltd.
(CDSC).

To be licensed as a custodian a firm must first be licensed to

operate as a bank, under the Banking Act, or as a financial
institution.

Meanwhile, President Mwai Kibaki has confirmed Mrs. Stella

Kilonzo as the Chief Executive of CMA. She has been working in
an acting capacity since December last year.

Here are the functions of the depository:-

Dematerialisation: One of the primary functions of depository is to

eliminate or minimise the movement of physical securities in the
market. This is achieved through dematerialisation of securities.
Dematerialisation is the process of converting securities held in
physical form into holdings in book entry form.

Account Transfer: The depository gives effects to all transfers

resulting from the settlement of trades and other transactions
between various beneficial owners by recording entries in the
accounts of such beneficial owners.

Transfer and Registration: A transfer is the legal change of

ownership of a security in the records of the issuer. For effecting a
transfer, certain legal steps have to be taken like endorsement,
execution of a transfer instrument and payment of stamp duty.

The depository accelerates the transfer process by registering the

ownership of shares in the name of the depository. Under a
depository system, transfer of security occurs merely by passing
book entries in the records of the depositories, on the instructions
of the beneficial owners.

Corporate Actions: A depository may handle corporate actions in

two ways. In the first case, it merely provides information to the
issuer about the persons entitled to receive corporate benefits. In
the other case, depository itself takes the responsibility of
distribution of corporate benefits.

Pledge and Hypothecation: The securities held with NSDL may be

used as collateral to secure loans and other credits by the clients.
In a manual environment, borrowers are required to deliver
pledged securities in physical form to the lender or its custodian.
These securities are verified for authenticity and often need to be
transferred in the name of lender. This has a time and money cost
by way of transfer fees or stamp duty. If the borrower wants to
substitute the pledged securities, these steps have to be
repeated. Use of depository services for pledging/ hypothecating
the securities makes the process very simple and cost effective.
The securities pledged/hypothecated are transferred to a
segregated or collateral account through book entries in the
records of the depository.

Linkages with Clearing System: Whether it is a separate clearing

corporation attached to a stock exchange or a clearing house
(department) of a stock exchange, the clearing system performs
the functions of ascertaining the pay-in (sell) or pay-out (buy) of
brokers who have traded on the stock exchange. Actual delivery
of securities to the clearing system from the

selling brokers and delivery of securities from the clearing system

to the buying broker is done by the depository. To achieve this,
depositories and the clearing system should be electronically
linked.

Having understood the depository system, let us now look at the

organisation and functions of National Securities Depository
Limited (NSDL).

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4. What do you mean by corporate advisory service? Explain

the main corporate advisory services.

Solution: Corporate Advisory Service (CAS)

CAS provides the intelligence you need to incorporate the latest

developments in industry trends, best practices, supply chain
management, asset and product lifecycle management,
production management and plant automation.Corporate
advisory refers to the activity of advising organisations, including
corporations, institutions and government bodies, on mergers and
acquisitions and other transactions that involve a change in
ownership of a company or business. In investment banking
circles, this activity is commonly known by the general term M&A
(Mergers and Acquisitions).
Transaction types include mergers, acquisitions, disposals,
defences, spin-offs, demergers, joint ventures, privatisations,
leveraged buyouts and many others. Transactions may be
"public" transactions, where the target is a listed public company,
or "private" transactions, where the target company is not listed.

There will normally be a minimum of two parties to an M&A

transaction, namely the bidder and the target. In a sale
transaction, there will also be a vendor, i.e. the seller of the target
business.

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5. Explain the process and mechanism of securitization and

discuss about the instruments of securitization.

Solution: Securitization is a structured finance process that

distributes risk by aggregating assets in a pool (often by selling
assets to a special purpose entity), then issuing new securities
backed by the assets and their cash flows. The securities are sold
to investors who share the risk and reward from those assets.

Securitization is similar to a sale of a profitable business

("spinning off") into a separate entity. The previous owner trades
its ownership of that unit, and all the profit and loss that might
come in the future, for present cash. The buyers invest in the
success and/or failure of the unit, and receive a premium (usually
in the form of interest) for doing so. In most securitized
investment structures, the investors' rights to receive cash flows
are divided into "tranches": senior tranche investors lower their
risk of default in return for lower interest payments, while junior
tranche investors assume a higher risk in return for higher
interest.

Securitization is designed to reduce the risk of bankruptcy and

thereby obtain lower interest rates from potential lenders. A
credit derivative is also sometimes used to change the credit
quality of the underlying portfolio so that it will be acceptable to
the final investors. As a portfolio risk backed by amortizing cash
flows - and unlike general corporate debt - the credit quality of
securitized debt is non-stationary due to changes in volatility that
are time- and structure-dependent. If the transaction is properly
structured and the pool performs as expected, the credit risk of
all tranches of structured debt improves; if improperly structured,
the affected tranches will experience dramatic credit deterioration
and loss.[1]

Securitization has evolved from its tentative beginnings in the

late 1970s to a vital funding source with an estimated
outstanding of $10.24 trillion in the United States and $2.25
trillion in Europe as of the 2nd quarter of 2008. In 2007, ABS
issuance amounted to $3,455 billion in the US and $652 billion in
Europe

The instruments of securitization:

Securitized debt instruments are the products of securitization,

which in turn is the process of passing debts onto entities that in
turn break them into bonds and sell them. As of 2010, the most
common form of securitized debt are mortgage-backed securities,
but moves are being made to securitize other debts, such as
credit cards and student loans.

Securitized debts have the benefit of lowering interest rates and

freeing up capital to banks, but they have the drawback of
encouraging lending for purposes other than long-term profit.

Process

Securitized debt instruments are created when the original holder

(like a bank) sells its debt obligation to a third party, called a
Special Purpose Vehicle (SPV).

The SPV pays the original lender the balance of the debt sold,
which gives it greater liquidity. It then goes on to divide the debt
into bonds, which are then sold on the open market. These bonds
are divided into "tranches," which represent different amounts of
risk and correspondingly different yields for the bondholder. There
are definite benefits to securitization of debt. For one, a bank with
a large amount of cash instead of a large amount of debt owed to
it is more liquid. This means it has more money to spend right
now, which in turn drives down interest rates on new mortgages
as the bank's supply of money rises.
Another benefit of securitization of debt is the fact that it allows
people to invest in things they would not otherwise be able to
invest in. To invest in an entire mortgage requires enough capital
to lend to someone--usually hundreds of thousands of dollars. To
invest in several small chunks of several mortgages, however,
does not require as much money and is not as risky.

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6. Explain in detail the concept of leasing and hire purchase.

Solution: Detail the Concept of Leasing

A leasing is a contract calling for the lessee (user) to pay the

lessor (owner) for use of an asset.[1] A rental agreement is a
leasing in which the asset is tangible property.[2] Leasings for
intangible property could include use of a computer program
(similar to a license, but with different provisions), or use of a
radio frequency (such as a contract with a cell-phone provider). A
gross leasing is when the tenant pays a flat rental amount and
the landlord pays for all property charges regularly incurred by
the ownership from lawnmowers and washing machines to
handbags and jewellry.[3]

A cancelable leasing is a leasing that may be terminated solely by

the lessee or solely by the lessor. A non-cancelable leasing is a
leasing that cannot be so terminated. In common parlance,
“leasing” may connote a non-cancelable leasing, whereas “rental
agreement” may connote a cancelable leasing.
The leasing will either provide specific provisions regarding the
responsibilities and rights of the lessee and lessor, or there will be
automatic provisions as a result of local law. In general, by paying
the negotiated fee to the lessor, the lessee (also called a tenant)
has possession and use (the rental) of the leasingd property to
the exclusion of the lessor and all others except with the
invitation of the tenant. The most common form of real property
leasing is a residential rental agreement between landlord and
tenant.[4] The relationship between the tenant and the landlord is
called a tenancy, and the right to possession by the tenant is
sometimes called a leasinghold interest. A leasing can be for a
fixed period of time (called the term of the leasing) but
(depending on the terms of the leasing) may be terminated
sooner.

A leasing should be contrasted to a license, which may entitle a

person (called a licensee) to use property, but which is subject to
termination at the will of the owner of the property (called the
licensor). An example of a licensor/licensee relationship is a
parking lot owner and a person who parks a vehicle in the parking
lot. A license may be seen in the form of a ticket to a baseball
game. The difference would be that if possession is subject to
ongoing, recurrent payments and is generally not subject to
termination except for misconduct or nonpayment, it is a leasing;
if it's a one-time entrance onto someone else's property, it's
probably a license. The seminal difference between a leasing and
a license is that a leasing generally provides for regular periodic
payments during its term and a specific ending date. If a contract
has no ending date then it may be in the form of a perpetual
license and still not be a leasing.
Under normal circumstances, owners of property are at liberty to
do what they want with their property (for a lawful purpose),
including dealing with it or handing over possession of the
property to a tenant for a limited period of time. If an owner has
surrendered possession to another (i.e., the tenant) then any
interference with the quiet enjoyment of the property by the
tenant in lawful possession is itself unlawful.

Similar principles apply to real property as well as to personal

property, though the terminology would be different. Similar
principles apply to sub-leasing, that is the leasing by a tenant in
possession to a sub-tenant. The right to sub-leasing can be
expressly prohibited by the main leasing, sometimes referred to
as a "master leasing".

The concept of Hire purchase:

Hire purchase (abbreviated HP) is the legal term for a contract, in

this persons usually agree to pay for goods in parts or a
percentage at a time. It was developed in the United Kingdom and
can now found in China, Japan, Malaysia, India, Australia, and New
Zealand. It is also called closed-end leasing. In cases where a
buyer cannot afford to pay the asked price for an item of property
as a lump sum but can afford to pay a percentage as a deposit, a
hire-purchase contract allows the buyer to hire the goods for a
monthly rent. When a sum equal to the original full price plus
interest has been paid in equal installments, the buyer may then
exercise an option to buy the goods at a predetermined price
(usually a nominal sum) or return the goods to the owner. In
Canada and the United States, a hire purchase is termed an
installment plan; other analogous practices are described as
closed-end leasing or rent to own.
Hire purchase differs from a mortgage and similar forms of lien-
secured credit in that the so-called buyer who has the use of the
goods is not the legal owner during the term of the hire-purchase
contract. If the buyer defaults in paying the installments, the
owner may repossess the goods, a vendor protection not
available with unsecured-consumer-credit systems. HP is
frequently advantageous to consumers because it spreads the
cost of expensive items over an extended time period. Business
consumers may find the different balance sheet and taxation
treatment of hire-purchased goods beneficial to their taxable
income. The need for HP is reduced when consumers have
collateral or other forms of credit readily available.

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7. Explain the concept of Factoring, Forfeiting and Bill

discounting.

Solution: Factoring is a financial transaction whereby a business

sells its accounts receivable (i.e., invoices) to a third party (called
a factor) at a discount in exchange for immediate money with
which to finance continued business. Factoring differs from a bank
loan in three main ways. First, the emphasis is on the value of the
receivables (essentially a financial asset)[1], not the firm’s credit
worthiness. Secondly, factoring is not a loan – it is the purchase of
a financial asset (the receivable). Finally, a bank loan involves two
parties whereas factoring involves three.
It is different from the forfeiting in the sense that forfeiting is a
transaction based operation while factoring is a firm-based
operation - meaning, in factoring, a firm sells all its receivables
while in forfeiting, the firm sells one of its transactions.

Factoring is a word often misused synonymously with invoice

discounting [citation needed] - factoring is the sale of receivables
whereas invoice discounting is borrowing where the receivable is
used as collateral.

The three parties directly involved are: the one who sells the
receivable, the debtor, and the factor. The receivable is
essentially a financial asset associated with the debtor’s liability
to pay money owed to the seller (usually for work performed or
goods sold). The seller then sells one or more of its invoices (the
receivables) at a discount to the third party, the specialized
financial organization (aka the factor), to obtain cash. The sale of
the receivables essentially transfers ownership of the receivables
to the factor, indicating the factor obtains all of the rights and
risks associated with the receivables. Accordingly, the factor
obtains the right to receive the payments made by the debtor for
the invoice amount and must bear the loss if the debtor does not
pay the invoice amount. Usually, the account debtor is notified of
the sale of the receivable, and the factor bills the debtor and
makes all collections. Critical to the factoring transaction, the
seller should never collect the payments made by the account
debtor, otherwise the seller could potentially risk further
advances from the factor. There are three principal parts to the
factoring transaction; a.) the advance, a percentage of the invoice
face value that is paid to the seller upon submission, b.) the
reserve, the remainder of the total invoice amount held until the
payment by the account debtor is made and c.) the fee, the cost
associated with the transaction which is deducted from the
reserve prior to it being paid back the seller. Sometimes the
factor charges the seller a service charge, as well as interest
based on how long the factor must wait to receive payments from
the debtor. The factor also estimates the amount that may not be
collected due to non-payment, and makes accommodation for this
when determining the amount that will be given to the seller. The
factor's overall profit is the difference between the price it paid
for the invoice and the money received from the debtor, less the
amount lost due to non-payment.

American Accounting considers the receivables sold when the

buyer has "no recourse", or when the financial transaction is
substantially a transfer of all of the rights associated with the
receivables and the seller's monetary Liability under any
"recourse" provision is well established at the time of the sale.[5]
Otherwise, the financial transaction is treated as a loan, with the
receivables used as collateral.

The concept of Bill discounting:

Business activities across borders are done through letter of

credit. Letter of credit is an instrument issued in the favor of the
seller by the buyer bank assuring that payment will be made after
certain timer frame depending upon the terms and conditions
agreed, it could be either sight, 30 days from the Bill of Lading or
120 days from the date of bill of lading. Now when the seller
receives the letter of credit through bank, seller prepares
documents and presents the same to the bank.
The most important element in the same is the bill of exchange
which is used to negotiate a letter of credit. Seller discounts that
bill of exchange with the bank and gets money. Discounting bill
terminology is used for this purpose. Now it is seller's bank
responsibility to send documents and bill of exchange to buyer's
bank for onward forwarding to the buyer for the acceptance and
the buyer finally, accepts bill of exchange drawn by the seller on
buyer's bank because he has opened that LC. Buyers bank than
get that signed bill of exchange from the buyer as guarantee and
release payment to the sellers bank and waits for the time span
will buyer will pay the bank against that bill of exchange.

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8. Explain the broad attributes of a Life Insurance Products.

Solution: Life insurance provides payment of a death benefit at

the death of the insured(s). However, life insurance has many
unique characteristics that may make it an appropriate solution
for a variety of uses in addition to the death benefit protection.
Some of these characteristics include:

* Policy cash values accumulate on a tax-deferred basis.

* Policy death benefits are received income tax-free.

* Policy cash values may be accessed on a tax advantaged

basis.
Please keep in mind loans and partial withdrawals may decrease
the death benefit and cash value and may be subject to policy
limitations and income tax.

Function: Insurance Sales

Life insurance salespeople or producers sell products that provide

money to a person's relatives or friends after he dies. The life
insurance producer helps customers determine how much
insurance a person's family will need to afford burial
arrangements, pay off bills and debt, and replace the income the
customer would have earned throughout his life.

Function: Annuity Sales

Life insurance producers also sell annuities. An annuity is an

investment product that helps investors earn interest and receive
income during retirement.

Use of Technology

Life insurance producers use computers to calculate insurance

benefits and needs, and to determine how much the insurance
will cost the customer monthly or yearly. They also enter
customer information required for the application into the
computer.

Education and Licensing

Most life insurance companies prefer applicants who have a

minimum of a bachelor's degree in a field such as business
administration, finance or economics. Before a producer can sell
insurance, she must receive a license in the state where she
wishes to work by passing a life, accident and health insurance
exam.

Considerations

Life insurance producers travel to meet with customers within a

defined territory, but this sometimes allows them to work from a
home-based office. The life insurance field is highly regulated at
the federal and state levels, with policies changing frequently.
Producers must stay abreast of regulations to avoid fees and
fines.

Compensation

Many life insurance sales positions are commission-based,

meaning that producers receive a percentage of the revenue
generated by sales and receive no compensation if they sell
nothing. The average annual median salary for insurance
producers in the United States was $60,440 in May 2008.

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