FINANCIAL INSTITUTIONS AND MARKETS( LW-2316)

MODULE-I:OVERVIEW OF FINANCIAL SYSTEM AND INTEREST RATES

1.1 Introduction to Financial Institutions , Markets and an overview.

1.2 Interest Rate-Meaning and their role in Valuation
1.3 Measurement of Interest Rates (Simple and Compound Interest)
1.4 Risk and the Term Structure of Interest Rates
1.5 Yield Curve
1.6 Present and Future Value Concepts

PRESENT VALUE AND FUTURE VALUE OF MONEY

(A) FUTURE VALUE OF A LUMP SUM (SIMPLE INTEREST)

In Simple Interest system , interest is paid on Principal only.

If you deposit Rs100/- in a bank for one year which pays an interest of 10% p.a. , the Maturity
amount will be 110/- ( Principal 100/- + Interest 10/- = Rs110/)

If you deposit 100/- in a bank for 2(two) years which pays an interest of 10% p.a. , the
Maturity amount will be 120 ( Principal 100/- + Interest 2x10/- = 120/).

If you deposit 100/- in a bank for 3(three) years which pays an interest of 10% p.a. , the
Maturity amount will be 130 ( Principal 100/- + Interest 3x10/- = 130/).

So the growth of the investment will be 100 =>110=>120=>130

On the other hand , if you withdraw at the end of the first year , you will get 110/- and if you
wait and withdraw at the end of 2nd year , you will get 120/-.

If you deposit 100/- in a bank for one year which pays an interest of 4% per quarters , the
Maturity amount after one year will be 116/- ( Principal 100/- + Interest 4*0.04*100 = 100/- +
16/-= 116/-). If you withdraw at the end of first quaters , you will get 104/-.

If you deposit 100/- in a bank for one year which pays an interest of 1% p.m. , the Maturity
amount after a year will be 110/- ( Principal 100/- + Interest 12*0.01 =100/- + 12/-= 112/) . If
you withdraw at the end of first month the maturity amount will be Rs101/-

Maturity amount is also called Future Value (FV). This FV can be calculated using formula
also.

FV= A*(1+ n*r) , where A=Amount deposited , n=Number of Period , r=Interest Rate.

If A=100/- , r=10% p.a. and n=5

FV=100*(1+5*0.10)=100*(1.5)=150/-

(B) FUTURE VALUE OF A LUMP SUM (COMPOUND INTEREST)

In compound Interest system , the depositor gets interests on the Principal as well as the
Interest or the Interest is paid on the last accumulated amount.
Now lets us understand the concept with an example.

If we invest 100/- in a bank offering 10% Interest p.a. compounded annually , what will be
the FV at the end of 1st,2nd and 3rd years.

1st Year= 100 + Interest on 100= 100+0.10*100=100+10=110/-

2nd Year=110 + Interest on 110=110+0.10*110=110+11=121/-
3rd Year=121 + Interest on 121=121+0.10*121=121+12.1=133.10/-

Please note that in Compound Interest system , the principal amount keeps changing. On the
other hand , in this system , the investor gets interest not only on the original principal , but
also on the interest.

So the growth of the investment will be 100 =>110=>121=>133.10/-

This means , Interest Rate and Periods remaining same , the FV will be higher in Compound
Interest system compared to Simple Interest system.

This FV can be calculated using formula also.

FV= A*(1+ r^n) , where A=Amount deposited , n=Number of Period , r=Interest Rate.

If A=100/- , r=10% p.a. and n=3

FV=100*((1+0.10)^3)=100*(1.331)=133.10

Here, we have considered the compounding on annual basis. Lets see the change in FV if the
compounding is on Half Yearly basis/ Quarterly basis/ Monthly.

HY compounding: A=100/- , r=10/2=5% h.y. and n=3*2=6

FV=100*((1+0.05)^6)=134.01

Quarterly compounding: A=100/- , r=10/4=2.5% h.y. and n=3*4=12

FV=100*((1+0.025)^12)=134.48

Monthly compounding: A=100/- , r=10/12=0.83% , and n=3*12=36

FV=100*((1+0.0083)^36)=134.65

From the above we can conclude , higher the frequency of compounding higher will be the
FV amount.

These amounts can also be calculated from the FV table.

Lets say , you wish to find out the FV , If A=100/- , r=10% p.a. and n=3.
FV=A*FV(n=3,r=10%)=100*1.3310=133.10
If you wish to get the FV , in case of HY compounding , n=3*2=6 and r=10/2=5%
FV=A*FV(n=6,r=5%)=100*1.3401=134.01

While the FV table can be used for whole numbers , the formula can be used for any period
and any interest rate.

(C) PRESENT VALUE OF A LUMP SUM

Present Value of a Lump sum= PV=A/[(1+r)^n]

Present value of 110/- to be received one year from now if the interest rate is 10% =
110/(1+0.1)^1=110/1.1=100
Present value of 121/- to be received two years from now if the interest rate is 10% =
121/(1+0.1)^2=121/1.21=100
Present value of 133.1/- to be received three years from now if the interest rate is 10% =
133.1/(1+0.1)^3=133.1/1.331=100

Present value of 110/- to be received one year from now if the interest rate is 10% and
compounded half yearly=110/((1+0.05)^2)=99.77
Present value of 110/- to be received one year from now if the interest rate is 10% and
compounded quarterly=110/((1+0.025)^4)=99.65

PV of a Lump sum can also be calculated from the PV Table.

(for compounded half yearly example.)
PV=A*PVA(n=2,r=5)=110*0.907=99.77

SOLVED PROBLEMS ON PRESENT VALUE AND FUTURE VALUE

1. You have Rs. 9,000 to deposit. ABC Bank offers 12 percent per year compounded
monthly, while King Bank offers 12 percent but will only compound annually. How much
will your investment be worth in 10 years at each bank?
Ans : 29,703.48 and 27,952.63.

Solution:

ABC Bank
Amount=A=9000
Rate of Interest=r=12/12=1% per month
Period=n=10 years x 12 = 120 months
FV=A*(1+r)^n=9000*(1.01^120)=29,703.48

King Bank
Amount=A=9000
Rate of Interest=r=12% per year
Period=n=10 years
FV=A*(1+r)^n=9000*(1.12^10)=27,952.63

2. You invest Rs. 10,000. During the first year the investment earned 20% for the year.
During the second year, you earned only 4% for that year. How much is your original
deposit worth at the end of the two years?
Ans : 12,480

Solution:

Amount at the beginning of the first year=10000

Rate of Interest=r=20% per year
Period=n=1years
FV at the end of the first year=A*(1+r)^n=10000*(1.20^1)=12000

Amount at the beginning of the 2nd year=12000

Rate of Interest=r=4% per year
Period=n=1years
FV at the end of the 2nd year=A*(1+r)^n=12000*(1.04^1)=12,480.
3. Find the future value of Rs. 100,000 for 15 years. The current five-year rate is 6%. Rates
for the second and third five-year periods and expected to be 6.5% and 7.5%, respectively.
Ans: 263,220

Solution:

Amount at the beginning of the first five years=10000

Rate of Interest=r=6% per year
Period=n=5 years
FV at the end of the 5th year=A*(1+r)^n=10000*(1.06^5)=13382.25

Amount at the beginning of the first five years=13382.25

Rate of Interest=r=6.5% per year
Period=n=5 years
FV at the end of the 10th year=A*(1+r)^n=13382.25*(1.065^5)=18334.84

Amount at the beginning of the first five years=18334.84

Rate of Interest=r=7.5% per year
Period=n=5 years
FV at the end of the 15th year=A*(1+r)^n=18334.84*(1.075^5)= 263,220

4.The Green Corporation needs Rs. 50 million to repay a loan which is due at the end of
seven years. If Green makes the following sinking fund payments, will there be sufficient
funds available to repay the loan on schedule?
12m today @11% , 10m after 2 years @10% and 8m@9% after 4 years.
Ans: 51.382m

Solution:

Amount =12m
Rate of Interest=r=11% per year
Period=n=7 years
FV at the end of the 7 year=A*(1+r)^n=12*(1.11^7)=24.94

Amount =10m
Rate of Interest=r=10% per year
Period=n=5 years
FV at the end of the 7 year=A*(1+r)^n=10*(1.10^5)=16.105

Amount =8m
Rate of Interest=r=9% per year
Period=n=3 years
FV at the end of the 7 year=A*(1+r)^n=8*(1.09^3)=10.360

FV(Total) at the end of 7th year=24.91+16.10+10.36=51.379

So , the FV at the end of the 7th year will be sufficient to meet the loan obligation.

5.Mr. Nadeem owes a total of $3,060 which includes 12% interest for the three years he
borrowed the money. How much did he originally borrow?
Ans : 2,178.05
Solution:

FV=A*(1+r)^n
A=Amount of loan taken (Unknown)
n= 3 years
r= 12% per year
A=3060/(1.12^3)= 2,178.05

6.What is the present value of $1,000 received in two years if the interest rate is?

(a) 12% per year discounted annually

(b) 12% per year discounted semi-annually
(c) 12% per year discounted daily

Ans: 797.19/792.09/786.66

Solution :

PV=A/(1+r)^n
A=1000
r=12%
n=2 years
PV=1000/(1.12^2)=797.19

A=1000
r= Semi-annual interest rate=12/2=6%
n=2*2= 4 half years
PV=1000/(1.06^4)= 792.09

A=1000
r=Daily interest rate=12/365=0,032877%
N=2*365=730 days
PV=1000/(1.00032877^730)=786.66

7.What is the present value of an offer of $14,000 two years from now if the opportunity cost
of capital (discount rate) is 17% per year discounted annually?
Ans : 10,227.19

Solution:

PV=A/(1+r)^n
Here ,
A=14000
r= 17% per
n=2 years
PV=14000/(1.17^2)=10,227.19

8. If you invested $50,000 at one point in time and received back $80,000 ten years later,
what annual interest (or growth) rate (compounded annually) would you have obtained?
Ans : 4.81%

Solution:
FV=A*(1+r)^n
FV=80000
A=50000
n=10 years
So, 80000=50000*(1*r)^10
=> (1+r)^10 =(80000/50000)=1.6
=> (1+r)=(1.6)^(1/10)=1.0481
=> r=1.0481-1=0.0481 or 4.81%

9.How much would you have to deposit today to have $10,000 in five years at 6% interest
compounded quarterly?
Ans: 7,424.46

Solution :

FV=A*(1+r)^n
FV=10000
A= Amount Deposited (unknown)
n= 5 years * 4=20 quarters
r= 6/4=1.5% per quater
10000=A*(1.015^20)
A=10000/(1.015^20)=7,424.70

10.What is the present value of an offer of $15,000 one year from now if the opportunity cost
of capital (discount rate) is 12% per year nominal annual rate compounded monthly?
Ans : 13,311.74

Solution :

PV=A/(1+r)^n
A=15000
n= 12 months
r= 12/12=1%
PV=15000/(1.01^12)= 13,311.74

11. The difference between Compound Interest and Simple Interest on a certain sum of
money at 10 % per annum for 3 years is Rs. 930. Find the principal if it is known that the
interest is compounded annually.
Ans: 30000

Solution:

Here r=10%
n= 3 years
A=Unknown
FV (Simple Interest)= A*(1+n*r)=A*(1+3*0.10)=1.30A
FV (Compound Interest) =A*(1+r)^n=A(1+0.1)^3=1.331A
S0, 1.331A-1.30A=930
=> 0.031A=930
=>A=930/0.031=30,000
12. An automobile financier claims to be lending money at simple interest, but he includes the
interest every six months for calculating the principal. If he is charging an interest of 10%, the
effective rate of interest becomes:
Ans : 10.25%

Solution:

Lets assume , Loan amount=A=100

r= 10% per year=5% per half year
n= 1 ( one six month ) + 1 ( one six month )
FV after 6 months=A*(1+r*n) =100*(1+0.05)=105
Principal at the beginning of the next six months=105
FV at the end of the year=105*(1+0.05)=110.25
Total Interest Charged=110.25-100=10.25
So the effective rate of interest=10.25%

13. The simple interest on a sum of money in 5 years at 12 % per annum is Rs. 400 less than
the simple interest accrued on the same sum in 7 years at 10 % per annum. Find the sum.
Ans : 4000

Solution:

Let the amount = A

So , A*(1+0.10*7)-A*(1+0.12*5)=400
=> 1.70A-1.60A=400
=> 0.10A=400
=> A=400/0.10=4000

14. Aastha lent Rs. 5000 to Bahubali for 2 years and Rs. 3000 to Chinky for 4 years on simple
interest at the same rate of interest and received Rs. 2200 in all from both of them as interest.
The rate of interest per annum is:
Ans: 10%

Solution:

Let the Interest rate=r

=> 5000*(2r)+3000*(4r)=2200
=>10000r+12000r=2200
=>22000r=2200
=. r=(2200/22000)=0.10 or 10%

15. A sum of Rs. 1000 was lent to two people, one at the rate of 5% and other at the rate of
8 %. If the simple interest after one year is Rs. 62, find the sum lent at each rate.
Ans: 400, 600

Solution:

Let A was given to one person and (1000-A) was given to the other
=> 0.05*A+0.08*(1000-A)=62
=>-0.03A+80=62
=>-0.03A=62-80=-18
=>A=(-18)/(-0.03)=600
Other person given =1000-600=400

FINANCIAL MARKETS
Financial Markets deals in finance or money. There is a segment of
people/business/institution who have surplus money and would like to invest that money for
fair return. Similarly , there is segment of people/business/institution who are short on money
and would like to borrow money from some source. They are willing to bear the cost of such
borrowed money.

There are various types of financial institutions who act as intermediary to suck seekers of
money and lenders of money:

1. Commercial Banks - Governed by Banking Regulation Act, 1949. They can be Public ,
Private and Foreign (SBI, ICICI , Citi Bank , ANZ Grindlays)
2. Co-operative Banks-Governed by the Co-operative Societies Act,1965. (Punjab and
Maharashtra Co-op Bank, Saraswat Co-op Bank etc)
3. Non-Banking Financial Institutions - ( LIC,IDBI, SIDBI,NABARD etc)
4. NBFCs - These organizations are registered under the Companies Act, 1956 ( Power
Finance Corporation , Tata Capital Financial Services , Bajaj Finance , Cholomandalam
Finance etc )
5. FDI and FII : Foreign direct investment (FDI) is an investment in a business by an investor
from another country for which the foreign investor has control over the company purchased.
On the other hand, Foreign institutional investors (FIIs) are those institutional investors which
invest in the assets belonging to a different country other than that where these organizations
are based. The FDI flows into the primary market, while the FII flows into secondary
market.While FIIs are short-term investments, the FDI’s are long term investment.FII can
enter the stock market easily and also withdraw from it easily. But FDI cannot enter and exit
that easily.The Foreign Direct Investment is considered to be more stable than Foreign
Institutional Investor.

The money that flows from the depositors to the borrowers is dependent on many factors.
Some of them are :
a) GDP , Per capita income , Inequality (Ginni Coefficient)
b) Fiscal Policy of the Government - Taxation of Individuals and Corporate , rebate/benefit
for various investments.
c) Monetary Policy of the Central Bank(RBI) - Repo Rate/Reverse Repo rate , SLR, CRR
d) Financial literacy and Risk taking ability of the investors - Some people who have lot of
money might just deposit in the FD of a PSU Bank which gives 8% interest as he is not
willing to put that same money in Shares which may give him as high as 20%. Similarly
investment is also dependent on the liquidity of the asset. Many people shy away from
Investments which can’t be converted into cash immediately. Many financial products have
lock-in period , before one could liquidate that.

Financial Market can be defined into different types:

1. Capital Market and Money Market : When the investment is for a period more than one
year it is called Capital Market and when it is less than one year it is called Money Market.
Equity, Bond and Derivatives are products under Capital Market. On the other hand Treasury
Notes , Inter-bank call money market comes under Money market. Most of the Commercial
Banks have a range of products - Savings a/c , Current a/c , Fixed Deposits , Recurrent
Deposits , Public Provident Fund etc. A fixed deposit can have a period as short as 7days and
as large as 10 years. So some products of Banks will fall under Capital market and some other
under Money Market.

2. Primary Market and Secondary Market : Primary market is the first stage market and
Secondary market is a subsequent stage market. For example , when we buy a new car from a
dealer of a car maker , it is a primary market. But when we buy a pre-owned car from another
person/dealer , it is a secondary market. Similarly , when a company goes for an Initial Public
Offering (IPO) for equity it is called Primary market as the Investors will buy the shares for
the first time for the company.But when these shares are traded through Stock Exchanges
(Bombay Stock Exchange , National Stock Exchange and many Regional Stock Exchanges) ,
it is called Secondary Market. Transaction in the Secondary Market can also happen in the
Over The Counter(OTC) mode bypassing the formal Exchange system.

Financial Regulators : Regulation is necessary as the participants in the financial markets

deals with public money . There is always a chance of mismanagement , corruption and
breach of public trust. RBI , IRDA and SEBI are the three important regulators in the
Financial Markets. RBI monitors the Banks. IRDA regulates the Insurance Companies in both
Life and Non-Life (General Insurance) segment. SEBI regulates the activities of the
companies registered under Companies Act.

RBI Link: https://www.rbi.org.in/home.aspx

SEBI Link: https://www.sebi.gov.in/
IRDAI Link: https://www.irdai.gov.in/
NSE Link: https://www1.nseindia.com/
ET Link: https://economictimes.indiatimes.com/
(Students must look at each menu/sub-menu of the above Regulators , Stock Exchange and
Newspaper)

It must be mentioned that not all financial transactions (lending/borrowing/hedging etc) etc
happens through organized financial intermediaries. Many such transactions happen in the
unorganized sector , where there is all chances of exploitation and breach of agreements. For
example , rural areas farmers take loan from money lenders at an interest rate of 5% per
month which converts to 60% per year. Similar loan is available at commercial banks at
10-12% per year. The farmer approaches the moneylender for the followings reasons:
a) There is no bank near his house
b) Banks asks for security before giving loan
c) Complex procedure for loans at banks
Many times a small farmer may mortgage gold ornaments with the money lender to get a loan.
Recently launched Jan Dhan Yojna is an attempt to bring the poor into the banking domain
and eliminate these exploitative practices.

Financial Products : Most of the banks have broadly two kinds of products - Interest bearing
products and fee-based products. When banks receive deposits from investors , they are
obligated to pay interest to them as per the contract. Banks in turn give out these amounts to
borrowers at a higher interest rate , whether it is an individual who is taking a loan to buy a
car or a automobile manufacturer who wants to money to launch a new product. The
differential interest ( lending rate - Savings rate) is one of the major source of income of the
banks. Besides this , banks also provide fee based services like Letter of Credit, Bank
Guarantee, Underwriting , Merchant Banking , Issue management etc. Of late many banks are
also selling non-banking products like Insurance and Mutual Fund.

Most of the business houses in addition to bank financing also get money from the public
through equity and bond.

Equity : When a person invests money in equity , he has two sources of income - dividend
and capital gain. When a company makes profit and decides to distribute the profit (full/part) ,
the investor gets his share of profit which is called dividend.But many times , the company
many not distribute the profit as they have good projects where they can reinvest the profit.
So there is no guarantee that a share holder will get dividend every year. But , here it is
relevant to mention that there are two types of share holders - Common Share holder and
Preferred Share Holder. A Preferred Share holder is entitled to a dividend at a fixed
percentage , whether the company has made a profit or not. If the company is not in position
to pay in particular year , that dividend payable gets accumulated and carried forward to the
subsequent years for payment. It must be mentioned that Preferred Share Holders have the
first right of payment of Dividend. After they have got their dues , dividend is paid to the
Common Share Holders. Many of the shares are traded in exchanges and the investor can sell
the shares when it is selling at a higher price and earn good profit which is called Capital
Gain.

Bonds : Bonds are debt instruments and the investors becomes creditors of the Bond Issuer or
the company. Every Bond has a Face Value , Coupon Rate and Maturity Period. Lets say a
Bond could have Face Value-1000/- , Coupon Rate-8% Half Yearly Payment and Maturity-10
Years. In such a case , the investor will get 40/- every half year for ten years (total-20 times)
and at the maturity he will get back the initial 1000/-. Many times Government also issues
Bonds , which are called Treasury Bonds. Unlike the Corporate Bonds , such bonds are sold
at discount. No Interest is paid on the Face Value. For Example a 49-days Treasury Bond of
Rs1000/- might be selling at 950/-. An investor can buy the bond at 950/- and then get 1000/-
at maturity ,I.e. at the end of 49th day.

Derivatives: Derivatives are financial instruments that derive their value from some other
asset. This asset can be equity , bond , gold , commodity , index , interest rate , forex rate etc.
Investment in Derivative market is made for three reasons - hedging , speculation and
arbitrage. Hedging is to protect oneself from the volatility of the market. A person who wants
to buy a stock after one month doesn’t want the price to go up. A person who wants to sell a
stock after one month doesn’t want the price to go down. There are people who take over
such risk at a premium. They are called sellers and those who want the risk coverage are
called buyers.

FOREIGN INSTITUTIONAL INVESTOR (FII)

A foreign institutional investor (FII) is an investor or investment fund registered in a country

outside of the one in which it is investing. Institutional investors most notably include hedge
funds, insurance companies, pension funds, and mutual funds. The term is used most
commonly in India and refers to outside companies investing in the financial markets of India.

Countries with the highest volume of foreign institutional investments are those that have
developing economies. These types of economies provide investors with higher growth
potential than in mature economies. This is why these investors are most commonly found in
India, all of which must register with the Securities and Exchange Board of India to
participate in the market.

If, for example, a mutual fund in the United States sees an investment opportunity in an
Indian-based company, it can purchase the equity on the Indian public exchange and take a
long position in a high-growth stock. This also benefits domestic private investors who may
not be able to register with the Securities and Exchange Board of India. Instead, they can
invest in the mutual fund and take part in the high growth potential.

All FIIs are allowed to invest in India's primary and secondary capital markets only through
the country's portfolio investment scheme (PIS). This scheme allows FIIs to purchase shares
and debentures of Indian companies on the normal public exchanges in India.

However, there are many regulations included in the scheme. There is a ceiling for all FIIs
that states the max investment amount can only be 24% of the paid-up capital of the Indian
company receiving the investment. The max investment can be increased above 24% through
board approval and the passing of a special resolution. The ceiling is reduced to 20% of the
paid-up capital for investments in public sector banks.
The Reserve Bank of India monitors daily compliance with these ceilings for all foreign
institutional investments. It checks compliance by implementing cutoff points 2% below the
max investment amounts. This gives it a chance to caution the Indian company receiving the
investment before allowing the final 2% to be invested.

FOREIGN DIRECT INVESTMENT (FDI)

Foreign direct investment (FDI) is when a company takes controlling ownership in a business
entity in another country. With FDI, foreign companies are directly involved with day-to-day
operations in the other country. This means they aren’t just bringing money with them, but
also knowledge, skills and technology.

FDI is an important monetary source for India's economic development. Economic

liberalisation started in India in the wake of the 1991 crisis and since then, FDI has steadily
increased in the country. India, today is a part of top 100-club on Ease of Doing Business
(EoDB) and globally ranks number 1 in the greenfield FDI ranking.

Apart from being a critical driver of economic growth, foreign direct investment (FDI) is a
major source of non-debt financial resource for the economic development of India. Foreign
companies invest in India to take advantage of relatively lower wages, special investment
privileges such as tax exemptions, etc. For a country where foreign investments are being
made, it also means achieving technical know-how and generating employment.

The Indian government’s favourable policy regime and robust business environment have
ensured that foreign capital keeps flowing into the country. The government has taken many
initiatives in recent years such as relaxing FDI norms across sectors such as defence, PSU oil
refineries, telecom, power exchanges, and stock exchanges, among others.

During Q1 2019-20, India received the maximum FDI equity inflows from Singapore
(US$ 5.33 billion), followed by Mauritius (US$ 4.67 billion), Netherlands (US$ 1.35 billion),
USA (US$ 1.45 billion), and Japan (US$ 0.47 billion).

Some of the recent significant FDI announcements are as follows:

In October 2019, French oil and gas giant Total S.A. have acquired a 37.4 per cent stake in
Adani Gas Ltd for Rs 5,662 crore (US$ 810 million) making it the largest Foreign Direct
Investment (FDI) in India’s city gas distribution (CGD) sector.

In August 2019, Reliance Industries (RIL) announced one of India's biggest FDI deals, as
Saudi Aramco will buy a 20 per cent stake in Reliance's oil-to-chemicals (OTC) business at
an enterprise value of US$ 75 billion.

In August 2018, Bharti Airtel received approval of the Government of India for sale of 20 per
cent stake in its DTH arm to an America based private equity firm, Warburg Pincus, for
around $350 million.

In June 2018, Idea’s appeal for 100 per cent FDI was approved by Department of
Telecommunication (DoT) followed by its Indian merger with Vodafone making Vodafone
Idea the largest telecom operator in India.

In May 2018, Walmart acquired a 77 per cent stake in Flipkart for a consideration of US$ 16
billion.
In February 2018, Ikea announced its plans to invest up to Rs 4,000 crore (US$ 612 million)
in the state of Maharashtra to set up multi-format stores and experience centres.
Call Money Market: The call money market (CMM) the market where overnight (one day)
loans can be availed by banks to meet liquidity. Banks who seeks to avail liquidity
approaches the call market as borrowers and the ones who have excess liquidity participate
there as lenders. The CMM is functional from Monday to Friday. Banks can access CMM to
meet their reserve requirements (CRR and SLR) or to cover a sudden shortfall in cash on any
particular day.

Loans are availed through auction/negotiation. The auction is made on interest rate. Highest
bidder (who is ready to give higher interest rate) can avail the loan. Average interest rate in
the call market is called call rate. Dealing in call money is done through the electronic trading
platform called Negotiated Trading System (NDS). This call money rate is an important
variable for the RBI to assess the liquidity situation in the economy. The CMM is known as
the most sensitive segment of the financial system.

Since the participants are banks, the call money rate tells about the overall liquidity position
in the economy. Higher call rate indicates liquidity stress in the economy. In this case, the
RBI may follow up with liquidity support measures by through its monetary policy
instruments – cutting CRR or allowing more repos. Hence, the call money rate is taken as the
operating target of monetary policy.

Forex Market : The forex market is the market in which participants can buy, sell, exchange,
and speculate on currencies. The forex market is made up of banks, commercial companies,
central banks, investment management firms, hedge funds, and retail forex brokers and
investors.

The foreign exchange market is not dominated by a single market exchange, but a global
network of computers and brokers from around the world. Forex brokers act as market makers
as well, and may post bid and ask prices for a currency pair that differs from the most
competitive bid in the market.

The forex market is made up of two levels; the interbank market and the over-the-counter
(OTC) market. The interbank market is where large banks trade currencies for purposes such
as hedging, balance sheet adjustments, and on behalf of clients. The OTC market is where
individuals trade through online platforms and brokers.

Up until World War I, currencies were pegged to precious metals, such as gold and silver. But
the system collapsed and was replaced by the Bretton Woods agreement after the second
world war. That agreement resulted in the creation of three international organizations to
facilitate economic activity across the globe. They were the International Monetary Fund
(IMF), General Agreement on Tariffs and Trade (GATT), and the International Bank for
Reconstruction and Development (IBRD). The new system also replaced gold with the US
dollar as peg for international currencies. The US government promised to back up dollar
supplies with equivalent gold reserves.

But the Bretton Woods system became redundant in 1971, when US president Richard Nixon
announced “temporary” suspension of the dollar’s convertibility into gold. Currencies are
now free to choose their own peg and their value is determined by supply and demand in
international markets.

LIBOR: LIBOR, stands for London Interbank Offered Rate , is a set of daily average rates at
which banks say they borrow money from one another. Usually just called the LIBOR, these
benchmark rates are widely used as a base interest rates by financial institutions all over the
world. As such, the LIBOR rates impact almost all players in the financial world from student
loans holders, mortgage holders, and small business owners to corporations and the world’s
largest banks.

LIBOR offers daily average interest rates for five currencies (the U.S. dollar, euro, British
pound, Japanese yen, and Swiss franc) and seven lending periods (ranging from overnight to
12 months)

LIBOR represents the lowest borrowing rate among banks and big financial institutions.
Other rates are fixed on top of the LIBOR. This is often expressed as “LIBOR + X bps”
where, bps stands for basis point and X is the premium charged over and above the LIBOR
rate by the lender to the borrower. Thus any increase or decrease in the base rate (which is the
LIBOR rate) impacts contracts tied to LIBOR or based on it as a benchmark.

RISK

All investments involve some degree of risk. In finance, risk refers to the degree of
uncertainty and/or potential financial loss inherent in an investment decision. In general, as
investment risks rise, investors seek higher returns to compensate themselves for taking such
risks.

Every saving and investment product has different risks and returns. Differences include:
how readily investors can get their money when they need it, how fast their money will grow,
and how safe their money will be. In this section, we are going to talk about a number of risks
investors face. They include:

Business Risk
With a stock, you are purchasing a piece of ownership in a company. With a bond, you are
loaning money to a company. Returns from both of these investments require that that the
company stays in business. If a company goes bankrupt and its assets are liquidated, common
stockholders are the last in line to share in the proceeds. If there are assets, the company’s
bondholders will be paid first, then holders of preferred stock. If you are a common
stockholder, you get whatever is left, which may be nothing.

If you are purchasing an annuity make sure you consider the financial strength of the
insurance company issuing the annuity. You want to be sure that the company will still be
around, and financially sound, during your payout phase.

Volatility Risk
Even when companies aren’t in danger of failing, their stock price may fluctuate up or down.
Large company stocks as a group, for example, have lost money on average about one out of
every three years. Market fluctuations can be unnerving to some investors. A stock’s price
can be affected by factors inside the company, such as a faulty product, or by events the
company has no control over, such as political or market events.

Inflation Risk
Inflation is a general upward movement of prices. Inflation reduces purchasing power,
which is a risk for investors receiving a fixed rate of interest. The principal concern for
individuals investing in cash equivalents is that inflation will erode returns.

Interest Rate Risk

Interest rate changes can affect a bond’s value. If bonds are held to maturity the investor
will receive the face value, plus interest. If sold before maturity, the bond may be worth
more or less than the face value. Rising interest rates will make newly issued bonds more
appealing to investors because the newer bonds will have a higher rate of interest than older
ones. To sell an older bond with a lower interest rate, you might have to sell it at a discount.

Liquidity Risk
This refers to the risk that investors won’t find a market for their securities, potentially
preventing them from buying or selling when they want. This can be the case with the more
complicated investment products. It may also be the case with products that charge a
penalty for early withdrawal or liquidation such as a certificate of deposit (CD).

INTEREST RATE THEORIES

There are three important theories on Interest rate.

1. The Classical Theory
2. The Loanable Fund Theory
3. The Keynesian Theory

The Classical Theory

The classical theory of interest also known as the demand and supply theory was propounded
by the economists like Marshall and Fisher. According to this theory rate of interest is
determined by the intersection of demand and supply of savings. It is called the real theory of
interest in the sense that it explains the determination of interest by analyzing the real factors
like savings and investment. Therefore, classical economists maintained that interest is a price
paid for the supply of savings.
From the diagram we can see that there is an equilibrium at 8% interest rate. It may be seen
that higher the interest rate , higher will be the savings. On the other hand when higher is the
interest rate lower will be the investment.

The Loanable Fund Theory

According to Dennis Roberston and neo-classical economists this price or the rate of interest
is determined by the demand for and supply of loanable funds. The market for loanable funds
consists of arrangements and procedures to carry out transactions between people who want
to borrow money and people who want to lend money.

The Keynesian Theory

Keynes’ analysis concentrates on the demand for and supply of money as the determinants of
interest rate. According to Keynes, the rate of interest is purely “a monetary
phenomenon.” Interest is the price paid for borrowed funds. People like to keep cash with
them rather than investing cash in assets. Thus, there is a preference for liquid cash.

People, out of their income, intend to save a part. How much of their resources will be held in
the form of cash and how much will be spent depend upon what Keynes calls liquidity
preference, Cash being the most liquid asset, people prefer cash. And interest is the reward for
parting with liquidity.

This is what Keynes called ‘liquidity trap’. In Fig. 6.20, Dm is the liquidity preference curve.
At minimum rate of interest, r-min, the curve is perfectly elastic. However, there is a ceiling
of interest rate, say r-r-max, above which it cannot rise. Thus, interest rate fluctuates between
r-max and r-min.
The supply of money in a particular period depends upon the policy of the central bank of a
country. Money supply curve, SM, has been drawn perfectly inelastic as it is institutionally
given. According to Keynes, the rate of interest is determined by the demand for money and
the supply of money. OM is the total amount of money supplied by the central bank. At point
E, demand for money becomes equal to the supply of money.

INTEREST RATE & YIELD

Interest Rate

The interest rate on any loan is the percentage of the principle that a lender will charge
annually until the loan is repaid. In consumer lending, it is typically expressed as the annual
percentage rate (APR) of the loan.
As an example of interest rates, say you go into a bank to borrow $1,000 for one year to buy a
new bicycle, and the bank quotes you a 10% interest rate on your loan. In addition to paying
back the $1,000, you would pay another $100 in interest on the loan.

Yield

Yield refers to the return that an investor receives from an investment such as a stock or a
bond. It is usually reported as an annual figure. In bonds, as in any investment in debt, the
yield is comprised of payments of interest known as the coupon.

In stocks, the term yield does not refer to profit from the sale of shares. It indicates the return
in dividends for those who hold the shares. Dividends are the investor's share of the
company's quarterly profit.

For example, if PepsiCo (PEP) pays its shareholders a quarterly dividend of 50 cents and the
stock price is $50, the annual dividend yield would be 4%.

If the stock price doubles to $100 and the dividend remains the same, then the yield is
reduced to 2%.
In bonds, the yield is expressed as yield-to-maturity (YTM). The yield-to-maturity of a bond
is the total return that the bond's holder can expect to receive by the time the bond matures.
The yield is based on the interest rate that the bond issuer agrees to pay.
Nominal Interest and Real Interest

To avoid purchasing power erosion through inflation, investors consider the real interest rate,
rather than the nominal rate.For example, if the nominal interest rate offered on a three-year
deposit is 4% and the inflation rate over this period is 3%, the investor’s real rate of return is
1%. On the other hand, if the nominal interest rate is 2% in an environment of 3% annual
inflation, the investor’s purchasing power erodes by 1% per year.

The Fisher equation provides the link between nominal and real interest rates. To convert
from nominal interest rates to real interest rates, we use the following formula:

real interest rate ≈ nominal interest rate − inflation rate.

To find the real interest rate, we take the nominal interest rate and subtract the inflation rate.
For example, if a loan has a 12 percent interest rate and the inflation rate is 8 percent, then the
real return on that loan is 4 percent.

In calculating the real interest rate, we used the actual inflation rate. This is appropriate when
you wish to understand the real interest rate actually paid under a loan contract. But at the
time a loan agreement is made, the inflation rate that will occur in the future is not known
with certainty. Instead, the borrower and lender use their expectations of future inflation to
determine the interest rate on a loan.

From that perspective, we use the following formula:

contracted nominal interest rate ≈ real interest rate + expected inflation rate.
We use the term contracted nominal interest rate to make clear that this is the rate set at the
time of a loan agreement, not the realized real interest rate.

Imagine two individuals write a loan contract to borrow P dollars at a nominal interest rate
of i. This means that next year the amount to be repaid will be P × (1 + i). This is a standard
loan contract with a nominal interest rate of i.

Now imagine that the individuals decided to write a loan contract to guarantee a constant real
return (in terms of goods not dollars) denoted r. So the contract provides P this year in return
for being repaid (enough dollars to buy) (1 + r) units of real gross domestic product (real GDP)
next year. To repay this loan, the borrower gives the lender enough money to buy (1 + r) units
of real GDP for each unit of real GDP that is lent. So if the inflation rate is π, then the price
level has risen to P × (1 + π), so the repayment in dollars for a loan of P dollars would be P(1
+ r) × (1 + π).

Here (1 + π) is one plus the inflation rate. The inflation rate πt+1 is defined—as usual—as the
percentage change in the price level from period t to period t + 1.
πt+1 = (Pt+1 − Pt)/Pt.

If a period is one year, then the price level next year is equal to the price this year multiplied
by (1 + π):
Pt+1 = (1 + πt) × Pt.

The Fisher equation says that these two contracts should be equivalent:
(1 + i) = (1 + r) × (1 + π).
As an approximation, this equation implies
i ≈ r + π.
To see this, multiply out the right-hand side and subtract 1 from each side to obtain
i = r + π + rπ.
If r and π are small numbers, then rπ is a very small number and can safely be ignored. For
example, if r = 0.02 and π = 0.03, then rπ = 0.0006, and our approximation is about 99 percent
accurate.

YIELD CURVE

A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but
differing maturity dates. The slope of the yield curve gives an idea of future interest rate
changes and economic activity. There are three main types of yield curve shapes: normal
(upward sloping curve), inverted (downward sloping curve) and flat.

A normal yield curve is one in which longer maturity bonds have a higher yield compared to
shorter-term bonds due to the risks associated with time. An inverted yield curve is one in
which the shorter-term yields are higher than the longer-term yields, which can be a sign of an
upcoming recession. In a flat or humped yield curve, the shorter- and longer-term yields are
very close to each other, which is also a predictor of an economic transition.

Normal Yield Curve

A normal or up-sloped yield curve indicates yields on longer-term bonds may continue to rise,
responding to periods of economic expansion. When investors expect longer-maturity bond
yields to become even higher in the future, many would temporarily park their funds in
shorter-term securities in hopes of purchasing longer-term bonds later for higher yields.
In a rising interest rate environment, it is risky to have investments tied up in longer-term
bonds when their value has yet to decline as a result of higher yields over time. The
increasing temporary demand for shorter-term securities pushes their yields even lower,
setting in motion a steeper up-sloped normal yield curve.

Inverted Yield Curve

An inverted or down-sloped yield curve suggests yields on longer-term bonds may continue
to fall, corresponding to periods of economic recession. When investors expect
longer-maturity bond yields to become even lower in the future, many would purchase
longer-maturity bonds to lock in yields before they decrease further.
The increasing onset of demand for longer-maturity bonds and the lack of demand for
shorter-term securities lead to higher prices but lower yields on longer-maturity bonds, and
lower prices but higher yields on shorter-term securities, further inverting a down-sloped
yield curve.
Flat Yield Curve

A flat yield curve may arise from the normal or inverted yield curve, depending on changing
economic conditions. When the economy is transitioning from expansion to slower
development and even recession, yields on longer-maturity bonds tend to fall and yields on
shorter-term securities likely rise, inverting a normal yield curve into a flat yield curve.

When the economy is transitioning from recession to recovery and potential expansion, yields
on longer-maturity bonds are set to rise and yields on shorter-maturity securities are sure to
fall, tilting an inverted yield curve toward a flat yield curve.