Sr. No. Topic Page No.

Submitted by
1 Bond Basic 2 Divya Sampath
2 Valuing Debt 16 Falguni Bavishi
3 Interest Rate Arbitrage 24 Neha Karve
4 Hedge Funds 28 Abhishek Singh
5 Futures 30 Craig Rodrigues
6 Mergers & Acquisitions 33 Praveen Kumar
7 Understanding Financial Statements 36 Upasana Rana
8 Mutual Funds 40 Yuvraj Singh
9 Banking 43 Sushil Gautam
10 Cost of Capital 47 Mahyar
11 Financing Decisions 53 Ravi
12 Interest rate Swaps 55 Arijit
13 Working Capital Mmgt. 57 Kartik
14 Infrastructure projects 59 Anjan
15 Cash Flow 70 Vivek
16 Capital A/c Convertibility 76 Rishabh
17 Credit Risk Pallavi
18 Technical Analysis 86 Priya
19 Mutual Funds Omkar
20 Securitisation Divyesh
21 Strategic Cost Mgmt. Janavi
22 Microfinance Anand
23 Investment Decisions 108 Pramath
24 Risk & Return 112 Nikhil
25 Credit Default Swaps 114 Puncham
26 Infrastructure Project(IDFC) 130 Shiv
27 Capital Budgeting 135 Angad Kalra
28 Securitization 139 Rachita Maheshwari
29 Credit Derivatives 149 Shraddha Chhabria
30 Synthetic CDOs 163 Ebrahim Mukadam
31 Business Valuation 177 Yogesh Chandorkar

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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 asset-
backed 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

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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-basis-
point 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 interest-
rate 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:

14
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

15
begins with the spot interest rate, which is the rate for the shortest maturity, and extends
out in time, typically to 30 years.

16
 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%

17
 Year Ct PV(Ct)at 4.9% [PV(Ct)/V] Total value*Time
1 68.75 65.54 0.060 0.060
2 68.75 62.48 0.058 0.115
3 68.75 59.56 0.055 0.165
4 68.75 56.78 0.052 0.209
5 1068.75 841.39 0.775 3.875
V=1085.74 1.000 4.424yrs

Here, duration =[1*PV(C1)] + [2*PV(C2)] + [3*PV(C3)]

V V V

C1 C2 1,000 + C N
where, PV = + + ... +
(1 + r ) (1 + r )
1 2
(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 = 4.22
1.049

Note: 1 percentage-point change in interest rates leads to 4.22 percent change

in bond price.
Change in bond price = 4.22 * Change in interest rates
Its called as one factor model of bond returns.

3 WHAT ARE STEPS IN VALUING THE BOND?

Ans 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

18
 BOND VALUE VALUE
BOND VALUE = ASSUMING NO CHANCE OF PUT
OF DEFAULT 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 = ASSET VALUE VALUE OF CALL OPTION

ON ASSETS

4) Example of valuing a bond

Ans 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 04 05 06 07
115 115 115 115 1115

115 115 115 115 1,115

PV = + + + +
1.075 (1.075) 2
(1.075) (1.075) (1.075) 5
3 4

= $1,161.84
1600

1400

1200

1000

800

600

400

200

0
0 2 4 6 8 10 12 14

5 Year 9% Bond 1 Year 9% Bond

19
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) Example of debt and risk. Calculate the duration of the bonds.

Ans Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM:

Year CF PV@YTM % of Total PV % x Year

1 90 82.95 .081 0.081
2 90 76.45 .075 0.150
3 90 70.46 .069 0.207
4 90 64.94 .064 0.256
5 1090 724.90 .711 3.555
1019.70 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
lower costs
2) 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
evaluating the loan. While in corporate bonds issue, the information will be
widely disseminated.
3) In order to issue bonds. firms usually have to submit to being rated which is not

20
 required in the bank debts.

8) WHAT IS YEILD TO MATURITY? EXPLAIN WITH EXAMPLE.

Ans 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 Prob

1090 0.80 = 872.00
0 0.20 = 0 .
872.00 (expected CF )

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

Conversly - If on top of default risk, investors require an additional 2 percent market risk
premium, the price and YTM is as follows:

872
Value = = $785.59
1.11
1090
YTM = = 38.8%
785.59

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-

21
 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) SOME BOND TERMINOLOGY

Ans
 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

22
 • Straight Bond vs. Callable Bond

Value of
bond Straight bond

100

75 bond callable
at 100

50

25

Value of
straight bond
25 50 75 100 125 150

23
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

24
 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.

25
 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.

26
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

27
 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.

28
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.

32
 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).

35
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

36
 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) Current Ratio = Current Assets / Current Liabilities

b) Quick Ratio = Cash + Marketable Securities / Current Liabilities
c) Account Receivable Turnover = Sales / Avg Account Receivables
d) Inventory Turnover = Cost of Goods Sold / Avg Inventory
e) Account Payable Turnover = Purchases / Avg Account Payables
f) Total Assets Turnover = Cost of goods Sold / Avg Total Assets
g) 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) Gross profit margin = (Gross Profit / Sales)*100

b) Operating Profit Ratio = EBIT / Net Sales
c) Net Profit Ratio = EAIT / Net Sales
d) EPS = Net Profit available to equity holders / No. of Ordinary share o/s

8. Importance of Ratio Analysis

37
 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.

38
10. Du Pont Chart

Rate of return
on assets

EAT as percentage
of sales Multiplied by Assets Turnover

EAT Sales Sales Total Assets

/ /

Gross Profit = Sales

Fixed Assets
– Cost of goods sold

minus +

Expenses: selling
administrative Current Assets
interest

minus

Income tax

39
 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?

40
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 4-
6 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, long-
term 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.

43
 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?

44
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 Specified

31 period
1993 four quarters
1994 Three quarters
1995 onwards 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,

45
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 non-
performing 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.

47
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, Asset-
Liability 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 long-
term 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

48
 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 day-
to-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

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 oInformation 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.

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 “public-
private 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

66
 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

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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?

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 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 non-
cash 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

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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 cash-
manipulating 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

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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) Overdraft/ Cash Credit

b) Trust Receipt Loans( Importer’s Loan)
c) Bills payable
d) Short term loan
e) Long term loan
f) 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 Basis of Judgement

I Best Risk. No significant political or economic problems
II No problem is expected with sovereign risk, but bond may
trade at a discount
III Best developing country risk
IV Significant political & economic risks, lending should be
done only in special circumstances
V High Risk
VI 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)

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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:

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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 publicly-
traded 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

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 • 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.

7. What are reasons for issuing MBS?

There are many reasons for mortgage originators to finance their activities by issuing mortgage-
backed securities. Mortgage-backed securities
• 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.

8. 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 tax-
deferred 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 Particulars Traditional Approach S.C.M Analysis

1 Most useful way  In terms of products,
to analyze costs customers & functions
 Strongly internal focus
 Value added is a key
concept
 In terms of various stages of
overall value chain.
 Strongly external focus
 Value added is seen as
dangerously narrow concept

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 2 Objective of cost  Score keeping,  All 3 objectives present but cost
analysis attention directing, management systems change
problem solving with depending upon strategic
no regard to strategic positioning i.e. cost leadership or
concept. product differentiation

3 Cost behavior  Cost is function of  Cost is a function of strategic

output choices in terms of structural &
 Variable Cost executional cost drivers.
 Fixed Cost
 Step Cost
 Mixed Cost

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

Ans.

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 S.C.M

Value Chain Strategic Position Cost Driver

Analysis Analysis Analysis

Traditionally cost are

Cost leadership
Value Chain related to output
Vs. (Target Costing)
Value added Product Differentiation S.C.M- 2 types of
perspective by (Marketing cost cost drivers
management
accounting analysis)
Value Added concept
has 2 big problems:
(a) Starts too late
Structural Executional
(b) Stops too early

Scale
Scope Commitment of workforce
Experience T.Q.M
Technology Capacity utilisation
Complexity 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 Features
 Implies goal of increased market share even at the expense of short
1 Build term earnings.
 Pursued by business units with low market share in high-growth
industries
 E.g. Apple Computers’ Macintosh business, Monsanto’s biotechnology
business
2  It is geared to protect market share of business & its competitive
Hold 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
3 Harvest 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 Less formal Longer Formal

decision payback Shorter payback
3 Capital expenditure More emphasis on non- More emphasis on financial
evaluation financial data such as market data, cost efficiency, cash
share, efficient use of R&D flows etc.
budget etc.
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 Particulars Build Harvest

1 Role of budget Short term Control tool
planning tool
2 Influence of unit manager in High Low
preparing annual budget
3 Revision of budget Easy Difficult
4 Role of standard costs in assessing Low High
performance
5 Importance of flexible budget Low High
6 Frequency of feedback Less More
7 Budget Flexibility More Less
8 Importance of achieving budgeted Low High
targets

The incentive compensation system is described as follow w.r.t. the build and harvest
strategies

No Particulars Build Harvest

1 Percentage Compensation as High Low
bonus
2 Bonus Criteria More emphasis on More emphasis on
non-financial financial criteria
criteria
3 Bonus Determination More subjective More formula
based

4 Frequency of bonus payment Less frequent More 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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 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 non-
commerical 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 non-
bank 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˜non-
regulated 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-

107
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 money-
lenders 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 credit-
based 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 on-
lending 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

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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 follows-
a) 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.

• 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.

• 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?

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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 non-
transient 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 no-
default 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

126
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:

• 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:

• expansion of import and export wings at international airports

• building of new, integrated cargo and airfreight terminals

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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:

• 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.

• Foreign equity participation can be as high as 100%.

• 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.

• A renewable license period of 30 years has been set.

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

• 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-Operate-
Transfer (BOOT) scheme and a Own-Your-Wagon-Scheme (OYWS).

Thrust areas identified for improvements and expansion include:

• 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.

133
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:

• 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 Infrastructure Project Finance –

Telecommunication?

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

134
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. Explain NPV.
2. What are properties of the NPV rule and its limitations?
3. Explain IRR with its limitations.
4. What is NPV profile and what does it show?
5. Explain MIRR.
6. Explain Pay Back period method with its limitations.
7. What is Discounted Payback method?
8. What is ARR method? give its features and limitations.
9. 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 - Initial Investment

(1+r)t

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.

137
4. NPV profile is the plot of different values of NPV for different discounting rates.

IRR

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 = ∑ I + F

(1+r)t (1+r)n

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 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.

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 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 lower-
risk, 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

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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 non-
par 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

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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

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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, time-
consuming, 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.

SYNTHETIC CLO STRUCTURE

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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 dealer-
hedging 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) Market value based approach to valuation
(iv) 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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