Financial Engineering, Risk Management & Financial Institutions 9789351194781, 9789351194293

Table of contents :
Cover Page
Title Page
Copy Right Page
Dedication Page
Preface
About the Book
About the Authors
Acknowledgements
Brief Contents
Detailed Contents
Part I: Financial Engineering and Risk Management
Chapter 1: Introduction
Introduction
Role of Financial Engineer
Definitions of Financial Engineering
Distinction between Financial Engineering and Financial Management
Distinction between Financial Engineer and Financial Analyst
Environment of Financial Engineering
Scope of Financial Engineering
Factors Contributing to the Growth of Financial Engineering
Finnerty Classification
Internal and External Factors
Benefits of Financial Engineering
Central Problems of Financial Engineering
Securities Pricing
Risk Management
Portfolio Optimization
Branches of Financial Engineering
The Physical and Conceptual Tools
Conceptual Tools
Physical Tools
Financial Engineering Course and Career Opportunities
Career Opportunities
Conclusion
Keywords
Review Questions
References
Case Study
Chapter 2: Financial Innovation
Introduction
Examples of Innovative Financial Instruments
Need for Financial Innovation
Objectives of Financial Innovation
Review of Literature
Types of Innovation
1. Innovation for the Tax Planning
2. Facilitate Adaptive Changes in the Existing Financial Instruments
Theorems and Theories of Innovation in Financial Engineering
Modigliani-Miller Theorem11
Markowitz Theorem12
Garman and Kohlhagen (1983) Theorem13
Ross Theory of Arbitrage Price Theory (APT)
Models and Mechanism of Innovation in Financial Engineering
John D Finnerty Model
Richard Rol Model
The Arrow-Debreu Model15
Treynor, Sharpe, Linter & Mossin Model
Black and Scholes (1973)
Vasicek (1977) Model17
Genesis of Finance Theory and Financial Engineering
Pioneers of Finance Theory
Modern Portfolio Theory (MPT)
Arbitrage and Equilibrium Theory
Finance and the Firm
Empiricists and the Efficient Markets Hypothesis
Conclusion
Keywords
Review Questions
References
Case Study
Chapter 3: New Product Development
Introduction
Definition of ‘Financial Product’
Definition of NPD
Stages of New Product Development
Stage1: New Strategy Formulation
Stage 1a: Planning
Stage 2: Idea Generation
Stage 2a: Design and Prototype
Stage 3: Screening and Evaluation
Stage 4: Business Analysis
Stage 5: Concept Development and Feature Development
Stage 5a: Pilot Production and Production
Stage 6: Market Testing
Stage 7: Commercialization
Stage 7a: Distribution
Stage 7b: Sales and Marketing
Stage 7c: After-sales Service
Financial Instruments
Best Practices for NPD
Project Team Leadership
Communication among Members
Prototype Designs and Test Marketing
Commercialization of Ideas
Effective Learning from Previous Projects
Implementing Effective Career Development
Benchmarking
NPD Cycle
How to Face Future Challenges?
Conclusion
Keywords
Review Questions
References
Case Study
Chapter 4: Valuation of Equity Shares
Introduction
Valuation of Equities
Anticipated Rate of Return
One Period Valuation Model
Generalized Dividend Valuation Model
The Gordon Growth Model
Price Earnings Valuation Model
Walter’s Approach to Dividend Policy
Modigliani and Miller ( M-M) – Dividend Irrelevancy Model
Valuation of Preference Shares
Conclusion
Practical Problems
Practice Problems
Keywords
Review Questions
References
Case Study
Chapter 5: Equity Related Instruments
Introduction
Equity Related Instruments
Equity Index
Warrants
Characteristics of Warrants
Valuation of Warrants
Equity Options Equity Derivatives
Stock Market Index Futures
Single-stock Futures
Equity Basket Derivatives
Equity Swap
Equity Index Swaps
Rights Issue
Value of Rights
Underwriting
Call Option
Valuation of Options
Example
Subscription Right
Foreign-exchange Option
Conclusion
Practice Problems
Keywords
Review Questions
References
Case Study
Chapter 6: Debt Market and Valuation of Bonds
Introduction
Debt Market
Definition of Debt Market1
Features of Debt Market
Debt Market Instruments
Government Securities
Zero-coupon Bonds
Classification of Zero-coupon Bonds
Treasury Bonds
Treasury Bills
Strip Bond
Bond Duration
Public Sector Bonds
Private Sector Bonds
Fixed vs Floating Rate Bonds
Inflation Linked Bonds
Asset-backed Securities
Senior & Subordinated Bonds
Perpetual Bonds
Bearer Bond
Registered Bond
Build America Bonds (BABs)
Book-entry Bond
Lottery Bond
Serial Bond
Revenue Bond
Climate Bond
Bonds in Foreign Currencies
Bonds: at Par, at Discount, at Premium
Market Price of a Bond
Interest Rate
Yield Curve
Bonds Market
Definition of Bond
Features of Bonds
Issue Price
Maturity Date
Coupon Rate
Classification of Debenture/Bonds
Valuation of Redeemable Debentures/ Bonds
Valuation of Deep Discount Bonds (DDB)
Valuation of Perpetual Bonds (PD)/on-Redeemable Debentures
Calculation of the Present Value of the Bond’s Interest Payments
Calculation of the Present Value of the Bond’s Maturity Amount
Combining the Present Value of a Bond’s Interest and Maturity Amounts
Accrued Interest
Duration of Bond
Bond Issue and Redemption Methods
Holding Period Return (HPR) or Holding Period Yield (HPY)
Practical Problems with Solution
Practice Problems
Debenture–Calculation of NPV for New Issue
Economic Size of the Issue of Debentures
Glossary of Selected Financial Instruments
Debt instruments
Asset-backed Securities
Equity Instruments
Hedging Instruments
Keywords
Review Questions
References
Case Study
Appendix
Chapter 7: Management of Financial Risk
Introduction
Understanding ‘Risk’
Financial Distress
Financial Risk
Types of Risks
Categorization of the Risks
Market versus Firm-specific Risk
Operating versus Financial Risk
Continuous Risks versus Event Risk
Catastrophic Risk versus Smaller Risks
Un-diversifiable Risks
Diversifiable Risks
Principles of Managing Risk
Quantification of Financial Risk
By Non-financial Companies through Sensitivity Analysis
By Financial Companies through Gap Analysis
Risk Reduction Measures
Managing Financial Risk
Understand the Different Types of Risks
Determine the Level of Risk
Determine the Portfolio’s Risk Level
Reduction of Risk Through Diversification
Strategies of Financial Risk Management
Hedging
Portfolio Management
Asset Liability Management
Quantitative Risk Management
Tools Used to Manage Risk in International Finance
Risk-reward Ratio
Black-Scholes Formula
Conclusion
Practical Problems
Risk-return Measures, Risk Diversification
Practice Problems
Return Calculation
Risk-Standard Deviation, Expected Return & Beta
Keywords
Review Questions
References
Case Study
Chapter 8: Hedging Tools and Techniques
Introduction
Definition of Hedging
Hedge Ratio
Off setting Interest Rate & Commodities Risk
The Risk to Be Hedged
Measuring Risk
Selection of Appropriate Hedge Strategy
Various Instruments of Hedging
Interest Rate Volatility
Exchange Rate Volatility
Commodity Price Volatility
Forward Contracts
Positions Long Position & Short Position
Hedging with Forwards
Futures Contracts
Financial Futures
SWAPS
Interest Rate Swap
Types of Swaps
Option Contracts
Seller’s Obligation
Hedging with Options
Payoff Profiles: Calls Payoff Profiles: Puts
Hedging with Options: Hedging Exchange Rate Risk with Options
Other Kinds of Hedging
Netting
Securitization
Insurance
Derivatives Definition2
Risk Diversification (Portfolio Management)
Hedging and Correlation
Tips & Techniques for Managing Risk
Factors Affecting Interest Rates
Exchange Rate Risk
Commodity Price Risk
Hedging & Value of Firm
The Costs of Hedging
Explicit Costs
Implicit Costs
Hedging & Financing Choices of Firm
Hedging through Lookback Option & Collateralization
Lookback Option
Exotic Option
American Option
European Option
Collateralization or Asset-backed Securitization
Additional Collateral
Building Block Approach
Time-line Cash Flow Method
Arithmetic Approach
Some Other Examples of Building Block Approach
Conclusion
Keywords
Review Questions
References
Case Study
Chapter 9: Asset Liability Management
Introduction
Objectives of Asset Liability Management
Liquidity Risk Management
Interest Rate Risk Management
Currency Risk Management
Classification of Assets
1. Gross Working Capital
2. Net Working Capital
3. Permanent Working Capital
4. Temporary Working Capital
TOOLS
Gap Analysis
Value at Risk (VaR)
Definition of Value At Risk ‘VaR’
Measuring Value at Risk
Variance-covariance Method
Simulation
Management of Fixed Assets and Current Assets
Management of Cash
Motives for Holding Cash
Liquidity Management in Banks
Asset-liability Management System in India
ALM Information Systems
ALM Organisation & Management
Procedure
Composition of ALCO
Three-tier Organizational Set-up for ALM Implementation
Committee of Directors
ALM process
Liquidity Risk Management
Currency Risk
Interest Rate Risk (IRR)
Classification of Components of Assets and Liabilities
Quality of Assets
1. Liquidity
2. Risk
Conclusion
Keywords
Review Questions
References
Case Study
Appendix
Chapter 10: Portfolio Considerations in Risk Management
Introduction
Definition of Portfolio
Diversification of Risk
Markowitz Theorem3
Measuring Risk
Calculation of Correlation between Two Assets
Nature of Concave Curve
Measuring the Portfolio Variance and Diversification
Optimal Risky Portfolios in Case of Two Risky Assets and a Risk-Free Asset
Risk Free Assets
Risky AssetsTobin’s Separation Theorem
Portfolio Optimization in Practice
Conclusion
Practice Problems
Keywords
Review Questions
References
Case Study
Chapter 11: Credit Risk Management
Introduction
Definition of Credit Risk
The Components of Credit Risk
Forms of Credit Risk
Building Blocks of CRM
Strategy and Policy
Organisational Structure
Operations/Systems
Credit Risk Management Framework
Policy Framework
Credit Risk Rating Framework
Credit Risk Limits
Credit Risk Modeling
1. Altman’s Z Score Model
2. Credit Metrics Model
3. Value at Risk Model
4. KMV Model
Risk Adjusted Return on Capital (RAROC)
Credit Risk Mitigation
Credit Audit
Credit Risk Mitigants as Per Basel 2 Accord
Recommendations of BASEL II
Credit Risk Mitigants Used by Different Banks
1. Collaterisation
Collateral Agreement
2. Guarantees
3. Break Trade Laws
4. Escrow Account
5. Insurance
6. Securitisation
7. Equator Principles*
Application of Equator Principle to Indian Banks
8. Credit Derivative
Types of Credit Derivatives
The Benefits Associated with Credit Derivatives
Growth of Credit Derivatives in India
9. Clearing Corporation of India Limited (CCIL)
Collateralised Borrowing and Lending Obligation (CBLO) Trading System
Forex Trading System
10. Netting
Types of Netting
Principles for the Management of Credit Risk1
Conclusion
Keywords
Review Questions
Appendix
Chapter 12: Operational Risk Management
Introduction
Literature Review
Policies Regarding the Operational Risk Management
Procedures to Administrate the Operational Risk
Benefits of Operational Risk Management
Frame of Operational Risk
Different Types of Operational Risks
The Fraud Risk
Reputation Risk
Liquidity Risk
The Risk of Losing the Control
Evaluation Stages of Operational Risk
Determinant Factors for the Operational Risk
Operational Risk Categories Basel Committee
Banking Risk Management
Process of Operational Risk Management
Conclusion
Keywords
Review Questions
References
Part II: Financial Institutions
Chapter 13: Financial Institutions
Introduction
Classification of Financial Institutions
(i) Term-lending Institutions
(ii) Refinance Institutions
(iii) Investment Institutions
(iv) State/Regional Level Institutions
(v) Housing Finance Companies
India’s Banking System
Public Sector Involvement in the Indian Financial System
Weaknesses in the Indian Financial System
Genesis of Regulatory Initiatives
Stock Exchanges
Clearing Corporation
Depository
Role of SEBI Regulating Mutual Funds
Role of Association of Mutual Funds in India (AMFI)
AMFI Guidelines & Norms for Intermediaries (“AGNI”)
Definitions of Financial Institution
Regulatory Framework of NBFC’s
NBFC under Acceptance of Public Deposits (Reserve Bank) Directions, 1998 (APD Directions)
Own Funds vs Net Owned Fund
Deposit vs Public Deposit
Rates of Interest
Conclusion
Keywords
Review Questions
Case Study
Chapter 14: Financial Intermediaries
Introduction
Underwriting
SEBI Guidelines
Underwriters
Registration
Code of Conduct for Underwriters
General Responsibilities
Compliance Officer
Power to Call for Information
Inspection and Disciplinary Proceedings
Action
Reasons for Devolvement
SEBI’s Model Underwriting Agreement
Registrar to Issue or Issue House
Appointment of Registrars
Conditions of Registration
General Obligations and Responsibilities
Books of Account/Record/Documents
Agreement with Issuing Companies
Inspection
Portfolio Managers
Procedure for Registration
Conditions of Registration
General Obligations of a Portfolio Manager
Code of Conduct
Contract with Clients
General Responsibilities of a Portfolio Manager
Maintenance of Books of Accounts/Records
Reports to be Furnished to the Clients
Disclosures to the SEBI
Appointment of Compliance Officer
Conclusion
Keywords
Review Questions
Case Study
Chapter 15: The Banking Institutions
Introduction
Role of Banking System in Economic Development
Development of Financial Infrastructure
Capital Formation
Entrepreneurial Development
Consumption, Production and Distribution of Goods and Services
Helping the Government
Recent Major Developments of the Banking Sector
Shift from Class to Mass Banking
Future Outlook of the Banks
Credit Risk Management (CRM)
Banking Technology Management
Technology Infusion and Upgradation Challenges
Technology Impact on Customers
Diversification
Public Sector Banks
New Private Banks
Profiles a Select Commercial Banks
State Bank of India Profile
Profile of ICICI Bank
Andhra Bank Profile
Andhra Bank
Performance Highlights for December 2013
Total Business
Income
Profit
Important Ratios
Asset Quality
Delivery Channels
Priority Sector
Agriculture
M S M E
Retail Credit
Advances to Micro & Small Enterprises
Weaker Section Lending
Credit to Minority Communities
Credit to Women
Self Help Groups
Integration of Land Records – Bhoomi Project
Agri Business & Agri Counselling Centers
Financial Inclusion
Direct Benefit Transfer (DBT) & Direct Benefit Transfer for LPG (DBTL) Scheme Implemenation.
Andhra Bank Rural Development Trust
Financial Literacy and Credut Counselling Centres
New Initiatives
Awards & Accolades
Conclusion
Keywords
Review Questions
Case Study
Appendix
Chapter 16: Financial Services
Venture Capital
Venture Capital Fund Operations
Structure of the Funds
Compensation
Raising Substantial Venture Capital
Venture Capital and Development
Venture Capital Fund
Factoring
Factoring Procedure
Differences from Bank Loans
Factors
Credit Rating
Credit Rating Agencies
Registration of Credit Rating Agencies
General Obligations of Credit Rating Agencies
Conclusion
Keywords
Review Questions
Case Study
Chapter 17: The Non-banking Financial Institutions (NBFI)
Investment Banking Companies (IBC)
Rules of Investment Company
Non-banking Financial Company (NBFC)
Registration Process
Different Types/Categories of NBFCS Registered with RBI
Requirements for Registration with RBI
Procedure for Application to the Reserve Bank for Registration
Definitions of ‘Deposit’ and ‘Public Deposit’
Regulation of Investment Companies by RBI
Core Investment Companies (CICs)
Group Company
Loan Company (LC)/Mortgage Guarantee Compny
Asset Finance Company (AFC)
The Regulatory and Supervisory Objective
Hire Purchase Financing
Lease Financing
Meaning of Lease Financing
Terms of a Lease
Types of Lease Agreements
Leasing of Real Property
Leasing of Tangible Personal Property
Private Property Rental
Commercial Leasehold
Advantages of Commercial Leasing
Disadvantages of Commercial Leasing
Housing Finance: Regulations & Guidelines by RBI
A. Direct Housing Finance
B. Indirect Housing Finance
Mutual Benefit Finance Companies (NIDHIs)
Residury Non-bank Finance Companies
Conclusion
Keywords
Review Questions
Case Study
Chapter 18: Insurance Industry in India
Introduction
Meaning and Definition of Insurance
Need for Insurance
Benefits of Insurance
Insurance as Investment
Insurance Sector in India
Market Size
Key Investments
Government Initiatives
Road Ahead
Life Insurance Corporation of India
Mobilization of Savings
Nation Building Activities
General Insurance
Overview of Business: LIC of India
Public Relations and Publicity Communication
Policy Lapses
List of Various Policies Introduced by LIC
Endowment Plans
Money Back Plans
Whole Life Plans
Health Plans
Children Plans
Pension Plans
Term Assurance Plans
Special Plans
Privatisation of L.I.C: Impact of Reforms
Myths of Privatization
Salient Features of IRDA Act 1999
Far Reaching Implications of Globalization
Life Insurance Corporation in International Scenario
Data Analysis
Potential Market
Conclusion
Keywords
Review Questions
Case Study
Chapter 19: Merchant Banking
Introduction
Categories of Merchant Bankers
Merchant Banker’s Activities Specified by SEBI
Role & Functions of Merchant Banker
Responsibilities of Lead Managers
Goverment Policy on Merchant Banking
Merchant Banking Institutions
Regulatory Mechanism
SEBI Criteria for Fit and Proper Person Regulation
Disqualfications
Conditions of Registration
Disclosure to the SEBI
Code of Conduct for Merchant Bankers
Restriction on Business
Compliance Officer
Procedure for Inspection
Action in Case of Default
Default by Merchant Bankers and Penalty Points
General Defaults
Minor Defaults
Major Defaults
Serious Defaults
Default in Prospectus
Over the Counter Exchange India (OTCEI): Eligibility Norms
Pricing Norms
Submission of Documents
Underwriters
Bankers to an Issue
Appointment of Bankers to Issue
Conclusion
Keywords
Review Questions
Appendix
Case Study
Terminology
Questions
Index

Citation preview

FINANCIAL ENGINEERING, RISK MANAGEMENT & FINANCIAL INSTITUTIONS

Dr. S.S. Prasada Rao & Dr. G. V. Satya Sekhar

Ideas for Tomorrow!

© Copyright 2014 by the Authors The book may not be duplicated in any way without the express written consent of the publisher, except in the form of brief excerpts or quotations for the purpose of the review. The information contained herein is for the personal use of the reader and must not be incorporated in any commercial programmes, other books, databases, or any kind of software without written consent of the publisher. Making copies of this book or any portion thereof for any purpose other than your own is a violation of copyright laws. Limits of Liability/ Disclaimer of Warranty The authors and publishers have used their best efforts in preparing this book. The authors make no representation or warranties with respect to the accuracy or completeness of the content of this book, and specifically disclaims any implied warranties of merchantability or fitness for any particular purpose. There are no warranties which extend beyond the description contained in this paragraph. No warranty may be created or extended by sales representatives or written sales materials. The accuracy and completeness of the information provided herein and the opinion stated herein are not guaranteed and warranted to provide any particular results, and the advice and strategies contained herein may not be suitable for every individual. Neither Biztantra (Dreamtech Press) nor the authors shall be liable for any loss of profit or any commercial damages, including but not limited to special, incidental, consequential, or other damages. Trademarks All brand names and product names used in this book are trademarks, registered trademarks, or trade names of their respective holders. Dreamtech Press is not associated with any product or vendor mentioned in this book.

ISBN: 978-93-5119-429-3 ISBN: 978-93-5119-478-1 (ebk) Note: CD content is not a part of eBOOK

Dedicated to

Our Wonderful Parents . .

Financial engineering creates financial instruments issued by financial institutions on a continual basis. When many drawbacks are found in the existing instruments, new instruments are engineered to replace or take over from the existing financial instruments. When a product/ service/contract is engineered before a need for the engineered features is felt, it is a hard sale. It takes quite a long time for the product to come into extensive use in the financial markets. A financial engineer is a person engaged in the practice of designing financial products. Financial Engineers require a broad but specific knowledge of financial instruments and markets, accounting and tax rules, and information technology. Financial Engineer must always try to maximize profits as well as maximize wealth of share holders of the corporate entity. Hence, he needs a deep understanding of both quantitative analytical tools and of the financial industry to do well in their field. Financial engineer’s goal is to control financial risk by diversifying combinations of portfolios. Financial institutions issue financial instruments to generate finance from investors who are always worried about risk and returns. Hence, this book is intended to understand the fundamentals issues of financial engineering, risk and financial institutions. The subject of ‘Financial engineering’ is intended to solve financial problems by using mathematical techniques and engineering principles to solve financial problems. Whereas, the subject of ‘Financial Management’ deals with four important decisions viz., investment decision, financing decision, liquidity decision and profitability decision, which are core decisions of any business management. The main objective of this book is to focus on elements of financial engineering, risk management and the role of risk management in financial institutions. Hence, it deals with various important issues like: valuation of equities, valuation of debt, hedging strategies, asset liability management and operational risk management.

Dr. S.S. Prasada Rao, Dr. G.V. Satya Sekhar

This book is divided into two parts. Part-I consists of 12 chapters relating to Financial Engineering and part-2 consists of 6 chapters relating to Financial Institutions. PART-I: The first chapter deals with introduction to the subject ‘Financial Engineering’, which involves the design, the development and the implementation of innovative financial instruments. It also discusses the processes, and the formulation of creative solutions to problems in finance. Hence, the study of ‘Financial Engineering’ that leads to creative financial solutions may involve a new customized financial instrument or a new financial instruments or security. The second chapter deals with ‘Financial Innovation’, which is an essential force motivating the financial system toward greater economic competence with considerable economic advantage accruing from the changes over time. In the process of creating a new financial product, a financial engineer needs to acquire knowledge of optimization and financial modeling techniques besides basic theory of financial management. The third chapter is intended to focus on the process of ‘New Product Development’ in general, and relating to financial products in particular. Financial markets are changing quicker now than in any other time in history. Hence, the present financial market needs are stimulating technological development in product. It is therefore necessary that companies should have effective and efficient new product development (NPD) skills to improve their competitive position and seek more investors. Financial institutions should let their NPD team focus on developing new products to keep up with the changing needs of the financial market. The fourth chapter deals with ‘Valuation of Equity Shares’. Every corporate entity gets capital in the form of ‘equity’ and ‘debt’. The word ‘Equity’ implies that equity stockholders have an equity stake in the company. An equity security is a share in the ‘equity share capital’ of a company. The holder of equity is a shareholder, owning a share, or fractional part of the issuer. Unlike debt securities, which typically require regular payments to the holder, equity securities are not entitled to any payment. Equity also enjoys the right to profits and capital gain.

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The fifth chapter is intended to understand various issues relating to ‘Equity Related Instruments’. It also deals with valuation of equity related issues like rights, exrights, options and warrants. The sixth chapter helps to understand debt market and valuation of Bonds. Every corporate entity acquires in the form of equity share capital and debt capital. Debt capital is raised through issue of bonds or debenture, which can be raised from ‘Debt Market’. The seventh chapter deals with management of risk relating to a corporate entity. Although financial risk has increased significantly in recent years, risk and risk management are very old issues. The result of increasingly global markets is that risk may originate with events thousands of miles away that have nothing to do with the domestic market. The economic climate and markets can be affected very quickly by changes in exchange rates, interest rates, and commodity prices. As a result, it is important to ensure that financial risks are identified and managed appropriately. The eighth chapter is allotted for discussing ‘Hedging Tools and Techniques’. Hedging is an investment technique designed to offset a potential loss on one investment by purchasing a second investment that you expect to perform in the opposite way. For example, you might sell short one stock, expecting its price to drop. At the same time, you might buy a call option on the same stock as insurance against a large increase in value. A strategy designed to reduce investment risk using call options, put options, shortselling, or futures contracts, a hedge can help lock in profits. Its purpose is to reduce the volatility of a portfolio by reducing the risk of loss. The ninth chapter considers ‘Asset Liability Management’, which is nothing but maintaining liabilities with sufficient assets. Excess of assets over liabilities will lead to under utilization, otherwise excess of liabilities over assets leads to deficit financing. Asset liability management is an approach that provides institutions with protection that makes such risk acceptable. Assetliability management models enable institutions to measure and monitor risk, and provide suitable strategies for their management. The tenth chapter discusses the importance of portfolio diversification and risk reduction. It also deals with various issues relating to risky assets and risk free assets. Any corporate entity or individual may opt to invest resources available with them according to the various avenues available and their willingness to take risk. However the investments can be classified into risk premium assets and risk less assets. This chapter reminds the lesson ‘slow and steady wins the race’, which is true for stock markets also. The eleventh chapter deals with various fundamental aspects of ‘Credit Risk Management’ in the corporate entities. Credit risk encompasses both default risk and market risk. Default risk is the objective assessment of the likelihood that counterparty will default. Market risk measures the financial loss that will be experienced should the client default. Credit risk includes not only the current replacement value but also the potential loss from default.

About the Book

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The twelfth chapter is intended to help understand the role of banks, which can manage the banking risks only if they admit the strategic role of administrating the risk, if they use the paradigm analyzemanagement in order to increase the efficiency, if they adopt precise measures to adjust the performance to risk and, of course, if they will create mechanisms to report performance. Nowadays, a lot of companies differentiate between the risks that can be controlled and the ones that don’t. The controlled risks are the risks where the banks’ activities can influence the result and they can be covered normally, without the need of a third party. The uncontrolled risks are those risks that can’t be internally controlled by the bank. They can be covered against natural catastrophes through insurance, from an insurance company, a third party. PART-II Chapter thirteen studies the various financial institutions that have traditionally been the major source of long-term funds for the economy in line with the development objective of the state. A wide variety of Financial Institutions (FIs) emerged over the years. While most of them extend direct finance, some also extend indirect finance and still some others extend largely refinance. FIs can be broadly categorized as all-India or state level institutions depending on the geographical coverage of their operation. Chapter Fourteen deals with the role of various intermediaries like underwriters, registrars and portfolio managers. It also focuses on the framework of inspection, disciplinary proceedings and action. In case of default the SEBI is broadly on the same pattern as applicable to lead managers. Bankers to an issue are engaged in activities such as acceptance of applications along with application money from the investors in respect of issues of capital and refund of application money. Chapter fifteen explains the role of banking in economic development, the emerging trends in banking activities, future outlook of banking and banker and customer relationship in brief. The ongoing economic reforms initiated in India during 1990s have led to relaxation of controls and increased customer service in terms of quality and quantity. This is due to the process of economic liberalization, privatization and globalization, information technology, changing customer expectations and increasing competition that posed a challenge to the existing banking scenario. Chapter sixteen helps in the understanding of the concept of Venture capital, which is a type of private equity capital typically provided by professional, outside investors to new, high-potentialgrowth companies in the interest of taking the company to an IPO or trade sale of the business. Venture capital investments are generally made as cash in exchange for shares in the invested company. Chapter seventeen discusses the investment banking that may involve subscribing investors to a security issuance, coordinating with bidders, or negotiating with a merger target. Other terms for the investment banking division include Mergers and Acquisitions (M&A) and corporate finance.

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The Investment Banking Division (IBD) is generally divided into industry coverage and product coverage groups. Industry coverage groups focus on a specific industry such as healthcare, industrials, or technology, and maintain relationships with corporations within the industry to bring in business for a bank. Chapter eighteen studies the Insurance sector. Insurance is basically a cooperative endeavor. It is a noble portfolio where in assurance is offered against contingencies unforeseen and / or fortuitous. The subject matter assurances may relate to life of non-life matters. In both the cases, insurance mitigates the hardships caused to individuals and through them to society. This helps in fulfilling a social obligation which results in keeping the economy sound. Insurance and social well being for social economy are therefore inter woven – flourish of one leads to the flourish of the other and vice versa. Chapter nineteen examines the importance of merchant banking. Merchant banking consisted initially of merchants who assisted in financing the transactions of other merchants in addition to their own trade. Merchant banks serve a dual role within the financial sector. SEBI envisages mandatory role for merchant banks in exercising due diligence apart from issue management, in buy-backs and public offer in takeover bids. Their underwriting and corporate financial services are all free rather than fund based and their significance is not reflected in their total assets in industry. Terminology provides explanations of Important Financial Instruments. Questions are given to let the student learn about Objective Type Questions, and Model Question Papers for their exams. Index at the end of the book helps students trace important Topics from inside the book.

Detailed Contents

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Dr. S.S. Prasada Rao is currently Director of Hyderabad Business School (HBS), GITAM University, Hyderabad Campus. Earlier, he worked as Professor in the area of Accounting and Finance at the GITAM Institute of Management and held many administrative positions including, Director - GITAM Centre for Distance Learning, Director - Internal Quality Assurance Cell (IQAC), Founder Coordinator of BBA (Honors) Programme, Member Secretary of Autonomous Undergraduate Management Programme in GITAM University, Visakhapatnam. He is M.Com; MBA, M.Phil; FDP (IIMA); Ph.D. He has been in teaching, research, training and consulting for the past twenty years. His teaching interests include Management Accounting, Insurance Management, Financial Management, Strategic Cost Management, Corporate Valuation, Mergers and Acquisitions. He served as consulting trainer for ILO-IPEC AP State Based Project on Elimination of Child Labor, Principal researcher for NTPC – Singrauli for Customer/Vendor/Employee and Society Survey. He has been associated with All India Management Association, Indian Society for Training and Development, Hyderabad Management Association and National HRD Network for the past several years. He has varied research interests and has several research papers in the areas of Banking, Insurance and Financial Services. He has also presented several research papers in many international and national conferences. He is also on the editorial board of GITAM Journal of Management and reviewed several text books in Accounting and Financial Management. He also serves as a member of academic committees of many management schools in India. Dr. G. V. Satya Sekhar, M.Com, MBA, M.Phil, Ph.D, Asst. Professor, Department of Finance, GITAM Institute of Management, GITAM University, Visakhapatnam, has 17 years of teaching and research experience at Post Graduate level. Besides this present book he has authored books on Management Information Systems; Managerial Economics; Business Policy and Strategic Management, Performance Appraisal of Indian Mutual Funds and Working Capital Management.

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He has contributed lessons to the study material of ‘Executive MBA Programme’ of Andhra University, Visakhapatnam and also study material published by Centre for Distance Learning, GITAM University. He has participated and presented papers in various national and international seminars. So far he has published 30 articles in various national and international reputed journals. He is a member of editorial advisory board of ‘Applied Research in Higher Education’ (ISSN 1758-1184), an official Journal of International Higher Education Teaching and Learning Association & Institute for Meaning-Centered Education, USA. He is also reviewer board member of ‘International Journal of Business Research and Management’, ISSN 21802165, published by CSC Journals, Kualalumpur, Malaysia. He is also Editorial Board Member, Independent Journal of Management and Production, ISSN: 2236-269X(online), Chief Editor, Dn. Paulo Cesar Chagas Rodrigues, Insituto Federal de Educação, Ciência e Tecnologia de São Paulo Campus Avaré, Universidade Estadual Paulista (UNESP), Campus Guaratinguetá, Brazil, and Reviewer of Journal of Risk Finance, ISSN: 1526-5943, published by Emerald Insight.

Detailed Contents

xiii

We would like to convey our regards to Dr. M.V.V.S. Murthi, President, GITAM University, Viskhapatnam, for appointing us in GITAM University. Our sincere thanks are due to Prof. G. Subrahmanyam, Vice-Chancellor, Prof. D. Harinarayana, Pro-Vice chancellor, Prof. Potha Raju, Registrar, and GITAM University and to Prof. K. Siva Rama Krishna, Dean and Principal, GITAM Institute of Management, who always encouraged us to go ahead. Our thanks are due to Prof. A. Narasimha Rao, Editor and Professor in Dept of Commerce and Management Studies, Andhra University, Visakhapatnam, for his guidance in preparing study material. We also express our sincere gratitude to publisher Mr. Rahul Gupta, Chief Editor Mr. Yoginder Singh and the editorial team of Biztantra, without whose help we would not have been able to complete this book. Finally, we express our heartfelt thanks are due to our loving parents and our family members for their patience and sacrifice, which helped us in successful completion of this book.

Dr. S.S. Prasada Rao, Dr. G.V. Satya Sekhar

Preface About the Book About the Authors Acknowledgements

v vii xi xiii

PART I: FINANCIAL ENGINEERING & RISK MANAGEMENT

1

CHAPTER 1: INTRODUCTION

3

CHAPTER 2: FINANCIAL INNOVATION

21

CHAPTER 3: NEW PRODUCT DEVELOPMENT

37

CHAPTER 4: VALUATION OF EQUITY SHARES

53

CHAPTER 5: EQUITY RELATED INSTRUMENTS

69

CHAPTER 6: DEBT MARKETS AND VALUATION OF BONDS

85

CHAPTER 7: MANAGEMENT OF FINANCIAL RISK

127

CHAPTER 8: HEDGING TOOLS AND TECHNIQUES

149

CHAPTER 9: ASSET LIABILITY MANAGEMENT

177

CHAPTER 10: PORTFOLIO CONSIDERATIONS IN RISK MANAGEMENT

213

xvi

Financial Engineering, Risk Management & Financial Institutions

CHAPTER 11: CREDIT RISK MANAGEMENT

227

CHAPTER 12: OPERATIONAL RISK MANAGEMENT

263

PART II: FINANCIAL INSTITUTIONS

277

CHAPTER 13: FINANCIAL INSTITUTIONS

279

CHAPTER 14: FINANCIAL INTERMEDIARIES

305

CHAPTER 15: THE BANKING INSTITUTIONS

327

CHAPTER 16: FINANCIAL SERVICES

371

CHAPTER 17: THE NON-BANKING FINANCIAL INSTITUTIONS (NBFI)

395

CHAPTER 18: INSURANCE INDUSTRY IN INDIA

441

CHAPTER 19: MERCHANT BANKING

467

TERMINOLOY

493

QUESTIONS

495

INDEX

505

Detailed Contents

Preface About the Book About the Authors Acknowledgements

PART I: FINANCIAL ENGINEERING

xvii

v vii xi xiii

AND

RISK MANAGEMENT

CHAPTER 1: INTRODUCTION Introduction Role of Financial Engineer Definitions of Financial Engineering Distinction between Financial Engineering and Financial Management Distinction between Financial Engineer Versus Financial Analyst Environment of Financial Engineering Scope of Financial Engineering Factors Contributing to the Growth of Financial Engineering Finnerty Classification Internal and External Factors Benefits of Financial Engineering Central Problems of Financial Engineering Securities Pricing Risk Management Portfolio Optimization Branches of Financial Engineering The Physical and Conceptual Tools Conceptual Tools Physical Tools Financial Engineering Course and Career Opportunities Career Opportunities Conclusion Keywords

1 3 4 5 5 6 6 7 8 9 9 9 11 12 12 13 13 13 14 14 14 16 16 17 17

xviii

Financial Engineering, Risk Management & Financial Institutions Review Questions References Case Study

CHAPTER 2: FINANCIAL INNOVATION Introduction Examples of Innovative Financial Instruments Need for Financial Innovation Objectives of Financial Innovation Review of Literature Types of Innovation 1. Innovation for the Tax Planning 2. Facilitate Adaptive Changes in the existing Financial Instruments Thoerems and Theories of Innovation in Financial Engineering Modigliani-Miller Theorem11 Markowitz Theorem12 Garman and Kohlhagen (1983) Theorem13 Ross Theory of Arbitrage Price Theory (APT)14 Models and Mechanism of Innovation in Financial Engineering John D Finnerty Model Richard Rol Model The Arrow-Debreu Model15 Treynor, Sharpe, Linter & Mossin Model Black and Scholes (1973)16 Vasicek (1977) Model17 Genesis of Finance Theory and Financial Engineering Pioneers of Finance Theory Modern Portfolio Theory (MPT) Arbitrage and Equilibrium Theory Finance and the Firm Empiricists and the Efficient Markets Hypothesis Conclusion Keywords Review Questions References Case Study

CHAPTER 3: NEW PRODUCT DEVELOPMENT Introduction Definition of ‘Financial Product’ Definition of NPD

18 19 19

21 22 22 23 23 24 26 26 26 27 27 27 28 28 28 28 28 29 29 29 30 30 31 32 32 32 32 33 33 34 34 35

37 38 38 38

Detailed Contents Stages of New Product Development Stage1: New Strategy Formulation Stage 1a: Planning Stage 2: Idea Generation Stage 2a: Design and Prototype Stage 3: Screening and Evaluation Stage 4: Business Analysis Stage 5: Concept Development and Feature Development Stage 5a: Pilot Production and Production Stage 6: Market Testing Stage 7: Commercialization Stage 7a: Distribution Stage 7b: Sales and Marketing Stage 7c: After-sales Service Financial Instruments Best Practices for NPD Project Team Leadership Communication among Members Prototype Designs and Test Marketing Commercialization of Ideas Effective Learning from Previous Projects Implementing Effective Career Development Benchmarking NPD Cycle How to Face Future Challenges? Conclusion Keywords Review Questions References Case Study

CHAPTER 4: VALUATION

OF

EQUITY SHARES

Introduction Valuation of Equities Anticipated Rate of Return One Period Valuation Model Generalized Dividend Valuation Model The Gordon Growth Model Price Earnings Valuation Model Walter’s Approach to Dividend Policy Modigliani and Miller ( M-M) – Dividend Irrelevancy Model Valuation of Preference Shares Conclusion

xix 39 40 40 40 40 41 41 41 42 43 43 43 43 43 44 45 45 45 46 46 46 47 47 48 49 49 49 50 50 51

53 54 54 55 56 56 57 57 58 59 59 60

xx

Financial Engineering, Risk Management & Financial Institutions Keywords Review Questions References Case Study

66 66 67 67

CHAPTER 5: EQUITY RELATED INSTRUMENTS

69

Introduction Equity Related Instruments Equity Index Warrants Characteristics of Warrants Valuation of Warrants Equity Options - Equity Derivatives Stock Market Index Futures Single-stock Futures Equity Basket Derivatives Equity Swap Equity Index Swaps Rights Issue Value of Rights Underwriting Call Option Valuation of Options Example Subscription Right Foreign-exchange Option Conclusion Keywords Review Questions References Case Study

CHAPTER 6: DEBT MARKET

AND

70 70 70 71 72 72 72 72 73 73 73 73 74 74 77 78 79 80 80 81 81 82 83 84 84

VALUATION

Introduction Debt Market Definition of Debt Market Features of Debt Market Debt Market Instruments Government Securities Zero-coupon Bonds Classification of Zero-coupon Bonds Treasury Bonds

OF

BONDS

85 86 86 86 87 87 87 88 88 89

Detailed Contents Treasury Bills Strip Bond Bond Duration Public Sector Bonds Private Sector Bonds Fixed vs Floating Rate Bonds Inflation Linked Bonds Asset-backed Securities Senior & Subordinated Bonds Perpetual Bonds Bearer Bond Registered Bond Build America Bonds (BABs) Book-entry Bond Lottery Bond Serial Bond Revenue Bond Climate Bond Bonds in Foreign Currencies Bonds: at Par, at Discount, at Premium Market Price of a Bond Interest Rate Yield Curve Bonds Market Definition of Bond Features of Bonds Issue Price Maturity Date Coupon Rate Classification of Debenture/Bonds Valuation of Redeemable Debentures/ Bonds Valuation of Deep Discount Bonds (DDB) Valuation of Perpetual Bonds (PD)/on-Redeemable Debentures Calculation of the Present Value of the Bond’s Interest Payments Calculation of the Present Value of the Bond’s Maturity Amount Combining the Present Value of a Bond’s Interest and Maturity Amounts Accrued Interest Duration of Bond Bond Issue and Redemption Methods Holding Period Return (HPR) or Holding Period Yield (HPY) Practical Problems with Solution Practice Problems Debenture–Calculation of NPV for New Issue Economic Size of the Issue of Debentures

xxi 89 89 90 90 91 91 91 91 91 92 92 92 92 93 93 93 93 93 93 94 94 95 95 95 96 96 96 97 97 97 98 99 99 99 100 101 101 101 102 103 103 112 114 115

xxii

Financial Engineering, Risk Management & Financial Institutions Glossary of Selected Financial Instruments Debt instruments Asset-backed Securities Equity Instruments Hedging Instruments Keywords Review Questions References Case Study Appendix

CHAPTER 7: MANAGEMENT

OF

FINANCIAL RISK

Introduction Understanding ‘Risk’ Financial Distress Financial Risk Types of Risks Categorization of the Risks Market versus Firm-specific Risk Operating versus Financial Risk Continuous Risks versus Event Risk Catastrophic Risk versus Smaller Risks Un-diversifiable Risks Diversifiable Risks Principles of Managing Risk Quantification of Financial Risk By Non-financial Companies - through Sensitivity Analysis By Financial Companies - through Gap Analysis Risk Reduction Measures Managing Financial Risk Understand the Different Types of Risks Determine the Level of Risk Determine the Portfolio’s Risk Level Reduction of Risk Through Diversification Strategies of Financial Risk Management Hedging Portfolio Management Asset Liability Management Quantitative Risk Management Tools Used to Manage Risk in International Finance Risk-reward Ratio Black-Scholes Formula Conclusion

115 115 117 118 118 119 121 121 121 122

127 128 128 129 129 130 131 131 131 131 131 132 132 133 134 134 134 134 135 135 135 136 136 136 136 137 137 138 138 138 138 139

Detailed Contents Keywords Review Questions References Case Study

CHAPTER 8: HEDGING TOOLS

xxiii 146 146 148 148

AND

TECHNIQUES

Introduction Definition of Hedging Hedge Ratio Off-setting Interest Rate & Commodities Risk The Risk to Be Hedged Measuring Risk Selection of Appropriate Hedge Strategy Various Instruments of Hedging Interest Rate Volatility Exchange Rate Volatility Commodity Price Volatility Forward Contracts Positions - Long Position & Short Position Hedging with Forwards Futures Contracts Financial Futures SWAPS Interest Rate Swap Types of Swaps Option Contracts Seller’s Obligation Hedging with Options Payoff Profiles: Calls Payoff Profiles: Puts Hedging with Options Hedging Exchange Rate Risk with Options Other Kinds of Hedging Netting Securitization Insurance Derivatives - Definition Risk Diversification (Portfolio Management) Hedging and Correlation Tips & Techniques for Managing Risk Factors Affecting Interest Rates Exchange Rate Risk Commodity Price Risk

149 150 150 151 151 151 151 151 152 152 152 153 153 153 154 154 154 155 156 157 157 158 158 158 158 159 159 159 159 159 160 160 160 161 161 163 163 164

xxiv

Financial Engineering, Risk Management & Financial Institutions Hedging & Value of Firm The Costs of Hedging Explicit Costs Implicit Costs Hedging & Financing Choices of Firm Hedging through Lookback Option & Collateralization Lookback Option Exotic Option American Option European Option Collateralization or Asset-backed Securitization Additional Collateral Building Block Approach Time-line Cash Flow Method Arithmetic Approach Some Others Examples of Building Block Approach Conclusion Keywords Review Questions References Case Study

CHAPTER 9: ASSET LIABILITY MANAGEMENT Introduction Objectives of Asset Liability Management Liquidity Risk Management Interest Rate Risk Management Currency Risk Management Classification of Assets 1. Gross Working Capital 2. Net Working Capital 3. Permanent Working Capital 4. Temporary Working Capital TOOLS Gap Analysis Value at Risk (VaR) Definition of Value At Risk - ‘VaR’ Measuring Value at Risk Variance-covariance Method Simulation Management of Fixed Assets and Current Assets Management of Cash Motives for Holding Cash

165 165 165 166 166 167 167 168 168 169 169 169 170 170 170 170 171 171 173 173 174

177 178 179 179 179 179 179 180 180 180 180 181 181 182 182 182 182 183 183 184 184

Detailed Contents Liquidity Management in Banks Asset-liability Management System in India ALM Information Systems ALM Organisation & Management Procedure Composition of ALCO Three-tier Organizational Set-up for ALM Implementation Committee of Directors ALM process Liquidity Risk Management Currency Risk Interest Rate Risk (IRR) Classification of Components of Assets and Liabilities Quality of Assets Liquidity Risk Conclusion Keywords Review Questions References Case Study Appendix

CHAPTER 10: PORTFOLIO CONSIDERATIONS

IN

RISK MANAGEMENT

Introduction Definition of Portfolio Diversification of Risk Markowitz Theorem Measuring Risk Calculation of Correlation between Two Assets Nature of Concave Curve Measuring the Portfolio Variance and Diversification Optimal Risky Portfolios in Case of Two Risky Assets and a Risk-Free Asset Risk Free Assets Risky Assets – Tobin’s Separation Theorem Portfolio Optimization in Practice Conclusion Keywords Review Questions References Case Study

xxv 184 185 186 186 187 187 188 188 188 189 190 191 193 193 194 194 195 195 197 197 198 201

213 214 216 216 216 217 217 218 218 219 220 220 221 222 224 224 224 225

xxvi

Financial Engineering, Risk Management & Financial Institutions

Chapter 11: Credit Risk Management Introduction Definition of Credit Risk The Components of Credit Risk Forms of Credit Risk Building Blocks of CRM Strategy and Policy Organisational Structure Operations/Systems Credit Risk Management Framework Policy Framework Credit Risk Rating Framework Credit Risk Limits Credit Risk Modeling Altman’s Z Score Model Credit Metrics Model Value at Risk Model KMV Model Risk Adjusted Return on Capital (RAROC) Credit Risk Mitigation Credit Audit Credit Risk Mitigants as Per Basel 2 Accord Recommendations of BASEL II Credit Risk Mitigants Used by Different Banks Collateral and Margins Collateral Agreement Guarantees Break Trade Laws Escrow Account Insurance Securitisation Equator Principles Application of Equator Principle to Indian Banks Credit Derivative Types of Credit Derivatives The Benefits Associated with Credit Derivatives Growth of Credit Derivatives in India Clearing Corporation of India Limited (CCIL) Collateralised Borrowing and Lending Obligation (CBLO) Trading System Forex Trading System Netting Types of Netting Principles for the Management of Credit Risk

227 228 228 229 229 229 229 230 230 231 231 231 232 232 232 233 235 235 235 236 237 237 237 240 241 242 242 243 243 243 244 244 245 245 245 246 246 248 248 249 250 251 253

Detailed Contents Conclusion Keywords Review Questions Appendix

Chapter 12: Operational Risk Management Introduction Literature Review Policies Regarding the Operational Risk Management Procedures to Administrate the Operational Risk Benefits of Operational Risk Management Frame of Operational Risk Different Types of Operational Risks The Fraud Risk Reputation Risk Liquidity Risk The Risk of Losing the Control Evaluation Stages of Operational Risk Determinant Factors for the Operational Risk Operational Risk Categories - Basel Committee Banking Risk Management Process of Operational Risk Management Conclusion Keywords Review Questions References

xxvii 255 256 259 260

263 264 265 269 269 269 269 270 270 271 271 271 271 272 272 273 274 275 275 276 276

PART II: FINANCIAL INSTITUTION

277

Chapter 13: Financial Institutions

279

Introduction Classification of Financial Institutions Term-lending Institutions Refinance Institutions Investment Institutions State/Regional Level Institutions Housing Finance Companies India’s Banking System Public Sector Involvement in the Indian Financial System Weaknesses in the Indian Financial System Genesis of Regulatory Initiatives1 Stock Exchange

280 280 280 280 281 281 281 281 282 284 284 284

xxviii Financial Engineering, Risk Management & Financial Institutions Clearing Corporation Depository Role of SEBI Regulating Mutual Funds Role of Association of Mutual Funds in India (AMFI) AMFI Guidelines & Norms for Intermediaries (“AGNI”) Definitions of Financial Institution Regulatory Framework of NBFC’s NBFC under Acceptance of Public Deposits (Reserve Bank) Directions, 1998 (APD Directions) Own Funds vs Net Owned Fund Deposit vs Public Deposit Rates of Interest Conclusion Keywords Review Questions Case Study

Chapter 14: Financial Intermediaries Introduction Underwriting SEBI Guidelines Underwriters Registration Code of Conduct for Underwriters General Responsibilities Compliance Officer Power to Call for Information Inspection and Disciplinary Proceedings Action Reasons for Devolvement SEBI’s Model Underwriting Agreement Registrar to Issue or Issue House Appointment of Registrars Conditions of Registration General Obligations and Responsibilities Books of Account/Record/Documents Agreement with Issuing Companies Inspection Portfolio Managers Procedure for Registration Conditions of Registration General Obligations of a Portfolio Manager Code of Conduct

286 288 289 292 292 292 294 295 296 296 297 298 298 299 300

305 306 306 307 308 308 309 312 312 312 312 312 313 313 314 314 314 315 315 315 315 316 316 317 317 317

Detailed Contents Contract with Clients General Responsibilities of a Portfolio Manager Maintenance of Books of Accounts/Records Reports to be Furnished to the Clients Disclosures to the SEBI Conclusion Keywords Review Questions Case Study

Chapter 15: The Banking Institutions Introduction Role of Banking System in Economic Development Development of Financial Infrastructure Capital Formation Entrepreneurial Development Consumption, Production and Distribution of Goods and Services Helping the Government Recent Major Developments of the Banking Sector Shift from Class to Mass Banking Future Outlook of the Banks Credit Risk Management (CRM) Banking Technology Management Technology Infusion and Upgradation Challenges Technology Impact on Customers Diversification Public Sector Banks New Private Banks Profiles a Select Commercial Banks State Bank of India Profile Profile of ICICI Bank Andhra Bank Profile Andhra Bank Performance Highlights for December 2013 Retail Credit Advances to Micro & Small Enterprises Weaker Section Lending Credit to Minority Communities Credit to Women Self Help Groups Integration of Land Records – Bhoomi Project Agri Business & Agri Counselling Centers Financial Inclusion

xxix 319 319 320 321 322 322 323 324 324

327 328 329 331 331 332 332 333 333 335 336 337 338 339 339 340 341 342 342 342 352 354 356 356 358 358 359 359 359 359 359 359 359

xxx

Financial Engineering, Risk Management & Financial Institutions Direct Benefit Transfer (DBT) & Direct Benefit Transfer for LPG (DBTL) Scheme Implemenation Andhra Bank Rural Development Trust Financial Literacy and Credut Counselling Centres New Initiatives Awards & Accolades Conclusion Keywords Review Questions Case Study Appendix

Chapter 16: Financial Services Venture Capital Venture Capital Fund Operations Structure of the Funds Compensation Raising Substantial Venture Capital Venture Capital and Development Venture Capital Fund Factoring Factoring Procedure Differences from Bank Loans Factors Credit Rating Credit Rating Agencies Registration of Credit Rating Agencies General Obligations of Credit Rating Agencies Conclusion Keywords Review Questions Case Study

Chapter 17: The Non-banking Financial Institutions (NBFI) Investment Banking Companies (IBC) Rules of Investment Company Non-banking Financial Company (NBFC) Registration Process Different Types/Categories of NBFCs Registered with RBI Requirements for Registration with RBI Procedure for Application to the Reserve Bank for Registration Definitions of ‘Deposit’ and ‘Public Deposit’

360 360 360 361 362 362 363 365 365 366

371 372 372 373 374 374 375 375 375 376 376 377 378 379 382 387 392 392 393 393

395 396 396 399 399 400 402 402 405

Detailed Contents Regulation of Investment companies by RBI Core Investment Companies (CICs) Group Company Loan Company (LC)/ Mortgage Guarantee Compny Asset Finance Company (AFC) The Regulatory and Supervisory Objective Hire Purchase Financing Lease Financing Housing Finance: Regulations & Guidelines by RBI A. Direct Housing Finance B. Indirect Housing Finance Mutual Benefit Finance Companies (NIDHIs) Residury Non-bank Finance Companies Conclusion Keywords Review Questions Case Study

Chapter 18: Insurance Industry in India Introduction Meaning and Definition of Insurance Need for Insurance Benefits of Insurance Insurance as Investment Insurance Sector in India Market Size Key Investments Government Initiatives Road Ahead Life Insurance Corporation of India Mobilization of Savings Nation Building Activities General Insurance Overview of Business: LIC of India Public Relations and Publicity Communication Policy Lapses List of Various Policies Introduced by LIC Privatisation of L.I.C: Impact of Reforms Myths of Privatization Salient Features of IRDA Act 1999 Far Reaching Implications of Globalization Life Insurance Corporation in International Scenario Data Analysis

xxxi 406 408 409 409 410 411 411 412 417 417 418 426 434 435 435 437 438

441 442 442 443 443 444 445 445 445 447 447 447 448 448 449 450 451 452 452 455 455 456 458 460 460

xxxii Financial Engineering, Risk Management & Financial Institutions Potential Market Conclusion Keywords Review Questions Case Study

Chapter 19: Merchant Banking Introduction Categories of Merchant Bankers Merchant Banker’s Activities Specified by SEBI Role & Functions of Merchant Banker Responsibilities of Lead Managers Goverment Policy on Merchant Banking Merchant Banking Institutions Regulatory Mechanism SEBI Criteria for Fit and Proper Person Regulation Code of Conduct for Merchant Bankers Restriction on Business Compliance Officer Procedure for Inspection Action in Case of Default Over The Counter Exchange India (OTCEI): Eligibility Norms Pricing Norms Submission of Documents Underwriters Bankers to an Issue Appointment of Bankers to Issue Conclusion Keywords Review Questions Appendix Case Study

461 462 462 462 463

467 468 469 469 470 472 472 474 474 475 477 480 480 480 481 483 484 484 484 485 485 485 486 487 487 491

TERMINOLOGY

493

QUESTIONS

495

INDEX

505

CHAPTER 1 Introduction

1

INTRODUCTION Introduction Role of Financial Engineer Definitions of Financial Engineering Distinction between FE & FM Distinction between FE & FA Environment of Financial Engineering Scope of Financial Engineering Factors Contributing to Growth of FE Benefit of FE Central Problems of FE Branches of FE The Physical and Conceptual Tools Financial Engineering Course and Career Oppurtunities Conclusion Keywords Review Questions References Case Study

4

Financial Engineering, Risk Management & Financial Institutions

Chapter Objectives

Chapter Objectives

After studying this chapter, the student will be able to: Understand the meaning and scope and benefits of financial engineering. Distinguish between financial engineering and financial management. Discuss about various factors contributing to the growth of financial engineering. Learn about branches, tools and central problems of financial engineering.

Introduction This chapter deals with introduction to the subject ‘Financial engineering’, which involves the design, the development and the implementation of innovative financial instruments. It also discusses about the processes, and the formulation of creative solutions to problems in finance. Hence, the study of ‘Financial Engineering’ leads to creative financial solutions may involve a new customized financial instrument or a new financial instruments or security. Financial Engineering it is the art of design create develop modify an Financial Instruments.

Financial engineering creates financial instruments on a continual basis. When many drawbacks are found in the existing instruments, new instruments are engineered to replace or take over from the existing financial instruments. When a product/service/contract is engineered before a need for the engineered features is felt, it is a hard sale. It takes quite a long time for the product to come into extensive use in the financial markets. In simple words, ‘Financial engineering’ is the study of the process relating to ‘bundling and unbundling of securities like forwards, futures, swaps, options, and related products’. These securities used to restructure or rearrange cash inflows in order to achieve goals of the corporate entity. Financial engineering involves a three dimensional approach viz., first dimension is ‘financial theory’, second dimension is ‘the tools of applied mathematics’, and third dimension is ‘the programming and engineering methodologies’. Hence this subject is useful for various issues like: pricing of financial products, trading and portfolio management decisions.

CHAPTER 1 Introduction

5

Role of Financial Engineer A financial engineer is a person engaged in the practice of designing financial products. Financial Engineers require a broad but specific knowledge of financial instruments and markets, accounting and tax rules, and information technology. Financial Engineer must always try to maximize profits as well as maximize wealth of share holders of the corporate entity. Hence, he needs a deep understanding of both quantitative analytical tools and of the financial industry to do well in their field. Financial engineer’s goal is to control financial risk by diversifying combinations of portfolios.

Financial Engineering should have knowlege of Theory of Finance, Mathematics and Computer Software

Definitions of Financial Engineering John D. Finnerty (1990) 1 defines financial engineering is the subject which enables the design, the development, and the implementation of innovative financial instruments and processes, and the formulation of creative solutions to problems in finance” Stephen Figlewski2 defines ‘financial engineering is the art of making practical applications of the knowledge of pure financial theory to solve real world problems”. Gary L. Gastineau3, states that financial engineering is the art (with contributions from science) of creating desirable cash flow and/or market value patterns from existing instruments or new instruments to meet an investment or risk management need. The creations of financial engineers are typically based on traditional instruments such as bonds and notes with forward and futures contracts, options, and swap components added.”

Finnerty is known as Father of Financial Engineering

Neil D. Pearson4, (Assoc. Prof. UIUC) sates that Financial engineering is the application of mathematical tools commonly used in physics and engineering to financial problems, especially the pricing and hedging of derivative instruments.

Investings financing Decision making is part of “Financial Management”

John D. Finnerty (1990),Financial Engineering in Corporate Finance: An Overview,” Chapter 3 in Clifford W. Smith, Jr. and Charles W. Smithson, The Handbook of Financial Engineering New Financial Product Innovations, Applications, and Analyses (New York: Harper Business, 1990), page 69.

1

Stephen Figlewski is a Professor of Finance at the New York University Leonard N. Stern School of Business,

2

Dictionary of Financial Risk Management,(New York: Swiss Bank Corporation, 1992), page 108. 3

Professor of Finance and Harry A. Brandt Distinguished Professor of Financial Markets and Options.

4

6

Financial Engineering, Risk Management & Financial Institutions Campbell R. Harvey5: Combining or carving up existing instruments to create new financial products.

Distinction between Financial Engineering and Financial Management Problem solving is the essence of “Financial Engineering”

The study of ‘financial management’ is useful to understand how to run the business and financial engineering helps to find solutions to financing problems through the design of financial instruments and hedging strategies. As stated earlier the subject of ‘Financial engineering’ is intended to solve financial problems by using mathematical techniques and engineering principles to solve financial problems. Whereas, the subject of ‘Financial Management’ deals with four important decisions like investment decision, financing decision, liquidity decision and profitability decision, which are core decisions of any business management. Thus, the main objective of financial management is ‘share holders wealth creation as well as profit maximization’.

Distinction between Financial Engineer and Financial Analyst Interpreting Financial statements is the duty of “Financial Analyst”

The role of a ‘financial engineer’ is quite different from that of ‘financial analyst’. Most of the organizations will have one person doing two jobs simultaneously. Hence, it is important to distinguish between the roles of these two. We know that financial engineers need to understand financial analysis. At the same time that the financial engineer can leave the financial analysis entirely to the finance department. It is known fact that a financial analyst is a person engaged in the real world of financial analysis.” For instance, the financial analyst comes to understand the financial position of the firm. However, financial engineer suggests how reduce risk and diversify the risk involved in the corporate finance. For example, a firm would like to know two significant issues like the sources of the instability, and how to reduce the instability in the cash flows. Thus, the financial analyst finds the trend, a seasonal component, an exchange rate component of the cash flow stream. Whereas the financial engineer structures a solution to this cash flow problem. 5

Campbell R. Harvey’s Hypertextual Financial Glossary, http://www.duke.edu/

~charvey/Classes/wpg/glossary.html

CHAPTER 1 Introduction

7

Environment of Financial Engineering The Environment of ‘Financial Engineering’ is Depicted in the Following Figure 1.1.

1. Investorsinvest through primary market or secondary market

f

2. InstitutionsFinancial institutions

f

3. Instruments- Shares/ bonds/ commercial paper/ Certificate of deposits

f

4. IntermediariesAgents/dealers/ brokers

f

f

Innovation/ Financial engineeringdesigning and modeling

f 5. Industry & Corporate

entities, which get capital from investors and f institutions through intermediaries by issue of instruments

f This structure is explained as under: 1. Investors: Investors will expect return on their investment from industry. This return may be in the form of dividend or interest. Dividend is distributable profit to the equity shareholders and interest is given for investing in debt capital viz debentures or bonds. The holder of a debt security is typically entitled to the payment of principal and interest, together with other contractual rights under the terms of the issue. 2. Institutions: These are several financial institutions which offer various financing services to the industry and investors. 3. Instruments: These are in the form of documentary evidence for the investment in corporate entities. These are various financial instruments which are designed by financial engineers to raise the capital by the industry and institutions.

Figure 1.1: Financial Engineering Designing and Modeling Diversification of Risk is the key function of a “Financial Engineering”

8

Financial Engineering, Risk Management & Financial Institutions 4. Intermediaries: There will be various financial intermediaries like agents, dealers, brokers, stock exchanges to facilitate transfer for ownership for various financial instruments.

Innovation involves various stakeholders like investors, Institutions intermeiaries & industry.

Figure 1.2: Scope of Financial Engineering

5. Industry: Industry means any entity which transforms raw materials in to finished goods according to the needs of customers. Industry includes service sector as well as manufacturing sector. It is known fact that huge amount of capital is required for establishment of industry. It acquires capital either in the form of equity or debt through issue of financial instruments with the help of intermediaries and institutions. 6. Innovation: This is the central idea of financial engineering, which is aimed to design the various financial instruments to attract institutions, industry and investors.

Scope of Financial Engineering SCOPE OF FINANCIAL ENGINEERING Chapter - 4 VALUATION OF EQUITY SHARES

Chapter - 3 Chapter -2 FINANCIAL INNOVATION

f

NEW PRODUCT DEVELOPMENT

f Chapter - 5

f

EQUITY RELATED INSTRUMENTS

Chapter - 1 INTRODUCTION

f

Chapter -7

f

f

MANAGEMENT OF

DEBT MARKET &

f

FINANCIAL RISK

fChapter - 6

Chapter - 8 HEDGING TOOLS AND TECHNIQUES

VALUATION OF BONDS f

CHAPTER 1 Introduction The subject of financial engineering is aimed to design a new and creative financial instruments to reduce risk and uncertainty. Hence, to understand this subject one should have knowledge of financial modeling, finance and mathematical skills. The financial engineering strategies are the best solution for reducing and diversifying the risks. The risks may be classified in to systematic and unsystematic risks. They may be further classified into market related risks and credit related risks. However, the market risks can easily be handled by the use of various techniques like risk management, risk measurements, and risk identification processes. The figure 1.2 given on page 8 depicts the Scope of Finacial Engineering.

9

The financial engineering strategies are the best solution for reducing and diversifying the risks.

Factors Contributing to the Growth of Financial Engineering Finnerty Classification Finnerty has been treated as the father of the financial engineering who described various forces that stimulate financial engineering, which are mentioned below: 1. The risk management for assets or projects held by either the issuer or the investor 2. Decrease of tax liability or shifting of the tax liability 3. Agency costs reduction 4. Issuance cost reduction 5. Convenient compliance with the regulation 6. Interest rate changes favorable to both the issuer and investor 7. Exchange rate changes addressing the problem of fluctuations of exchange rates 8. Technological advances, 9. Accounting gimmicks essentially benefitting the issuers, and 10.The promotion of academic research.

Internal and External Factors Another classification which are contributing to the growth of financial engineering may be classified as i) Internal factors and ii) External factors.

Finnerty identified 10 major factors for the growth of “Financial Engineering”.

10

Financial Engineering, Risk Management & Financial Institutions

Internal factors are rising with industry, like: Liquidity, Agency Costs & Risk Aversion.

Some innovations are designed to provide easier access to cash.

1. INTERNAL FACTORS i. Liquidity Needs: Every corporate entity should maintain liquid resources to meet day-to-day contingencies. Hence, the financial engineer of any corporate entity should maintain reserves for their “free cash flows”. To make use of funds temporarily not needed, money markets and sweep markets have developed rapidly. Liquidity means the ability to put the cash to work and the ability of asset to be converted into cash. Some innovations are designed to provide easier access to cash while others were designed to make it easier to put for the time being unneeded cash to work. Measures will be taken by structuring the instrument in such a way that it can be more easily traded in the secondary market. ii. Policies of Risk Aversion: Financial engineer of a corporate entity should see the ‘risk policy’ of its entity. Some firms aims to maintain ‘the risk aversion policy’. Hence, increasing risks has been an important driving force in motivating innovations.

Financial engineering and modern techniques will help the firm to trim down agency costs.

iii. Agency Costs: Agency costs arise because of center troubles such as conflicts of interest between shareholders and management. By plummeting agency costs the firm will get the profit. Hence, financial engineering and modern techniques will help the firm to trim down agency costs. Marshall shows how leveraged buyouts were motivated by the desire to reduce agency costs. The financing of such activity required new forms of financing, including junk bonds. iv. Quantitative Sophistication of Management Training: The increase in the quantitative skills possessed by managers has led to a demand for better tools of financial engineering. v. Accounting Objectives: At times, financial innovation has been fuelled by the desire to improve accounting figures. 2. EXTERNAL FACTORS

External factors mostly caused by business environment like: Globalization, Privatization, Deregulation etc.

i. Increase in Price Volatility: ‘Volatility’ means fluctuations in the price changes may be relating to the price of money, foreign exchange, stocks, and commodities. Thus, prices of financial instruments are subject to external vis-à-vis internal environmental factors. ii. Globalization: The concept of LPG (Liberalization, Privatization and Globalization) has created more competition in the market. Hence, every firm needs to seek strategies for survival in the competition.

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iii. Deregulation: The new government policy about deregulation of the financial markets has brought in new entrants into the financial markets. Hence, more private institutions are aggressively competing with those who are working in public sector. iv. Recent Developments in Technology: Financial engineers now concentrate on the recent development in technology which also helps in designing innovative financial products like: smart cards, debit cards, visa-cards etc. v. Virtual Financial Market: Now, the system of virtual financial market is developing. Every investor is now expected to acquaint with online trading systems, online banking systems and e-financial markets. vi. Tax Asymmetries: It is known fact that the Tax policies differ across countries. Now, there are various policies like: double taxation avoidance agreements and transfer pricing policies are taking place to reduce tax asymmetries. ix. Arbitrage Opportunities: The globalization of the financial markets has meant that arbitrage opportunities across different capital markets could be identified and exploited. In theory, exploiting these differentials through arbitrage should eventually lead to their disappearance.

Benefits of Financial Engineering The following benefits can be reaped through financial engineering: 1. The modifications of features in the existing financial products, services and contracts take place, these modifications stay long because developing countries need more funds circulation exercise to improve their poor financial markets. 2. The contribution of financial engineering to the developed countries will be to sustain the existing financial markets while to the developing countries it will be to develop them. 3. The beneficiaries of financial engineering are industry, government and households. 4. Financial engineering in the banking sector benefits the government. Because the apex bank of the economy can influence the flow of funds of banking sector with an immediate effect.

Balanced financial markets, diversified risk management, and regulated money markets are major benefits expected from “Financial Engineering”.

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Financial engineering in the main market segment will benefit industry as the investors may bypass the banking channel and investments are directly made in the industry.

5.

Restructuring various public financial institutions to lessen the burden on the part of the state is made possible.

6.

Financial engineering may prove useful in finding alternatives that allow for coordinated policies as well as measuring the costs of implementing one policy over another.

7.

Financial engineering in the main market segment will benefit industry as the investors may bypass the banking channel and investments are directly made in the industry.

8.

Financial engineering has to fill the persisting gaps in the financial markets, address the preferences of investors, and offer new pay-offs that investors want.

9.

Even issuers who raise funds through few financial instruments would find few other innovative financial instruments worth investing in that have been a creation of financial engineering.

10. Financial engineering enables locking, interlocking and unlocking of the funds making the financing activity a continuous one in reality like those of production and selling. 11. Accounting benefits: Many of the financial innovations of the last few years have been directed at humanizing firm’s financial position. They helped in produce short-term benefits, with adequate rewards for management as well as long-run benefits also. 12. Handling complex situations: Any corporate entity can handle complex situations in the organization by apply mathematical manipulations, models and quantitative classiness.

The 3 major problems to be addressed by Finacial Engineering are: 1. Security Pricing 2. Risk Managemnt 3. Portfolio Optimization

Central Problems of Financial Engineering There are many problems relating to financial decision making may be considered as financial engineering problems like: securities pricing, risk management and portfolio optimization.

Securities Pricing Fundamental problem in the capital market is ‘pricing of securities’. In general there are two classes of securities: primitive securities and derivative securities. Thus, primitive securities are stocks and bonds and products like: options, futures and swaps are examples of derivative securities. The

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economics approach to pricing is equilibrium arguments (e.g., supply= demand). While, Financial engineering is typically more concerned with pricing derivative securities and uses arbitrage arguments to do so. Moreover, some models such as the Capital Asset Pricing Model (CAPM), are equilibrium-based models that are of fundamental importance to both financial economists and financial engineers.

Risk Management Another important problem is risk management, which is concerned with understanding the risks that are inherent to your portfolio of securities. Any financial engineer must also understand risk reduction and risk management techniques.

Portfolio Optimization Last but not the least, portfolio optimization is the problem of choosing a better portfolio. Application mathematical models are necessary to solve problems relating to portfolio optimization.

Branches of Financial Engineering There are three According to John D. Finnerty6, there are three branches of activities involved branches: in corporate financial engineering. They are explained below: 1. Securities First Branch – Securities Innovation: Involves the development of innovation innovative financial instruments, including those developed primarily 2. Development of for consumer-type applications such as new types of bank accounts, new products and new forms of mutual funds, new types of life-insurance products and 3. Creative Solutions new forms of residential mortgages. Second Branch – Development of Innovative Financial Processes: These new process reduce the cost of effective financial transactions, and are generally the result of legislative or regulatory changes or technological developments. Third Branch – Creative Solutions to Corporate Financial Problems: It encompass innovative cash management strategies, innovative debt management strategies, and corporate financing structures. Executive Vice President and Chief Financial Officer, College Savings Bank, Princeton, and is a Professor of Finance, Fordham University, New York 6

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The Physical and Conceptual Tools Financial Engineering is an vital profession within the financial services industry. Financial Engineering is built on diagnostic foundations, and the discipline also draws heavily upon the theoretical foundations of modern finance. Financial engineering use a vide variety of instruments, theories and ideas, and processes in its operation to custom design solutions to incredible array of problems in finance. All these knowledge, instruments, processes and rules together are considered as tools of financial engineering. These tools can be divided into two broad categories including: a. Conceptual Tools b. Physical Tools

Conceptual Tools “Conceptual tools” are the theoretical foundations, where as “physical tools” are practical and documentation processes.

The conceptual tools engage the ideas and concepts which be the cause of finance as a formal discipline. These are essential knowledge base for people who are working in this field. Examples of conceptual tools are valuation theory, portfolio theory, hedging theory, interest rate theory, foreign exchange rate determination, speculation, arbitrage, and market efficiency theory, etc.

Physical Tools The physical tools of financial engineering include the instruments and the processes which can be pieced together to accomplish some specific purpose. The process include diverse trading mechanisms and techniques, such things as electronic securities trading, public offering, private placements of securities, self-registration, and electronic fund transfer and any other innovative methods. I. Cash Market Instruments: These instruments are fixed income securities, and equity and equity related securities. Cash market characterized by delivering of traded asset, either immediately or shortly thereafter. Payment usually is made immediately, although credit arrangements are sometimes used. II. Derivatives: These are financial contracts whose values depend on the value of some underlying assets or references. They serve valuable purposes in providing a mean of risk management, speculation, arbitrage, and efficient portfolio adjustment. In contrast with cash market/spot market, derivative markets are for contractual instruments

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whose performance is determined by how another assets, indices, or price references perform. Derivatives can be in different forms varying from plain vanilla to exotics. The four most basic types of derivatives stand out: forward contracts, futures contracts, swaps, and options. Typical forward, futures, and swap contracts are self financing or zero cost instruments. Forward: Forward contract represents the responsibility on both parties of transaction to buy/sell an asset at pre-specified price, at predetermined future date. Forwards are traded in OTC market and all the terms regarding the transaction are subject to mutual accord between two parties. Futures: Future contract is standardized form of forward contract traded in futures exchanges. The transactions are carried out through clearing association along with different requirements to minimize the possibility of default risk associated with forward contracts. The key distinguishing feature of forward and futures contracts is that future positions call for daily settlement of cash (i.e. making to market), rather than single settlement of cash flow at maturity. Options: Option is s a contract between two parties-a buyer and a seller-that gives the buyer the right, but not obligation, to purchase or sell something at later date at a agreed price. Option buyer pays the seller a sum of money called premium. Options enable their holders to lever their resources while at the same time limiting their risk. Swaps: These transactions are forward transaction involving an exchange of promises, two parties agree on a swap rate on a notional principal and series of maturity dated. A swap is really just a portfolio of forward contracts. In fact two counter parties exchange cash flows in future based on a predetermined formula. Warrants: These are like options contract where the holder has the right to buy shares of specified company during the given period. There are different types of options. • Security options • Options on futures • OTC options • Hybrid

Forward, futures, options & warants swaps, are best examples of Financial Derivatives.

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Financial Engineering, Risk Management & Financial Institutions Convertibles: These are hybrid securities which combine the basic attributes of fixed interest and variable return securities, popular among them are: • Convertible bonds • Debentures • Preference shares

The subject knowledge of “Financial engineering and risk Management” will be helpfu; for career development.

Financial Engineering Course and Career Opportunities Candidates who wish to join the course in financial engineering must have finished their gradation. Numerous career opportunities are available for the candidates. Professionals in this field can get employed in fields like banking, securities trading, insurance and engineering consultancies. The salary of the candidates is based on their qualifications and proficiency. There are institutions like:GARP (GlobalAssociation of Risk Management) & PRMIA (Professional Risk Managers International Association) certificaate courses in risk management.

Career Opportunities There are numerous career avenues like: Asset management companies Bonds or debt issue management Corporate financial strategic planning Demat trading Derivatives market Financial information systems management Govt. sector institutions Investment banking Liability management Portfolio management/ optimization Options market Primary and derivatives securities valuation Risk management

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Security trading/security pricing Treasury management

Conclusion This chapter is intended to introduce the subject matter of financial engineering and its benefits. Financial engineers are often called upon to develop new instrument to secure the fund necessary for the operation of large scale businesses. Financial engineers are also employed in securities and derivatives product trading. They are particularly trained at developing trading strategies of an arbitrage nature. Arbitrage across instrument explains many new developments which have given rise to “synthetic” instruments and ‘repacking’ of cash flows. Investment vehicles such as “high yield” mutual fund, money market fund, sweep system and Repo market etc. This subject is categorized into 9 chapters i) Introduction 2) Financial Innovation 3) New Product Development 4) Equity and Equity Related Instruments 5) Bond and Debt Market 6) Financial Risk Management and 7) Hedging Techniques 8) Asset Liability Mangement and 9) Portfolio Consideration in Risk management.

Keywords

Keywords

Financial Engineering: It is the study of the process relating to ‘bundling and unbundling of securities like forwards, futures, swaps, options, and related products’. Financial Engineer: A financial engineer is a person engaged in the practice of designing financial products. Financial Management: ‘Financial Management’ deals with four important decisions like investment decision, financing decision, liquidity decision and profitability decision, which are core decisions of any business management. Financial Analyst: A financial analyst is a person engaged in the real world of financial analysis. Institutions: These are several financial institutions which offer various financing services to the industry and investors. Instruments: These are various financial instruments which are designed by financial engineers to raise the capital by the industry and institutions. Intermediaries: There are various financial intermediaries like agents, dealers, brokers, stock exchanges to facilitate transfer for ownership for various financial instruments.

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Financial Engineering, Risk Management & Financial Institutions Industry: Industry means any entity which transforms raw materials in to finished goods according to the needs of customers. Industry includes service sector as well as manufacturing sector. Innovation: This is the central idea of financial engineering, which is aimed to design the various financial instruments to attract institutions, industry and investors. Liquidity: Liquidity means the ability to put the cash to work and the ability of asset to be converted into cash. Conceptual Tools: The conceptual tools engage the ideas and concepts which are cause of finance as a formal discipline. Physical Tools: The physical tools of financial engineering include the instruments and the processes which can be pieced together to accomplish some specific purpose. Cash Market Instruments: These instruments are fixed income securities, and equity and equity related securities. Derivatives: These are financial contracts or the instruments which derive their value from the underlying asset. E.g., forward, futures, options, swaps, warrants and convertibles. Forward Contract: Forward contract represents the responsibility on both parties of transaction to buy/sell an asset at pre-specified price, at predetermined future date. Futures Contract: Futures contract is a standardized form of forward contract traded in futures exchanges. The transactions are carried out through clearing association along with different requirements to minimize the possibility of default risk associated with forward contracts.

Review Questions

Review Questions

1. Give meaning and definitions of financial engineering.

5. What are the various factors contributing to the growth of financial engineering?

2. Illustrate the role of a financial engineer.

6. Define various branches and tools of financial engineering.

3. Discuss the scope and benefits of financial engineering. 4. Elaborate distinctions between financial engineering and financial management.

7. Define the central problems of financial engineering. 8. Discuss financial engineering course and career opportunities in it.

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References

References

1. Financial Management by Dr. Paresh P. Shah, 2 nd Ed. Biztantra (Dreamtech Press)

4. Advanced Financial Management by Dr. U. M. Premalatha, Biztantra (Dreamtech Press)

2. Strategic Financial Management by Dr. Meena Goyal, Biztantra (Dreamtech Press)

5. International Financial Management by Dr. S.P. Srinivasan & Dr. B.Janakiram, Biztantra.

3. Financial Wisdom by Dr. A. P. Dash, Biztantra (Dreamtech Press)

Case Study

Case Study

Note: Students are advised to go through the following news item and find out solution using the subject knowledge of financial engineering tools and techniques.

CYPRUS BAILOUT TEMPLATE RATTLES SPANISH BONDS1 25th March, 2013: Spanish and Italian bond yields rose on Monday as policymakers fuelled worries that Cyprus’s bailout, which hit investors hard, could be used as a template for the region’s other struggling countries. Initial relief that Cyprus had reached a last-gasp deal to avoid financial meltdown quickly reversed to drive safe-haven German Bunds higher and put peripheral bonds under pressure after comments from Jeroen Dijsselbloem, who heads the Eurogroup of euro zone finance ministers. Among other measures, the Cypriot bailout wound down the country’s largely state-owned Popular Bank of Cyprus, wiping out senior bondholders, while depositors with more than 100,000 euros in their accounts will face a large levy. Dijsselbloem said this structure represented a new template for resolving euro zone banking problems and other countries may have to restructure their banking sectors. That turned the spotlight on Spain, whose banks have suffered badly from souring property loans. “We’re all now coming round to the idea of bail-ins along with bail-outs, but to maybe suggest that the first point of call is the sovereign state of a bank, or the creditors of banks - that’s a big leap,” a London-based bond trader said. “If you’re an uninsured depositor at a bank in Spain you wouldn’t be too happy about this.” http://articles.economictimes.indiatimes.com/2013-03-25/ news/38010389_1_euro-zone-peripheral-bondsbond-yields 1

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Spanish 10-year bond yields rose 10 basis points on the day, to 4.96 percent, while the Italian equivalent bond yield rose 5 bps to 5.58 percent. Both were within recent ranges but the implication of the Cyprus deal could make investors more sensitive to the two countries’ problems. Spain’s economy is in recession and data points to a further deterioration that will hamper Madrid’s efforts to rein in public finances and keep government borrowing under control.

ITALY RISKS In Italy, investor concern is focused on the fallout from inconclusive elections a month ago that left the euro zone’s third largest economy struggling to form a government, raising worries that reform efforts would be impaired. “The situation in Italy has been overshadowed, but it remains a big risk factor,” said Niels From, chief analyst at Nordea in Copenhagen. “There could be more focus on it now that they have to start more seriously to find a government. The risk is of new or early elections and what the outlook is for how the parties will be (represented) in the parliament.” Former prime minister Silvio Berlusconi, whose strong showing in the election rattled many investors, has demanded to be included in any new government, but there was no sign his centre-left rival Pier Luigi Bersani was considering such a move. German Bund futures, sought in times of market stress for their low risk and high liquidity, rose 36 ticks to 144.73 - back to levels seen last week before Cyprus’s bailout was agreed. While the list of concerns continues to grow for euro zone investors, traders said the flow behind Monday’s market moves was minimal, indicating that many long-term investors had yet to decide on the implications of recent events. Market participants said the European Central Bank’s long-standing promise to start buying government bonds if a struggling state needs assistance was helping to keep panic selling to a minimum.

FINANCIAL INNOVATION

Introduction Need for Innovation Objectives of Financial Innovation Review of Literature Types of Innovation Theorems & Theories of Innovation in FE Models and Mechanism of Innovation in FE Genesis of Finance Theory and FE Pioneers of Finance Theory Conclusion Keywords Review Questions References Case Study

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Chapter Objectives

Chapter Objectives

After studying this chapter the student will be able to: Understand meaning and definitions of financial innovation. Learn about the need and objectives of financial innovation. Know about various types of innovation for tax planning. Define models, mechanisms and theorems of innovation in financial engineering.

Introduction Innovation is basic need of the hour to attract new customers to the financial markets. ‘Financial Innovation’ means finding new products and new features for existing financial products. Thus creating a new financial product or adding new features to existing financial product is the central theme of financial engineering. Hence, the innovative products should try to reduce financial risk and it should aim to reach ‘financial optimization’. Financial Innovation is the way to find new products, & new features to attract more investors.

Financial innovation is an essential force motivating the financial system toward greater economic competence with considerable economic advantage accruing from the changes over the time. In the process of creating a new financial product, a financial engineers needs to acquire knowledge of optimization and financial modeling techniques besides basic theory of financial management. John D Finnerty defines ‘financial engineering’ as one that involves design, development and implementation of innovative financial instruments and processes and the formulation of creative solutions to the problems in finance. Financial engineering facilitates the development, refinement, and broad-based adoption of derivative securities such as futures, options, swaps and other contractual agreements.

Examples of Innovative Financial Instruments 1. Interest rate future 2. Interest rate options 3. Stock index future 4. Stock-index options.

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5. Currency future 6. Currency options 7. Over-the-counter contracts: Forward rate agreements,forward exchange agreements 8. Swap products: Interest rate swaps, currency swaps, commodity swaps and equity swaps.

Need for Financial Innovation A crucial function of the financialinnovation is to help companies and households to manage risks. The discharge of this function depends on the type of financial products or contracts available to companies and households to hedge and take on exposures in close alignment with their individual risk preference and tolerance, as well as the capability of the institutions that make up the financial system to manage the risk inherent in these products. One must also be borne in mind that imperfections within financial markets will affect the performance of these innovative financial products that may in turn limit their availability. One might call such assets ‘natural assets’ as the same instrument that is issued by the borrower is also held by the investor. In this example, the role of the financial system is simply to facilitate the intermediation between end-borrowers and endinvestors, and, in some cases, to provide a secondary market in the asset, intermediating between alternate end-investors.

Financial Innovation helps in hedging strategies of households as well as corporate entities.

Objectives of Financial Innovation Financial Innovation’ should adopt the following issues: 1. Facilitating liquidity 2. Bearing with the market volatility with respect to volume, price and competition 3. Convenience of investing 4. Flexible duration for investment 5. Achieving corporate entity goal 6. Designing viable financial instruments 7. Consistency in growth rate 8. High yield for the product should be basic aim 9. Ability to attract more consumers

Financial Innovation helps in risk reduction, liquidity, consistency and maximizing return on investments.

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Financial Engineering, Risk Management & Financial Institutions 10. Maximizing the return on investment and frequency of return, 11. Maintaining financial security for the potentiality of investment 12. Sustaining good grades by rating agencies 13. Scope for securitization 14. Try to reduce the tax complications to the investors

Review of Literature Levich (19851) study made a broad assessment of these recent developments surrounding financial innovation, including their impact on financial stability and national policy-making. This theme suggests several basic questions: (i) What financial product and process changes have occurred over the last twenty to twenty-five years in U.S. and international financial markets? (ii) What factors account for these changes? (iii) What are the implications of these changes for individuals and the aggregate macro economy from both a positive and policy perspective? Tufano (1989 2) examines a cross-section of new securities to examine whether financial product innovators enjoy first mover advantages. He finds that, over the 1974-1986 period, investment banks that created new products did not charge higher prices in the period before imitative products appear and in the long run charge lower prices than rivals. Smith, Smithson, and Wilford (19903) document the increase in the volatility of interest rates, exchange rates, and commodity prices, and draw a relation between increase in riskiness and financial innovation. Verghese (19904) states that it is necessary to take a close look at the main features of the current wave of financial innovation and evaluate objectively what it has achieved and at what cost. It is also important to identify the lessons the financial change and innovation. He made a comprehensive study of Indian financial system and financial innovation. Levich, Richard M. 1985, ‘A View from the International Capital Markets’, In I. Walter, ed., Deregulating Wall Street. New York: John Wiley. 1

Tufano, Peter, 1989, ‘Financial Innovation and First Mover Advantages,’ Journal of Financial Economics, 25, 213-240 2

3 Smith, Clifford W., Jr., Smithson, Charles W., and Wilford, D. Sykes (1990), ‘Managing Financial Risk’, Harper Collins Publishers.

Verghese SK, ‘Financial Innovation and Lessons for India’, special articles, Economic and Political Weekly, Feb 3, 1990. 4

CHAPTER 2 Financial Innovation Merton (19925), focused on the future perspective of financial innovation and he explained functional perspective of financial intermediation. His studies are about financial innovations, lower cost of capital, reduce financial risks, improve financial intermediation, and hence welfare enhancing. According to him ‘the growing need of financial innovation in stimulating economic growth and businesses operations indeed can be viewed by explaining functions it has performed’. Levine (19976) opines that the most of the empirical studies had confirmed that finance or financial system is the heart of the economy which determined economic growth in an economy. This perhaps displays the growing significance of financial innovation as a casual contributor in stimulating the economic growth and reengineering businesses particularly in emerging economies. Tufano (20037) provides the standard explanation for financial innovation is that it helps correct some kind of market inefficiency or imperfection. For example, if markets are incomplete then financial innovation can improve opportunities for risk sharing. If there are agency conflicts, then new types of security can improve the alignment of interests. Other important motivations for financial innovation are to lower taxes or to avoid the effects of regulations. Since both issuers and buyers must benefit from an innovation for it to be successfully introduced, the traditional view of financial innovation has been that it is desirable. John D Finnerty (20028) compiled an informative list of the financial innovations and factors that are primarily responsible for innovation. The compilation covered consumer type financial instruments, securities, financial processes, and financial strategies/solutions based on the tax advantages, reduction of risk of volatility in interest rates, reallocation of risk, reduction of transaction and agency costs, increase in liquidity etc.

5 Miller, Merton H., 1992. ‘Financial Innovation: Achievements and Prospects,’ Journal of Applied Corporate Finance, 4 (Winter), 4-12.

Levine, Ross, 1997. ‘Financial Development and Economic Growth: Views and Agenda.’ Journal of Economic Literature, 35 (June), 688-726. 6

Tufano, P., (2003). ‘Financial Innovation,’ G., Harris, M., Stulz, R. (Eds.), Handbook of the Economics of Finance, Volume 1a, Corporate Finance, Elsevier, 307-336. 7

8 Finnerty, John and Douglas Emery, 2002. ‘Corporate Securities Innovation: An Update,’ Journal of Applied Finance, 12 (Spring/Summer), 21-47.

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Financial Engineering, Risk Management & Financial Institutions Frame and White (20049) found that regulations tend to spur a series of financial innovations. There exists a positive relationship between individual’s education and income and use of the new financial technology by consumers. Financial innovators tend to gain by first mover advantages and recompensated well for their efforts. Draghi (200810), observed that “regulation must not prevent innovation, which is necessary if we are to improve product choices for consumers and an expanded access to credit. Thus, the goal will be to strengthen the resilience of the system without hindering the process of market discipline and innovation that are essential to the financial sector’s contribution to economic growth.”

Types of Innovation Innovation may be applied for two issues: 1. Tax planning, and 2. Modify features of existing financial product.

Engineering over financial instrument is the description of promised yield, liquidity, maturity, security and risk. Given that innovation has the same characteristics in different packaging to suit the constantly varying needs of the issues and the investor’s constitute the indivisible condition of such concept. These innovations are of two kinds: 1. Innovation for the tax planning 2. Facilitate adaptive changes in the existing financial instruments.

1. Innovation for the Tax Planning Financial engineers are called upon to develop special instrument or a combination of instrument to attract more investors which will enables them to reduce tax burden. Besides that they need to design the products which diminishesagency costs emanating form the conflict between share holders, managers and creditors, lowers the combined burden of tax to the issuer also.

2. Facilitate Adaptive Changes in the Existing Financial Instruments Financial engineers are expected to design new features which facilitates adaptive changes in the existing financial instruments of the capital market. Frame, W. and Scoot and Lawrence J. White 92004), “Empirical Studies of Financial Innovations: Lots of Talk, Little Action”, Journal of economic literature, Vol.42, No.1, 116-144. 9

Draghi M (2008), “How to Restore Financial Stability”, Bundesbank Lecture Series, September 16 10

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For instance, profit-linked interest rate securities, optionally dual currency bonds, rating-linked interest rate bonds, and special incorporation equity etc. Some recent developments in the financial products are mentioned below: a. Instruments that offer security with a fixed interest rate coupon and a percentage of the profits derived on the projects. b. Dual currency bonds can be purchased in any of the two currencies specified and can be redeemed as per the indenture at the intervals provided in any of the two designated currencies. c. Securities bearing variable interest rate. These rates, though fixed, change in response to a change in the rating. d. Instrument like special incorporation equity, which is a venture capital investment with a sort of buyback arrangement at the market price plus a fixed monetary premium. For example, Certificate of Deposits (CDS) can be used to separate the return on a corporate bond into the compensation for default risk and the compensation earned on a riskfree security.

Theorems and Theories of Innovation in Financial Engineering Modigliani-Miller Theorem11 Modigliani and Miller (1958) proved that the financial structure of the firm, i.e., the firm’s choice between equity and debt financing, does not affect its value. Their study finds that taxes and regulation are the only reason for investors to mind what kinds of securities firms issue. The theorem states that the structure of a firm’s liabilities should have no bearing on its net worth. The securities may trade at different prices depending on their composition, but they must finally add up to the same value.

Markowitz Theorem12 Markowitz (1959) developed the mean-variance portfolio selection theory, which suggests that investors should fully broaden their horizons and their portfolios should be a mixture of the “market” and a risk-free investment.

Modigliani, Franco and Merton H. Miller. ‘The Cost of Capital, Corporation Finance and the Theory of Investment,’ American Economic Review, 1958.

11

Markowitz H. M., (1959). Portfolio Selection: Efficient Diversification of Investments, Yale University Press, Wiley

12

Prominent Finacial expertsare: Modigliani-Miller, Markowitz, German and Kohlhagen and Ross, who contributed theories for financial innovation.

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Financial Engineering, Risk Management & Financial Institutions Investors with different risk/return goals can use leverage to increase the ratio of the market return to the risk-free return in their portfolios.

Garman and Kohlhagen (1983) Theorem13 Garman and Kohlhagen mathematical theorem is identical to Merton’s (1973) theorem for options on dividend-paying stocks. They have extended the Black-Scholes valuation formula in order to incorporate options on forex. Only the term q, which did represent a stock’s dividend yield, now represents the foreign currency’s continuously compounded risk-free rate.

Ross Theory of Arbitrage Price Theory (APT)14 The Arbitrage Pricing Theory (APT) was developed primarily by Ross (1976). It is a one-period model in which every investor believes that the stochastic properties of returns of capital assets are consistent with a factor structure. He states that if equilibrium prices offer no arbitrage opportunities over static portfolios of the assets, then the expected returns on the assets are approximately linearly related to the factor loadings.

Models and Mechanism of Innovation in Financial Engineering There are various mathematical models are proposed by: Finnerty, Richard Roi, Treynor, Sharpe Jensen, Black and Scholes.

John D Finnerty Model This model identified numerous financial innovations from adjustable rate preferred stock to zero-coupon convertible debt. These can be further classified into three types of activities viz., 1) securities innovation, 2) innovative financial processes and 3) creative solutions to corporate financial problems.

Richard Rol Model This model states that there should be demand for instruments that open up new types of investment opportunities, but not for instruments that merely repackage existing risks. Thus, investors cannot invest in the entire market. This implies there should be demand for instruments that open up new types of investment opportunities. Because investors are closer to being Garman, Mark B. and Steven W. Kohlhagen (1983), ‘Foreign Currency Option Values’, Journal of International Money and Finance, 2, 231-237.

13

14 Ross, S., 1976a, ‘The Arbitrage Theory of Capital Asset Pricing’, Journal of Economic Theory, 13, 341–60.

CHAPTER 2 Financial Innovation able to buy the entire market. But not for instruments that merely repackage existing risks As investors already have as much exposure to those risks in their portfolio. If the world existed as the Arrow-Debreu model posits, then there would be no need for financial innovation.

The Arrow-Debreu Model15 Arrow (1953) and Debreu (1959) extended the existing economic models by incorporating uncertainty and showed how to solve the corresponding asset allocation problem. This model assumes that investors are competent to purchase securities that pay off if and only if a certain state of the world occurs. Investors can then combine these securities to create portfolios that have whatever payoff they desire. The fundamental theorem of finance states that the price of assembling such a portfolio will be equal to its expected value under the appropriate risk-neutral measure.

Treynor, Sharpe, Linter & Mossin Model Sharpe (1964), Lintner (1965), and Mossin (1966) extended the Markowitz theory and created the so-called capital asset pricing model (CAPM).This is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset’s non-diversifiable risk. The model takes into account the asset’s sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often represented by the quantity beta (â) in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset.

Black and Scholes (1973)16 This is a mathematical model of a financial market containing certain derivative investment instruments. From the model, one can deduce the Black– Scholes formula, which gives the price of European-style options. The formula led to a boom in options trading and legitimised scientifically the activities of the Chicago Board Options Exchange and other options markets around the world. Arrow, K. J.; Debreu, G. (1954), ‘Existence of an Equilibrium for a Competitive Economy’, Econometrica, 22: 265-290. 15

Black, Fischer; Myron Scholes (1973), ‘The Pricing of Options and Corporate Liabilities’, Journal of Political Economy, 81 (3): 637-654. 16

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Vasicek (1977) Model17 Vasicek model is a mathematical model describing the evolution of interest rates.

This was the ûrst to propose an analytically tractable model taking into account the mean reversion property of the instantaneous interest rate and the pull-topar property. This model is a mathematical model describing the evolution of interest rates. It is a type of “one-factor model” as it describes interest rate movements as driven by only one source of market risk. The model can be used in the valuation of interest rate derivatives, and has also been adapted for credit markets, although its use in the credit market is in principle wrong, implying negative probabilities

Genesis of Finance Theory and Financial Engineering The development of financial engineering starts with the work of the French mathematician Louis Bachelier who, in the year 1900, published the now famous memoir entitled ìTheorie de la spÈculationî. Bachelierís. To mention just one, he developed (before Einstein and others) the first theory of Brownian motion which he used in order to quantify the evolution of stock prices.

The gross roots of engineering can be found in the year 1900 with the work of French mathematician “Louis Bachelier”

Arrow (1953) and Debreu (1959) extended the existing economic models by incorporating uncertainty and showed how to solve the corresponding asset allocation problem. Modigliani and Miller (1958) proved that the financial structure of the firm, i.e., the firm’s choice between equity and debt financing, does not aûect its value. Markowitz (1959) developed the mean-variance portfolio selection theory. Sprenkle (1961), Boness (1964), and Samuelson (1965) proposed a more adequate description of the stock price evolution by assuming that this price follows the geometrical Brownian motion and, consequently, is distributed log-normally which guarantees its positivity. Sharpe (1964), Lintner (1965), and Mossin (1966) extended the Markowitz theory and created the so-called capital asset pricing model (CAPM).

17 Vasicek, Oldrich (1977). ‘An Equilibrium Characterisation of the Term Structure’. Journal of Financial Economics 5 (2): 177–188.

CHAPTER 2 Financial Innovation Black and Scholes (1973) and Merton (1973) discovered a consistent pricing formula for stock options depending on the volatility of the underlying stock and the riskless interest rate at which the money can be borrowed overnight. Black (1976) derived the formula for the valuation of options on futures. Ross (1976) developed the arbitrage-pricing theory (APT) as an alternative to CAPM. Vasicek (1977) was the ûrst to propose an analytically tractable model taking into account the mean reversion property of the instantaneous interest rate and the pull-to-par property. Margrabe (1978) valued the right to exchange one risky asset for another (via an elegant application of the principle of homogeneity). Harrison and Kreps (1979) and Harrison and Pliska (1981) developed an approach to pricing and hedging of derivatives which complements the one developed by Black and Scholes and Merton. Garman and Kohlhagen (1983) extended the Black-Scholes valuation formula in order to incorporate options on forex. Merton and Rubinstein and Reiner (1991), used the method of images in order to price the so-called barrier options which disappear when the price of the underlying hits a predetermined barrier.

Pioneers of Finance Theory Irving Fisher, 1867-1947. John Maynard Keynes, 1883-1946. Sir John R. Hicks, 1904-1989. Nicholas Kaldor, 1908-1986. Jacob Marschak, 1898-1977. John Burr Williams, 1902-1989. •

Theory of Investment Value, 1938.

•

International trade under flexible exchange rates, 1954.

•

Founder and developer of “fundamentalist” theory of asset valuation.

Benjamin Graham, 1894-1976.

31

32

Financial Engineering, Risk Management & Financial Institutions Samuel Eliot Gould •

Stock Growth and Discount Tables, 1931.

•

Often credited as the founder of the “intrinsic value” or “fundamentalist” theory of stock markets.

Modern Portfolio Theory (MPT) Harry M. Markowitz, 1923 James Tobin, 1918 William J. Baumol, 1922 William F.Sharpe, 1934 John Lintner, 1916

Arbitrage and Equilibrium Theory Roy Radner, 1927 Stephen A. Ross, 1944 Fisher Black, 1938 Myron S. Scholes, 1941 Robert C. Merton, 1944 Oliver D. Hart, 1948 David M. Kreps, 1950 Darrell J. Duffie

Finance and the Firm Merton H. Miller, 1927 Franco Modigliani, 1918 Michael C. Jensen, 1939 Joseph E. Stiglitz, 1943 Paul R. Milgrom, 1948 Douglas Gale, 1950

Empiricists and the Efficient Markets Hypothesis Louis Bachelier, 1870-1946. Holbrook Working, 1895-1985.

CHAPTER 2 Financial Innovation

33

Alfred Cowles, 3rd., 1891-1984 - (1), image •

“Can Stock Market Forecasters Forecast?”, 1933, Econometrica.

•

“Some Posteriori Probabilities in Stock market Action” with H. Jones, 1937, Econometrica.

•

Common Stock Indexes, 1871-1937, 1938.

•

“Stock Market Forecasting”, 1944, Econometrica

•

“A Revision of Previous Conclusions Regarding Stock Price Behavior”, 1960, Econometrica

Oskar Morgenstern, 1902-1976. Paul A. Samuelson, 1915 Benoit B. Mandelbrot, 1924 Hendrick S. Houthakker, 1924 Eugene F. Fama, 1939 Robert E. Lucas, Jr., 1937

Conclusion This chapter deals with various important issues of financial innovation. The process of creating innovative financial securities in terms of technical aspects and derivative pricing that offers new pay-offs to investors is the part of financial innovation. This chapter also discusses various models and theorems of innovation, genesis of finance and financial engineering.

Keywords

Keywords

Financial Innovation: Financial innovation is an essential force motivating the financial system toward greater economic competence with considerable economic advantage accruing from the changes over the time. Modigliani-Miller Theorem: Modigliani and Miller (1958) proved that the financial structure of the firm, i.e., the firm’s choice between equity and debt financing, does not aûect its value. Markowitz Theorem: Markowitz (1959) developed the mean-variance portfolio selection theory, which suggests that investors should fully broaden their horizons and their portfolios should be a mixture of the “market” and a risk-free investment.

34

Financial Engineering, Risk Management & Financial Institutions Garman and Kohlhagen (1983) Theorem: Garman and Kohlhagen mathematical theorem is identical to Merton’s (1973) theorem for options on dividend-paying stocks. Ross Theory of Arbitrage Price Theory(APT): Developed primarily by Ross, it is a one period model in which every investor believes that the stochastic properties of returns of capital assets are consistent with a factor structure. Richard Rl Model: This model states that there should be demand for instruments that open up new types of investment opportunities, but not for instruments that merely repackage existing risks. Arrow-Debreu Model: This model assumes that investors are competent to purchase securities that pay off if and only if a certain state of the world occurs. Treynor, Sharpe, Linter & Mossin Model: This is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already welldiversified portfolio, given that asset’s non-diversifiable risk. Black and Scholes Model: This is a mathematical model of a financial market containing certain derivative investment instruments. Vasicek (1977) Model: This is a mathematical model describing the evolution of interest rates.

Review Questions

Review Questions

1. Give meaning and definitions of financial innovation.

4. Define models and theorems of innovation in financial engineering.

2. Discuss the need and objectives of financial innovation.

5. Illustrate various models and theorems of innovation in financial engineering.

3. What do you know about various types of innovation for tax planning?

References

References

1. Financial Management by Dr. Paresh P. Shah, 2nd Ed. Biztantra (Dreamtech Press) 2. Strategic Financial Management by Dr. Meena Goyal, Biztantra (Dreamtech Press) 3. Financial Wisdom by Dr. A. P. Dash, Biztantra (Dreamtech Press)

4. Advanced Financial Management by Dr. U. M. Premalatha, Biztantra (Dreamtech Press) 5. International Financial Management by Dr. S.P. Srinivasan & Dr. B.Janakiram, Biztantra.

CHAPTER 2 Financial Innovation

35

Case Study

Case Study

Note: Students are advised to go through the following article and find need for financial innovation in india.

WHY FINANCIAL INNOVATION MAKES SENSE1 Aug 18, 2010: To innovate, or not to innovate, that is the question being asked in the financial sector, both here and in the mature markets abroad. The Reserve Bank of India has put out a discussion paper on the issue of introducing credit default swaps (CDS), financial instruments meant to mitigate risks and insure against default on loans, bonds etc. But then CDS, and certain other instruments of ‘high fi-nance,’ such as collateralised debt obligation, CDO, which led to massive issuance of structured products like mortgage-backed securities, have been blamed for much of the excesses that precipitated the global financial crisis of 2007-9. The study does aver that there is a mix of ‘good and bad financial innovations,’ but on balance, finds ‘more good ones than bad ones.’ It goes on to call for a conducive environment for such innovation, and underlines the need for close oversight and proactivity on the part of policymakers, such as the ‘need to spot rapid growth in any particular asset class, for this tends to be a strong sign of potential excess.’ The paper elaborates that innovations in finance in the past several decades have improved payments, saving, investment and risk-bearing activity across the board, and in ways that are convenient and economically beneficial. The simplest example of a financial instrument is a bank deposit. But as one progresses from innovations meant for consumers–payments, saving and consumer-lending products–on to those serving financial institutions, institutional investors and corporates, to better finance investment and allocate risk, it can mean much complex structuring. The paper reiterates the need for the standardisation of financial instruments–essentially contracts–noting that bonds are nothing more than standardised loans. On CDS, for instance, what’s proposed is the ‘creation and extensive use of a central clearing house for standardised trades.’ The study posits that in the run-up to the financial crisis, some innovations, for example CDOs were ‘poorly designed,’ while others, like CDS, ‘were misused.’ Besides, the ‘explosive’ growth of CDOs in the US should have been a warning sign ‘that something was amiss,’ never mind the bipartisan political intention to encourage home-ownership for all and sundry. When the housing

1

Jaideep Mishra, ET Bureau: http://articles.economictimes.indiatimes.com/2010-08-18/news/ 28488402_1_financial-innovation-financial-crisis-cdos

36

Financial Engineering, Risk Management & Financial Institutions

bubble went brust, it led to massive default on mortgage payments, with the result that CDOs worth tens of billions of dollars become toxic assets, and fast. Hence the credit crisis. The paper adds that it is necessary to distinguish between the innovation itself, and ‘how it can and may be used or misused.’

NEW PRODUCT DEVELOPMENT Introduction Stages of New Product Development Financial Instruments Best Practices for NPD Benchmarking How to Face Future Challenges? Conclusion Keywords Review Questions References Case Study

38

Financial Engineering, Risk Management & Financial Institutions

Chapter Objectives

Chapter Objectives

After studying this chapter the student will be able to:

™

Understand meaning and definitions of financial product.

™

Learn about the stages of new product development.

™

Assist in the development of new finacial products to achieve organizational goal of F M.

™

Illustrate with examples the best practices in new product development from Indian industry.

Introduction Financial product is a tool useful for savings (or) investment.

This chapter is intended to focus on the process of new product development in general, and relating to financial products in particular. As compared to earlier, financial markets are changing quicker than in any other time in history. Hence, the present financial market needs are stimulating technological development in product. It is therefore necessary that companies should have effective and efficient new product development (NPD) skills to improve their competitive position to seek more investors. Financial institutions should focus their NPD team on developing new products to keep up with the changing needs of the financial market. Financial engineers assist in the development of new financial products to achieve a common goal of ‘financial optimization’

Definition of ‘Financial Product’ A product that is connected with the way in which you manage and use your money, such as a bank account, a credit card, insurance, etc. In common usage, a product is a tangible good. However, the financial services industry tends to use the word “product” to describe the vast majority of what it sells, from services to investment instruments or products like stocks and bonds.

Definition of NPD Innovativeness is the base for “New Product Development”.

New Product Development is defined as ‘the process of developing a product from initial stage of ‘Design’ to ‘Physical Reality’. New products are the means of support to the organisation in competitive markets. Any products have a finite life span and this is influenced by the type of product, its innovativeness, the management of the product through its life cycle, as well as the markets in which it is sold.

CHAPTER 3 New Product Development

Stages of New Product Development The new product development process has the potential to be all over the place because of the intrinsic uncertainty in the process, as well as the innumerable methods available for product development. The following figure 3.1 depicts the stages of new product development.

Figure 3.1: Stages of New Product Development

Stage -2 Idea Generation Stage -2a

Stage - 1 Strategy Formulation

Design and Prototype

f

f Screening and Evaluation f

Stage - 1a

Stage - 3

Planning

Stage - 4 Business Analysis

f

Stage - 5 Concept and Feature Development

Stage - 6 f

Market Testing

f

Stage - 5a Pilot Production and Production

f

f

Stage - 7 Commercialization Stage - 7a Distribution Stage - 7b Sales and Marketing Stage - 7c After-sales Service

f

39

40

Financial Engineering, Risk Management & Financial Institutions

Stage1: New Strategy Formulation There are seven stages for formulating (or) developing a new financial product/ service.

New strategy formulation is nothing but ‘the process of deciding on objectives, on the changes in objectives, on the resources used to attain these objectives, and on the policies that are to govern the acquisition, used and disposition of resources’. Formulation of strategy involves decision-making by corporate management thatA. objectives, goals and aim of organization can be determined. B. long-term and short-term plans to achieve aim and goals are prepared.

Stage 1a: Planning In the Planning stage of NPD, project is usually geared toward international business when feasible in order to increase geographical markets and market potential. With an increased market potential, the NPD investment decisions become more salable. The aggregate product plan is considered during the planning stages. Overextending the company’s resources during this phase can adversely affect NPD efforts by decreasing productivity across the development teams. Once the concepts have taken form, the concept ideas are deduced based on a set of screening criteria that fits the company’s posture while satisfying its strategic and financial needs.

Stage 2: Idea Generation The basic approach is to tie together inventiveness in some form for the development of new ideas.

The second stage of innovation is the idea generation which will be based on brainstorming, Delphi and focus groups. The basic approach is to tie together inventiveness in some form for the development of new ideas. While there is much to advocate for the more qualitative approaches, ideas for new products can be obtained from basic research and analysis. Lots of ideas are generated about the new product. Out of these ideas very few are implemented.

Stage 2a: Design and Prototype Engineering and manufacturing departments should work together to design a new product.

Once senior management approves the planning stage, the product development cycle is rotated to the design & prototype stage. During this time, marketing team uses knowledge of the customer and how products will be used to help guide product design. The design goal is to create products that surpass traditional product specifications by addressing how the products will be used. Engineering defines and verifies the product and process architecture and tries to use the latest technology to improve product quality and/or lower costs. The marketing group then defines target market parameters, develops sales and profit forecasts. These forecasts require interaction with engineering

CHAPTER 3 New Product Development

41

and manufacturing who chose components, interact with suppliers, and develop cost estimates based on the material and processes needed for manufacture. The design phase naturally evolves into the prototype testing phase that involves building early systems prototypes with the objective of maximizing performance and matching customer expectations. Early prototypes are built and often used by the marketing group for early customer interaction. Near the end of the prototype and design phase, engineering and operations management validate feasibility of processes, validate suppliers, and test and install tooling and equipment. Senior management approves the product and process architecture and parameters to rotate the development cycle to the next stage.

Stage 3: Screening and Evaluation The objective of screening and evaluation is to eliminate unsound concepts prior to devoting resources to them. This will be done a separate committee appointed by management. They will concentrate on various issues like: ¾ Will the customer in the target market gain from the product? ¾ What is the size and growth forecasts of the target market? ¾ What is the predictable competitive pressure for the product idea?

Stage 4: Business Analysis In this stage ‘SWOT (Strengths, Weaknesses, Opportunities & Threats) analysis’ will be carried out. It aims at the following issues: ¾ Analyze present capacity and turnover. ¾ Estimate competition and make comparative study. ¾ Estimate opportunities, likely selling price and sales volume. ¾ Estimate profitability and break-even point.

Stage 5: Concept Development and Feature Development Concept development and Feature development are two sides of the same coin. Concept development is intended to review the existing financial product, which enables to suggest new features for the product. Concept development occurs during the planning stages and includes new product and process ideas from many sources. Inputs from all areas of the organization, customers, noncustomers, suppliers and external research organizations are taken into deliberation for new product concepts. Feature development is the process of identifying features that would be of interest to customers. While in case of feature development, combinations of features are used to build or evaluate the product. Usually prices are provided at the feature level to ensure that

Concept development is intended to review the existing financial product and takes inputs from all stakeholders.

42

Financial Engineering, Risk Management & Financial Institutions respondents make realistic decisions. The Optimizer is different in that respondents make choices from among fully formed products. Information from their choices is taken into account in creating successive products that are more preferred till the process finally converges on the investor’s ideal product.

In a msnufacturing division, pilot production is carried out to integrate all tools, equipment, assembly sequences.

Stage 5a: Pilot Production and Production The pilot production & production stages have two phases. Pilot production is the phase that tests the whole system by integrating designs, detailed engineering, tools, equipment, components, assembly sequences, and employees. It involves using the individual components that are built and tested on production equipment. Assembling and testing the final product is performed in the factory. The pilot production phase results in many units produced while modifying the manufacturing processes if necessary. Once the pilot production phases have been refined, the production phase starts high yield volume production. The volume increases incrementally once the NPD team is confident with the quality of the final product at each level. Products are tested for compliance with quality and cost targets resulting in improvement of processes to meet these expectations. Engineering then evaluates and tests the pilot units, solves problems, and works with marketing to train field service personnel. The assembly line is designed to be as flexible as possible in order to adapt to the new products or processes it will be expected to produce. This flexibility allows the assembly line to produce a variety of products. Companies can no longer make the same item in large volumes for an extended period because product life cycles are shrinking. The goal is to make entire families of products or a unique item on the same production line. A flexible production line cuts down on the cycle time for any new products in the future. The decrease in cycle time increases profitability of companies and makes them more competitive. This is especially important in high technology areas because the rate at which newer generations of products are entering the market is shorter for each successive generation. To stay competitive, companies must offer the latest technological advancements to their customers (Michael, Summe, & Uttal, 1990)1.

Nevens, T. Michel, George, Summe and Bro uttal, (1990), Commercializing Technology; what the best companies do; Harvard Business Review (May/June) 154-62.

1

CHAPTER 3 New Product Development

43

Stage 6: Market Testing The following are some important steps for market testing: ¾ Construct a physical prototype or mock-up. ¾ Test the product in representative usage situations. ¾ Perform focus group customer interviews or introduce at trade show. ¾ Produce an initial run of the product and sell it in a test market area to determine customer acceptance.

Stage 7: Commercialization This activity of the launching the product and it is often considered postNPD. The following are various issues in the commercialization: ¾ Produce and place advertisements and other promotions ¾ Fill the distribution pipeline with product

Stage 7a: Distribution The distribution stage requires marketing to formulate the channel strategy. Distribution channels are filled and new channels are explored. A channel distribution map is an effective tool to help plan distribution strategy. This map displays sales and market share information by channel over a particular period. The map makes it easier to see trends and competitors’ changes in channel activity. Channel information is gathered from trade publications, surveys and other forms of market research.

Stage 7b: Sales and Marketing

For a financial product, customer expectation ‘after-sales service’ and customer feedback is vital for further improvement (or) modifications in the product/ service.

By the time the sales and marketing stage arrives, the sales force knows the details of the product technology and its uses. It is also familiar with the after-sales service support available. The sales force also understands and responds to customers’ requirements, needs, wants, methods of using the product, and complaints.

Stage 7c: After-sales Service The after-sales service stage of the NPD cycle occurs when customer feedback is gathered and deployed back into the organization. Once a product or service is sold, the company should then provide after-sales servicing, offer regular servicing and repairs, deal with customer complaints, anticipate customer dissatisfactions and their needs and wants for the future. Customer feedback is used to control and improve the quality assurance system. This feedback

Once a product or service is sold, the company should then provide after-sales servicing, offer regular servicing and repairs.

44

Financial Engineering, Risk Management & Financial Institutions promotes design changes to existing products or after-sales service organizations and is used for new product development planning stages for other projects.

Customer feedback is important because customer attitude directly affects repeat purchases of products.

Any corporate entity has to monitor customers through surveys, interviews, focus groups, and complaint handling. Through these means the corporation will use after-sales service customer feedback to understand customers’ operations, how they use products, and what problems they have. Customer feedback introduces a range of human experiences and should be monitored, understood and used by the company. This feedback is important because customer attitude directly affects repeat purchases of products. Satisfaction resulting from a purchase feeds back into the confidence and attitude of the buyer. That, in turn, affects the intentions to buy a product. When goods and/ or services are purchased, consumers anticipate their expectations regarding the products will be met. Once this has occurred, the consumers’ attitude and confidence are boosted. This generally increases the customers’ intentions to buy the product again and to promote products by word of mouth. Without customer satisfaction, there will be little second time purchases and the market will easily be lost to competitors who produce products that do satisfy customer expectations.

Financial Instruments The main instruments can be organized into a table as follows: Instrument Type Asset Class Like -> Debt (Long term)

Securities

Other Cash

Exchange-traded Derivatives Bond futures Options on bond futures

Interest rate swaps Interest rate caps and floors Interest rate options Exotic instruments

Bonds

Loans

Bills, e.g. T-Bills Commercial Paper

Deposits Certificates of deposite

Short-term intrest rate futures

Forward rate agreement

Stock

N/A

Stock option

Stock options

Equity futures

Exotic instruments

>1 year Debt (Short term) Rc i.e., the firm can earn higher return than what the shareholders can earn on their investments, the firm should retain the earning. Such firms are termed as growth firms, and in their case the optimum dividend policy would be to plough back the earnings. If Ra < Rc i.e., the firm does not have profitable investment opportunities, the optimum dividend policy would be to distribute the entire earnings as dividend. In case of firms, where Ra = Rc, it does not matter whether the firm retains or distribute its earning. Assumptions: Walter’s dividend policy is based on the following assumptions: (i)

The firm does the entire financing through retained earnings. It does not use external sources of funds such as debt or new equity capital.

(ii) Rc and Ra remain constant with additional investment. (iii) There is no change in the key variables, namely, beginning E, D. (iv) The firm has a very long life.

CHAPTER 4 Valuation of Equity Shares

59

The relationship between dividend and share price on the basis of Walter’s formula is shown below: Vc = { D + Ra ( E- D)/ Rc} / Rc Where, ¾ Vc = Market value of ordinary shares of the company. ¾ Ra = Return on internal retention, i.e., the rate company earns on retained profits. ¾ Rc = Capitalisation rate, i.e., the rate expected by investors by way of return from particular category of shares. ¾ E = Earning per share. ¾ D = Dividend per share.

Modigliani and Miller ( M-M) – Dividend Irrelevancy Model ¾ P0 = (P1 + D 1) / ( 1 + Ke) ¾ Where ¾ Po = Existing market price per share ¾ P1 = Market price of share at the year end (to be determined) ¾ D1 = Contemplated dividend per share ¾ Ke = Capitalisation rate

Valuation of Preference Shares By definition preference shares have a constant dividend kp = D/MV(ex div) where D = constant annual dividend If you have cumulative preference shares, the MV is increased by the outstanding amount to be paid. Preference dividends are normally quoted as a percentage, e. g., 10% preference shares. This means that the annual dividend will be 10% of the nominal value, not the market value. Share prices change, often dramatically, on a daily basis. The dividend valuation model will not predict this, but will give an estimate of the underlying value of the shares.

Modigliani & Miller Model shows that there is no importance for dividend.

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Financial Engineering, Risk Management & Financial Institutions

Conclusion Value of preference share depends on the rate of dividend.

This chapter is intended to understand various issues relating to equity and valuation of equity. The word ‘Equity’ implies that equity stockholders have an equity stake in the company. An equity security is a share in the ‘equity share capital’ a company. The holder of equity is a shareholder, owning a share, or fractional part of the issuer. Unlike debt securities, which typically require regular payments to the holder, equity securities are not entitled to any payment. Equity also enjoys the right to profits and capital gain.

Practical Problems 1. What is the value of a preferred stock where the dividend rate is 16 percent on a Rs.100 par value? The appropriate discount rate for a stock of this risk level is 12 percent. Solution: Value(Vps) = (0.16 x 100)/ 0.12 = Rs.133.33 2. Rishi’s preferred stock is selling for Rs.55.16 and pays Rs.2.35 in dividends. What is your expected rate of return if you purchase the security at the market price? Solution: Expected Rate of Return 2.35 K ps = Dividend = = 4.26% Selling Price 55.16 3. Ishwar owns 250 shares of Swathy Resources’ preferred stock, which currently sells for Rs.38.50 per share and pays annual dividends of Rs.3.25 per share. a. What is your expected return? b. If you require an 8 percent return, given the current price, should you sell or buy more stock? Solution: a. Expected retur =

Dividend 3.25 = = .0844 = 8.44% Price 38.50

b. Given your 8 percent required rate of return, the stock is worth Rs.40.62 to you 3.25 Dividend Value = =Rs. 40.625 = Required Rate of Return .08

CHAPTER 4 Valuation of Equity Shares Since the expected rate of return (8.44%) is greater than your required rate of return (8%) or since the current market price (Rs.38.50) is less than Rs.40.62, the stock is undervalued and you should buy. 4. You intend to purchase Kogent, Inc., Equity shares at Rs.52.75 per share, hold it one year, and sell after a dividend of Rs.6.50 is paid. How much will the stock price have to appreciate if your required rate of return is 16 percent? Value (Vcs) = Rs.52.75

=

Dividend in Year 1 (1 + Required Rate) 6.50 (1 + .16)

=

+

Price in Year 1 (1 + Required Rate)

P1 (1 + .16)

Rearranging and solving for P1: P1 = Rs.52.75 (1.16) - Rs.6.50 P1 = Rs.54.69 The stock would have to increase Rs.1.94 (Rs.54.69 - Rs.52.75) or 3.6 percent (Rs.1.94/Rs.52.75) to earn a 16% rate of return. 5. Arjuna’s Equity shares currently sells for Rs.23 per share. The company’s executives anticipate a constant growth rate of 10.5 percent and an end-of-year dividend of Rs.2.50. a. What is the expected rate of return if you buy the stock for Rs.23? b. If you require a 17 percent return, should you purchase the stock? Solution: 1. a.

Expected (k cs) = rate of return 2.50 (kcs) = 23.00

Dividend in Year1 Market Price

+

growth rate

+ .105= .2137 (k cs) = 21.37%

b.

vcs =

2.50 .17 - .105

= Rs. 38.46%

The expected rate of return exceeds your required rate of return, which means that the value of the security to you is greater than the current market price. Thus, you should buy the stock.

61

62

Financial Engineering, Risk Management & Financial Institutions 6. Kogent Inc., paid a Rs.3.75 dividend last year. At a constant growth rate of 6 percent, what is the value of the Equity shares if the investors require a 20 percent rate of return? Value (Vcs )

=

Vcs =

Last Year Dividend (1 + Growth Rate) Required Rate - Growth Rate 3.75(1 + .06) .20 - .06

Vcs = Rs.28.39 7. Given that a firm’s return on equity is 24 percent and management plans to retain 60 percent of earnings for investment purposes, what will be the firm’s growth rate? Growth rate = return on equity x retention rate = (24%) (60%) = 14.4% 8. The Equity shares of Micky Mouse Co. is selling for Rs.33.84. The stock recently paid dividends of Rs.3 per share and has a projected constant growth rate of 8.5 percent. If you purchase the stock at the market price, what is your expected rate of return? Solution: Expected Rate of Return (K cs) = Last Year Dividend (1 + Growth Rate) + Growth Rate Price

(Kcs) = 3.00(1.085) + 0.085 = 0.181 = 18.1% 33.84

9. Sleepwell Equity shares is expected to pay Rs.1.85 in dividends next year, and the market price is projected to be Rs.40 by year end. If the investor’s required rate of return is 12 percent, what is the current value of the stock? Solution: Value (Vcs)=

Dividend in Year 1 + Price in year 1 (1 + Required Rate) (1 + Required Rate)

Vcs=

1.85 40.00 + (1.12) (1.12)

Vcs =

Rs.37.37

CHAPTER 4 Valuation of Equity Shares 10. The market price for Dharmendra & Co.’s Equity shares is Rs.44. The price at the end of one year is expected to be Rs.47, and dividends for next year should be Rs.2. What is the expected rate of return? Solution: If the expected rate of return is represented by Kcs: Current Price=

Dividend in Year 1 + (1+ Kcs )

Price in Year 1 (1+Kcs)

Kcs = Dividend in Year 1 + Price in Year -1 Current Price Kcs =

2.00 + 47.00 44.00

-1 = 0.1136

Kcs =11.36% 11. Abhilasha’s preferred stock is selling for Rs.35 in the market and pays a Rs.4 annual dividend. a. What is the expected rate of return of the stock? b. If an investor’s required rate of return is 10 percent, what is the value of the stock for the investor? c. Should the investor acquire the stock? Solution: Kps = b.

Dividend 4.00 = 11.43% = Price 35.00

Value (Vps) =

Dividend Required Rate of Return

= 4.00 = Rs. 40 0.10

c. The investor’s required rate of return (10 percent) is less than the expected rate of return for the investment (11.43 percent). Also, the value of the stock to the investor (Rs.40) exceeds the existing market price (Rs.35). You should buy the stock. 12. The Equity shares of Jaya & Co Ltd paid Rs.1 in dividends last year. Dividends are expected to grow at an 8 percent annual rate for an indefinite number of years. a. If the current market price is Rs.25, what is the stock’s expected rate of return?

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Financial Engineering, Risk Management & Financial Institutions b. If your required rate of return is 11 percent, what is the value of the stock for you? c. Should you make the investment? Solution: a. Expected Rate of Return =

b. Investor’s Value

Dividend in Year 1 Growth + Market Price Rate

=

1.00(1.08) +0.08= 0.1232 25.00

=

12.32%

=

Dividend in Year 1 Required Rate of Return - Growth Rate

=

1.00(1.08) 0.11 - 0.08

=

Rs.36.00

c. Yes, the expected rate of return is greater than your required rate of return (12.32 percent versus 11 percent). Also, your value of the stock (Rs.36.00) is larger than the current market price (Rs.25.00).

Practice Problems 1. What is the value of a preferred stock where the dividend rate is 14 percent on a Rs.200 par value? The appropriate discount rate for a stock of this risk level is 13 percent. 2. Rishi’s preferred stock is selling for Rs.75.56 and pays Rs.4.35 in dividends. What is your expected rate of return if you purchase the security at the market price? 3. Ishwar owns 550 shares of Swathy Resources’ preferred stock, which currently sells for Rs.58.50 per share and pays annual dividends of Rs.9.25 per share. a. What is your expected return? b. If you require an 10 percent return, given the current price, should you sell or buy more stock? 4. You intend to purchase Kogent Inc., Equity shares at Rs.72.75 per share, hold it one year, and sell after a dividend of Rs.16.50 is paid.

CHAPTER 4 Valuation of Equity Shares How much will the stock price have to appreciate if your required rate of return is 15 percent? 5. Arjuna’s Equity shares currently sells for Rs.53 per share. The company’s executives anticipate a constant growth rate of 11.5 percent and an end-of-year dividend of Rs.5.50. a. What is the expected rate of return if you buy the stock for Rs.53? b. If you require a 15 percent return, should you purchase the stock? 6. Kogent Inc., paid a Rs.5.75 dividend last year. At a constant growth rate of 9 percent, what is the value of the Equity shares if the investors require a 14 percent rate of return? 7. Given that a firm’s return on equity is 22 percent and management plans to retain 70 percent of earnings for investment purposes, what will be the firm’s growth rate? 8. The Equity shares of Angry Bird Co. is selling for Rs.63.84. The stock recently paid dividends of Rs.5 per share and has a projected constant growth rate of 9.5 percent. If you purchase the stock at the market price, what is your expected rate of return? 9. Sleepwell Equity shares is expected to pay Rs.4.85 in dividends next year, and the market price is projected to be Rs.90 by year end. If the investor’s required rate of return is 11 percent, what is the current value of the stock? 10. The market price for John & Co.’s Equity shares is Rs.74. The price at the end of one year is expected to be Rs.77, and dividends for next year should be Rs.4. What is the expected rate of return? 11. L&T Ltd, stock is selling for Rs.120 per share and it just declared an annual dividend of Rs.4.50. According to fundamental analysis, it is estimated that the company will continue to grow at the rate of 25% per year for the next three years and then it will maintain a growth rate of 10% per year forever. Its dividend payout ratio is expected to remain constant. If the investor required rate of return is 18% what is your decision for investment? 12. Corfoam Ltd, stock is selling for Rs.150 per share and it just declared an annual dividend of Rs.14.50. According to fundamental analysis, it is estimated that the company will continue to grow at the rate of 20% per year for the next three years and then it will maintain a growth rate of 12% per year forever. Its dividend payout ratio is expected to remain constant. If the investor required rate of return is 19% what is your `decision for investment?

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Financial Engineering, Risk Management & Financial Institutions 13. Biztantra Co. has paid Rs.3.00 annual dividend per share. The dividends are expected to growth at the rate of 5% annually for next 12 years. After 12 years there will be no growth, but it will continue to pay dividend at a constant rate. What is price of Stock, if discount rate is 14%. 14. Rahul Gupta & Co. has paid Rs.3.75 annual dividend per share. The dividends are expected to growth at the rate of 6% annually for next 8 years. After 8 years there will be no growth, but it will continue to pay dividend at a constant rate. What is price of Stock, if discount rate is 15%.

Keywords

Keywords

¾ Equity: The word ‘Equity’ implies that equity stockholders have an equity stake in the company. ¾ Equity Security: An equity security is a share in the ‘equity share capital’ a company. The holder of equity is a shareholder, owning a share, or fractional part of the issuer. ¾ Cost of Equity: Cost of equity is the cost to the company of providing equity holders with the return they require on their investment. ¾ Value of Equity: The value of equity is obtained by discounting expected cash flows to equity, i.e., the residual cash flows after meeting all expenses, tax obligations and interest and principal payments, at the cost of equity, i.e., the rate of return required by equity investors in the firm. ¾ Dividend Discount Model: The dividend discount model is a specialized case of equity valuation, and the value of a stock is the present value of expected future dividends. ¾ Price Earnings Ratio: The price earnings ratio (PE) is a widely watched measure of how much the market is willing to pay for Rs.1 of earnings from a firm. ¾ Walter’s Approach to Dividend Policy: This approach supports the doctrine that the investment policy of a firm cannot be separated from its dividend policy and both are according to him interlinked.

Review Questions

Review Questions

1. What do you understand by equity and valuation of equity?

4. Define and distinguish the Gordon Growth Model and Price Earning Valuation Model.

2. Discuss the anticipated rate of return.

5. Discuss about Walter’s Approach to Dividend Policy and Modigliani and Miller Model.

3. What are the uses of One Period Valuation Model and Generalized Dividend Valuation Model?

6. How does Walter’s approach to Dividend Policy supports the doctrine that the investment policy of a firm cannot be separated from its dividend policy?

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References

References

1. Financial Management by Dr. Paresh P. Shah, 2nd Ed. Biztantra(Dreamtech Press)

4. Advanced Financial Management by Dr.U.M. Premalatha, Biztantra (Dreamtech Press)

2. Strategic Financial Management by Dr. Meena Goyal, Biztantra(Dreamtech Press)

5. International Financial Management by Dr. S.P. Srinivasan & Dr. B. Janakiram, Biztantra.

3. Financial Wisdom by Dr. A. P. Dash, Biztantra (Dreamtech Press)

6. Accounting for Managers by Dr. Meena Goyal, Biztantra

Case Study

Case Study

Case-1 The equity stock of Rose Ltd is currently selling for Rs.30 per share. The dividend expected next year is Rs.2.00. The investor’s required rate of return on this stock is 15 percent. If the constant growth model applies to Rose Ltd, what is the expected growth rate? In case the growth rate rises to 12 per cent, at what price the stock is likely to be sold?

Case-2 The expected return and betas are given below for three stocks: Particulars

Expected return

Beta

Hero

14%

1.20

Iocon

15%

0.75

Jack

20%

1.50

Assume risk-free return as 9 per cent, and market return as 15 per cent. Determine which stock(s) are undervalued or Overvalued.

Case-3 The equity stock of Rare Ltd is previously selling for Rs.30 per share. The dividend expected next year is Rs.2.00. The investor’s required rate of return on this stock is 12 percent. If the constant growth model applies to company is 6 per cent, at what price the stock is likely to be sold? If the growth rate is raised to 10 per cent and investors required return is 14 per cent what is expected price of the share?

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Case-4 The following information is available: particulars

Q Ltd

R Ltd

Dividend

Nil

Nil

Selling price

Rs.50

Rs.100

After one year expected Price

Rs.57 or Rs.61

Rs.117 or Rs.113

Probability

0.55

0.45

Which stock, Q or R would you prefer to purchase now? Why?

Case-5 For the first four years Wipro firm assumed to grow at a rate of 14% after four years the growth rate of dividend is assumed to decline linearly to 10%. After 7 years the firm is assumed to grow at a rate of 10% infinitely. The next year dividend is Rs.4 and the required rate of return is 16%. Find out the value of the stock (two phase model).

EQUITY RELATED INSTRUMENTS Introduction Equity Related Instruments Warrants Equity Options - Equity Derivatives Stock Market Index Futures Single-stock Futures Equity Basket Derivatives Equity Swap Equity Index Swaps Rights Issue Underwriting Call Option Valution of Options Subscription Rights Foreign-exchange Options Conclusion Practice Problems Keywords Review Questions References Case Study

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Chapter Objectives

Chapter Objectives

After studying this chapter the student will be able to: Learn about various equity related instruments. Understand equity index and the methods of constructing it. Discuss about meaning characteristics and valuation of warrants. Analyze various types of equity futures and options.

Introduction This chapter is intended to understand various issues relating to equity relating instruments. It also deals with valuation of equity related issues like rights, exrights, options and warrants. Every corporate entity will get capital in the form of ‘equity’ and ‘debt’. The word ‘Equity’ implies that equity stockholders have an equity stake in the company. An equity security is a share in the ‘equity share capital’ a company. The holder of equity is a shareholder, owning a share, or fractional part of the issuer.

Equity Related Instruments Equity Index

Equity Index is a compilation of several stock prices into a single number.

A equity index1 is a compilation of several stock prices into a single number. Indexes come in various shapes and sizes. Some are broad-based and measure moves in broad, diverse markets. Others are narrow-based and measure more specific industry sectors of the marketplace. Understand that it is not the number of stocks that comprise the average that determine if an index is broad-based or narrow-based, but rather the diversity of the underlying securities and their market coverage. Thus, indexes are based on identical securities, they may measure the relevant market differently because of differences in methods of calculation, which are mentioned below: i) Capitalization-Weighted Method: An index can be constructed so that weightings are biased toward the securities of larger companies, a method of calculation known as capitalization-weighted. In calculating the index value, the market price of each component security is multiplied by the number of shares outstanding. 1

http://www.optionseduction.org/

CHAPTER 5 Equity Related Instruments ii) Simple Average Method: In this method, Index can be calculated by simply adding up the prices of the securities in the index and dividing by the number of securities, disregarding numbers of shares outstanding. iii) Daily Percentage Movement Method: In this method, daily percentage movements of prices by averaging the percentage price changes of all securities included in the index. Adjustments & Accuracy 1. Securities may be dropped from an index because of events such as mergers and liquidations or because a particular security is no longer thought to be representative of the types of stocks constituting the index.

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Equity Index measures are based on three methods: viz., (1) Capitalization Weighted Method (2) Simple Average Method & (3) Daily percentage Movement Method

2. Securities may also be added to an index from time to time. 3. Adjustments to indexes might be made because of such substitutions or due to the issuance of new stock by a component security. However, an adjustment panel has authority to make adjustments if the publisher of the underlying index makes a change in the index’s composition or method of calculation that, in the panel’s determination, may cause significant discontinuity in the index level. 4. Finally, an equity index will be accurate only to the extent that: The component securities in the index are being traded. The prices of these securities are being promptly reported. The market prices of these securities, as measured by the index, reflect price movements in the relevant markets.

Warrants A warrant is a security that entitles the holder to buy stock of the company that issued it at a specified price, which is much higher than the stock price at time of issue. Warrants are frequently attached to bonds or preferred stock as a sweetener, allowing the issuer to pay lower interest rates or dividends. They can be used to enhance the yield of the bond, and make them more attractive to potential buyers. Warrants have similar characteristics to that of other equity derivatives, such as options, for instance:

‘Warrant’ is a security that entitles the holder to buy stock of the company.

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Characteristics of Warrants Exercise Price, premium, gearing and expiration rate are important assumptions of warrants.

a) Exercise Price: A warrant is exercised when the holder informs the issuer their intention to purchase the shares underlying the warrant. The warrant parameters, such as exercise price, are fixed shortly after the issue of the bond. b) Premium: A warrant’s “premium” represents how much extra you have to pay for investor shares when buying them through the warrant as compared to buying them in the regular way. c) Gearing: A warrant’s “gearing” is the way to ascertain how much more exposure investor have to the underlying shares using the warrant as compared to the exposure you would have if you buy shares through the market. d) Expiration Date: The expiry date is the date on which the right to exercise ceases to exist. One can plan on exercising the warrant before the expiration date. The more time remaining until expiry, the more time for the underlying security to appreciate, which, in turn, will increase the price of the warrant.

Valuation of Warrants Warrants Value = (Share price – Exercise price) x Exchange ratio A Warrant is a certificate, normally issued long with a debenture instrument, in which a company gives the holder the right to buy a specific number of ordinary shares for a particular price for a specified length of period.

Equity Options - Equity Derivatives Equity derivatives derive their value from the price of underlying stock(s).

Equity options are the most common type of equity derivative. They provide the right, but not the obligation, to buy (call option) or sell (put option) a quantity of stock for example: 1 contract = 100 shares of stock, at a set price which is also called as ‘strike price’, within a certain period of time prior to the expiration date. Investors can gain exposure to the equity markets using futures and options. These can be done on single stocks, a customized basket of stocks or on an index of stocks. These equity derivatives derive their value from the price of the underlying stock or stocks.

Stock Market Index Futures Stock market index futures are ‘contracts’ used to replicate the performance of an underlying stock market index. They can be used for hedging against

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73

an existing equity position, or speculating on future movements of the index. Example: S&P, FTSE, DAX, CAC40 and other G12 country indices.

Single-stock Futures Single-stock futures are ‘Exchange-traded futures contracts’, which are based on an individual underlying security rather than a stock index. Their performance is similar to that of the underlying equity itself, although as futures contracts they are usually traded with greater leverage. Another difference is that holders of long positions in single stock futures typically do not receive dividends and holders of short positions do not pay dividends. Single-stock futures may be cash-settled or physically settled by the transfer of the underlying stocks at expiration.

Equity Basket Derivatives Equity basket derivatives are futures, options or swaps where the underlying is a non-index basket of shares. They have similar characteristics to equity index derivatives, but are always traded OTC (Over The Counter), i.e., between established institutional investors, as the basket definition is not standardized in the way that an equity index is.

Equity based derivatives are futures, options or swaps.

Equity Swap An equity swap, like an equity index swap, is an agreement between two parties to swap two sets of cash flows. In this case the cash flows will be the price of an underlying stock value swapped, for instance, with LIBOR2. A typical example is the Contract for difference (CFD) where one party gains exposure to a share price without buying or selling the underlying share.

Equity Index Swaps An equity index swap is an agreement between two parties to swap two sets of cash flows on predetermined dates for an agreed number of years. The cash flows will be an equity index value swapped, for instance, with LIBOR. Swaps can be considered as being a relatively straightforward way of gaining exposure to an asset class you require. They can also be relatively cost efficient. 2

LIBOR - London Inter Bank Offered Rate

Equity swap & Equity Index swaps are mutual agrements to swap cash flows.

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Rights Issue ‘Rights Issue’, is a privelege to existing shareholders.

A rights issue is an option that a company can opt for to raise capital under a secondary market offering. The rights issue is a special form of shelf offering or shelf registration. With the issued rights, existing shareholders have the privilege to buy a specified number of new shares from the firm at a specified price within a specified time. A rights issue is in contrast to an initial public offering, where shares are issued to the general public through market exchanges. A rights issue is straightforwardly offered to all shareholders of record or through broker dealers of record and may be exercised in full or partially. Subscription rights may either be transferable, allowing the subscriptionright-holder to sell them privately, on the open market or not at all. A right issuance to shareholders is generally issued as a tax-free dividend on a ratio basis. Because the company receives shareholders’ money in exchange for shares, a rights issue is a source of capital. The following are important aspects to be considered: The value of rights vs. trading price of the subscription rights The effect of rights on the value of the current share The effect of rights to shareholders of record and new shareholders and right-holders Manager or Broker Dealer to manage the Offering processes Selling Group and broker dealer participation Subscription price per new share Number of new shares to be sold

Value of Rights Number of new shares to be issued will be dependent on subscription price.

A rights issue is an invitation to existing shareholders to purchase additional new shares in the company. More specifically, this type of issue gives existing shareholders securities called “rights”, which, well, give the shareholders the right to purchase new shares at a discount to the market price on a stated future date. The company is giving shareholders a chance to increase their exposure to the stock at a discount price. An often overlooked means of raising new capital is through a rights offerings or rights issuance. Rights issues occur when a firm sells new shares to those investors who have “rights.” Rights give their holders the right to buy the new shares at the

CHAPTER 5 Equity Related Instruments subscription price. To see how these work, an example is necessary. The first step is to determine how much the firm needs to raise. For example, suppose a firm needs to raise Rs.50 million. Currently, they have 22 million shares outstanding at a price of Rs.25 a share. The next step is to determine a subscription price. The subscription price is the price at which the rights holders purchase the new shares. In this case let the subscription price be Rs.15/share. How many shares must you sell? Number of new shares = (Amount you need to raise)/(subscription price) So in this case: Rs.50,000,000/Rs.15=3,333,334 new shares How many rights will be needed to buy a single new share? (Number of rights granted)/(Number of shares being sold) 22,000,000/3,333,334 6.6 rights/new share We assume that the everyone will exercise their rights, and more importantly that the investment opportunities will not change and further that the rights issuance does not change the operations of the firm. If this is true, then pricing is quite simple: Overall equity value after issuance = Equity value before issuance + amount raised = (shares * Price) + amount raised = 22,000,000* Rs.25 + Rs.50,000,000 = Rs.600,000,000 Total number of shares (post issuance) Number of shares outstanding before the issuance + new shares issued 22,000,000 + 3,333,334 25,333,334 Price per share = new total market value/new number of shares = Rs.600,000,000/25,333,334 = Rs.23.68

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Financial Engineering, Risk Management & Financial Institutions Now we can calculate the value of each right. New price = subscription price + [(number of rights needed) * (value of each right)] Rs. 23.68 = Rs.15.00 + [( 6.6) * (value of each right)] Solve for the value of each right Right = Rs.1.315 Note that ex-right price plus value of right = old stock price. 23.68 + 1.315 = 24.995= Rs.25.00 This can also be found by Right price = (Old price - subscription price) / (number of rights per new share + 1) =(Rs.25.00 - 15.00) / (6.6 + 1) =(Rs.10.00)/(7.6) = Rs.1.315 If these rights are deemed as transferable, they can be sold on the secondary market. Most rights offerings involve transferable rights. Value of Ex-Rights Px = WoPo + WsPs Wo - No .of old shares per no.of total shares Ws - No.of new shares per no.of total shares Po - The price of rights-on-shares Ps - The subscription price Example: Calculate the price for right issue and the bonus issue. At this moment, the share price is 6.40 at PAR value of 0.25, below is the announcement from the company : (1) rights issue of 267,807,215 new ordinary shares of Rs. 0.25 each on the basis of one new Share for every four existing Shares held (“Proposed Rights Issue”). Ans: To calculate you would have post the rights issue: 4 shares at 6.40=25.60 + 1 share at x. Theoretical ex-rights price =(25.60+x)/5.

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Underwriting The role of the underwriter is to guarantee that the funds sought by the company will be raised. The agreement between the underwriter and the company is set out in a formal underwriting agreement. Typical terms of an underwriting require the underwriter to subscribe for any shares offered but not taken up by shareholders. The underwriting agreement will normally enable the underwriter to terminate its obligations in defined circumstances. A sub-underwriter in turn sub-underwrites some or all of the obligations of the main underwriter; the underwriter passes its risk to the sub-underwriter by requiring the sub-underwriter to subscribe for or purchase a portion of the shares for which the underwriter is obliged to subscribe in the event of a shortfall. Underwriters and sub-underwriters may be financial institutions, stock-brokers, major shareholders of the company or other related or unrelated parties. The Panel’s guidance covers both non-underwritten and underwritten rights issues. Basic Example An investor: Mr. A had 100 shares of company X at a total investment of Rs.40,000, assuming that he purchased the shares at Rs.400 per share and that the stock price did not change between the purchase date and the date at which the rights were issued. Assuming a 1:1 subscription rights issue at an offer price of Rs.200, Mr. A will be notified by a broker dealer that he has the option to subscribe for an additional 100 shares of common stock of the company at the offer price. Now, if he exercises his option, he would have to pay an additional Rs.20,000 in order to acquire the shares, thus effectively bringing his average cost of acquisition for the 200 shares to Rs.300 per share ((40,000+20,000)/200=300). Although the price on the stock markets should reflect a new price of Rs.300, the investor is actually not making any profit nor any loss. In many cases, the stock purchase right can be traded at an exchange. In this example, the price of the right would adjust itself to Rs.100. The company: Company X has 100 million outstanding shares. The share price currently quoted on the stock exchanges is Rs.400 thus the market capitalization of the stock would be Rs.40 billion. If all the shareholders of the company choose to exercise their stock option, the company’s outstanding shares would increase to 200 million.

Underwriting is the process of guaranteeing that the funds sought by the company will be raised.

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Financial Engineering, Risk Management & Financial Institutions The market capitalization of the stock would increase to Rs.60 billion, implying a share price of Rs.300 (Rs.60 billion/200 million shares). If the company were to do nothing with the raised money, its Earnings per share (EPS) would be reduced by half. However, if the equity raised by the company is reinvested, the EPS may be impacted depending upon the outcome of the reinvestment.

Call Option Call option is a finacial contract between buyer and seller.

A call option, often simply labeled a “call”, is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument the seller of the option at a certain time for a certain price. The seller is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee for this right. The buyer of a call option purchases it in the hope that the price of the underlying instrument will rise in the future. The seller of the option either expects that it will not, or is willing to give up some of the upside from a price rise in return for the premium and retaining the opportunity to make a gain up to the strike price. Call options are most profitable for the buyer when the underlying instrument moves up, making the price of the underlying instrument closer to, or above, the strike price. The call buyer believes it’s likely the price of the underlying asset will rise by the exercise date. The risk is limited to the premium. The profit for the buyer can be very large, and is limited by how high the underlying instrument’s spot price rises. When the price of the underlying instrument surpasses the strike price, the option is said to be “in the money”. The call writer does not believe the price of the underlying security is likely to rise. The writer sells the call to collect the premium and does not receive any gain if the stock rises above the strike price. The initial transaction in this context, either buying or selling a call option, is not the supplying of a physical or financial asset. Rather it is the granting of the right to buy the underlying asset, in exchange for a fee — the option price or premium.

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Exact specifications may differ depending on option style. A European call option allows the holder to exercise the option only on the option expiration date. An American call option allows exercise at any time during the life of the option. Call options can be purchased on many financial instruments other than stock in a corporation. A traceable call option should not be confused with either Incentive stock options or with a warrant. An incentive stock option, the option to buy stock in a particular company, is a right granted by a corporation to a particular person to purchase treasury stock. When an incentive stock option is exercised, new shares are issued. Incentive stock options are not traded on the open market. In contrast, when a call option is exercised, the underlying asset is transferred from one owner to another.

Valuation of Options Option values vary with the value of the underlying instrument over time. The price of the call contract must reflect the “likelihood” or chance of the call finishing in-the-money. The call contract price generally will be higher when the contract has more time to expire and when the underlying financial instrument shows more volatility. Determining this value is one of the central functions of financial mathematics. The most common method used is the Black–Scholes formula. Whatever the formula used, the buyer and seller must agree on the initial value, otherwise the exchange of the call will not take place. Adjustment to Call Option: When a call option is in-the-money i.e., when the buyer is making profit, he has many options. Some of them are as follows: 1. He can sell the call and book his profit. 2. If he still feels that there is scope of making more money he can continue to hold the position. 3. If he is interested in holding the position but at the same time would like to have some protection, he can buy a protective “put” of the strike that suits him. 4. He can sell a call of higher strike price and convert the position into “call spread” and thus limiting his loss if the market reverses.

“Option Value” is dependent on the value of underlying instrument over time.

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Financial Engineering, Risk Management & Financial Institutions Similarly if the buyer is making loss on his position i.e. the call is out-ofthe-money, he can make several adjustments to limit his loss or even make some profit.

Example The market price of wipro is Rs.28 at present. Six months call option is written on stock with an exercise price of rs.30/- presently, the option has a market price of Rs. 30/-expected market price of stock and their probabilities are as follows: Price

24

28

32

37

43

Probability

0.1

0.2

0.4

0.2

0.1

Find Expected value using weighted average and value of options. Solution: Price

Probability

Price x probability

24

0.1

2.4

28

0.2

5.6

32

0.4

12.8

37

0.2

7.4

43

0.1

4.3

Expected market price

32.5

Value of Option If share price < Exercise Price = 0 If share price > Exercise Price, Value of option is: V Opt = SP---EP Note: In this, share price is less than exercise price. Hence, value of option is zero.

Subscription Right Subscription Right is called a “First option to buy”.

The right of current shareholders to maintain their fractional ownership of a company by buying a proportional number of

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shares of any future issue of common stock. Most states consider preemptive rights valid only if made explicit in a corporation’s charter. also called subscription privilege or preemptive right. It is a contractual right to acquire certain property newly coming into existence before it can be offered to any other person or entity. Also called a “first option to buy.” A right to acquire existing property in preference to any other person is usually referred to as a right of first refusal. In practice, the most common form of pre-emption right is the right of existing shareholders to acquire new shares issued by a company in a rights issue, a usually but not always public offering. In this context, the pre-emptive right is also called subscription right o r subscription privilege. This is the right, but not the obligation, of existing shareholders to buy the new shares before they are offered to the public. In this way, existing shareholders can maintain their proportional ownership of the company, preventing stock dilution. In many jurisdictions, subscription rights are automatically provided for by statute, for example the UK, but in other jurisdictions it only arises if provided for under the constitutional documents of the relevant company, for example the US. Other situations in which pre-emption rights are seen to arise are in property developments; parties close to the investors are often given a right of pre-emption in relation to new flats or condominiums within a development.

Foreign-exchange Option A foreign-exchange option (commonly shortened to just FX option o r currency option) is a derivative financial instrument that gives the owner the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date.

Conclusion This chapter, we have discussed various issues relating to equity relating instruments. It also deals with valuation of related issues like rights, ex-

FX option is the right to exchange money denominated in one currency into another currency.

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Financial Engineering, Risk Management & Financial Institutions rights, options and warrants. Every corporate entity will get capital in the form of ‘equity’ and ‘debt’. The word ‘Equity’ implies that equity stockholders have an equity stake in the company. An equity security is a share in the ‘equity share capital’ a company. The holder of equity is a shareholder, owning a share, or fractional part of the issuer. Unlike debt securities, which typically require regular payments to the holder, equity securities are not entitled to any payment. Equity also enjoys the right to profits and capital gain.

Practice Problems Philips has Warrants outstanding which will allow the holder to buy 3 shares of equity for a total of Rs.60 per Warrant. The market price of equity share is Rs.18 at present. The holders believe the following Probabilities about equity stock six months hence, Market price

16

18

20

22

24

Probabilities

15

20

30

20

15

a. What is the present theoretical value of the warrant? b. What is expected value of stock rice after 6 months? c. What is theoretical value, expected of the warrant 6 months hence?

Keywords

Keywords

Equity: The word ‘Equity’ implies that equity stockholders have an equity stake in the company. Equity Security: An equity security is a share in the ‘equity share capital’ a company. Stock Index: A stock index is a compilation of several stock prices into a single number. Indexes come in various shapes and sizes. Capitalization-weighted Method: It is a method of calculation known as capitalizationweighted. In calculating the index value, the market price of each component security is multiplied by the number of shares outstanding. Simple Average Method: In this method, Index can be calculated by simply adding up the prices of the securities in the index and dividing by the number of securities, disregarding numbers of shares outstanding. Warrant: A warrant is a security that entitles the holder to buy stock of the company that issued it at a specified price, which is much higher than the stock price at time of issue.

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Equity Options: Equity options are the most common type of equity derivative. They provide the right, but not the obligation, to buy (call option) or sell (put option) a quantity of stock. Single-stock Futures: Single-stock futures are ‘Exchange-traded futures contracts’, which are based on an individual underlying security rather than a stock index. Equity Basket Derivatives: Equity basket derivatives are futures, options or swaps where the underlying is a non-index basket of shares. Equity Swap: An equity swap, like an equity index swap, is an agreement between two parties to swap two sets of cash flows. Equity Index Swap: An equity index swap is an agreement between two parties to swap two sets of cash flows on predetermined dates for an agreed number of years. Rights Issue: A rights issue is an option that a company can opt for to raise capital under a secondary market offering. Value of Rights: A rights issue is an invitation to existing shareholders to purchase additional new shares in the company. Underwriter: The role of the underwriter is to guarantee that the funds sought by the company will be raised. Underwriting Agreement: The agreement between the underwriter and the company is set out in a formal underwriting agreement. The underwriting agreement will normally enable the underwriter to terminate its obligations in defined circumstances. Call Option: A call option, often simply labeled a “call”, is a financial contract between two parties, the buyer and the seller of this type of option. The Pre-emptive Right: The pre-emptive right is also called subscription right or subscription privilege. A Foreign Exchange Option: A foreign-exchange option is a derivative financial instrument that gives the owner the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date.

Review Questions

Review Questions

1. What do you understand by various types of equity related instruments?

4. Discuss the formula and method of pricing of options.

2. Define equity futures and equity options. What are the different types of options?

5. Illustrate the meaning and concept of subscription right.

3. Analyze the Single-stock futures as ‘Exchange-traded futures contracts’.

6. Discuss the uses of the financial instrument foreign exchange option.

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References

References

1. Financial Management by Dr. Paresh P. Shah, 2 nd Ed. Biztantra (Dreamtech Press)

4. Advanced Financial Management by Dr.U.M.Premalatha, Biztantra (Dreamtech Press)

2. Strategic Financial Management by Dr. Meena Goyal, Biztantra (Dreamtech Press)

5. International Financial Management by Dr. S.P. Srinivasan & Dr. B. Janakiram, Biztantra.

3. Financial Wisdom by Dr. A. P. Dash, Biztantra (Dreamtech Press)

6. Accounting for Managers by Dr. Meena Goyal, Biztantra

Case Study

Case Study

VALUATON OF RIGHTS ISSUE The Mukharjee Chartered Co. is raising new capital through a rights offering. Mukharjee Chartered Co currently has outstanding 100,000 shares and wants to raise Rs.1 million by selling new shares for Rs. 40 each. The share price is currently Rs. 46 per share. (a) What is the market value of Mukharjee Chartered Co.? (b) How many new shares will be issued? (c) How many rights will be issued? (d) How many rights will be required to buy one share? (e) What is the value of one right? (f) What will the share price be after the offering? Solution: (a) The market value of shares is 100 000 x 46 = 4 600 000 (b) The number of new shares is 1 000 000:40 = 25 000 (c) Number of old shares = number of rights = 100 000 (d) Number of old shares/number of new shares: 100 000:25000 = 4 4 rights will be required to buy a new share (e) R = ( Po - S)/(N + 1) R = (46 -40)/(4 + 1) = 1.2 (f) The value of one share will be: 46 – 1.2 = 44.8

DEBT MARKET AND VALUATION OF BONDS Introduction Debt Market Debt Market Instruments Government Securities Public Sector Bonds Private Sector Bonds Bonds in Foreign Currencies Bonds: at Par, at Discount, at Premium Bonds Market Definition of Bond Valuation of Redeemable Debentures/Bonds Conclusion Practical Problems Practice Problems Glossary of Selected Financial Instruments Keywords Review Questions References Case Study

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Chapter Objectives

Chapter Objectives

After studying this chapter the student will be able to: Learn about meaning features and classification of bonds. Understand the debt market and various trading debt market instruments. Know about government securities, and various types of bonds. Calculate valuation of redeemable debentures/bonds.

Introduction A Bond is a formal contract to repay borrowed money with a specified interest at fixed intervals.

This chapter is focused to understand about debt market and valuation of Bonds. Every corporate entity will acquire in the form of equity share capital and debt capital. Debt capital is raised through issue of bonds or debenture, which can be raised from ‘Debt Market’.

Debt Market Definition of Debt Market1

The Debt market is the market where fixed income securities are traded.

The Debt Market is the market where fixed income securities of various types and features are issued and traded. Debt Markets are therefore, markets for fixed income securities issued by Central and State Governments, Municipal Corporations, Govt. bodies and commercial entities like Financial Institutions, Banks, Public Sector Units, Public Ltd. companies and also structured finance instruments. The following are various connotations of Debt Market. i) Bond Market: In the event that the market deals mainly with the trading of municipal and corporate bond issues, the debt market may be known as a bond market. ii) Credit Market: If mortgages and notes are the main focus of the trading, the debt market may be known as a credit market. iii) Fixed Income Market: When fixed rates are connected with the debt instruments, the market may be known as a fixed income market. 1

Note: This definition is given by Bombay Stock Exchange.

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Features of Debt Market A debt market establishes a structured environment where these types of debt can be traded with ease between interested parties. Individual investors as well as groups or corporate partners may participate in a debt market.

Debt Market Instruments Debt instruments typically have maturities of more than one year. The instruments traded can be classified into the following segments based on the characteristics of the identity of the issuer of these securities: Market Segment

Issuer

Instruments

Government Securities

Central Government

Zero Coupon Bonds, Coupon Bearing Bonds, Treasury Bills, STRIPS

State Governments

Coupon Bearing Bonds.

Government Agencies/Statutory Bodies

Govt. Guaranteed Bonds, Debentures

Public Sector Units

PSU Bonds, Debentures, Commercial Paper

Corporates

Debentures, Bonds, Commercial Paper, Floating Rate Bonds, Zero Coupon Bonds, Inter-corporate Deposits

Banks

Certificates of Deposits, Debentures, Bonds

Financial Institutions

Certificates of Deposits, Bonds

Public Sector Bonds

Private Sector Bonds

Source: Encyclopedia of Banking & Finance (9h Edition) by Charles J Woelfel

Government Securities Government securities called G-secs or Gilts. Like T-bills, Gilts are issued by RBI on behalf of the Government. These instruments form a part of the

Government Securities are T-Bills and G- Secs or Gilts

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Financial Engineering, Risk Management & Financial Institutions borrowing program approved by Parliament in the Finance Bill each year. Typically, they have a maturity ranging from 1 year to 20 years. Like TBills, Gilts are issued through auctions but RBI can sell/buy securities in its Open Market Operations (OMO). OMOs cover repos as well and are used by RBI to manipulate short-term liquidity and thereby the interest rates to desired levels. The other types of government securities include Inflation-linked bonds, Zero-coupon bonds, State government securities.

Zero-coupon Bonds Zero coupon bonds are issued at a substantial discount to par value.

Pay no regular interest. They are issued at a substantial discount to par value, so that the interest is effectively rolled up to maturity (and usually taxed as such). The bondholder receives the full principal amount on the redemption date. Zero-coupon bonds may be created from fixed rate bonds by a financial institution separating (“stripping off”) the coupons from the principal. In other words, the separated coupons and the final principal payment of the bond may be traded separately. It is a bond bought at a price lower than its face value, with the face value repaid at the time of maturity. It does not make periodic interest payments, or have so-called “coupons”, hence the term zero-coupon bond. When the bond reaches maturity, its investor receives its par (or face) value. Examples of zero-coupon bonds include U.S. Treasury bills, U.S. savings bonds, long-term zerocoupon bonds. In contrast, an investor who has a regular bond receives income from coupon payments, which are usually made semi-annually. The investor also receives the principal or face value of the investment when the bond matures. Some zero-coupon bonds are inflation indexed, so the amount of money that will be paid to the bond holder is calculated to have a set amount of purchasing power rather than a set amount of money, but the majority of zero coupon bonds pay a set amount of money known as the face value of the bond.

Classification of Zero-coupon Bonds Based on Periodicity

1. Short-term 2. Long-term

Based on Nature

1. Face value 2. Inflation Indexed

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Zero-coupon bonds may be long or short-term investments. Long-term zero coupon maturity dates typically start at ten to fifteen years. The bonds can be held until maturity or sold on secondary bond markets. Short-term zero coupon bonds generally have maturities of less than one year and are called bills.

Treasury Bonds Treasury bond, also called government bond, is issued by the Federal government and is not exposed to default risk. It is characterized as the safest bond, with the lowest interest rate. A treasury bond is backed by the “full faith and credit” of the federal government. For that reason, this type of bond is often referred to as risk-free.

Treasury bond is characterized as the safest bond, with the lowest interest rate.

Treasury Bills Treasury bills (or T-Bills) mature in one year or less. Like zero-coupon bonds, they do not pay interest prior to maturity; instead they are sold at a discount of the par value to create a positive yield to maturity. Regular weekly T-Bills are commonly issued with maturity dates of 28 days (or 4 weeks, about a month), 91 days (or 13 weeks, about 3 months), 182 days (or 26 weeks, about 6 months), and 364 days (or 52 weeks, about 1 year). Treasury bills are sold by single-price auctions held weekly. Offering amounts for 13-week and 26-week bills are announced each Thursday for auction, usually at 11:30 a.m., on the following Monday and settlement, or issuance, on Thursday. Offering amounts for 4-week bills are announced on Monday for auction the next day, Tuesday, usually at 11:30 a.m., and issuance on Thursday. Offering amounts for 52-week bills are announced every fourth Thursday for auction the next Tuesday, usually at 11:30 am, and issuance on Thursday. Purchase orders at Treasury Direct must be entered before 11:00 on the Monday of the auction. Banks and financial institutions, especially primary dealers, are the largest purchasers of T-bills.

T-Bills are mostly issued to banks, financial institutions & Primary dealers.

Strip Bond “STRIPS” stands for Separate Trading of Registered Interest and Principal Securities. It is a bond where both the principal and regular coupon payments—which have been removed—are sold separately. An investment firm will usually buy a debt instrument and “strip” it into its separate parts. Strip bonds usually trade at a discount and mature to par value. Zero coupon bonds have a duration equal to the bond’s time to maturity, which makes

Strips Bonds usually trade at a discount and mature to par value.

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Financial Engineering, Risk Management & Financial Institutions

The coupons and residue are sold separately to investors.

them sensitive to any changes in the interest rates. Investment banks or dealers may separate coupons from the principal of coupon bonds, which is known as the residue, so that different investors may receive the principal and each of the coupon payments. This creates a supply of new zero coupon bonds. The coupons and residue are sold separately to investors. Each of these investments then pays a single lump sum. This method of creating zero coupon bonds is known as stripping and the contracts are known as strip bonds. Dealers normally purchase a block of high-quality and non-callable bonds— often government issues—to create strip bonds. A strip bond has no reinvestment risk because the payment to the investor occurs only at maturity.

Bond Duration Strips Bonds are primarily administered by a central bank or central securities depository.

The impact of interest rate fluctuations on strip bonds, known as the bond duration, is higher than for a coupon bond. A zero coupon bond always has a duration equal to its maturity; a coupon bond always has a lower duration. Strip bonds are normally available from investment dealers maturing at terms up to 30 years. In Canada, investors may purchase packages of strip bonds, so that the cash flows are tailored to meet their needs in a single security. These packages may consist of a combination of interest (coupon) and/or principal strips. In New Zealand, bonds are stripped first into two pieces—the coupons and the principal. The coupons may be traded as a unit or further subdivided into the individual payment dates.

Public Sector Bonds are medium and long-term obligation issued by public sector companies.

In most countries, strip bonds are primarily administered by a central bank or central securities depository. An alternative form is to use a custodian bank or trust company to hold the underlying security and a transfer agent/ registrar to track ownership in the strip bonds and to administer the program. Physically created strip bonds (where the coupons are physically clipped and then traded separately) were created in the early days of stripping in Canada and the U.S., but have virtually disappeared due to the high costs and risks associated with them.

Public Sector Bonds These are usually issued by public sector companies, called a public sale, where both members of the public and banks may bid for bond. Since the

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coupon is fixed, but the price is not, the percent return is a function both of the price paid as well as the coupon. However, because the cost of issuance for a publicly auctioned bond can be cost prohibitive for a smaller loan, it is also common for smaller bonds to avoid the underwriting and auction process through the use of a private placement bond. In the case of a private placement bond, the bond is held by the lender and does not enter the large bond market. Sometimes the documentation allows the issuer to borrow more at a later date by issuing further bonds on the same terms as before, but at the current market price.

Private Sector Bonds Fixed vs Floating Rate Bonds Fixed rate bonds have a coupon that remains constant throughout the life of the bond. Floating rate notes (FRNs) have a variable coupon that is linked to a reference rate of interest, such as LIBOR or Euribor. For example, the coupon may be defined as three month USD LIBOR + 0.20%. The coupon rate is recalculated periodically, typically every one or three months.

Inflation Linked Bonds In which the principal amount and the interest payments are indexed to inflation. The interest rate is normally lower than for fixed rate bonds with a comparable maturity (this position briefly reversed itself for short-term UK bonds in December 2008). However, as the principal amount grows, the payments increase with inflation. The United Kingdom was the first sovereign issuer to issue inflation linked Gilts in the 1980s. Treasury InflationProtected Securities (TIPS) and I-bonds are examples of inflation linked bonds issued by the U.S. government.

TIPS & I-Bonds are examples of inflation linked bonds issued by USA.

Asset-backed Securities Asset-backed securities are bonds whose interest and principal payments are backed by underlying cash flows from other assets. Examples of assetbacked securities are mortgage-backed securities (MBS’s), collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs).

Senior & Subordinated Bonds Subordinated bonds are those that have a lower priority than other bonds of the issuer in case of liquidation. In case of bankruptcy, there is a hierarchy of creditors. First the liquidator is paid, then government taxes, etc. The

Senior bonds will have first priority over subordinated bonds while liquidation.

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Financial Engineering, Risk Management & Financial Institutions first bond holders in line to be paid are those holding what is called senior bonds. After they have been paid, the subordinated bond holders are paid. As a result, the risk is higher. Therefore, subordinated bonds usually have a lower credit rating than senior bonds. The main examples of subordinated bonds can be found in bonds issued by banks, and asset-backed securities. The latter are often issued in tranches.

Perpetual Bonds Perpetual bonds also known as Treasury Annuities or Undated Treasuries.

Perpetual bonds are also often called perpetuities or ‘Perps’. They have no maturity date. The most famous of these are the UK Consols, which are also known as Treasury Annuities or Undated Treasuries. Some of these were issued back in 1888 and still trade today, although the amounts are now insignificant. Some ultra-long-term bonds (sometimes a bond can last centuries: West Shore Railroad issued a bond which matures in 2361) are virtually perpetuities from a financial point of view, with the current value of principal near zero.

Bearer Bond Bearer bonds are very risky because they can be lost or stolen.

Bearer bond is an official certificate issued without a named holder. In other words, the person who has the paper certificate can claim the value of the bond. Often they are registered by a number to prevent counterfeiting, but may be traded like cash. Bearer bonds are very risky because they can be lost or stolen. In India, bearer bonds are ‘currency notes’ issued by RBI.

Registered Bond Registered bond is a bond whose ownership is recorded by the issuer, or by a transfer agent. It is the alternative to a Bearer bond. Interest payments, and the principal upon maturity, are sent to the registered owner.

Build America Bonds (BABs) Build America bonds is a new form of municipal bond authorized by the American Recovery and Reinvestment Act of 2009. Unlike traditional municipal bonds, which are usually tax exempt, interest received on BABs is subject to federal taxation. However, as with municipal bonds, the bond is tax-exempt within the state it is issued. Generally, BABs offer significantly higher yields (over 7 percent) than standard municipal bonds.

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Book-entry Bond Book-entry bond is a bond that does not have a paper certificate. As physically processing paper bonds and interest coupons became more expensive, issuers have tried to discourage their use.

Lottery Bond Lottery bond is a bond issued by a state, usually a European state. Interest is paid like a traditional fixed rate bond, but the issuer will redeem randomly selected individual bonds within the issue according to a schedule. Some of these redemptions will be for a higher value than the face value of the bond.

In lottery bond interest is paid like a traditional fixed rate bond.

Serial Bond Serial bond is a bond that matures in installments over a period of time. In effect, a Rs.100,000, 5-year serial bond would mature in a Rs.20,000 annuity over a 5-year interval.

Revenue Bond Revenue bond is a special type of municipal bond distinguished by its guarantee of repayment solely from revenues generated by a specified revenue-generating entity associated with the purpose of the bonds. Revenue bonds are typically “non-recourse,” meaning that in the event of default, the bond holder has no recourse to other governmental assets or revenues.

Climate Bond Climate bond is a bond issued by a government or corporate entity in order to raise finance for climate change mitigation or adaptation related projects or programs.

Bonds in Foreign Currencies Some companies, banks, governments, and other sovereign entities may decide to issue bonds in foreign currencies. Issuing bonds denominated in foreign currencies also gives issuers the ability to access investment capital available in foreign markets. The proceeds from the issuance of these bonds can be used by companies to break into foreign markets, or can be converted into the issuing company’s local currency to be used on existing operations

“Samurai bond” is issued by Japanese govt. in Europe Market.

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Financial Engineering, Risk Management & Financial Institutions through the use of foreign exchange swap hedges. Foreign issuer bonds can also be used to hedge foreign exchange rate risk. Some foreign issuer bonds are called by their nicknames, such as the “samurai bond.” These can be issued by foreign issuers looking to diversify their investor base away from domestic markets. These bond issues are generally governed by the law of the market of issuance, e.g., a Samurai bond, issued by an investor based in Europe, will be governed by Japanese law.

Bonds: at Par, at Discount, at Premium Bonds may be issued at Par, (or) at discount (or) at Premium.

The interest rate that the issuer of a bond must pay is influenced by a variety of factors, such as current market interest rates, the length of the term and the creditworthiness of the issuer. These factors are likely to change over time, so the market price of a bond will vary after it is issued. This price is expressed as a percentage of nominal value. Bonds are not necessarily issued at par, but bond prices converge to par when they approach maturity as this is the price the issuer will pay to redeem the bond. This is referred to as “Pull to Par”. At other times, prices can be above par, which is called trading at a premium, or below par, which is called trading at a discount. Most government bonds are denominated in units of Rs.1000 in India, or in units of £100 in the United Kingdom. Hence, a deep discount US bond, selling at a price of 75.26, indicates a selling price of $.752.60 per bond sold. Some short-term bonds, such as the U.S. Treasury Bill, are always issued at a discount, and pay par amount at maturity rather than paying coupons. This is called a discount bond.

Market Price of a Bond

“Dirty Price” is price including accured interest.

The market price of a bond is the present value of all expected future interest and principal payments of the bond discounted at the bond’s redemption yield, or rate of return. That relationship defines the redemption yield on the bond, which represents the current market interest rate for bonds with similar characteristics. The yield and price of a bond are inversely related so that when market interest rates rise, bond prices fall and vice versa. Thus the redemption yield could be considered to be made up of two parts: the current yield and the expected capital gain or loss: roughly the current yield plus the capital gain per year until redemption.

CHAPTER 6 Debt Market and Valuation of Bonds The market price of a bond may include the accrued interest since the last coupon date. The price including accrued interest is known as the “full” or “dirty price”. The price excluding accrued interest is known as the “flat” or “clean price”.

95

‘Clean Price’ is price excluding accured interest.

Interest Rate The interest rate adjusted for the current price of the bond is called the current yield. There are other yield measures that exist such as the yield to first call, yield to worst, yield to first par call, yield to put, cash flow yield and yield to maturity.

Yield Curve The relationship between yield and maturity for otherwise identical bonds is called a yield curve. A yield curve is essentially a measure of the term structure of bonds. The function of bond securities and the secondary market for bonds makes the relationship between bond yields, prices and maturities somewhat complicated. The current yield and yield to maturity of bonds is based on several factors that can change over time. Two key features of a convertible are its current yield and its yield to maturity. The current yield indicates the yield of the security based on its current market value. It is calculated by dividing the annual interest payment by the market price. For example, the current yield of a bond with a 5% coupon selling at Rs. 875.00 would be 5.7% {(Rs.50/Rs.875) x 100}. This does not take into account the total return over the life of the bond, nor does it consider reinvestment. The yield to maturity of a bond is the interest rate (compounded) that would equate interest and principal payments to be received in the future relative to the present cost.

A Yield curve is essentially a measure of the term structure of bonds.

Bonds Market Bonds markets, unlike stock or share markets, often do not have a centralized exchange or trading system. Rather, in most developed bond markets such as the U.S., Japan and western Europe, bonds trade in decentralized, dealerbased over-the-counter markets. In such a market, market liquidity is provided by dealers and other market participants committing risk capital to trading activity. In the bond market, when an investor buys or sells a bond, the counterparty to the trade is almost always a bank or securities firm acting as a dealer. In some cases, when a dealer buys a bond from an investor, the dealer carries the bond “in inventory.” The dealer’s position is

In ‘bonds market’ a bank or security firm will be acting as a ‘dealer’.

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Financial Engineering, Risk Management & Financial Institutions then subject to risks of price fluctuation. In other cases, the dealer immediately resells the bond to another investor.

A bond is a formal contract to repay borrowed money with interest at fixed intervals.

Bond markets can also differ from stock markets in that, in some markets, investors sometimes do not pay brokerage commissions to dealers with whom they buy or sell bonds. Rather, the dealers earn revenue by means of the spread, or difference, between the price at which the dealer buys a bond from one investor—the “bid” price—and the price at which he or she sells the same bond to another investor—the “ask” or “offer” price. The bid/offer spread represents the total transaction cost associated with transferring a bond from one investor to another.

Definition of Bond The holder of the bond is the lender and the issuer of the bond is the borrower.

A bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest at a given rate or the coupon rate to use and/or to repay the principal at a later date, termed maturity. A bond is a formal contract to repay borrowed money with interest at fixed intervals like: monthly, Quarterly, half-yearly, annual. The holder of the bond is the lender and the issuer of the bond is the borrower. Bonds provide the borrower with external funds to finance long-term investments, or, in the case of government bonds, to finance current expenditure.

Features of Bonds The most important features of a bond are: nominal, principal, par or face amount — the amount on which the issuer pays interest, and which, most commonly, has to be repaid at the end of the term. Some structured bonds can have a redemption amount which is different from the face amount and can be linked to performance of particular assets such as a stock or commodity index, foreign exchange rate or a fund. This can result in an investor receiving less or more than his original investment at maturity.

Issue Price Debt may be obtained in the form of Bills, Notes & Bonds.

The price at which investors buy the bonds when they are first issued, which will typically be approximately equal to the nominal amount. The net proceeds that the issuer receives are thus the issue price, less issuance fees.

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Maturity Date The date on which the issuer has to repay the nominal amount. As long as all payments have been made, the issuer has no more obligation to the bond holders after the maturity date. The length of time until the maturity date is often referred to as the term or tenor or maturity of a bond. The maturity can be any length of time, although debt securities with a term of less than one year are generally designated money market instruments rather than bonds. Most bonds have a term of up to thirty years. Some bonds have been issued with maturities of up to one hundred years, and some do not mature at all. In the market for U.S. Treasury securities, there are three groups of bond maturities: i.

Short-term (bills): Maturities between one to five year; (instruments with maturities less than one year are called Money Market Instruments)

ii. Medium-term (notes): Maturities between six to twelve years; iii. Long term (bonds): maturities greater than twelve years.

Coupon Rate The interest rate that the issuer pays to the bond holders. Usually this rate is fixed throughout the life of the bond. It can also vary with a money market index, such as LIBOR, or it can be even more exotic. The name coupon originates from the fact that in the past, physical bonds were issued which had coupons attached to them. On coupon dates the bond holder would give the coupon to a bank in exchange for the interest payment. Coupons can be paid at different frequencies. It is generally semi-annual or annual. The “quality” of the issue refers to the probability that the bondholders will receive the amounts promised at the due dates.

Classification of Debenture/Bonds 1. Based on Periodicity:

1. Redeemable 2. Irredeemable.

2. Based on Nature:

1. Transferable 2. Non-transferable

Coupon Rate is the interest rate, paid by issuer to the “Bond Hoder”.

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Financial Engineering, Risk Management & Financial Institutions 3. Convertibility:

1. Convertible 2. Non-convertible 3. Partly Convertible

Valuation of Redeemable Debentures/ Bonds Basically, the value of a bond is the present value of all the future interest payments and the maturity value, discounted at the required return on bond commensurate with the prevailing interest rate and risk. Bond value=

Interest 1 + Interest2 + ........+ (Interestn + Maturity value) (1+r)1 (1+r)2 (1+r) n

Where: Interest 1 to n = Interests in periods 1 to n. r = Rate of interest Or, Vd = I x PVIFA r,n + M x PVIF r,n Where: Vd = Value of debenture or Bond I = Interest amount to be received every year M= Maturity value r – investors required rate of return n – maturity period or duration PVIFA - Presevent value of interest factor for an annuity at the given rate (r) for the period (n) PVIF- present value or interest factor for single amount for the given rate (r) at nth period Unless otherwise mentioned, the maturity value of the bond is the face value. Value of a bond depends on its required rate and coupon rate.

1. When the required rate of return is equal to the coupon rate, the bond value equals the par value. 2. When the required rate of return is more than the coupon rate, the bond value would be less than its par value. The bond in this case would sell at a discount.

CHAPTER 6 Debt Market and Valuation of Bonds 3. When the required rate of return is less than the coupon rate, the bond value would be more than its par value. The bond in this case would sell at a premium.

Valuation of Deep Discount Bonds (DDB) Vd = M x PVIFr,n Where: Vd = Value of debenture or Bond M= Maturity value r – investors required rate of return n – maturity period or duration PVIF– present value or interest factor for single amount for the given rate (r) at nth period

Valuation of Perpetual Bonds (PD)/on-Redeemable Debentures Vd = (I/r) x 100 Vd = Value of debenture or Bond I= Interest amount to be received r – investors required rate of return

Calculation of the Present Value of the Bond’s Interest Payments The first step in calculating the bond’s present value is to calculate the present value of the bond’s interest payments. The interest payments form an ordinary annuity consisting of 10 payments of Rs. 4,500 occurring at the end of each six month period as shown in the following timeline: Interest:

Rs. 4,500 Rs.4,500 Rs.4, 500 Rs. 4,500

Rs.4,500 Rs.4,500

..... months

months

months

months

months

01/01/12 06/30/12 12/31/12 06/30/13 12/31/13 6/30/16 12/31/16 0 Period No.

1

2

3

4

9

10

99

100 Financial Engineering, Risk Management & Financial Institutions To obtain the present value of the interest payments you must discount them by the market interest rate per semiannual period. In our example, the market interest rate is 5% per semiannual period. The 5% market interest rate per semiannual period is symbolized by i. (The market rate of 10% per year was divided by 2 semiannual periods per year to arrive at the market interest rate of 5% per semiannual period.) The bond’s life of 5 years is multiplied by 2 to arrive at 10 semiannual periods. The number of semiannual periods is symbolized by n. Each semiannual interest payment of Rs. 4,500 (100,000 x 9% x 6/ 12) occurring at the end of each of the 10 semiannual periods is represented by ”PMT”. We use the above amounts (i = 5%, n = 10, PMT = 4,500) in the following equation for calculating the present value of the ordinary annuity (PVOA): PVOA (Present Value of an Ordinary Annuity)= PMT x [PVOA factor for n=10 semiannual periods, i=5% per semiannual period] PVOA = Rs. 4,500 x [7.722] PVOA = Rs. 34,749

Calculation of the Present Value of the Bond’s Maturity Amount Present value of bond also depends on the bonds maturity amount.

The second step in calculating the present value of a bond is to calculate the present value of the maturity amount of the bond. Since the corporation’s payment of the maturity amount occurs on a single date, we need to use the factors from table. When using the PV of 1 Table we use t h e same number of periods and the same market interest rate that was used to discount the semiannual interest payments. In this case we use n = 10 semiannual periods, i = 5% per semiannual period, and the future value, FV = Rs. 100,000. Using the PV of 1 table, we see that the present value factor for n = 10, and i = 5% is 0.614. The calculation of the present value (PV) of the single maturity amount (FV) is: PV = FV x [PV factor for n=10 semiannual periods, i=5% per semiannual period] PV = Rs.100,000 x 0.614= Rs. 61,400

CHAPTER 6 Debt Market and Valuation of Bonds

Combining the Present Value of a Bond’s Interest and Maturity Amounts Recall that the present value of a bond = 1. The present value of a bond’s interest payment, and the present value of a bond’s maturity amount. 2. The present value of the 9% 5-year bond that is sold in a 10% market is Rs.96,149 consisting of: Rs.34,749 of present value for the interest payments and Rs. 61,400 of present value for the maturity amount. The bond’s total present value of Rs. 96,149 is approximately the bond’s market value and issue price.

Accrued Interest When the buyer compensates the seller for the coupon interest earned from the time of the last coupon payment to the purchase (settlement) date. This amount is called accrued interest and is calculated as Coupon interest earned from the last coupon payment to the purchase date of the bond. Accrued = interest

coupon payment x (no. of days from last coupon to purchase date/no. of days in coupon period)

Duration of Bond The measure, duration, which was developed in 1938 by Frederick Macaulay, is the most widely used measure of interest-rate sensitivity of an asset, and is the effective maturity of an asset/liability expressed in units of time. The Macaulay duration is given by: D=

-(dS/S) (dR/R)

where S is the instrument’s spot price and R equals 1 plus the asset’s yield (for example, yield to maturity). Thus, D measures the response of price to a proportional change in the interest rate. If V is the value of the firm and _ represents the change operator, then, _V/V

= _(1+r)/(1+r) x D

101

102 Financial Engineering, Risk Management & Financial Institutions

Bond Issue and Redemption Methods For example: If face value of bond = Rs.100 Face Value of Bond

Type of Issue

Mode of Redemption

Loss (or) gain to Investor

1. OPTION

At Par Rs.100

At par Rs.100

100- 100= 0

2. OPTION

At Par Rs.100

At discount

90-100= -10

For example:.10% = Redeemed at 90 3. OPTION

At Par Rs.100

At Premium For example : 5% = Redeemed at 105

105-100=5

4. OPTION

At discount

At par Rs.100

100-90=10

For example:.10% = Issued at 90 5. OPTION

At discount For example:.10% = Issued at 90

At discount For example:.10% = Redeemed at 90

90-90= 0

6. OPTION

At discount For example:.10% = Issued at 90

At Premium For example : 5% = Redeemed at 105

105-90= 15

7. OPTION

At Premium For example : 5% = Issued at 105

At par Rs.100

100-105= -5

8. OPTION

At Premium For example : 5% = Issued at 105

At discount For example:.10% = Redeemed at 90

90-105= -15

9. OPTION

At Premium For example : 5% = Issued at 105

At Premium For example : 5% = Redeemed at 105

105-105= 0

Note: Hypothetical percentage of discount and or premium considered to calculate loss or gain to investor.

CHAPTER 6 Debt Market and Valuation of Bonds Gain/ Loss = Redemption Value – Issue value This is required to calculate Holding Period Return

Holding Period Return (HPR) or Holding Period Yield (HPY) Holding Period Return = (Gain or Loss + Coupon payment)/purchase price Gain = Market Value or Redemption Value > Purchase price or Investment Loss= Market Value or Redemption Value < Purchase price or Investment Example: Calculate one year holding period yield for the following data: a. Coupon Rate = 10% b. Present Market Price of Bond = Rs. 930 (Purchase price) c. Face Value = Rs.1000 d. Expected market Price after one year = Rs.950 Solution: HPY = ( 20 + 100) / 930 = 0129 or 13%

Practical Problems with Solution 1. Calculate the value of a bond that expects to mature in 10 years and has a Rs.1,000 face value. The coupon interest rate is 9 percent and the investors’ required rate of return is 15 percent. 10

1A. Value (Vb)

=

∑ t =1

90 (1 + .15) t

+

1,000 (1 + .15)10

= Rs.90(5.018) + Rs.1,000 (.247) = Rs.451.62 + Rs.247.00 = Rs.698.62 2. Pratik Inc. bonds have a 10 percent coupon rate. The interest is paid semiannually and the bonds mature in 11 years. Their par value is Rs.1,000. If your required rate of return is 9 percent, what is the value of the bond? What is its value if the interest is paid annually? If the interest is paid semiannually:

103

104 Financial Engineering, Risk Management & Financial Institutions 22

Value (Vb)

=

50 (1.045) t

∑ t =1

1,000 (1.045) 22

+

Vb = Rs.50 (13.784) + Rs.1,000 (0.380) Vb = Rs.1,069.20 If interest is paid annually: 11

Value (Vb)

=

∑ t =1

100 (1.09) t

+

1,000 (1.09)11

Vb = Rs.100(6.805) + Rs.1,000 (0.388) Vb = Rs.1,068.50 3. The market price is Rs.950 for an 8-year bond (Rs.1,000 par value) that pays 9 percent interest (4.5 percent semiannually). What is the bond’s expected rate of return? 16

Rs.950

=

∑ t =1

45 (1 + k b /2) t

+

1,000 (1 + k b /2)16

At 5%: Rs.45(10.838) + Rs.1,000(0.458) = Rs.945.71 At 4%: Rs.45(11.652) + Rs.1,000(0.534) = Rs.1,058.34 Interpolation: Expected rate of return = 4% + 0.96% = 4.96% The rate is equivalent to 9.92 percent annual rate, compounded semiannually or 10.17 percent (1.04962 - 1) compounded annually. 4. Donald 20-year bonds pay 10 percent interest annually on a Rs.1,000 par value. If the bonds sell at Rs.975, what is the bond’s expected rate of return? 20

4A.

Rs.975 =

∑ t =1

100 (1 + k b ) t

+

1,000 (1 + k b ) 20

At 10%: Rs.100(8.514) + Rs.1,000(0.149) H” At 11%: Rs.100(7.963) + Rs.1,000(0.124) = Interpolation: 10%

11%

1,000

1,000

975

920

25

79.70

Rs.1,000.00 Rs.920.30

CHAPTER 6 Debt Market and Valuation of Bonds $25.00

k b % = 10% + $79.40 (1% ) = 10.32% 5. Hrishi Co.’s bonds mature in 15 years and pay 8 percent interest annually. If you purchase the bonds for Rs.1,175, what is your expected rate of return? 5A. Rs.1,175

=

15

∑ t =1

80 (1 + k b ) t

1,000 (1 + k b )15

+

At 6%:

Rs.80(9.712) + Rs.1,000(0.417) = Rs.1,193.96

At 7%:

Rs.80(9.108) + Rs.1,000(0.362) = Rs.1,090,64

Interpolation: 6%

7%

1193.96

Rs.1,193.96

1,175.00

1,090.64

Rs.18.96

Rs.103.32

$18.96 (1%) = 6.18% $103.32

= 6% +

6. Ravi Co’s 14-year, Rs.1,000 par value bonds pay 9 percent interest annually. The market price of the bonds is Rs.1,100 and your required rate of return is 10 percent. a. Compute the bond’s expected rate of return. b. Determine the value of the bond to you, given you required rate of return. c. Should you purchase the bond? 14

6A.

Rs.1,100 =

∑ t =1

90 (1 + kb) t

+

1,000 (1 + kb) 14

Interpolation: At 7%

Rs.90(8.746) + Rs.1,000(0.388) = Rs.1,175.14

At 8%

Rs.90(8.2445)+ Rs.1,000(0.341) = Rs.1,082.96 7%

8%

1,175.14

1,175.14

1,100.00

1,082.96

75.14

92.18

105

106 Financial Engineering, Risk Management & Financial Institutions kb %

= 7% + 14

Vb =

6B.

∑ t=1

$75.14 $92.18

90 (1.10) t

+

(1%) = 7.82%

1,000 (1.10)14

Vb = Rs.90(7.367) + Rs.1,000(0.263) Vb = Rs.926.03 Since the expected rate of return, 7.82 percent, is less than your required rate of return of 10 percent, the bond is not an acceptable investment. This fact is also evident because the market price, Rs.1,100, exceeds the value of the security to the investor of Rs.926.03. 7. You own a bond that pays Rs.75 in annual interest, with a Rs.1,000 par value. It matures in 15 years. Your required rate of return is 6 percent. a. Calculate the value of the bond. b. How does the value change if your required rate of return (i) increases to 10 percent or (ii) decreases to 4 percent? c. Explain the implications of your answers in part (b) as they relate to interest rate risk, premium bonds, and discount bonds. d. Assume that the bond matures in 5 years instead of 15 years. Recompute your answers in part (b). e. Explain the implications of your answers in part (d) as they relate to interest rate risk, premium bonds, and discount bonds. a. Value Par Value

Rs.1,000.00

Coupon

Rs.75.00

Required Rate of Return

0.06

Years to Maturity

15

Market Value Rs.

1,145.68

b. Value at Alternative Rates of Return Required Rate of Return

0.10

Market Value

Rs.809.85

CHAPTER 6 Debt Market and Valuation of Bonds Required Rate of Return

0.04

Market Value

Rs.1,389.14

c. As required rates of return change, the price of the bond changes, which is the result of “interest-rate risk.” Thus, the greater the investor’s required rate of return, the greater will be his/her discount on the bond. Conversely, the less his/her required rate of return below that of the coupon rate, the greater the premium will be. Value at Alternative Maturity Dates Years to Maturity

5

Required Rate of Return

0.06

Market Value

Rs. 1,063.19

Required Rate of Return

0.10

Market Value

Rs.905.23

Required Rate of Return

0.04

Market Value

Rs.1,155.82

The longer the maturity of the bond, the greater the interest-rate risk the investor is exposed to, resulting in greater premiums and discounts. 8. The Rs.1,000 face value ABC bond has a coupon rate of 6%, with interest paid semi-annually, and matures in 5 years. If the bond is priced to yield 8%, what is the bond’s value today? Ans:

FV = Rs.1,000 CF = Rs.60/2 = Rs.30 N = 5 x 2 = 10 i = 8%/2 = 4% PV = Rs.918.89

9. The Rs.1,000 face value EFG bond has a coupon of 10% (paid semiannually), matures in 4 years, and has current price of Rs.1,140. What is the EFG bond’s yield to maturity? Ans:

FV = Rs.1,000 CF = Rs.100/2 = Rs.50 N=4x2=8

107

108 Financial Engineering, Risk Management & Financial Institutions PV = Rs.1,140 i = 3% yield-to-maturity = 3% x 2 = 6% 10. The HIJ bond has a current price of Rs.800, a maturity value of Rs.1,000, and matures in 5 years. If interest is paid semi-annually and the bond is priced to yield 8%, what is the bond’s annual coupon rate? Ans:

PV = Rs.800 FV = Rs.1,000 N = 5 x 2 = 10 i = 8% / 2 = 4% CF = Rs.15.34 Coupon = Rs.30.68 per year or 3.068%

11. The KLM bond has a 8% coupon rate (with interest paid semiannually), a maturity value of Rs.1,000, and matures in 5 years. If the bond is priced to yield 6%, what is the bond’s current price? Ans:

CF = Rs.40 FV = Rs.1,000 N = 10 i = 6%/2 = 3% PV = Rs.1,085

12. The NOP bond has an 8% coupon rate (semi-annual interest), a maturity value of Rs.1,000, matures in 5 years, and a current price of Rs.1,200. What is the NOP’s yield-to-maturity? Ans:

CF = Rs.40 FV = Rs.1,000 N = 5 x 2 = 10 PV = Rs.1,200 i = 1.797% yield-to-maturity = 1.797% x 2 = 3.594%

13. You are considering three investments. The first is a bond that is selling in the market at Rs.1,200. The bond has a Rs.1,000 par value, pays interest at 14 percent, and is scheduled to mature in 12 years.

CHAPTER 6 Debt Market and Valuation of Bonds For the bonds of this risk class you believe that a 12 percent rate of return should be required. The second investment that you are analyzing is a preferred stock (Rs.100 par value) that sells for Rs.80 and pays an annual dividend of Rs.12. Your required rate of return for this stock is 14 percent. The last investment is a Equity shares (Rs.35 par value) that recently paid a Rs.3 dividend. The firm’s earnings per share have increased from Rs.4 to Rs.8 in 10 years, which also reflects the expected growth in dividends per share for the indefinite future. The stock is selling for Rs.25, and you think a reasonable required rate of return for the stock is 20 percent. a. Calculate the value of each security based on your required rate of return. b. Which investment(s) should you accept? Why? c. 1. If your required rates of return changed to 14 percent for the bond, 16 percent for the preferred stock, and 18 percent for the Equity shares, how would your answers change to parts (a) and (b)? 2. Assuming again that your required rate of return for the Equity shares is 20 percent, but the anticipated constant growth rate changes to 12 percent, would your answers to parts (a) and (b) be different? Solution: a. Value (Vb) based upon your required rate of return: Bond:

12 Vb

=

∑

t =1

140 (1 + . 12)t

+

1,000 (1 + .12 )12

= Rs.140(6.194) + Rs.1,000(.257) = Rs.867.16 + Rs.257 = Rs.1,124.16 Preferred Stock:

∞ Vps =

∑

t =1

12 (1 + . 14) t

109

110 Financial Engineering, Risk Management & Financial Institutions However, since the dividend is a constant amount each year with no maturity date (infinity), the equation can be reduced to Dividend Required Rate of Return

Vps = =

12 .14

= Rs.85.71 Equity Shares Step 1: Estimate Growth Rate Company’s earnings have doubled (Rs.4 to Rs.8) in ten years. What annual compound growth rate would cause an investment to double in ten years? Looking in Appendix B (Compound sum of Rs.1) an interest factor of 2.000 for ten years is closest to seven percent (1.967). Thus, at about seven percent, money would double in ten years. (The same conclusion could have been reached by using Appendix D but by using a. 500 present value interest factor.) Growth Rate (g) = 7% Step 2: Solve for Value

∞ Vcs =

∑

t =1

3(1 + .07 ) t (1 + .20) t

If the seven percent growth rate (g) is assumed constant, the equation may be reduced to Vcs = =

Dividend at Year End Required Rate of Return - Growth Rate D1 kcs - g

=

3 (1 + .07) .20 - .07

=

3.21 .20 - .07

=

Rs.24.69

CHAPTER 6 Debt Market and Valuation of Bonds b.

Your Value

Selling Price

Bond

Rs.1,124.16

Rs.1,200.00

Preferred stock

85.71

80.00

Equity shares

24.69

25.00

Buy only the Preferred stock; it is the only investment in which the market price is less than the value to you. c. (1) Bond: Vb

=

12

∑

t =1

140 1000 + t (1 + . 14) (1+.14)12

= Rs.140(5.660) + Rs.1,000(.2076) = Rs.792.40 + Rs.207.60 = Rs.1,000.00 Still do not buy; it is not worth Rs.1,200.00. Preferred Stock: Vps =

12 .16

= Rs.75.00 Do not buy. Your value is less than what you would have to pay for the stock. Equity shares: Vcs =

3.21. 18 - .07

= Rs.29.18 Buy. Your value is greater than what you would have to pay for the stock. (2) Assuming a growth rate of 12 percent: Vcs = =

3(1 + .12) .20 - .12 3.36 .08

= Rs.42

111

112 Financial Engineering, Risk Management & Financial Institutions Buy. Because of the expected increase in future dividends, the stock is now worth more to you (Rs.42) than you would have to pay for it (Rs.25)—assuming that the selling price did not increase also.

Practice Problems 1. Find the value of debenture based on the following data: a. Interested paid 12% b. Face value Rs.100 c. Redeemed with the premium : 5% d. Duration: 5 years e. Investors expected rate of return is 14% 2. Find the value of debenture based on the following data: a. Interested paid 13% b. Face value Rs.100 c. Redeemed at discount : 5% d. Duration: 10 years e. Investors expected rate of return is 16% 3. Find the value of debenture based on the following data: a. Interested paid 12% b. Face value Rs.100 and Issued with a premium 15% c. Redeemed at discount : 10% d. Duration: 12 years e. Investors expected rate of return is 15% 4. Find the value of debenture based on the following data: a. Interested paid 11% b. Face value Rs.100 and Issued at a discount 15% c. Redeemed at discount : 5% d. Duration: 9 years e. Investors expected rate of return is 15% 5. Find the value of debenture based on the following data: a. Interested paid 12.5% b. Face value Rs.100 and Issued at a discount 15%

CHAPTER 6 Debt Market and Valuation of Bonds c. Redeemed with premium : 12% d. Duration: 7 years e. Investors expected rate of return is 14.5% 6. Calculate the value of a bond that expects to mature in 12 years and has a Rs.1,000 face value. The coupon interest rate is 9.5 percent and the investors’ required rate of return is 14 percent. 7. Rishi bonds have a 11 percent coupon rate. The interest is paid semiannually and the bonds mature in 12 years. Their par value is Rs.1,000. If your required rate of return is 7.5 percent, what is the value of the bond? What is its value if the interest is paid annually? 8. The market price is Rs.850 for an 9-year bond (Rs.1,000 par value) that pays 12 percent interest. What is the bond’s expected rate of return? 9. John’s 21-year bonds pay 13 percent interest annually on a Rs.1,000 par value. If the bonds sell at Rs.1175, what is the bond’s expected rate of return? 10. Peter & Co.’s bonds mature in 14 years and pay 7 percent interest annually. If you purchase the bonds for Rs.1,275, what is your expected rate of return? 11. Rahul & Co’s 16-year, Rs.1,000 par value bonds pay 13.5 percent interest annually. The market price of the bonds is Rs.1,200 and your required rate of return is 16 percent. a. Compute the bond’s expected rate of return. b. Determine the value of the bond to you, given you required rate of return. c. Should you purchase the bond? 12. You own a bond that pays Rs.175 in annual interest, with a Rs.1,000 par value. It matures in 19 years. Your required rate of return is 21 percent. a. Calculate the value of the bond. b. How does the value change if your required rate of return (i) increases to 10 percent or (ii) decreases to 10 percent? 13. The Rs.1,000 face value XYZ bond has a coupon rate of 9.8%, with interest paid semi-annually, and matures in 9 years. If the bond is priced to yield 12.5%, what is the bond’s value today?

113

114 Financial Engineering, Risk Management & Financial Institutions 14. The Rs.1,000 face value Raksha bond has a coupon of 12.9% (paid semi-annually), matures in 6 years, and has current price of Rs.1,240. What is the bond’s yield to maturity? 15. The Ajanta bond has a current price of Rs.950, a maturity value of Rs.1,100, and matures in 7 years. If interest is paid semi-annually and the bond is priced to yield 11%, what is the bond’s annual coupon rate? 16. Adhya Ltd bonds current market price is 120, with 30 years to maturity and semi annual interest payments. The coupon rate was 19%. If your required rate of return is 16% at the time, would you have bought these bonds? 17. The Sunrise company bonds have a coupon of 10% paying interest semiannually. They will mature in 10 years. However, because of poor financial status of company you do not expect to receive more than 5 interest payments. Also, you do not expect to receive more than 60% of principal, after 4 years. Your required rate of return is 11%. What is the maximum price you are willing to pay? Show your calculations clearly. 18. Charter Corporation 9.5% bonds pay interest semiannually. On April 15 and October 15, and they will mature on April 15, 2020. They are selling at Rs.99 on October 16, 2009. Considering its risk characteristics, your required rate of return for this bond is 11%. a. Do you think you should buy this bond? b. Suppose you buy the bond at the market price, what is its approximate yield to maturity.

Debenture–Calculation of NPV for New Issue 19. A firm has 12% 20-year of Rs.10 lakh debentures. The debentures were issued 5 years ago involving a floatation cost of Rs.25,000. the floatation cost is being charged off for tax purpose as an expense at the rate of Rs.1,250 annually flat for 20 years. The debentures incorporate call features with a premium of Rs.60,000. Now the firm is considering a new issue of 10% 15-year Rs.10 lakh debentures that will involve a floatation cost of Rs.30,000. The tax rate is 30% Calculate the NPV of the refunding operation. 20. A firm has 14% 20-year of Rs.12 lakh debentures. The debentures were issued 5 years ago involving a floatation cost of Rs.20,000. the

CHAPTER 6 Debt Market and Valuation of Bonds floatation cost is being charged off for tax purpose as an expense at the rate of Rs.1,250 annually flat for 20 years. The debentures incorporate call features with a premium of Rs.70,000. Now the firm is considering a new issue of 12% 15-year Rs.10 lakh debentures that will involve a floatation cost of Rs.50,000. The tax rate is 40%. Calculate the NPV of the refunding operation.

Economic Size of the Issue of Debentures 21. A firm needs Rs.10 lakh in the form of debt over a 5-year period. If the flotation cost is Rs.500, the interest on debt 12%, and the return on investment 10%. What is the optimal size of debenture issue? Hint: FD/I = I (int –B)/2 22. A firm needs Rs.5 lakh in the form of debt over a 5-year period. If the flotation cost is Rs.500, the interest on debt 12%, and the return on investment 11%. What is the optimal size of debenture issue?

Glossary of Selected Financial Instruments The following “Glossary of Selected Financial Instruments” has been published in the Journal of Accountancy, November 1989, using the following categories: Debt instruments; Asset-backed securities; equity instruments; hedging instruments.

Debt instruments Commercial Paper: Unsecured short-term (up to 270 days) obligations issued through brokers or directly. The interest is usually discounted. Universal commercial paper: Foreign currency denominated commercial paper that trades and settles in the United States. Convertible Bonds: Debt securities that are convertible into the stock of the issuer at a specified price at the option of the holder. Carrot and Stick Bonds: Carrots have a low conversion premium to encourage early conversion, and sticks allow the issuer to call the bond at a specified premium if the common stock is trading at a specified percentage above the strike price. Convertible Bonds with a Premium Put: Convertible bonds issued at face value with a put entitling the bondholder to redeem the bonds for more than their face value.

115

116 Financial Engineering, Risk Management & Financial Institutions Debt with Equity Warrants: Bonds issued with warrants for the purchase of shares. The warrants are separately tradeable. Dual-currency Bonds: Bonds that are denominated and pay interest in one currency and are redeemable in another currency – thus allowing interest rate arbitrage between two markets. COPS (Covered Option Securities): Short-term debt that gives the issuer an option to repay the principal and interest in U.S. dollars or a mutually acceptable foreign currency. ECU Bonds (European Currency Unit Bonds): A Eurobond denominated in a basket of currencies of the 10 countries that constitute the European Community. The bonds pay interest and principal in ECUs or in any of the 10 currencies at the option of the holder. ICONs (Indexed Currency Option Notes): A bond denominated and paying interest and principal in dollars but with principal payments linked to the exchange rate of another currency. PERLS (Principal Exchange-Rate-Linked Securities): Securities paying interest and principal in dollars but with principal payments linked to the exchange rate between the dollar and a second currency. Flip-flop Notes: An instrument that allows investors to switch between two types of securities – for example, to switch from a long-term bond to a short-term fixed-rate note. FRNs (Floating Rate Notes): Debt instruments that feature periodic interest rate adjustments. Capped Floater: An FRN with an interest rate ceiling. Convertible FRNs: The issuer can convert the FRNs into long-term fixed rate bonds. Drop-lock FRNs: The FRNs automatically convert to fixed-rate bonds when short-term interest rates fall below a specified level. Minimax FRNs: FRNs with upper and lower interest limits – that is, a ceiling and a floor. Indexed Debt Instruments: Instruments with guaranteed and contingent payments, the latter being linked to an index or prices of certain commodities (oil or gold, for example). Bull and Bear Bonds: Bonds linked to upward and downward movements in a designated index. Bulls yield more in a rising market; bears yield more in a falling market.

CHAPTER 6 Debt Market and Valuation of Bonds SPINs (Standard and Poor’s Indexed Notes): A debt instrument payments linked to the performance of the Standard and Poor’s stock indexes. Put Bonds: Bonds that the investor can put (or tender) back to issuer after a specified period. Stripped Government Securities: A type of zero coupon bond, these securities represent long-term Treasury bonds “stripped” of semiannual interest coupons by an investment banker who resells these coupons and an interest in the principal payments. Investment banks market these stripped securities under such registered acronyms as: CATs: Certificates of Accrual on Treasury certificates. COUGRs: Certificates of Government Receipts. STAGs: Sterling Transferrable Accruing Government Securities. STRIPs: Separate Trading of Registered Interest and Principal of Securities. TIGRs: Treasury Investment Growth Certificates ZEBRAs: Zero Coupon Eurosterling Bearer or Registered Accruing Certificates. Zero-coupon Bonds: A bond that’s sold at a deep discount from its face value. It carries no interest coupon, but investors receive the gradual appreciate to face value. LYONs: (Liquid Yield Option Notes): Zero-coupon bonds that are convertible into the issuer’s common stock.

Asset-backed Securities CMOs: (Collateralized Mortgage Obligations): Debt obligations that are backed by a pool of whole mortgages or mortgage-backed securities such as Ginnie Maes. Mortgage Backed Securities: A participation in an organized pool of residential mortgages, including Ginnie Maes (Government National Mortgage Association), Fannie Maes (Federal National Mortgage Association) and Freddie Macs (Federal Home Loan Mortgage Corporation). Securitized Receivables: Debt securities collateralized by a pool of receivables. CARDs: (Certificates of Amortizing Revolving Debts): Backed by credit card debt.

117

118 Financial Engineering, Risk Management & Financial Institutions CARs: (Certificates of Automobile Receivables): Backed by automobile loans. CLEOs: (Collateralized Lease Equipment Obligations): Backed by leasing receivables. FRENDS: (Floating Rate Enhanced Debt Securities): Backed by LBO loan participations.

Equity Instruments MMP: (Money Market Preferred Stock or Dutch Auction Preferred Stock): Preferred stock are trading dividends that are reset at a Dutch auction – that is, an action in which the securities are sold at the lowest yield necessary to sell the entire issue. Several investment banks have issued these instruments under such registered names as CAMPS: cumulative auction market preferred stock. CMPS: (Capital Market Preferred Stock). Convertible MMP stock: MMPs that can be converted into common stock. DARTS: Dutch-auction Rate Transferable Securities. FRAPS: Fixed Rate Auction Preferred Stock. MAPS: market auction preferred stock. STARS: Short-term Auction Rate Cumulative Preferred Stock. STRAPS: Stated Rate Auction Preferred Stock. PIK (Pay in Kind) Preferred Stock: Dividends are paid in additional shares of preferred stock. Exchangeable PIK Preferred Stock: The issuer can convert the PIK stock into debt.

Hedging Instruments Butterfly Spread: Options strategy involving two calls and two puts in the same or different markets, with several maturity dates. Calendar Spread: Options strategy that involves buying and selling options on the same security with different maturities. Cancelable Forward Exchange Contracts: The holder has the unilateral right to cancel the contract at maturity. CIRCUS: Combined currency and interest rate swap. Convertible Option Contracts: A foreign currency option that converts to a forward contract if the forward exchange rate falls below a trigger price.

CHAPTER 6 Debt Market and Valuation of Bonds

119

Cross-hedging: Hedging one exposure with an instrument pegged to another market or index. Cylinder Options: A combined call option and put option on currency. Range Forwards: A forward exchange contract specifying a range of exchange rates within which currencies will be exchanged at maturity. ZCRO (Zero Cost Ratio Option): A cylinder option with a put written in an amount offsetting the call premiums. OPOSSMS: Options to purchase or sell specified mortgage-backed securities. Perpendicular Spread: Options strategy using options with the same maturities but different strike prices. Swaption: An option to enter or be forced to enter a swap. Synthetic Instruments: Two or more transactions that have the effect of a financial instrument. For example, a fixed-rate bond combined with an interest rate swap can result in a synthetic floating rate instrument. Zero-coupon Swap: A swap of zero-coupon debt into floating rate debt.

Keywords

Keywords

Bond: A bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest at a given rate or the coupon rate to use and/or to repay the principal at a later date, termed maturity. Issue Price: The price at which investors buy the bonds when they are first issued, which will typically be approximately equal to the nominal amount. The net proceeds that the issuer receives are thus the issue price, less issuance fees. Maturity Date: The date on which the issuer has to repay the nominal amount. As long as all payments have been made, the issuer has no more obligations to the bond holders after the maturity date. A Foreign Exchange Option: A foreign-exchange option is a derivative financial instrument. Coupon: It is the interest rate that the issuer pays to the bond holders. Bond Market: In the event that the market deals mainly with the trading of municipal and corporate bond issues, the debt market may be known as a bond market. Credit Market: If mortgages and notes are the main focus of the trading, the debt market may be known as a credit market. Fixed Income Market: When fixed rates are connected with the debt instruments, the market may be known as a fixed income market.

120 Financial Engineering, Risk Management & Financial Institutions Government Securities: The main types are government securities called G-secs or Gilts. Like T-bills, Gilts are issued by RBI on behalf of the Government. These instruments form a part of the borrowing program approved by Parliament in the Finance Bill each year. Zero-coupon Bonds: Zero-coupon bonds pay no regular interest. These are issued at a substantial discount to par value, so that the interest is effectively rolled up to maturity (and usually taxed as such). An example of zero coupon bonds is Series E savings bonds issued by the U.S. government. Treasury Bills/ Treasury Bonds: Treasury bond, also called government bond, is issued by the Federal government and is not exposed to default risk. Strip Bond: It is a bond where both the principal and regular coupon payments—which have been removed—are sold separately. Perpetual Bonds: These are also often called perpetuities or ‘Perps’. These have no maturity date. Bearer Bond: It is an official certificate issued without a named holder. In other words, the person who has the paper certificate can claim the value of the bond. Registered Bond: Registered bond is a bond whose ownership is recorded by the issuer, or by a transfer agent. It is the alternative to a Bearer bond. Interest payments, and the principal upon maturity, are sent to the registered owner. Build America Bonds (BABs): It is a new form of municipal bond authorized by the American Recovery and Reinvestment Act of 2009. Unlike traditional municipal bonds, which are usually tax exempt, interest received on BABs is subject to federal taxation. Book-entry Bond: Book-entry bond is a bond that does not have a paper certificate. As physically processing paper bonds and interest coupons became more expensive, issuers have tried to discourage their use. Lottery Bond: Lottery bond is a bond issued by a state, usually a European state. Interest is paid like a traditional fixed rate bond, but the issuer will redeem randomly selected individual bonds within the issue according to a schedule. Serial Bond: Serial bond is a bond that matures in installments over a period of time. Revenue Bond: Revenue bond is a special type of municipal bond distinguished by its guarantee of repayment solely from revenues generated by a specified revenue-generating entity associated with the purpose of the bonds. Climate Bond: Climate bond is a bond issued by a government or corporate entity in order to raise finance for climate change mitigation or adaptation related projects or programs. Market Price of a Bond: The market price of a bond is the present value of all expected future interest and principal payments of the bond discounted at the bond’s redemption yield, or rate of return.

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121

Yield to Maturity: The yield to maturity of a bond is the interest rate (compounded) that would equate interest and principal payments to be received in the future relative to the present cost.

Review Questions

Review Questions

1. Discuss the meaning, features and classification of bonds.

3. Define government securities, zero-coupon bonds, treasury bonds and strip bonds.

2. What do you understand by the debt market and various trading debt market instruments?

4. Illustrate various types of bonds. 5. Discuss the various methods for calculating valuation of redeemable debentures/bonds.

References

References

1. Financial Management by Dr. Paresh P. Shah, 2nd Ed. Biztantra(Dreamtech Press) 2. Strategic Financial Management by Dr. Meena Goyal, Biztantra(Dreamtech Press) 3. Financial Wisdom by Dr. A. P. Dash, Biztantra(Dreamtech Press)

4. Advanced Financial Management by Dr.U.M. Premalatha, Biztantra (Dreamtech Press) 5. International Financial Management by Dr. S.P. Srinivasan & Dr. B. Janakiram, Biztantra. 6. Accounting for Managers by Dr. Meena Goyal, Biztantra

Case Study

Case Study

Case-1 A Rs.100 par value bond bearing a coupon rate of 12 per cent will mature after five years. What is the value of the bond, if the required rate of return is 15 per cent. You are also required to calculated value for the following options also: OPTION

COUPON RATE

REQUIRED RATE

OPTION-A

14%

16%

OPTION-B

15%

15%

OPTION-C

20%

22%

OPTION-D

11%

12%

122 Financial Engineering, Risk Management & Financial Institutions Case-2 Kalyan is considering the purchase of a bond currently selling at Rs.980. The bond has four years to maturity, face of Rs.1000 and 9% coupon rate. The next annual interest payment is due after 1 year from today. The required rate of return is 11%. i) Calculate the intrinsic value of the bond. Should Kalyan buy the bond? ii) Calculate the yield to maturity of the bond.

Case-3 An 8% coupon bond selling for Rs.953 with 3 years until maturity making annual payments. The interest rates in the next three years will be, with certainty, ri=8%, and r2= 10% and r3=12%. You are required to calculate YTM.

Appendix

Appendix

Appendix-1 RECENT BOND ISSUES IN INDIA DURING 2012-13 The following ten companies authorised to issue tax-free bonds this fiscal. Name of Company

Bond Issue Size in Rs crore

NHAI (National Highways Authority of India)

10,000

IRFC (Indian Railway Finance Corporation)

10,000

IIFCL (India Infrastructure Finance Company)

10,000

HUDCO (Housing and Urban Development Corporation)

5,000

NHB (National Housing Bank)

5,000

PFC (Power Finance Corporation)

5,000

REC (Rural Electrification Corporation)

5,000

Jawaharlal Nehru Port Trust

2,000

Ennore Port

1,000

Dredging Corporation of India

500

CHAPTER 6 Debt Market and Valuation of Bonds

INTEREST RATES OF VARIOUS BOND ISSUES 10 Year Bond

15 Year Bond

IIFCL coupon for retail investors

7.69%

7.86%; 7.90% for 20 year bond

IIFCL coupon for others

7.19%

7.36%; 7.40% for 20 year bond

IIFCL credit rating

AAA by ICRA, CARE and Brickworks

AAA by ICRA, CARE and Brickworks.

Hudco coupon for retail investors 7.84%

8.01%

Hudco coupon for others

7.34%

7.51%

Hudco credit rating

AA+ by CARE and AA+ by CARE and India Ratings and India Ratings and Research Private Limited Research Private Limited

IRFC coupon for retail investors

7.68%

7.84%

IRFC coupon for others

7.18%

7.34%

IRFC credit rating

AAA

AAA

123

124 Financial Engineering, Risk Management & Financial Institutions Appendix-2 IIFCL Tax Free Bonds – Public Issue Brief Terms Issue Size

Up to Rs. 1,500 Crore with an option to retain oversubscription of up to the Shelf Limit^ of Rs. 9,215 Crore.

Instrument

Tax free bonds in the nature of secured redeemable non-convertible bonds of the Company of face value of Rs. 1,000 each, having tax benefits under section 10(15)(iv)(h) of the Income Tax Act, 1961.

Rating

[ICRA] AAA (Stable) by ICRA Ltd, CARE AAA by Credit Analysis and Research Limited and BWR AAA ( Stable ) by Brickwork Rating India Private Limited. Instruments with this rating are considered to have the highest degree of safety regarding timely servicing of financial obligations. Such instruments carry lowest credit risk.

Issue Opening Date December 26, 2012 Issue Closing Date

January 11, 2013**

Allocation Ratio

QIB Portion Domestic HNI Portion (15% of the Corporate (15% (30% of the Issue Size) of the Issue Size) Issue Size)

Security

The Bonds issued by the Company will be secured by way of pari passu first charge on receivables of the Company with an asset cover of one time of the total outstanding amount of Bonds, pursuant to the terms of the Bond Trust Agreement.

Deemed Date of Allotment

The Deemed Date of Allotment will be the date on which the Board of Directors or a duly constituted committee thereof (“Board of Directors”) is deemed to have approved the Allotment of Bonds for each Tranche Issue or any such date as may be determined by the Board of Directors. All benefits under the Bonds including payment of coupon rate (as specified in the Prospectus Tranche - I) will accrue to the Bondholders from the Deemed Date of Allotment. Actual Allotment may occur on a date other than the Deemed Date of Allotment.

Retail Individual Investor Portion (40% of the Issue Size)

Interest on Same as coupon rate applicable for the respective category, for a Application Money# particular Series. Interest on refund# 5.00% per annum Issuance

In physical and dematerialized form as specified by an Applicant in the Application Form

Listing

On BSE. The Company will use best efforts to ensure that all steps for the completion of the necessary formalities for listing at the Stock Exchangesare taken within 12 Working Days of the Tranche Issue Closing Date.

CHAPTER 6 Debt Market and Valuation of Bonds

125

Option

Tranche I Series 1 Tranche I Series 2 Tranche I Series 3

Tenor

10 years from the Deemed Date of Allotment

15 Years from the Deemed Date of Allotment

20 Years from the Deemed Date of Allotment

Frequency of Coupon Payment

Annual

Annual

Annual

Minimum Application

Five Bonds (Rs. 5000) individually or collectively across series

In Multiples of

One Bond (1000)

Face Value/ Issue Price( per NCD)

Rs. 1,000/-

Coupon Rate (%) per annum - Category I , Category II & Category III

7.19

7.36

7.40

Coupon Rate (%) per annum - Category IV *

7.69

7.86

7.90

Annualized Yield (%) Category I , Category II and Category III

7.19

7.36

7.40

Annualized Yield (%) Category IV *

7.69

7.86

7.90

Put and Call Option

None

None

None

Coupon Payment Date

First Coupon: The date, which is the day falling one year from the Deemed date of allotment. Subsequent Coupons: Same date every year, until redemption date

Trading lot

1 bond

Redemption Amount (per NCD)

Repayment of the face value along with any interest that may have accrued at the Redemption Date.

Utilization of Issue Proceeds

The proceeds of Issue may be utilised towards lending in infrastructure sector and augmenting our resource base.

126 Financial Engineering, Risk Management & Financial Institutions Category I Qualified Institutional Buyers (QIBs) ·

Public Financial institutions specified in Section 4A of the Companies Act, Scheduled commercial Banks; Mutual funds registered with SEBI; Alternative Investment Funds registered with SEBI; Multilateral and bilateral development financial institutions; State industrial development Corporations Insurance companies registered with the Insurance Regulatory and Development Authority; Provident funds with a minimum corpus of Rs. 250 million; Pension funds with a minimum corpus of Rs. 250 million; The National Investment Fund set up by resolution F. No. 2/3/ 2005-DD-II dated November 23, 2005 of the GoI, published in the Gazette of India; Insurance funds set up and managed by the army, navy, or air force of the Union of India and Insurance funds set up and managed by the Department of Posts, India.

Category IIDomestic Corporates·

Companies within the meaning of section 3 of the Companies Act,1956, as amended and bodies corporate registered under the applicable laws in India and authorized to invest in Bonds.

Category IIIHigh Net worth · Individuals (HNIs)

Resident Indian individuals who apply for Bonds aggregating to a value more than Rs. 10 lacs across all Series of Bonds in this Tranche I Issue; Hindu Undivided Families through the Karta who apply for Bonds aggregating to a value more than Rs. 10 lacs across all Series of Bonds in this Tranche I Issue.

Category IVRetail Individual · Investors (RIIs)

Resident Indian individuals who apply for Bonds aggregating upto and including Rs. 10 lacs across all Series of Bonds in this Tranche I Issue; Hindu Undivided Families through the Karta who apply for Bonds aggregating upto and including Rs. 10 lacs across all Series of Bonds in this Tranche I Issue.

MANAGEMENT OF FINANCIAL RISK Introduction Understanding Risk Types of Risks Categorization of the Risk Principles of Managing Risk Quantification of Financial Risk Risk Reduction Measures Managing Financial Risk Strategies of Financial Risk Management Portfolio Management Asset Liability Management Quantitative Risk Managment Tools used to manage Risk in International Finance Conclusion Practical Problems Practice Problems Terminology Keywords Review Questions References Case Study

128 Financial Engineering, Risk Management & Financial Institutions

Chapter Objectives

Chapter Objectives

After studying this chapter the student will be able to: Understand meaning and sources of financial risk. Discuss different types and categories of risk. Learn about the principles and steps of risk management. Define tools used to manage risk in international finance.

Introduction Risk may be defined as an event which can impair corporate earnings.

From the investors point of view, ‘Risk’ is defined “as the probability of not getting expected return is known as risk. It refers to the loss of the tangible amount of investment. The risk that shareholders will lose money when they invest in a company that has debt, if the company’s cash flow proves scarce to meet its financial obligations. However from the corporate entity point of view, ‘Financial Risk’ refers to the possibility of a corporate entity or government defaulting on its bonds, which would cause those bondholders to lose money. In the financial market, risk may be defined as ‘an event which can impair corporate earnings or cash flow over the period of time.” This chapter deals with management of risk relating to corporate entity. Although financial risk has increased significantly in recent years, risk and risk management are very old issues. The result of increasingly global markets is that risk may originate with events thousands of miles away that have nothing to do with the domestic market. The economic climate and markets can be affected very quickly by changes in exchange rates, interest rates, and commodity prices. As a result, it is important to ensure financial risks are identified and managed appropriately.

Understanding ‘Risk’ Exposure refers to the possibility of loss.

Risk provides the basis for opportunity. The terms risk and exposure have subtle differences in their meaning. Risk refers to the probability of loss, while exposure is the possibility of loss, although they are often used interchangeably. Risk arises as a result of exposure. Exposure to financial

CHAPTER 7 Management of Financial Risk markets affects most organizations, either directly or indirectly. When an organization has financial market exposure, there is a possibility of loss but also an opportunity for gain or profit. Financial market exposure may provide strategic or competitive benefits. Hence, risk is the probability of losses resulting from events such as changes in market prices. Events with a low probability of occurring, but that may result in a high loss, are particularly troublesome because they are often not anticipated. Thus, every business activity has upside and downside risk. However the magnitude of risk varies according to nature of financial product offered by a financial institution.

129

Every business activity has upside and downside risk.

Financial Distress Financial distress and liquidity crisis are two sides of the same coin. Most of the global financial institutions are facing the problem of distress, the inability to manage funds, sustain liquidity, which ultimately leads to the position of insolvency of the financial institutions like; Banks, mutual fund organizations, and financial service providers. Typically, mutual funds are managed by asset management companies, ideally a hub of business qualification and professional insight, who manage the funds of their shareholders and invest in a number of securities and bonds there by reducing the risk of investing in a single security. This inherent diversification of portfolio that the investors can achieve by investing in a mutual funds, coupled with attraction of liquidity and transparency has been the major factor in a continuous growth of the mutual fund industry all over the world.

Financial distresses the inability to manage funds, sustain liquidity, which ultimately leads to the position of insolvency of the financial institutions like; Banks, mutual fund organizations, and financial service providers.

Financial Risk Financial risk arises through numerous transactions of a financial nature viz., sales and purchases, investments and loans, and various other business activities. It may take place as a result of legal transactions, or through the activities of management, or political environment. Financial fluctuations may make it more complex to make various financial decisions like: plan and budget, price goods and services, and allocate capital. Sources of Financial Risk 1. Financial risks arising from an organization’s exposure to changes in market prices. 2. Financial risks arising from transactions with other organizations such as vendors, customers etc.

Financial risks may arise due to fluctuations in financial markets.

130 Financial Engineering, Risk Management & Financial Institutions 3. Financial risks resulting from internal actions or failures of the organization. 4. Financial risks while mobilization of funds, transfer of funds and sanction of credit. 5. Financial risks due to changes in government policy like RBI monetary policy, economic policy etc.

Types of Risks The risks of any corporate entity can be broadly classified into: a) Undiversifiable Risk or Systematic Risk or market risk and b) Diversifiable risk or unsystematic risk. MANGNITUDE BASED/ CATASTROPHIC RISK

f

f

vs.

OPERATING RISKS

f

SMALLER RISK

FINANICIAL RISK

Market vs.

UN-SYSTEMATIC RISK:

Firm Speciifc Risks

Controllable

f

Diversifiable

f

f

SYSTEMATIC RISK: Credit Risk

f

Uncontrollable

CONTINUOUS RISK

Undiversifiable

Liquidity Risk

vs.

f

EVENT RISK Interest Rate Risk

Commodity Price Risk

f

f

Equity Risk

f

Exchange Rate Risk

Figure 7.1: Types of Risks of Corporate Entity

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131

Categorization of the Risks A listing of all risks that a firm faces can be overwhelming. One step towards making them manageable is to sort risk into broad categories. In addition to organizing risks into groups, it is a key step towards determining what to do about these risks. In general, risk can be categorized based on the following criteria:

Market versus Firm-specific Risk We can categorize risk into risk that affects one or a few companies (firm-specific risk) and risk that affects many or all companies (market risk). The former can be diversified away in a portfolio but the latter will persist even in diversified portfolios; in conventional risk and return models, the former have no effect on expected returns whereas the latter do.

Operating versus Financial Risk Risk can also be categorized as coming from a firm’s financial choices (its mix of debt and equity and the types of financing that it uses) or from its operations. An increase in interest rates or risk premiums would be an example of the former whereas an increase in the price of raw materials used in production would be an example of the latter.

Continuous Risks versus Event Risk Some risks are dormant for long periods and manifest themselves as unpleasant events that have economic consequences whereas other risks create continuous exposure. For example, the coffee bean company’s risk exposure in Columbia. A political revolution or nationalization of coffee estates in Columbia would be an example of event risk whereas the changes in exchange rates would be an illustration of continuous risk.

Catastrophic Risk versus Smaller Risks Some risks are small and have a relatively small effect on a firm’s earnings and value, whereas others have a much larger impact, with the definition of small and large varying from firm to firm. Political turmoil in its Indian software operations will have a small impact on Microsoft, with is large market cap and cash reserves allowing it to find alternative sites, but will have a large impact on a small software company with the same exposure.

Corporate entity should ready to face any type of risks.

132 Financial Engineering, Risk Management & Financial Institutions Un-diversifiable Risks Undiversifiable risks are also called as “Systematic Risk.”

This is also known as “systematic” or “market risk”. Thus, the ‘Market risk’ is the day-to-day fluctuations in a stock’s price. Market risk applies mainly to stocks and options. As a whole, stocks tend to perform well during a bull market and poorly during a bear market - volatility is not so much a cause but an effect of certain market forces. Volatility is a measure of risk because it refers to the behavior, or “temperament”, of your investment rather than the reason for this behavior. Because market movement is the reason why people can make money from stocks, volatility is essential for returns, and the more unstable the investment the more chance there is that it will experience a dramatic change in either direction. Un-diversifiable risks are associated with every company, which is influenced by various factors like: inflation rates, exchange rates, political instability, war and interest rates. This type of risk is not specific to a particular company or industry, and it cannot be eliminated, or reduced, through diversification.

Diversifiable Risks Diversifiable risks are also called as “Unsystematic Risks.”

This risk is also known as “unsystematic risk,” and it is specific to a company, industry, market or economy. It can be reduced through diversification. The most common sources of unsystematic risk are credit risk and liquidity risk. Thus, the aim is to invest in various assets so that they will not all be affected the same way by market events. i. Credit Risk: Credit risk is the risk that a company or individual will be unable to pay the contractual interest or principal on its debt obligations. This type of risk is of particular concern to investors who hold bonds in their portfolios. Government bonds, especially those issued by the central government, have the least amount of default risk and the lowest returns, while corporate bonds tend to have the highest amount of default risk but also higher interest rates. Bonds with a lower chance of default are considered to be investment grade, while bonds with higher chances are considered to be junk bonds. Many companies use credit to pay for short-term supplies or to fund long-term growth. While most companies view loans and credit lines as a necessary part of business, those who understand how to mitigate credit risk are far more likely to succeed. To mitigate credit risk a company wants to be sure it is not seeking more credit than it can feasibly repay in a timely fashion. A growing

CHAPTER 7 Management of Financial Risk

133

company may not want to grow in phases that allow it to recoup some of the debt spent. Companies can increase their credit rating, thus reduce their credit risk, by starting to establish credit long before they need it. This can be accomplished with vendor credits, small business credit cards and loans. Measurement of Credit Risk: Altman Z Score Model: Z = 1.2X1 + 1.4 X2 + 3.3 X3 + 0.6 X 4 + 1.0 X5 • If Z < 1.81 ----- High default risk • If Z > 1.81 ----- Low default risk ii. Liquidity Risk: It is the risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss. It’s usually reflected in a wide bid-ask spread or large price movements.

Principles of Managing Risk Financial literature has concerned itself mainly with the systematic risk of a firm, measured through its beta. In fact, as per the capital asset pricing model, not managing unsystematic risk does not increase the rate of return required by investors. However, by significantly lowering the level of the firm’s expected cash flows, it can and does, in practice, reduce the value of the firm. It is necessary therefore to manage unsystematic risk in cases where it could adversely impact on a firm’s existence. Total risk is the sum of the systematic and unsystematic risks. Shapiro and Titman (1986) advocate a total risk approach to risk management. Total risk, being the sum of systematic and unsystematic risks, should be considered by the firm. The objective of the shareholders would then be to search for an optimal risk profile, where the marginal cost of bearing risk equals the marginal cost of managing it. Risk management requires the identification of the risks to which the firm is exposed, quantification of these exposures-wherever possible, determination of the desired outcomes, and engineering a strategy to achieve these outcomes. A look at the coverage ratios is a good first step. But for detailed identification of risk, a series of cash budgets must be prepared using different economic variables and considering the use of different riskreducing mechanisms Each time, the risk must be identified/evaluated in terms of the probability of not being able to meet essential payments obligations.

Total risk is the sum of the systematic and unsystematic risks.

134 Financial Engineering, Risk Management & Financial Institutions

Quantification of Financial Risk Quantification of financial risk is carried out by both finance and non-financial companies.

By Non-financial Companies - through Sensitivity Analysis Wherever possible, risk should be quantified. Non-financial companies can carry out a sensitivity analysis by making a computer model which determines the relationship of inputs/ outputs/ sales, etc., to different prices, such as interest rates. By varying prices, their effect on pre-tax income can be determined. Alternatively, the historical sensitivity of the company’s equity value to changes in prices can be measured. The coefficients of a simple linear regression are used to estimate the sensitivity of the value of the firm to changes in the respective variables. There are some other methods like: a. Scenario Analysis: Based on situation analysis b Monte Carlo Simulation: Based on statistics.

By Financial Companies - through Gap Analysis They can measure the degree of interest rate risk through gap and duration analysis. Gap is the difference between RSA and RSL, where RSA is the market value of the rate sensitive assets and RSL is the value of the rate sensitive liabilities. Using gap, the impact on the firm of changes in the interest rate is given by _NII = gap x _r, where NII is the net interest income, and _r represents the change in interest rate. There are some other measures like: 1. Earning at Risk 2. Value at Risk 3. Daily Earning at Risk

Risk Reduction Measures There are various ways in which risks can be reduced. The following are some of the major risks reduction measures: I. Risks can be reduced by economic research and forecasting because it makes aware of the management regarding the shape of future business environment. II. Risks can be reduced by conducting consumer research and prediction-because it reduces the risks of over production or the production of wrong products.

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135

III. Risks can also be reduced by product/ services research and quality control measures. It facilitates consumer in getting quality products/ servicess. IV. Risks can be reduced by careful screening of customers. This facilitates in the reduction of bad debt and so that risks of credit collection is reduced. V. Risks can be reduced by proper training and development programmes.

Managing Financial Risk According to C. Arthur Williams Jr. and Richard M. Heins, the risk management process typically includes the following steps:

Understand the Different Types of Risks Most financial risk can be categorized as either systematic or non-systematic. There are several types of systematic risks viz., interest risk, inflation risk, and liquidity risk. a. Interest risk is the risk that changing interest rates will make your current investment’s rate look unfavorable. b. Inflation risk is the risk that inflation will increase, making your current investment’s return smaller in relation. c. Liquidity risk is associated with “tying up” your money in longterm assets that cannot be sold easily.

Determine the Level of Risk It should be noted that the level of risk will be varying according to the nature of investment or type of the financial instrument. For instance, one may purchase stocks, bonds or cash equivalent investments. Hence, risk associated with them is explained below: i. Stocks are some of the riskiest investments. Stocks carry no guarantee of repayment, and changing investor confidence can create market volatility, driving stock values down. ii. Bonds are less risky than stocks. The risk level of a bond is therefore dependent on the credit worthiness of the issuer; a company with shakier credit is more likely to default on a bond repayment. iii. Cash-equivalent investments, such as money market accounts, savings accounts, or government bonds are the least risky. These investments are also highly liquid, but they provide low returns.

Management of financial risk can be done through understanding a. types of risk b. level of risk c. divesifying risk.

136 Financial Engineering, Risk Management & Financial Institutions Determine the Portfolio’s Risk Level The first key to lowering risk is to allocate available money between different investment classes, which is called as ‘determination of portfolio’, which should include stocks, bonds, cash equivalents etc. The proportion of these allocations will depend on the level of risk can be tolerable by the corporate entity.

Reduction of Risk Through Diversification Diversifying the portfolio means buying a single type of asset from many different companies. This hedges against the risk that a single company or industry will perform poorly or go bankrupt. MARKET

CREDIT

FINANCING/LIQUIDITY

Interest rate risk Equity risk Commodity price risk Exchange rate risk

Bank risk Customer risk Supplier risk

Cash flow risk Finance risk Liquidity risk

Internal strategies

Natural hedging Internal netting Joint ventures

Vetting Position limits Monitoring Netting Credit enhancement

Lines of credit/Working capital management Debt/Equity mix management

Risk-sharing strategies

Forwards Futures Swaps

Credit derivative swaps/Total return swaps Credit-linked notes/Purchase of credit Guarantees

Swaps for reducing risk

Risk-transfer strategies

Options Insurance Securitization

Insurance Securitization

Category of financial risk

Table 7.1: Risk Management Tools for Financial Risk Hedging is offsetting potential losses/gains.

Liquidity

Strategies of Financial Risk Management Hedging A hedge is an investment position intended to offset potential losses/gains that may be incurred by a companion investment. In simple language, a hedge is used to reduce any substantial losses/gains suffered by an individual

CHAPTER 7 Management of Financial Risk or an organization. A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of over-the-counter and derivative products, and futures contracts.

137

Hedge is used to reduce any losses suffered by Organization.

Portfolio Management A Portfolio Management refers to the science of analyzing the strengths, weaknesses, opportunities and threats for performing wide range of activities related to the one’s portfolio for maximizing the return at a given risk. It helps in making selection of Debt vs. Equity, Growth vs. Safety, and various other tradeoffs. In terms of mutual fund industry, a portfolio is built by buying additional bonds, mutual funds, stocks, or other investments. If a person owns more than one security, he has an investment portfolio. The main target of the portfolio owner is to increase value of portfolio by selecting investments that yield good returns. As per the modern portfolio theory, a diversified portfolio that includes different types or classes of securities; reduces the investment risk. It is because any one of the security may yield strong returns in any economic climate.

Portfolio management is based SWOT analysis.

Major tasks involved with Portfolio Management are as follows: 1. Taking decisions about investment mix and policy 2. Matching investments to objectives 3. Asset allocation for individuals and institution 4. Balancing risk against performance.

Asset Liability Management The goal of asset/liability management (ALM) is to properly manage the risk related to changes in interest rates, the mix of balance sheet assets and liabilities, the holding of foreign currencies, and the use of derivatives. These risks should be managed in a manner that contributes adequately to earnings and limits risk to the financial margin and member equity. Proper management of asset/liability risk is facilitated through board approved policy, which sets limits on asset and liability mix, as well as the level of interest rate risk and foreign currency risk to which the credit union is willing to expose itself. Policy should also set out guidelines for the pricing, term and maturity of loans and deposits. The use of derivatives, if any, should also be controlled by policy, which should state among other things that

ALM is the balancing of assets and liabilities in the balance sheet.

138 Financial Engineering, Risk Management & Financial Institutions derivatives must only be used to limit interest rate risk and must never be used for speculative or investment purposes. Credit unions which offer either fixed rate loans or deposits will mitigate interest rate risk by ensuring that management is properly measuring risk. The standard measure of this risk is balance sheet gap, and it is essential that management measure this regularly.

Quantitative Risk Management Quantitative risk management involves mathematical and statistical tools.

Quantitative financial risk management tools involve mathematical and statistical concepts. A quantitative risk manager uses complex econometric formulas and computer algorithms to detect, appraise and monitor financial risks in corporate transactions. These quantitative tools include VAR (value at risk), Monte Carlo simulation and stress testing. Financial risk includes losses due to unfavorable changes in commodity and security prices as well as negative variations in currency and interest rates. A company often hires a specialist, to help develop quantitative financial risk management tools.

Tools Used to Manage Risk in International Finance The purpose of International Finance is no different from that of domestic finance: to identify profitable business opportunities and invest in them as effectively as possible. However, when trading crosses international borders a whole new layer of complexity appears. This complexity breeds risk factors particular to international finance. The major risks international finance has to deal with are changes in foreign exchange rates and shifts in economic and political climates. The use of financial tools can help mitigate these and other risks.

Risk-reward Ratio

Risk-reward ratio and Black-Scholes formula are used international financial measures.

Risk-reward Ratio compares the potential profit of an investment with the risk involved in the transaction. Calculate it by dividing the projected profit of the trade by what you stand to lose if the trade goes wrong. In the Foreign Exchange market (Forex) the minimum acceptable risk-reward ratio is 1:2, although beginners should try and keep to ratios of 1:3 and above.

Black-Scholes Formula Black-Scholes formula is a mathematical tool widely used in the pricing of options. It provides an approximation to the right long and short position

CHAPTER 7 Management of Financial Risk in a stock. Use this formula with caution as it relies on unsubstantiated assumptions like the “normality assumption,” which ignores the possibility of an extreme change in the market.

Conclusion This chapter discusses various basic issues relating to ‘risk’ and ‘financial risk’. It also deals with various types of risks and their management. Although financial risk has increased significantly in recent years, risk and risk management are very old contemporary issues. The result of increasingly global markets is that risk may originate with events thousands of miles away that have nothing to do with the domestic market. The economic climate and markets can be affected very quickly by changes in exchange rates, interest rates, and commodity prices. As a result, it is important to ensure financial risks are identified and managed appropriately.

Practical Problems Risk-return Measures, Risk Diversification 1. Stock A has the following probability distribution of expected returns: Probability

Rate of Return

0.1

-15%

0.2

0

0.4

5

0.2

10

0.1

25

What is Stock A’s expected rate of return and standard deviation? Solution: ∧

r A = 0.1 (-15%) + 0.2(0%) + 0.4(5%) + 0.2(10%) + 0.1(25) = 5.0%. Variance = 0.1( 0.15 – 0.05)2 + 0.2(0.0 – 0.05)2 + 0.4(0.05 – 0.05) 2 + 0.2(0.10 – 0.05)2 + 0.1(0.25 – 0.05)2 = 0.009. Standard deviation =

0.009 = 0.0949 = 9.5%.

139

140 Financial Engineering, Risk Management & Financial Institutions 2. If rRF = 5%, rM = 11%, and b = 1.3 for Stock X, what is rX, the required rate of return for Stock X? What would rX be if investors expected the inflation rate to increase by 2 percentage points? What would rX be if an increase in investors’ risk aversion caused the market risk premium to increase by 3 percentage points? rRF remains at 5 percent. Solution: r X = r RF + (r M – rRF)bX = 5% + (11% – 5%)1.3 = 12.8%. r X = r RF + (r M – rRF)bX = 7% + (13% – 7%)1.3 = 14.8%. A change in the inflation premium does not change the market risk premium (r M - rRF) since both rM and rRF are affected. r X = r RF + (r M – rRF)bX = 5% + (14% – 5%)1.3 = 16.7%. 3. Jan Middleton owns a 3-stock portfolio with a total investment value equal to Rs.300,000. Stock

Investment

Beta

A

Rs.100,000

0.5

B

Rs.100,000

1.0

C

Rs.100,000

1.5

Total

Rs.300,000

What is the weighted average beta of Jan’s 3-stock portfolio? Solution: The calculation of the portfolio’s beta is as follows: bp = (1/3)(0.5) + (1/3)(1.0) + (1/3)(1.5) = 1.0. 4. The Apple Investment Fund has a total investment of Rs.450 million in five stocks. Stock

Investment (Millions)

Beta

1

$130

0.4

2

110

1.5

3

70

3.0

4

90

2.0

5

50

1.0

Total

Rs.450

CHAPTER 7 Management of Financial Risk What is the fund’s overall, or weighted average, beta? Solution: 5

bp = ∑ wi bi i =1

=

$130 $110 $70 $90 $50 (0.4) + (1.5) + (3.0) + (2.0) + (1.0) = 1.46. $450 $450 $450 $450 $450

5. Consider the following information for the Alachua Retirement Fund, with a total investment of Rs.4 million. Stock

Investment

Beta

A

Rs.400,000

1.2

B

600,000

-0.4

C

1,000,000

1.5

D

2,000,000

0.8

Total

Rs.4,000,000

The market required rate of return is 12 percent, and the risk-free rate is 6 percent. What is its required rate of return? Solution: Determine the weight each stock represents in the portfolio: Stock

Investment

wi

Beta wi x Beta.

A

400,000

0.10

1.2.

B

600,000

0.15

-0.4. -0.0600

C

1,000,000

0.25

1.5.

0.3750

D

2,000,000

0.50

0.8.

0.4000

0.1200

bp = 0.8350 = Portfolio beta Write out the SML equation, and substitute known values including the portfolio beta. Solve for the required portfolio return. rp

= rRF + (rM – rRF)bp = 6% + (12% – 6%)0.8350 = 6% + 5.01% = 11.01%.

141

142 Financial Engineering, Risk Management & Financial Institutions 6. You are given the following distribution of returns: Probability

Return

0.4

$30

0.5

25

0.1

-20

What is the coefficient of variation of the expected dollar returns? Solution: ∧

∧

0.4 x

$30 = $12.0

0.5 x

25 =

12.5

25

- 22.5

=

2.5

6.25

3.125

0.1 x

-20 =

-2.0

-20

- 22.5

=

-42.5

1,806.25

180.625

r

ri

∧

ri

∧

Pi ri

∧

Pi

$30

r

- $22.5 =

( ri − r )

( ri − r ) 2

P ( ri − r ) 2

$ 7.5

$ 56.25

$ 22.500

= $22.5

σ 2 = Variance = $206.250 Use the given probability distribution of returns to calculate the expected value, variance, standard deviation, and coefficient of variation. The standard deviation (σ ) of

∧ r is

.

Use the standard deviation and the expected return to calculate the coefficient of variation: $14.3614/$22.5 = 0.6383. 7. The Beta Co-efficient of Target Ltd. is 1.4. The company has been maintaining 8% rate of growth in dividends and earnings. The last dividend paid was Rs. 4 per share. Return on Government securities is 10%. Return on market portfolio is 15%. The current market price of one share of Target Ltd. is Rs. 36. (i) What will be the equilibrium price pr share of Target Ltd.? (ii) Would you advise purchasing the share? Solution: (i) CAPM formula = E(Rs) = Rf + b [E (Rm) – Rf]. Where, E(Rs) = Expected rate of return of the security (OR) the cost of equity Rf = risk free returns

CHAPTER 7 Management of Financial Risk E(Rm) = market rate of return b = Beta co-efficient given 1.4 Substituting the values E(Rs) = 10 + 1.4 (15% – 10%) E(Rs) = 17%

Practice Problems Return Calculation 1. Find the return, sample mean and sample variance for the Copper price in percentage for each year: Year

Copper price Cents per pound

1

49.65

2

49.85

3

49.70

4

51.25

5

51.10

6

53.30

7

54.20

8

55.10

9

54.90

10

55.65

Hint: R (t) = {Price (t + 1) / Price t} - 1

Risk-Standard Deviation, Expected Return & Beta 2. Calculate standard deviation and expected return Returns

Probability

20

0.15

21

0.20

22

0.50

23

0.10

24

0.05

143

144 Financial Engineering, Risk Management & Financial Institutions 3. The following are the return and their probabilities in respect of security, S, and the market portfolio, M. Probabilities

Return % S

M

0.30

10

11

0.40

16

20

0.30

32

19

Calculate the beta factor. Is acceptance of the investment worth while based upon its level of risk? The risk free rate may be taken at 6 percent. 4. The following are the different state of economy, the probability of occurrence of that state and the expected rate of return form Security A and B in these different states. Probabilities

Return % A

B

Recession 0.30

-0.15

0.20

Normal 0.40

0.20

0.30

Boom 0.30

0.60

0.40

Find out the expected return and standard deviations for these two securities, suppose, an investor has Rs.20,000 to invest. He invests Rs.15,000 in security A and balance in Security B, what will be the expected return and the standard deviation of the portfolio? Hint: 1. Calculate : Expected return of A,B 2. Calculate : Standard deviation of A.B 3. Calculate: expected return of the investor based on the proportion of investment and standard deviation. CAPM: 5. The risk-free interest rate is 8 per cent and the expected return on the market portfolio is 16 per cent. Calculate the expected return on the following securities;

CHAPTER 7 Management of Financial Risk Security

Beta

A

0.4

B

1.0

C

2.6

D

2.0

145

TERMINOLOGY ON DIFFERENT TYPES OF RISKS i.

Default Risk: The uncertainty associated with the payment of financial obligations when they come due. Put simply, the risk of non-payment.

ii. Interest Rate Risk: The uncertainty associated with the effects of changes in market interest rates. There are two types of interest rate risk identified; price risk and reinvestment rate risk. iii. Price Risk: The uncertainty associated with potential changes in the price of an asset caused by changes in interest rate levels and rates of return in the economy. This risk occurs because changes in interest rates affect changes in discount rates which, in turn, affect the present value of future cash flows. The relationship is an inverse relationship. iv. Reinvestment Rate Risk: The uncertainty associated with the impact that changing interest rates have on available rates of return when reinvesting cash flows received from an earlier investment. It is a direct or positive relationship. v.

Liquidity Risk: The uncertainty associated with the ability to sell an asset on short notice without loss of value. A highly liquid asset can be sold for fair value on short notice. This is because there are many interested buyers and sellers in the market. An illiquid asset is hard to sell because there there few interested buyers.

A highly liquid asset can be sold for fair value on short notice.

vi. Inflation Risk (Purchasing Power Risk): The loss of purchasing power due to the effects of inflation. When inflation is present, the currency loses it’s value due to the rising price level in the economy. The higher the inflation rate, the faster the money loses its value. vii. Market Risk: Within the context of the Capital Asset Pricing Model (CAPM), the economy wide uncertainty that all assets are exposed to and cannot be diversified away. Often referred to as systematic risk, beta risk, non-diversifiable risk, or the risk of the market portfolio. viii. Firm Specific Risk: The uncertainty associated with the returns generated from investing in an individual firm’s common stock. Within the context of the Capital Asset Pricing Model (CAPM), this is the investment risk that is eliminated through the holding of a well diversified portfolio.

Investment risk is eliminated through the holding of a well diversified portfolio.

146 Financial Engineering, Risk Management & Financial Institutions ix. Project Risk: In the advanced capital budgeting topics, the total risk associated with an investment project. Sometimes referred to as standalone project risk. In advanced capital budgeting, project risk is partitioned into systematic and un-systematic project risk. x. Financial Risk: The uncertainty brought about by the choice of a firm’s financing methods and reflected in the variability of earnings before taxes (EBT), a measure of earnings that has been adjusted for and is influenced by the cost of debt financing. xi. Business Risk: The uncertainty associated with a business firm’s operating environment and reflected in the variability of earnings before interest and taxes (EBIT). Since this earnings measure has not had financing expenses removed, it reflects the risk associated with business operations rather than methods of debt financing. xii. Foreign Exchange Risks: Uncertainty that is associated with potential changes in the foreign exchange value of a currency. There are two major types: translation risk and transaction risks. xiii.Translation Risks: Uncertainty associated with the translation of foreign currency denominated accounting statements into the home currency. xiv.Transactions Risks: Uncertainty associated with the home currency values of transactions that may be affected by changes in foreign currency values.

Keywords

Keywords

Financial Risk: ‘Financial Risk’ refers to the possibility of a corporate entity or government defaulting on its bonds, which would cause those bondholders to lose money. Risk: Risk refers to the probability of loss, while exposure is the possibility of loss, although they are often used interchangeably. Financial Risk: Financial risk arises through numerous transactions of a financial nature viz., sales and purchases, investments and loans, and various other business activities. Financial Distress: Most of the global financial institutions are facing the problem of distress, the inability to manage funds, sustain liquidity, which ultimately leads to the position of insolvency of the financial institutions like; Banks, mutual fund organizations, and financial service providers. Un-diversifiable Risks: This is also known as “systematic” or “market risk”. Market Risk: Market risk applies mainly to stocks and options.

CHAPTER 7 Management of Financial Risk

147

Volatility: Volatility is a measure of risk because it refers to the behavior, or “temperament”, of your investment rather than the reason for this behavior. Diversifiable Risks: This risk is also known as “unsystematic risk,” and it is specific to a company, industry, market or economy. Credit Risk: Credit risk is the risk that a company or individual will be unable to pay the contractual interest or principal on its debt obligations. This type of risk is of particular concern to investors who hold bonds in their portfolios. Financing/Liquidity Risk: It is the risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss. Hedging: A hedge is an investment position intended to offset potential losses/gains that may be incurred by a companion investment. Portfolio Management: A Portfolio Management refers to the science of analyzing the strengths, weaknesses, opportunities and threats for performing wide range of activities related to the one’s portfolio for maximizing the return at a given risk. Asset Liability Management: The goal of asset/liability management (ALM) is to properly manage the risk related to changes in interest rates, the mix of balance sheet assets and liabilities, the holding of foreign currencies, and the use of derivatives. Quantitative Risk Management: Quantitative financial risk management tools involve mathematical and statistical concepts. Quantitative Risk Manager: A quantitative risk manager uses complex econometric formulas and computer algorithms to detect, appraise and monitor financial risks in corporate transactions. Financial Risk: Financial risk includes losses due to unfavorable changes in commodity and security prices as well as negative variations in currency and interest rates. International Finance: The purpose of International Finance is to identify profitable business opportunities and invest in them as effectively as possible. Risk-reward Ratio: This ratio compares the potential profit of an investment with the risk involved in the transaction.

Review Questions

Review Questions

1. Discuss the meaning and sources of financial risk.

4. What do you understand by risk reduction measures?

2. What are different types and categories of risk?

5. Analyze the tools used to manage risk in International Finance.

3. Define the principles and steps of risk management.

6. Discuss principles of managing risk.

148 Financial Engineering, Risk Management & Financial Institutions

References

References

1. Financial Management by Dr. Paresh P. Shah, 2nd Ed. Biztantra (Dreamtech Press)

4. Advanced Financial Management by Dr.U.M. Premalatha, Biztantra (Dreamtech Press)

2. Strategic Financial Management by Dr. Meena Goyal, Biztantra (Dreamtech Press)

5. International Financial Management by Dr. S.P. Srinivasan & Dr. B. Janakiram, Biztantra.

3. Financial Wisdom by Dr. A. P. Dash, Biztantra (Dreamtech Press)

6. Accounting for Managers by Dr. Meena Goyal, Biztantra

Case Study

Case Study

Case-1 The following are the annual returns of two premier tyre manufacturing companies in the last five years: Year

MRF Ld (%)

JK Ltd (%)

2006

21

23

2007

-12

-10

2008

27

32

2009

-12

-13

2010

37

35

Determine expected return and risk of stocks of these companies; also indicate the stocks in which you would like to invest.

Case-2 The following are the annual returns of two premier TV manufacturing companies: Probabilities

Samsung

Sony

0.3

15

21

0.3

13

13

0.4

12

15

Rank the securities on the basis of risk.

Case-3 The following three portfolios provide the particulars given below Portfolio FUND A

Average return

Standard deviation

17

20

Correlation coefficient 0.7

FUND B

13

17

0.5

FUND C

14

7

0.8

FUND D

12

10

0.6

Risk free rate of interest is 10%. Rank these funds using Sharpe’s and Treynor’s methods. Compute both indices.

HEDGING TOOLS AND TECHNIQUES Introduction Off Setting Interest Rate & Commodities Risk Various Instruments of Hedging Forward Contracts Futures Contracts SWAPS Option Contracts Hedging with Options Other Kinds of Hedging Risk Diversification Hedging and Correlation Tips & Techniques for Managing Risk Factors Affecting Interest Rates Hedging & Value of Firm The Costs of Hedging Hedging & Financing Choices of Firm Buliding Block Approach Conclusion Keywords Review Questions References Case Study

150 Financial Engineering, Risk Management & Financial Institutions

Chapter Objectives

Chapter Objectives

After studying this chapter the student will be able to: Understand the meaning and definitions of hedging and hedging ratio. Learn about how to reduce pricing risks with effective hedging strategies. Know the way to hedge exchange rate risk with options. Define hedging through lookback option & collateralization.

Introduction

Hedging is the process of ‘setting off’ loss expected on existing investments.

Hedging is an investment technique designed to offset a potential loss on one investment by purchasing a second investment that you expect to perform in the opposite way. For example, you might sell short one stock, expecting its price to drop. At the same time, you might buy a call option on the same stock as insurance against a large increase in value. A strategy designed to reduce investment risk using call options, put options, shortselling, or futures contracts. A hedge can help lock in profits. Its purpose is to reduce the volatility of a portfolio by reducing the risk of loss. Merck’s CFO in 1990 1, Judy Lewent, and John Kearny described the company’s policy on identifying and hedging currency risk. They rationalized the hedging of currency risk by noting that the earnings variability induced by exchange rate movements could affect Merck’s capacity to pay dividends and continue to invest in R&D, because markets would not be able to differentiate between earnings drops that could be attributed to the managers of the firm and those that were the result of currency risk. A drop in earnings caused entirely by an adverse exchange rate movement, they noted, could cause the stock price to drop, making it difficult to raise fresh capital to cover needs.

Definition of Hedging Hedging is a risk management strategy.

Hedging is “A risk management strategy used in limiting or offsetting probability of loss from fluctuations in the prices of commodities, currencies, or securities. In effect, hedging is a transfer of risk without buying insurance policies.” Hedging employs various techniques but, basically, involves taking Ref:Lewent, J.C and Kearney, A.S (1990) Identifying, Measuring and Hedging Currency Risk at Merck, Journal of Applied Corporate Finance, z: 19-28 doi: 10.1111/ J1745-6622

1

CHAPTER 8 Hedging Tools and Techniques

151

equal and opposite positions in two different markets such as cash and futures markets. Hedging is used also in protecting one’s capital against effects of inflation through investing in high-yield financial instruments like bonds, notes, shares, real estate, or precious metals.

Hedge Ratio Hedge ratio is the rate of change in the price of an option relative to price of the underlying futures contract or asset (security). It is between 0 and +1 for calls and between 0 and -1 for puts, and indicates the probability of an option to be in-the-money by its expiration date.

Off setting Interest Rate & Commodities Risk Risk is an unavoidable fact of business life. The strategies that we use to recognize and mitigate risk can often determine the success or failure of a business. One of the most important, yet often misunderstood, mitigation tools is the hedging of financial risk. What steps can an average business take to offset unfavorable swings in commodities and interest rates? When effectively conceived and executed, hedging can benefit companies of almost any size.

The Risk to Be Hedged Define the specific risk that you wish to offset. Interest rate and commodity price concerns will generally require different mechanisms to offset, so each will require separate strategies.

Measuring Risk Determine the basis for establishing the initial pricing for the interest rate or commodity. This requires an in-depth knowledge of the market behavior that you wish to hedge against often called “visibility”. Research the drivers of market pricing and seek guidance from professionals that can provide background for your inquiry. Develop a structure to incorporate your findings in to a workable model to track and measure the results of your hedge activities. Tracking the long-term success of the program is an important step in managing best practices.

Selection of Appropriate Hedge Strategy Choose your hedge strategy carefully based on your understanding of the risks that you wish to mitigate and the best options available for offset.

Modelling is the best way of measuring risk & hedging activities.

152 Financial Engineering, Risk Management & Financial Institutions There are many ways to hedge risk. A few of the basic strategies for interest rate or commodity hedge programs are: Interest Rate Hedge - Swaps Interest rate swaps & futures are best ways to ‘hedge’ price related risks.

Swaps are used to hedge many interest rate risks. Essentially, rate swaps are an agreement between two counterparties exchanging one stream of future interest payments for another. Interest rate swaps can exchange a fixed payment for a floating payment or vice versa, depending on the strategy you wish to employ. Commodity Hedge - Futures There are many ways to hedge against commodity price risk, but best method is the purchase of a futures contract, guaranteeing a particular price at a certain point in time. In this case, the price is guaranteed and no unexpected loss can occur. Another option is to enter a short sale against an investment that you believe performs inversely to the commodity that you wish to hedge. In so doing, the gain you experience in the decline of the short sale can offset price increase in your commodity.

Various Instruments of Hedging Instruments have been developed to hedge the following types of volatility: a. Interest Rate b. Exchange Rate c. Commodity Price

Interest Rate Volatility There are three types of volatility: Interest rate, Exchange rate & Commodity price.

Debt is a key component of a firm’s capital structure. Interest rates can fluctuate dramatically in short periods of time. Companies that hedge against changes in interest rates can stabilize borrowing costs. Available tools: forwards, futures, swaps, futures options, and options.

Exchange Rate Volatility Forwards, Futures Swaps & options are available tools for Hedging.

Companies that do business internationally are exposed to exchange rate risk. The more volatile the exchange rates, the more difficult it is to predict the firm’s cash flows in its domestic currency. If a firm can manage its exchange rate risk, it can reduce the volatility of its foreign earnings and do a better analysis of future projects. Available tools: forwards, futures, swaps, futures options, and options.

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153

Commodity Price Volatility Most firms face volatility in the costs of materials and in the price that will be received when products are sold. Depending on the commodity, the company may be able to hedge price risk using a variety of tools. This allows companies to make better production decisions and reduce the volatility in cash flows. Available tools (depends on type of commodity): forwards, futures, swaps, futures options, and options.

Forward Contracts A contract where two parties agree on the price of an asset today to be delivered and paid for at some future date. Forward contracts are legally binding on both parties. They can be customized to meet the needs of both parties and can be quite large in size. Because they are negotiated contracts and there is no exchange of cash initially, they are usually limited to large, creditworthy corporations. Forward contracts is an agreement to buy or sell an asset at a certain date at a certain price. Forward contracts can help reduce volatility in certain markets, but they contain the risks inherent to all speculative investing. These contracts may be sold on the secondary market, but the person holding the contract at its end must take delivery of the underlying asset. Forward contracts are identical to futures contracts except that their provisions are not standardized. That is, forwards may be written with any provisions the parties desire. While this allows for greater flexibility, this makes the contracts less liquid on the secondary market and prevents them from being traded on an exchange.

Positions - Long Position & Short Position Long – agrees to buy the asset at the future date (buyer). Short – agrees to sell the asset at the future date (seller).

A contract between two parties to be executed at a future date is “Forward Contract”

Figure: 8.1 Payoff Profiles for a Forward Contract

154 Financial Engineering, Risk Management & Financial Institutions Hedging with Forwards

Figure: 8.2 Hedging with Forwards

Future contracts are ‘Market to Market’ on a daily basis.

Entering into a forward contract can virtually eliminate the price risk a firm faces. It does not completely eliminate risk because both parties still face credit risk. Since it eliminates the price risk, it prevents the firm from benefiting if prices move in the company’s favor. The firm also has to spend some time and/or money evaluating the credit risk of the counterparty. Forward contracts are primarily used to hedge exchange rate risk.

Futures Contracts Futures contracts trade publicly on organized securities exchange. Require an upfront cash payment called margin. Small relative to the value of the contract. “Marked-to-market” on a daily basis. Clearinghouse guarantees performance on all contracts. The clearing house and margin requirements virtually eliminate credit risk. Future contract is an agreement to buy or sell an asset at a certain date at a certain price. That is, Investor A may make a contract with Farmer B in which A agrees to buy a certain number of bushels of B’s corn at $15 per bushel. This contract must be honored whether the price of corn goes to $1 or $100 per bushel. Futures contracts can help reduce volatility in certain markets, but they contain the risks inherent to all speculative investing. These contracts may be sold on the secondary market, but the person holding the contract at its end must take delivery of the underlying asset. Futures contract are standard instruments; that is, unlike forward contracts, their provisions are standardized. As such, they may be traded on an exchange.

Financial Futures Financial futures are used primarily to trade interest rate risk. The markets for financial futures are very liquid; and of course there is no cost of storage. Most financial futures contracts fall into three categories:

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155

i. Interest Rate Futures: These include futures on interest bearing instruments such as T-bills, T-notes, T-bonds, certificates of deposit, Eurodollars, etc., are a popular and useful method of hedging interest rate risk. These contracts enable borrowers to lock in interest rates for some future period. ii. Foreign Currency Futures: These are available in all major currencies, and are used for hedging foreign exchange risk. iii. Share Price Index Futures: The first of these was introduced in the U.S.A. only in 1982. They are traded on the Standard and Poor’s 500 index, the New York Stock Exchange Composite index, and the Value Line index. These are obviously non-deliverable. Instead, these are settled in cash by marking to the market “at the closing value of the respective underlying spot stock market index on the last trading day”.

SWAPS A long-term agreement between two parties to exchange (or swap) cash flows at specified times based on specified relationships. Swaps can be viewed as a series of forward contracts. These are limited to large creditworthy institutions or companies. Another broad category of contracts that result from financial engineering are referred to as swaps. Swaps represent exchanges of cash flows generated by distinct sets of assets or tied to distinct measures of value. An early example of an engineered swap is the currency swap. In this example, consider two firms in different countries each having continuing financial obligations in the other’s country. For example, consider a French firm with a U.S. subsidiary that requires dollars to operate and a U.S. firm with a French subsidiary that has need for French francs. One alternative is to borrow the funds in the home country and exchange them for the foreign currency needed by the subsidiary. Another alternative is for the subsidiary to borrow the needed funds in the local currency. This second alternative will provide needed funds for the subsidiary and avoid the costs associated with foreign exchange transactions. It is also likely, however, that the subsidiary is at a disadvantage when negotiating the rate on a loan in the local currency. For example, the U.S.-based subsidiary of a French corporation may not have the perceived creditworthiness of a U.S. corporation with foreign subsidiaries and as a result will be forced to pay a higher rate of interest on

‘SWAP’ is an agreement to exchange cash flows at specified times.

156 Financial Engineering, Risk Management & Financial Institutions the dollar-denominated loan. If each firm becomes aware of the other’s needs, they can do the following. First, each parent corporation should borrow an equivalent amount in their home currencies. These amounts will be equal based on the current exchange rate between dollars and francs. Second, they will simultaneously transfer the proceeds of the loan to the other firm’s subsidiary. As interest payments become due, the French-based subsidiary pays the French parent and the U.S.-based subsidiary pays the U.S. parent. Finally, when the term of the loans expires, each subsidiary will repay the other’s parent. Note that this financially engineered contract has (1) effectively exploited each firm’s ability to borrow at more favorable rates in its home country and (2) avoided all need for foreign currency exchange.

Interest Rate Swap Interest rate swap is the process of exchange between fixed & floating rates.

Complex swaps involve trades of fixedrate and floating-rate payments denominated in different currencies.

The interest rate swap typically takes the form of an exchange of a fixedrate interest payment for a floating-rate interest payment. For example, a bank has made a large number of loans at a fixed rate, but most of its liabilities are floating-rate obligations. If interests rise materially, its expenses will rise but its revenues are fixed. Profitability will suffer. If the bank can swap its fixed-rate loans for a comparable amount of floating-rate obligations that generate the yield on any Treasury bonds. In this case once the bank has found a willing swap partner, the parties will agree to a notional principal amount. That is, the counterparties will agree on the amount of interest-generating capital that will be used to design the agreement. Typically, the parties will not exchange these notional amounts because they are identical. As time elapses, the bank will swap interest payments with its counterparty. For example, if the Treasury bond rate is 6 percent during a particular period, the agreement mandates that the bank receive 10 percent while it pays 9 percent. The swap agreement will require only that the net difference be exchanged, I percent paid to the bank in this case. If the Treasury bond rate drops to 4.5 percent, then the bank is obligated to pay the net difference between 8.5 percent (or 4.5 percent + 4 percent) and 9 percent, or 0.5 percent to the counterparty. If the Treasury bond rate remains at 5 percent, the fixed and floating rates are equivalent and no cash exchange would be necessary. More complex swaps could involve trades of fixed-rate and floating-rate payments denominated in different currencies. Others could involve swaps of the income from debt instruments for the income generated by an equity investment in a specific portfolio such as the S&P 500.

CHAPTER 8 Hedging Tools and Techniques The swap can be engineered to provide immediate international diversification. Suppose two portfolio managers, one in the United States and another in Japan, manage purely domestic portfolios. They may agree to swap notional values that would generate returns on their own managed portfolios or generate cash flows commensurate with an investment in a market index.

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‘Swap’ can be engineered to provide immediate international diversification.

For example, the U.S. manager may agree to provide the cash flow generated by a $100 million investment in the S&P 500 in exchange for returns generated from a similar-sized investment in the Nikkei 225 index. This would provide instant international diversification without the sizable cost of purchasing a large number of individual foreign securities. In addition, many countries impose fees or taxes on returns to foreign owners. A properly engineered swap agreement can avoid most or all of these expenses.

Types of Swaps a. Interest Rate Swaps – the net cash flow is exchanged based on interest rates. b. Currency Swaps – two currencies are swapped based on specified exchange rates or foreign vs. domestic interest rates. c. Commodity Swaps – fixed quantities of a specified commodity are exchanged at fixed times in the future.

Option Contracts A contract in which the writer (seller) promises that the contract buyer has the right, but not the obligation, to buy or sell a certain security at a certain price (the strike price) on or before a certain expiration date, or exercise date. The asset in the contract is referred to as the underlying asset, or simply the underlying. An option gives the buyer the right to buy at a certain price is called a call, while one that gives him/her the right to sell is called a put. An option gives the right, but not the obligation, to buy (or sell) an asset for a set price on or before a specified date. Option consists of: Call – right to buy the asset Put – right to sell the asset Specified exercise or strike price Specified expiration date.

An ‘option’ gives the right to buy or sell an asset.

158 Financial Engineering, Risk Management & Financial Institutions Seller’s Obligation Buyer has the right to exercise the option, but the seller is obligated Call – option writer is obligated to sell the asset if the option is exercised Put – option writer is obligated to buy the asset if the option is exercised Option seller can also be called the writer.

Hedging with Options Unlike forwards and futures, options allow the buyer to hedge their downside risk, but still participate in upside potential. The buyer pays a premium for this benefit.

Payoff Profiles: Calls

Figure: 8.3 Payoff Profiles: Calls

Payoff Profiles: Puts

Figure: 8.4 Payoff Profiles: Option

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Hedging with Options:

Figure: 8.5 Hedging with Options

Hedging Exchange Rate Risk with Options This may use either futures options on currency or straight currency options. This is used primarily by corporations that do business overseas. Canadian companies want to hedge against a strengthening dollar (receive fewer dollars when you convert foreign currency back to dollars).

The hedged profile is created by purchasing a put option, thereby eleminating the downside risk.

Protected if the value of the foreign currency falls relative to the dollar. Still benefit if the value of the foreign currency increases relative to the dollar. Buying puts is less risky.

Other Kinds of Hedging Netting A netting agreement is legal agreement that comes into force in the event of a bankruptcy. It enables one to net the value of trades with a defaulted counterparty before settling the claims. They are crucial to recognize the benefit of offsetting trades with a defaulted counterparty.

Netting, Securitization, Insurance & Diversification are also considered as hedging techniques.

Securitization In its widest sense, it implies every process that converts a financial relation into a transaction. Thus, securitization is not just a funding device or an alternative to secured funding; it is a new-found way of lending a tradable character to business relationships, not limited to financial relationships. Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming them into a security.

Securitization is the process of taking an illiquid asset, or group of assets, transforming them into a security.

160 Financial Engineering, Risk Management & Financial Institutions Insurance A contract (policy) in which an individual or entity receives financial protection or reimbursement against losses from an insurance company. The company pools clients’ risks to make payments more affordable for the insured.

Derivatives - Definition2 Value of derivatives is dependent on its underlying asset.

Derivatives are traded widely among financial institutions and on organized exchanges. The value of derivatives contracts, such as futures, forwards, options, and, is derived from the price of the underlying asset. Derivatives trade on interest rates, exchange rates, commodities, equity and fixed income securities and credit. The products and strategies used by market participants to manage financial risk are the same ones used by speculators to increase leverage and risk. Although it can be argued that widespread use of derivatives increases risk, the existence of derivatives enables those who wish to reduce risk to pass it along to those who seek risk and its associated opportunities.

Risk Diversification (Portfolio Management) Risk diversification is also called as portfolio Management.

For many years, the riskiness of an asset was assessed based only on the variability of its returns. In contrast, modern portfolio theory considers not only an asset’s riskiness, but also its contribution to the overall riskiness of the portfolio to which it is added. Organizations may have an opportunity to reduce risk as a result of risk diversification. In portfolio management terms, the addition of individual components to a portfolio provides opportunities for diversification, within limits. A diversified portfolio contains assets whose returns are dissimilar, in other words, weakly or negatively correlated with one another. It is useful to think of the exposures of an organization as a portfolio and consider the impact of changes or additions on the potential risk of the total. Diversification is an important tool in managing financial risks. Diversification among counterparties may reduce the risk that unexpected events adversely Definition: A security whose price is dependent upon or derived from one or more underlying assets. 2

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impact the organization through defaults. Diversification among investment assets reduces the magnitude of loss if one issuer fails. Although the risk of loss still exists, diversification may reduce the opportunity for large adverse outcomes.

Hedging and Correlation Hedging is the business of seeking assets or events that offset, or has weak or negative correlation to, an organization’s financial exposures. Correlation measures the tendency of two assets to move, or not move, together. This tendency is quantified by a coefficient between –1 and +1. Correlation of +1.0 signifies perfact positive correlation and means that two assets can be expected to move together. Correlation of –1.0 signifies perfect negative correlation, which means that two assets can be expected to move together but in opposite directions.

Risk management involves pairing a financial exposure with an instrument or strategy.

The concept of negative correlation is central to hedging and risk management. Risk management involves pairing a financial exposure with an instrument or strategy that is negatively correlated to the exposure. A long futures contract used to hedge a short underlying exposure employs the concept of negative correlation. If the price of the underlying short exposure begins to rise, the value of the (long) futures contract will also increase, offsetting some or all of the losses that occur. The extent of the protection offered by the hedge depends on the degree of negative correlation between the two.

Tips & Techniques for Managing Risk The risk management process involves both internal and external analysis. The first part of the process involves identifying and prioritizing the financial risks facing an organization and understanding their relevance. It may be necessary to examine the organization and its products, management, customers, suppliers, competitors, pricing, industry trends, balance sheet structure, and position in the industry. It is also necessary to consider stakeholders and their objectives and tolerance for risk. The ability to estimate the likelihood of a financial loss is highly desirable. However, standard theories of probability often fail in the analysis

Risk management is concerned with negative correlation.

162 Financial Engineering, Risk Management & Financial Institutions of financial markets. Risks usually do not exist in isolation, and the interactions of several exposures may have to be considered in developing an understanding of how financial risk arises. Sometimes, these interactions are difficult to forecast, since they ultimately depend on human behavior. The process of financial risk management is an ongoing one. Strategies need to be implemented and refined as the market and requirements change. Refinements may reflect changing expectations about market rates, changes to the business environment, or changing international political conditions, for example. In general, the process can be summarized as follows: Identify and prioritize key financial risks. Determine an appropriate level of risk tolerance. Implement risk management strategy in accordance with policy. Measure, report, monitor, and refine as needed. Once a clear understanding of the risks emerges, appropriate strategies can be implemented in conjunction with risk management policy. For example, it might be possible to change where and how business is done, thereby reducing the organization’s exposure and risk. Alternatively, existing exposures may be managed with derivatives. Another strategy for managing risk is to accept all risks and the possibility of losses. There are three broad alternatives for managing risk: 1. Do nothing and actively, or passively by default, accept all risks. 2. Hedge a portion of exposures by determining which exposures can and should be hedged. 3. Hedge all exposures possible. Risk management involves both external & internal analysis.

Measurement and reporting of risks provides decision makers with information to execute decisions and monitor outcomes, both before and after strategies are taken to mitigate them. Since the risk management process is ongoing, reporting and feedback can be used to refine the system by modifying or improving strategies. An active decision-making process is an important component of risk management. Decisions about potential loss and risk reduction provide a forum for discussion of important issues and the varying perspectives of stakeholders.

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Factors Affecting Interest Rates Interest rates are a key component in many market prices and an important economic barometer. They are comprised of the real rate plus a component for expected inflation, since inflation reduces the purchasing power of a lender’s assets. The greater the term to maturity, the greater the uncertainty. Interest rates are also reflective of supply and demand for funds and credit risk. Interest rates are particularly important to companies and governments because they are the key ingredient in the cost of capital. Most companies and governments require debt financing for expansion and capital projects. When interest rates increase, the impact can be significant on borrowers. Interest rates also affect prices in other financial markets, so their impact is far-reaching. Other components to the interest rate may include a risk premium to reflect the creditworthiness of a borrower. For example, the threat of political or sovereign risk can cause interest rates to rise, sometimes substantially, as investors demand additional compensation for the increase risk of default. Factors that influence the level of market interest rates include: Expected levels of inflation General economic conditions Monetary policy and the stance of the central bank Foreign exchange market activity

Exchange Rate Risk Research consistently indicate that the most widely hedged risk at MNC’S remains currency risk. The reasons are following: a. It is Omnipresent: It is not just large multi-national firms that are exposed to exchange rate risk. Even small firms that derive almost all of their revenues domestically are often dependent upon inputs that come from foreign markets and are thus exposed to exchange rate risk. An entertainment software firm that gets its software written in India for sale in the United States is exposed to variations in the U.S. dollar/ Indian Rupee exchange rate. b. It Affects Earnings: Accounting conventions also force MNC’S to reflect the effects of exchange rate movements on earnings in the

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164 Financial Engineering, Risk Management & Financial Institutions periods in which they occur. Thus, the earnings per share of firms that do not hedge exchange rate risk will be more volatile than firms that do. As a consequence, firms are much more aware of the effects of the exchange rate risk, which may provide a motivation for managing it. c. It is Easy to Hedge: Exchange rate risk can be managed both easily and cheaply. Firms can use an array of market-traded instruments including options and futures contracts to reduce or even eliminate the effects of exchange rate risk.

Commodity Price Risk Tufano’s study3 of gold mining companies, notes that most of the mining firms hedge against gold price risk. While gold mining and other commodity companies use hedging as a way of smoothing out the revenues that they will receive on the output, there are companies on the other side of the table that use hedging to protect themselves against commodity price risk in their inputs. Southwest Airlines use of derivatives to manage its exposure to fuel price risk provides a simple example of input price hedging and why firms do it. While some airlines try to pass through increases in fuel prices through to their customers (often unsuccessfully) and others avoid hedging because they feel they can forecast future oil price, Southwest has viewed it as part of its fiduciary responsibility to its stockholders to hedge fuel price risk. They use a combination of options, swaps and futures to hedge oil price movements and report on their hedging activities in their financial statements. The motivations for hedging commodity price risk may vary across companies and are usually different for companies that hedge against output price risk as opposed to companies that hedge against input price risk but the end result is the same. The former are trying to reduce the volatility in their revenues and the latter are trying to do the same with cost, but the net effect for both groups is more stable and predictable operating income, which presumably allows these firms to have lower distress costs and borrow more. Tufano, Peter (1996), “Who Manage Risk; An Emprical Examination of Risk Management Practices in the Gold Mining Industry” Journal of Finance S7:4, pp1097137

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Hedging & Value of Firm Hedging risks has both implicit and explicit costs that can vary depending upon the risk being hedged and the hedging tool used, and the benefits include better investment decisions, lower distress costs, tax savings and more informative financial statements. The trade off seems simple; if the benefits exceed the costs, you should hedge and if the costs exceed the benefits, you should not. This simple set-up is made more complicated when we consider the investors of the firm and the costs they face in hedging the same risks. If hedging a given risk creates benefits to the firm, and the hedging can be done either by the firm or by investors in the firm, the hedging will add value only if the cost of hedging is lower to the firm than it is to investors. Thus, a firm may be able to hedge its exposure to sector risk by acquiring firms in other businesses, but investors can hedge the same risk by holding diversified portfolios. The premiums paid in acquisitions will dwarf the transactions costs faced by the latter; this is clearly a case where the risk hedging strategy will be value destroying. In contrast, consider an airline that is planning on hedging its exposure to oil price risk because it reduces distress costs. Since it is relatively inexpensive to buy oil options and futures and the firm is in a much better position to know its oil needs than its investors, this is a case where risk hedging by the firm will increase value.

Hedging risk is having a direct impact on value of firm.

If hedging a given risk creates benefits to the firm, and the hedging can be done either by the firm or by investors in the firm, the hedging will add value only if the cost of hedging is lower to the firm than it is to investors.

The Costs of Hedging In this section, we consider the magnitude of explicit and implicit costs of hedging against risk and how these costs may weigh on the final question of whether to hedge in the first place.

Explicit Costs Most businesses insure against at least some risk and the costs of risk protection are easy to compute. They take the form of the insurance premiums that you have to pay to get the protection. In general, the trade off is simple. The more complete the protection against risk, the greater the cost of the insurance. In addition, the cost of insurance will increase with the likelihood and the expected impact of a specified risk. A business located in coastal Florida of USA4 will have to pay more to insure against floods and hurricanes than one in the mid-west. Businesses that hedge against risks using options can also measure their hedging costs explicitly. A farmer 4

United States of America

There are two types of cost of hedging viz., explicit and implicit costs.

166 Financial Engineering, Risk Management & Financial Institutions who buys put options to put a lower bound on the price that he will sell his produce at has to pay for the options. Similarly, an airline that buys call options on fuel to make sure that the price paid does not exceed the strike price will know the cost of buying this protection.

Implicit Costs The hedging costs become less explicit as we look at other ways of hedging against risk.

Hedging & Financing Choices of Firm Derivatives, Futures, Forwards & Swaps are various financing choices of a firm.

Derivatives: Derivatives have been used to manage risk for a very long time, but they were available only to a few firms and at high cost, since they had to be customized for each user. The development of options and futures markets in the 1970s and 1980s allowed for the standardization of derivative products, thus allowing access to even individuals who wanted to hedge against specific risk.

A futures contract, like a forward contract, is an agreement to buy or sell an underlying asset at a specified time in the future.

Futures and Forwards: The most widely used products in risk management are futures, forwards, options and swaps. These are generally categorized as derivative products, since they derive their value from an underlying asset that is traded. A futures contract, like a forward contract, is an agreement to buy or sell an underlying asset at a specified time in the future. Therefore, the payoff diagram5 on a futures contract is similar to that of a forward contract. There are, however, three major differences between futures and forward contract. First, futures contracts are traded on exchanges whereas forward contracts are not. Consequently, futures contracts are much more liquid and there is no default or credit risk; this advantage has to be offset against the fact that futures contracts are standardized and cannot be adapted to meet the firm’s precise needs. Second, futures contracts require both parties (buyer and seller) to settle differences on a daily basis rather than waiting for expiration. Thus, if a firm buys a futures contract on oil, and oil prices go down, the firm is obligated to pay the seller of the contract the difference. Because futures contracts are settled at the end of every day, they are converted into a sequence of one-day forward contracts. This 5

Ref: See pay off diagram figure 8.1

CHAPTER 8 Hedging Tools and Techniques can have an effect on their pricing. Third, when a futures contract is bought or sold, the parties are required to put up a percentage of the price of the contract as a “margin.” This operates as a performance bond, ensuring there is no default risk. Options: Options differ from futures and forward contracts in their payoff profiles, which limit losses to the buyers to the prices paid for the options. Call options give buyers the rights to buy a specified asset at a fixed price anytime before expiration, whereas put options give buyers the right to sell a specified asset at a fixed price.

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Call options give buyers the rights to buy a specified asset at a fixed price anytime before expiration, whereas put options give buyers the right to sell a specified asset at a fixed price.

The buyer of a call option makes as a gross profit the difference between the value of the asset and the strike price, if the value exceeds the strike price; the net payoff is the difference between this and the price paid for the call option. If the value is less than the strike price, the buyer loses what he or she paid for the call option. The process is reversed for a put option. The buyer profits if the value of the asset is less than the strike price and loses the price paid for the put if it is greater. There are two key differences between options and futures. The first is that options provide protection against downside risk, while allowing you to partake in upside potential. Futures and forwards, on the other hand, protect you against downside risk while eliminating upside potential. Swaps: In its simplest form, titled a plain vanilla swap, you offer to swap a set of cash flows for another set of cash flows of equivalent market value at the time of the swap. Thus, a U.S., company that expects cash inflows in Euros from a European contract can swaps thee for cash flows in dollars, thus mitigating currency risk.

Futures and forwards, on the other hand, protect you against downside risk while eliminating upside potential.

Hedging through Lookback Option & Collateralization Lookback Option An exotic option that allows investors to “look back” at the underlying prices occurring over the life of the option and then exercise based on the underlying asset’s optimal value. This type of option reduces uncertainties associated with the timing of market entry. There are two types of lookback options:

‘Lookback option’ is an exotic option depends on value of underlying asset.

168 Financial Engineering, Risk Management & Financial Institutions Options strike price may be ‘fixed’ or ‘floating’.

1. Fixed: The option’s strike price is fixed at purchase. However, the option is not exercised at the market price. In the case of a call, the option holder can look back over the life of the option and choose to exercise at the point when the underlying asset was priced at its highest over the life of the option. In the case of a put, the option can be exercised at the asset’s lowest price. The option settles at the selected past market price and against the fixed strike. 2. Floating: The option’s strike price is fixed at maturity. For a call, the strike price is fixed at the lowest price reached during the life of the option. For a put, it is fixed at the highest price. The option settles at market and against the floating strike.

Exotic Option An option that differs from common American or European options in terms of the underlying asset or the calculation of how or when the investor receives a certain payoff. These options are more complex than options that trade on an exchange, and generally trade over the counter. For example, one type of exotic option is known as a chooser option. This instrument allows an investor to choose whether the options is a put or call at a certain point during the option’s life. Because this type of option can change over the holding period, it is not be found on a regular exchange, which is why it is classified as an exotic option.

American Option An option that can be exercised anytime during its life. The majority of exchange-traded options are American. Since investors have the freedom to exercise their American options at any point during the life of the contract, they are more valuable than European options which can only be exercised at maturity. F o r example, If you bought a Ford March Call option expiring in March of 2015, you would have the right to exercise the call option at anytime up until its expiration date. Had the Ford option been a European option, you could only exercise the option at the expiry date in March 2015. During the year, the share price could have been most optimal for exercise in December of 2014, but you would have to wait to exercise your option until March 2015, where it could be out-of-the-money and virtually worthless.

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European Option An option that can only be exercised at the end of its life, at its maturity. European options tend to sometimes trade at a discount to its comparable American option. This is because American options allow investors more opportunities to exercise the contract. European options normally trade over the counter, while American options usually trade on standardized exchanges. A buyer of a European option that does not want to wait for maturity to exercise it can sell the option to close the position.

Collateralization or Asset-backed Securitization The act where a borrower pledges an asset as recourse to the lender in the event that the borrower defaults on the initial loan. Collateralization of assets gives lenders a sufficient level of reassurance against default risk, which allows loans to be issued to individuals/companies with less than optimal credit history/ debt rating. Mortgage financing allows borrowers to hold title over their own home despite acquiring it via borrowed funds. However, in the terms of the mortgage, if the borrowers default on the mortgage payments, the lender has a right to sell the property to recoup the loan amount.

‘Collateralization’ is also called as asset backed securitization.

Businesses can use collateralization for debt offerings. Such bonds may go into details as to the specific asset, such as equipment and/or property that is being pledged for the repayment of the bond offering in the event of default. The increased level of security offered to a bondholder typically means that the coupon rate offered on the bond will be lower as well.

Additional Collateral Additional assets put up as collateral by a borrower against debt obligations. Additional collateral is used to lessen the risk to the lender. Creditors might require extra collateral in order for a given loan to remain at a constant interest level, or to appease investors or a credit committee. Such collateral might include cash, certificates of deposit, equipment, stock or letters of credit. Collateral is commonly used when securing loans as a way to increase the likelihood of repayment. If the borrower defaults on a loan, the lender would have the right to acquire the collateral in an attempt to pay off the remaining debt. If additional funds are lent, then more collateral might also be required. For example, if a lender requires that a Rs.2,000 asset be pledged as collateral for a Rs.10,000 loan, the Rs.2,000 asset is considered collateral. If at some point additional funds are required or the lender feels that the borrower has become too risky, then additional collateral might be needed.

Additional collateral is used to lessen the risk to the lender.

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Building Block Approach There are three major methods of actually working on the building block approach: (i) to look at the risk and payoff profiles, (ii) to look at timeline cash flow diagrams and (iii) lastly, there is the arithmetic approach recently introduced by Donald J. Smith. The boxed cash flow diagrams approach is also sometimes used. In Building Block approach first of all a graphical or mathematical view of the current risk exposure is projected. Then the residual or net cash flows are examined.

In each of these approaches, the process is essentially the same. First of all a graphical or mathematical view of the current risk exposure is projected. This picture is overlaid with the cash flows associated with the hedging instruments under consideration. Then the residual or net cash flows are examined. Ultimately, by varying the delivery months and the strike prices, etc., the risk exposure is manipulated in the desired manner. To facilitate the calculations and analysis, spreadsheets and special software packages are put to use. It is usually possible to achieve the objective using different combinations of hedging instruments. The combination or strategy which is least costly is then accepted. The securities resulting from this process are often given special names, or simply called synthetic securities. Some examples of synthetic securities are given as under:

Time-line Cash Flow Method The time-line cash flow diagrams are very intuitive and easy to grasp. Usually, the direction of the arrows represents the direction of the cash flows; the long arrow denotes the principal, and short arrows the exchange of other cash flows. A denotes fixed interest rate and denotes floating interest rate.

Arithmetic Approach The notation of the arithmetic approach is illustrated by: A = B + C, where A, B, and C represent expected cash flows from these securities. The “ = “ sign represents identical cash flows in terms of amount, currency and timing. A “ + “ indicates a long position and a “ - “ indicates a short position.

Some Other Examples of Building Block Approach Listed below are some other common examples of the building block approach to financial engineering. i. Synthetic Futures: These can be built from forward contracts. We can also use an appropriate combination of single-period options to synthesize a futures contract.

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ii. Synthetic Options: Black and Scholes showed that a call option can be synthesized from forward contracts and riskless securities. ii. Bonds with Embedded Options: Varieties of bonds have also been synthesized, which give the bondholder an option. Bonds with warrants/convertible bonds/callable bonds have options embedded in them. In a convertible bond, the bondholder has the right (but not the obligation) to convert the bond into some specified asset of the issuer. In a callable bond the issuer has the right (but not the obligation) to call the bond for redemption prior to maturity.

Bonds with warrants/ convertible bonds/ callable bonds have options embedded in them.

iv. Synthetic Swaps: Since the payoff profile of swaps is similar to that of a forward contract, they can easily be synthesized from forwards. A swap can also be synthesized from an appropriate strip of futures or from a strip of futures-like option combinations.

Conclusion Financial engineering has proved extremely effective in managing the increased financial risk witnessed over the past few decades, and particularly in the last decade. “It’s rare that a day goes by in the financial markets without hearing of at least one new or hybrid product. Using a building block approach, it appears that almost all requirements of risk management can be met by a suitable product. These instruments and their everexpanding markets also seem to be playing a role in increasing efficiency in capital markets. Cox (1976) has suggested that “futures trading increases market information and thereby increases the efficiency of spot prices. By “efficiency” he meant that spot prices provide more accurate signals for resource allocation when the given commodity has a futures market.

Keywords

Keywords

Hedging: Hedging is an investment technique, designed to offset a potential loss on one’s investment by purchasing a second investment, that you expect to perform in the opposite way. Hedge Ratio: Hedge ratio is the rate of change in the price of an option relative to price of the underlying futures contract or asset (security). Interest Rate Hedge: Swaps are used to hedge many interest rate risks. Essentially, rate swaps are an agreement between two counterparties exchanging one stream of future interest payments for another.

172 Financial Engineering, Risk Management & Financial Institutions Interest Rate Swaps: Interest rate swaps can exchange a fixed payment for a floating payment or vice versa, depending on the strategy you wish to employ. Commodity Hedge: There are many ways to hedge against commodity price risk, but one of the most straightforward mechanisms involves the purchase of a futures contract, guaranteeing a particular price at a certain point in time. Exchange Rate Volatility: Companies that do business internationally are exposed to exchange rate risk. The more volatile the exchange rates, the more difficult it is to predict the firm’s cash flows in its domestic currency. Commodity Price Volatility: Most firms face volatility in the costs of materials and in the price that will be received when products are sold. Depending on the commodity, the company may be able to hedge price risk using a variety of tools. The Risk Management Process: Identify the types of price fluctuations that will impact the firm. Forward Contract: A contract where two parties agree on the price of an asset today to be delivered and paid for at some future date. Futures Contract: It is an agreement to buy or sell an asset at a certain date at a certain price. Swaps: A long-term agreement between two parties to exchange (or swap) cash flows at specified times based on specified relationships. Option Contract: A contract in which the writer (seller) promises that the contract buyer has the right, but not the obligation, to buy or sell a certain security at a certain price (the strike price) on or before a certain expiration date, or exercise date. Netting: A netting agreement is legal agreement that comes into force in the event of a bankruptcy. Securitization: In its widest sense, it implies every process that converts a financial relation into a transaction. Insurance: A contract (policy) in which an individual or entity receives financial protection or reimbursement against losses from an insurance company. The company pools clients’ risks to make payments more affordable for the insured. Derivatives: Derivatives are traded widely among financial institutions and on organized exchanges. Hedging and Correlation: Hedging is the business of seeking assets or events that offset, or has weak or negative correlation to, an organization’s financial exposures. Correlation measures the tendency of two assets to move, or not move, together. Look Back Option: An exotic option that allows investors to “look back” at the underlying prices occurring over the life of the option and then exercise based on the underlying asset’s optimal value.

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Exotic Option: An option that differs from common American or European options in terms of the underlying asset or the calculation of how or when the investor receives a certain payoff. American Option: An option that can be exercised anytime during its life. The majority of exchange-traded options are American. European Option: An option that can only be exercised at the end of its life, at its maturity. Collateralization: The act where a borrower pledges an asset as recourse to the lender in the event that the borrower defaults on the initial loan. Additional Collateral: Additional assets put up as collateral by a borrower against debt obligations. Additional collateral is used to lessen the risk to the lender. Convertible Bond: In a convertible bond, the bondholder has the right (but not the obligation) to convert the bond into some specified asset of the issuer. Financial Product Markup Language: It is a business information exchange standard based on Extensible Markup Language (XML) that enables business-to-business over-the-counter (OTC) financial derivative transactions using the Internet.

Review Questions

Review Questions

1. Give meaning and definitions of hedging and hedging ratio.

4. Define hedging through lookback option & collateralization.

2. What are the methods of reducing pricing risks with effective hedging strategies?

5. What do you understand by financial product markup language?

3. Discuss the various ways to hedge exchange rate risk with options.

References

References

1. Financial Management by Dr. Paresh P. Shah, 2 nd Ed. Biztantra (Dreamtech Press).

4. Advanced Financial Management by Dr.U.M. Premalatha, Biztantra(Dreamtech Press).

2. Strategic Financial Management by Dr. Meena Goyal, Biztantra (Dreamtech Press).

5. International Financial Management by Dr. S.P. Srinivasan & Dr. B. Janakiram, Biztantra.

3. Financial Wisdom by Dr. A. P. Dash, Biztantra (Dreamtech Press).

6. Accounting for Managers by Dr. Meena Goyal, Biztantra.

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Case Study

Case Study

Note: Students are advised to go through the following review on global status of hedgingwrite a detailed note on its implications on Indian economy. Higher hedging expenses - India’s current account deficit - Decline in demand for the rupee -Jeanette Rodrigues 1 3rd April, 2013- Mumbai: Carry trades in India’s rupee, the world’s second-highest yielding currency since 2010, are losing their appeal after the cost to hedge against foreign-exchange swings surged to a two-year high. The price of contracts that fix the conversion rate for buying dollars with rupees in a year’s time jumped 103 basis points this year to an annualized 6.84% over the spot rate Tuesday, the most since May 2011, data compiled by Bloomberg show. The onshore forward premium on the dollar against South Korea’s won fell 29 basis points to 1.78%. Higher hedging expenses and India’s record current-account deficit will hurt demand for the rupee from global investors who borrow currencies with low interest rates to buy higher-yielding ones, said HSBC Holdings Plc a n d IndusInd Bank Ltd. The increase in forward-market costs reflects both a surge in local short- term borrowing costs and rising bets the Indian currency is headed for a third year of losses, according to the lenders. “There is no carry trade in the rupee right now as forward premiums on the dollar are very high”, Hitendra Dave, Mumbai- based head of global markets for India at HSBC, Europe’s largest bank, said in an interview on 28 March. The core assumption is that there will be orderly currency weakness, which is desirable to fix the current account. The rupee will depreciate in the new fiscal year.

Second Best Dollar-based investors earned 23% interest from the rupee since the end of 2010, the most after the 68% on Argentina’s peso, according to data compiled by Bloomberg. Rupee-denominated government debt returned 12.2% in the past 12 months, the second-best performance among the 10 Asian markets monitored by HSBC. The pressure from India’s current-account deficit may cause the rupee to lose out at a time when signs of a global recovery rekindle demand for higher-yielding assets. The UBS AG V24 Carry Trade Index, which tracks holdings of 24 currencies in the forwards market, completed a fourthstraight monthly advance in March, the best streak since June 2009. http://www.livemint.com/Money/Tq1ilYp5Ex1uqp6NrI6NpM/Rupee-carry-trades-choked-as-hedging-costs-at2011-high.html

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The shortfall in India’s current account, the broadest measure of trade, widened to $32.6 billion in the quarter ended 31 December, or 6.7% of gross domestic product, as imports of oil and gold surged while export growth slowed. Finance minister P. Chidambaram said the gap is a greater worry than the government’s budget deficit, which he needs to trim as well to avert a sovereign credit downgrade to junk. Meanwhile, an inflation rate that has stayed above the central bank’s 5% comfort level has limited governor D. Subbarao’s ability to slash borrowing costs to revive economic growth from a decade low. Political developments that affect policy decisions in India may drive currency fluctuations, requiring hedging of foreign investment in the local debt market, according to Standard Chartered Plc. A key ally in Prime Minister Manmohan Singh’s ruling coalition pulled out last month, raising concern a government short of a majority in parliament will find it difficult to pull through legislation. The six-month rupee implied volatility, a gauge of expected moves in the exchange rate used to price options, was at 9.46% Tuesday, the highest in developing Asia, according to data compiled byBloomberg. “Given the political uncertainties that have emerged over the last few weeks, we would recommend investors hedge,” Priyanka Kishore, a currency strategist at Standard Chartered in Mumbai, said in an e-mailed response to questions on 2 April. Barclays Plc recommends investors refrain from hedging purchases of Indian bonds as it predicts the rupee will remain little changed at 55 a dollar by the end of 2013. Further, hedging costs may erase returns from capital gains and carry, according to a research note dated 1 April. The lender predicts the yield on the benchmark 10-year bond will fall to 7.40% by the end of September from 7.99%. The yield on the 8.15% note due 2022 rose three basis points Tuesday, offering 615 basis points more than similar-maturity US Treasuries. The rupee was little changed at 54.43 per dollar. “While carry traders have stayed away earlier this year, hedge funds last week resumed funding rupee purchases by selling euros,” according to Bank of America Merrill Lynch.

Hedge Funds Euro-based investors will earn 8.5% including interest, the most in Asia, by holding rupees until the end of this year, according to data compiled by Bloomberg from surveys and prevailing deposit rates. After nine weeks of selling, hedge funds have returned to buying Asian currencies, Richard Cochinos, a strategist at the bank, wrote in a 31 March note to clients. Hedge fund flow holds a 73% correlation with Asian spot prices and was responsible for the foreignexchange weakness from 18 January onwards. This is the first week of a trend reversal.

176 Financial Engineering, Risk Management & Financial Institutions The cost of insuring the debt of State Bank of India, considered a proxy for the sovereign, using fiveyear credit-default swaps slid 130 basis points in the past year to 211, according to data provider CMA, which is owned by McGraw-Hill Cos. and compiles prices quoted by dealers in privately negotiated markets.

Cash Shortage A cash squeeze in India’s banking system has kept the forward premium elevated and this has killed the carry trade as arbitrage lost its allure, according to IndusInd Bank. One-year commercial paper pays 146 basis points more than the RBI’s repurchase rate of 7.5%, compared with a low of 105 basis points on 29 January. The monetary authority on 19 March cut borrowing costs for the second time this year and said room for further easing is quite limited. Costlier forward contracts will also deter overseas loans for rupee-denominated expenditure, HSBC’s Dave said. A top-rated Indian company can borrow onshore rupees for a year by paying 9%, according to data compiled by Bloomberg. The spread for an overseas loan would be about 275 basis points above the London interbank offered rate of about 1.7915%. Dave estimates. This would increase the half yearly cost to around 9% or 9.5% after including the hedging cost of around 7% and a withholding tax, he said. India’s $1.8 trillion economy may need more than $75 billion of foreign capital in the year through March 2014 to fund the current-account deficit, Chidambaram said in an interview last month. “There’s no great confidence of rupee gains given the macro woes,” J. Moses Harding, executive vice-president at IndusInd in Mumbai, said in a telephone interview on 1 April. The forward premium will drop and carry trade will pick up only when there are signs of strong rupee appreciation. Harding forecasts the one-year premium will stay around 6.75% for at least this quarter, and HSBC’s Dave predicts the rupee will weaken 6% to 8% by March 2014. A chief executive officer (CEO) of a major corporation has accumulated a significant equity stake in his firm. While the CEO has other investments, he is not effectively diversified since he has an enormous amount of his own firm’s stock. The CEO can contact a swap dealer who will arrange to swap the cash flows generated from the CEO’s stock (capital gains and/or dividends) for a cash flow generated by an identically valued investment in a broadly diversified portfolio or market index.

ASSET LIABILITY MANAGEMENT Introduction Objectives of Asset Liability Management Classification of Assets Tools Value at Risk (VaR) Managment of Fixed Assets and Current Assets Managment of Cash Liquidity Management in Banks Asset-liability Managment System in India Liquidity Risk Managment Currency Risk Interest Rate Riak (IRR) Classification of Components of Assets and Liabilities Quality of Assets Conclusion Keywords Review Questions References Case Study Appendix

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Chapter Objectives

Chapter Objectives

After studying this chapter the student will be able to: Understand the meaning and objectives of asset liability management. Discuss about the classification of assets and liabilities. Know about the three-tier organizational set-up for ALM liabilities. Define management of cash, VAR & EBIT.

Introduction Asset Liability Management is a tool to monitor risk.

“Asset Liability Management” is nothing but maintaining liabilities with sufficient assets. Excess of assets over liabilities will lead to under utilization, otherwise excess of liabilities over assets leads to deficit financing. Asset liability management is an approach that provides institutions with protection that makes such risk acceptable. Asset-liability management models 1 enable institutions to measure and monitor risk, and provide suitable strategies for their management.

The aim of asset/ liability management (ALM) is to properly manage the risk related to changes in interest rates.

The goal of asset/liability management (ALM) is to properly manage the risk related to changes in interest rates, the mix of balance sheet assets and liabilities, the holding of foreign currencies, and the use of derivatives. These risks should be managed in a manner that contributes adequately to earnings and limits risk to the financial margin and member equity. Proper management of asset/liability risk is facilitated through board approved policy, which sets limits on asset and liability mix, as well as the level of interest rate risk and foreign currency risk to which the credit union is willing to expose itself. Policy should also set out guidelines for the pricing, term and maturity of loans and deposits. The use of derivatives, if any, should also be controlled by policy, which should state among other things that derivatives must only be used to limit interest rate risk and must never be used for speculative or investment purposes. Credit unions which offer either fixed rate loans or deposits will mitigate interest rate risk by ensuring that management is properly measuring Vaidyanathan, Asset-liability management: Issues and trends in Indian context, ASCI JOURNAL OF MANAGEMENT 29(1). 39-48

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risk. The standard measure of this risk is balance-sheet gap, and it is essential that management measure this regularly.

Objectives of Asset Liability Management Liquidity Risk Management Liquidity risk refers to the risk that the institution might not be able to generate sufficient cash flow to meet its financial obligations. It is the risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss. It’s usually reflected in a wide bid-ask spread or large price movements.

Interest Rate Risk Management The uncertainty associated with the effects of changes in market interest rates. There are two types of interest rate risk identified; price risk and reinvestment rate risk.

Currency Risk Management

There are two types of interest rate risk; price risk and reinvestment rate risk.

Uncertainty that is associated with potential changes in the foreign exchange value of a currency. There are two major types: translation risk and transaction risks.

Classification of Assets ‘Assets’ of any corporate entity can be classified into two categories viz., a) Fixed Assets and b) Current Assets. Further fixed assets may be grouped into tangible assets and intangible assets. Tangible assets, which can be seen in the physical form, like Machine, Land, Building, Whereas, Intangible assets cannot be found in physical form, they are mostly in the document form like Goodwill, Patent rights, copy rights etc. ‘Liabilities’, of any corporate entity can be classified into two categories viz., a) Long term-liabilities and 2) Current liabilities. Long-term liabilities may be in the form of bonds, debentures or long-term loans from banks or any other financial institutions. In case of current assets, they are shortterm in nature which include bills payable, short-term loans, bank overdraft, sundry creditors etc.

Assets can be classified into ‘Fixed Assets’ & ‘Current Assets’.

180 Financial Engineering, Risk Management & Financial Institutions Working Capital can be categorized into four groups.

Capital structure can be divided into two categories i.e., 1) Fixed Capital and 2) Working Capital. Whereas, Fixed capital refers to equity share capital and debt (raised either in form of loans or debentures) and working capital is the amount available to meet day-to-day operations of the business entity. Working capital can be broadly categorized into four groups: 1. Gross Working Capital 2. Net Working Capital 3. Permanent Working Capital 4. Temporary Working Capital

1. Gross Working Capital It refers to the funds invested in current assets, i.e., investment in stock, sundry debtors, cash and other current assets. It is obvious that certain amount of funds is always tied up in raw material, inventories, work-inprogress, finished goods, consumable stores, sundry debtors and day-today cash requirements.

2. Net Working Capital This is the difference between an organisation’s current assets and its current liabilities.

3. Permanent Working Capital It refers to that minimum level of investment in the current asset that is carried by the business at all times to carry out minimum level of its activities. It is also referred as hard-core working capital or core current asset. It grows with the growth in the size of the business. The concept of permanent working capital is very significant from the point of view of its financing. Since permanent working capital remains in the company on long-term basis, it should be financed from long-term sources. The volume of temporary working capital keeps on fluctuating from time-totime according to the business activities.

4. Temporary Working Capital It refers to that part of total working capital, which is required by a business over and above permanent working capital. It is also called variable working capital since the volume of temporary working capital keeps on fluctuating from time-to-time according to the business activities. It may be financed from short-term sources.

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TOOLS Gap Analysis2 Gap analysis is a technique of asset-liability management that can be used to assess interest rate risk or liquidity risk. It measures at a given date the gaps between rate sensitive liabilities (RSL) and rate sensitive assets (RSA) (including off-balance sheet positions) by grouping them into time buckets according to residual maturity or next repricing period, whichever is earlier. An asset or liability is treated as rate sensitive if i) within the time bucket under consideration, there is a cash flow; ii) the interest rate resets/reprices contractually during the time buckets; iii) administered rates are changed and iv) it is contractually prepayable or withdrawal allowed before contracted maturities. Thus, 1. Gap = RSA – RSL; 2. Gap Ratio = RSAs/RSLs. 3. This gap is used as a measure of interest rate sensitivity. The positive or negative gap is multiplied by the assumed interest changes to derive the Earnings at Risk (EaR). A bank benefits from a positive Gap (RSA>RSL), Frederick Macaulay Duration. The following formula gives about calculation of duration of a financial instrument: D = W (t). (t/m)

W(t). (t/m)

Modified duration – m refer to Cash flows per year

= Weighted duration - W 1,W2 are weights. W1.D1+W2.D 2=DL W1+W2=1 Dr. B. Charumathi, Interest Rate Risk Measurement in Indian Banking Industry - An Analytical Research Study, International Journal of Economic Resear ch Vol. 7, No. 13, January-June, 2010 ISSN 0972-9380 2

GAP: =RSA-RSL

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Value at Risk (VaR) Definition of Value At Risk - ‘VaR’ Value at Risk is a statistical measure for financial risk.

A statistical technique used to measure and quantify the level of financial risk within a firm or investment portfolio over a specific time frame. Value at risk is used by risk managers in order to measure and control the level of risk which the firm undertakes. The risk manager’s job is to ensure that risks are not taken beyond the level at which the firm can absorb the losses of a probable worst outcome. Further, Value at Risk is measured in three variables: the amount of potential loss, the probability of that amount of loss, and the time frame. For example, a financial firm may determine that it has a 5% one month value at risk of Rs.100 million. This means that there is a 5% chance that the firm could lose more than Rs.100 million in any given month. Therefore, a Rs.100 million loss should be expected to occur once every 20 months.

Measuring Value at Risk3 Value at Risk, can be computed analytically by making assumptions about return distributions for market risks, and by using the variances in and covariances across these risks.

There are three basic approaches that are used to compute Value at Risk, though there are numerous variations within each approach. The measure can be computed analytically by making assumptions about return distributions for market risks, and by using the variances in and covariances across these risks. It can also be estimated by running hypothetical portfolios through historical data or from Monte Carlo simulations.

Variance-covariance Method4 Since Value at Risk measures the probability that the value of an asset or portfolio will drop below a specified value in a particular time period, it should be relatively simple to compute if we can derive a probability distribution of potential values. That is basically what we do in the variancecovariance method, an approach that has the benefit. The VaR of the portfolio at the confidence level is given by the smallest number I such that the probability that the loss L exceeds I is at most (1-a). Mathematically, if L is the loss of a portfolio, then VaR (L) is the level quantile, i.e. Jorion, P., 2001, Value at Risk: The New Benchmark for Managing Financial Risk, McGraw Hill. 3

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www.GloriaMundi.org.5

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VaRα(L) = lnf{l∈R:P(L>i)α}. Value at Risk refers to the maximum expected loss that a bank can suffer over a target horizon, given a certain confidence interval. It enables the calculation of market risk of a portfolio for which no historical data exists. It enables one to calculate the net worth of the organization at any particular point of time so that it is possible to focus on long-term risk implications of decisions that have already been taken or that are going to be taken. It is used extensively for measuring the market risk of a portfolio of assets and/or liabilities.

Value at Risk refers to the maximum expected loss that a bank can suffer over a target horizon, given a certain confidence interval.

Simulation 5 Simulation models help to introduce a dynamic element in the analysis of interest rate risk. Gap analysis and duration analysis as stand-alone too for asset-liability management suffer from their inability to move beyond the static analysis of current interest rate risk exposures. Basically simulation models utilize computer power to provide what if scenarios. For example: What if: The absolute level of interest rates shift. There are nonparallel yield curve changes. Marketing plans are underor-over achieved. Margins achieved in the past are not sustained/ improved. Bad debt and prepayment levels change in different interest rate scenarios.

Management of Fixed Assets and Current Assets The management of current assets is similar to that of fixed assets in the sense that both cases a firm analyses their effects on its return and risk. The management of fixed and current assets, however, differs in three important ways: First, in managing fixed assets, time is a very important factor. Consequently, discounting and compounding techniques play a significant role in capital budgeting and a minor one in the management of current assets. Second, the large holding of current assets, especially cash, strengthens the firm’s liquidity position, but also reduces the overall profitability. Thus, a risk-return trade-off is involved in holding current assets. 5

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‘Simulation’ models utilize a special software to analysis.

184 Financial Engineering, Risk Management & Financial Institutions Third, levels of fixed as well as current assets depend upon expected sales, but it is only current assets, which can be adjusted with sales fluctuations in the short-run. Thus, the firm has a greater degree of flexibility in managing current assets.

Management of Cash There are four motives of ‘cash management’.

It is the duty of the finance manager to provide adequate cash to all segments of the organisation. He has also to ensure that no funds are blocked in idle cash since this will involve cost in terms of interest to the business. A sound cash management scheme, therefore, maintain the balance between the twin objectives of liquidity and cost.

Motives for Holding Cash a. Transaction Motive: A firm’s enters in to a variety of business transactions resulting in both inflows and outflows. In order to meet the business obligations in such situation, it is necessary to maintain adequate cash balance. b. Precautionary Motive: A firm cash balance to meet unexpected contingencies such as flood, strikes, presentment of bill for payment earlier than the expected date, unexpected slowing down of collection of accounts receivable, sharp increase in prices of raw materials etc., the more is the possibility of such contingencies, more is the amount of cash kept by the firm for meeting them. c. Speculative Motive: A firm also keeps cash balance to take advantage of unexpected opportunities typically outside the normal course of the business. d. Compensation Motive: Banks provide certain services to their client’s free of charge. They, therefore, usually require clients to keep minimum cash balance with them, which help them to earn interest and thus compensate them for the free services so provided.

Liquidity Management in Banks ‘Liquidity’ means convertibility without any loss.

Bank liquidity is the ability to promptly and without loss to meet their obligations to depositors and creditors. The bank’s liabilities consist of the actual and potential. Real commitments are reflected in the bank’s balance sheet in the form of demand deposits, time deposits, inter-bank resources of creditors. Contingent liabilities primarily expressed in the passive off-

CHAPTER 9 Asset Liability Management balance sheet operations of banks. This group of bank liabilities should be classified and timely satisfaction of customer needs to obtain new loans without credit lines. Implementation of the client’s request means that the bank is able to efficiently provide themselves with the necessary resources. Sources of funds to meet liabilities are cash bank balances denominated in cash on hand and on correspondent accounts assets that can quickly turn into cash, inter-bank loans, which if necessary can be obtained from the inter-bank market or from the Central Bank. Using these sources should not be accompanied by a loss to the bank, i.e., to turn around losses. For example, the sale of securities or other assets as the source of the appearance of liquid assets should be carried out normally at pre-negotiated terms of price and terms. But the presence of these two attributes the bank’s liquidity is determined by many factors, internal and external order, determining the quality of the bank. Strong capital base of the bank means that there is a significant absolute value of equity as the main source of protective absorption of risk assets and the guarantee of depositors and creditors. The basis of the share equity fund and other funds of the bank, for different purposes, including to ensure financial sustainability of the bank. The greater the bank’s own capital, the higher its liquidity.

Asset-liability Management System in India Over the last few years the Indian financial markets have witnessed wide ranging changes at fast pace. Intense competition for business involving both the assets and liabilities, together with increasing volatility in the domestic interest rates as well as foreign exchange rates, has brought pressure on the management of banks to maintain a good balance among spreads, profitability and long-term viability. These pressures call for structured and comprehensive measures and not just ad hoc action. The Management of banks has to base their business decisions on a dynamic and integrated risk management system and process, driven by corporate strategy. Banks are exposed to several major risks in the course of their business - credit risk, interest rate risk, foreign exchange risk, equity/ commodity price risk, liquidity risk and operational risks. The initial focus of the ALM function would be to enforce the risk management discipline viz. managing business after assessing the risks involved. The objective of good risk management programmes should be that these programmes will evolve into a strategic tool for bank management.

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Bank liquidity is influenced by internal and external factors.

186 Financial Engineering, Risk Management & Financial Institutions The ALM Process Rests on Three Pillars ALM information systems Management Information System Information availability, accuracy, adequacy and expediency ALM organisation Structure and responsibilities Level of top management involvement ALM process Risk parameters Risk identification Risk measurement Risk management Risk policies and tolerance levels.

ALM Information Systems ‘ABC’ approach is used for ALM Information System.

Information is the key to the ALM process. Considering the large network of branches and the lack of an adequate system to collect information required for ALM which analyses information on the basis of residual maturity and behavioural pattern it will take time for banks in the present state to get the requisite information. The problem of ALM needs to be addressed by following an ABC approach i.e. analysing the behaviour of asset and liability products in the top branches accounting for significant business and then making rational assumptions about the way in which assets and liabilities would behave in other branches. In respect of foreign exchange, investment portfolio and money market operations, in view of the centralised nature of the functions, it would be much easier to collect reliable information. The data and assumptions can then be refined over time as the bank management gain experience of conducting business within an ALM framework. The spread of computerisation will also help banks in accessing data.

ALM Organisation & Management a. The Board should have overall responsibility for management of risks and should decide the risk management policy of the bank and set limits for liquidity, interest rate, foreignexchange and equity price risks.

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b. The Asset - Liability Committee (ALCO) consisting of the bank’s senior management including CEO should be responsible for ensuring adherence to the limits set by the Board as well as for deciding the business strategy of the bank (on the assets and liabilities sides) in line with the bank’s budget and decided risk management objectives. c. The ALM desk consisting of operating staff should be responsible for analysing, monitoring and reporting the risk profiles to the ALCO. The staff should also prepare forecasts (simulations) showing the effects of various possible changes in market conditions related to the balance sheet and recommend the action needed to adhere to bank’s internal limits.

Procedure The ALCO is a decision making unit responsible for balance sheet planning from risk-return perspective including the strategic management of interest rate and liquidity risks. Each bank will have to decide on the role of its ALCO, its responsibility as also the decisions to be taken by it. The business and risk management strategy of the bank should ensure that the bank operates within the limits/parameters set by the Board. The business issues that an ALCO would consider, inter alia, will include product pricing for both deposits and advances, desired maturity profile of the incremental assets and liabilities, etc. In addition to monitoring the risk levels of the bank, the ALCO should review the results of and progress in implementation of the decisions made in the previous meetings. The ALCO would also articulate the current interest rate view of the bank and base its decisions for future business strategy on this view. In respect of the funding policy, for instance, its responsibility would be to decide on source and mix of liabilities or sale of assets. Towards this end, it will have to develop a view on future direction of interest rate movements and decide on a funding mix between fixed vs floating rate funds, wholesale vs retail deposits, money market vs capital market funding, domestic vs foreign currency funding, etc. Individual banks will have to decide the frequency for holding their ALCO meetings.

Composition of ALCO The size (number of members) of ALCO would depend on the size of each institution, business mix and organisational complexity. To ensure commitment of the Top Management, the CEO/CMD or ED should head

ALCO plays a key role in decision making.

188 Financial Engineering, Risk Management & Financial Institutions the Committee. The Chiefs of Investment, Credit, Funds Management/ Treasury (forex and domestic), International Banking and Economic Research can be members of the Committee. In addition the Head of the Information Technology Division should also be an invitee for building up of MIS and related computerisation. Some banks mayeven have sub-committees.

Three-tier Organizational Set-up for ALM Implementation ALM Implementation requires three levels of hierachy.

Management Committee of the Board (MC) consisting of the following members: a. ALCO headed by E.D. b. GM (T) – (Nodal Officer). c. GMs: Central Accounts, P&D, Credit, Risk Management Functions Implementation of ALM System Monitor the risk levels of the Bank. Articulate the Interest Rate Position & fix interest rate on Deposits & Advances. Fix differential rate of interest rate on Bulk Deposits. Facilitating and coordinating to put in place the ALM System in the Bank.

Committee of Directors Banks should also constitute a professional Managerial and Supervisory Committee consisting of three to four directors which will oversee the implementation of the system and review its functioning periodically.

ALM process The scope of ALM function can be described as follows: Liquidity risk management Management of market risks (including Interest Rate Risk) Funding and capital planning Profit planning and growth projection Trading risk management

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Liquidity Risk Management Measuring and managing liquidity needs are vital activities of commercial banks. By assuring a bank’s ability to meet its liabilities as they become due, liquidity management can reduce the probability of an adverse situation developing. The importance of liquidity transcends individual institutions, as liquidity shortfall in one institution can have repercussions on the entire system. Bank management should measure not only the liquidity positions of banks on an ongoing basis but also examine how liquidity requirements are likely to evolve under crisis scenarios. Experience shows that assets Commonly considered as liquid like Government securities and other money market instruments could also become illiquid when the market and players are unidirectional. Therefore liquidity has to be tracked through maturity or cash flow mismatches. For measuring and managing net funding requirements, the use of a maturity ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates is adopted as a standard tool. The format of the Statement of Structural Liquidity is given in Annexure I. The Maturity Profile as given in Appendix I could be used for measuring the future cash flows of banks in different time buckets. The time buckets given the Statutory Reserve cycle of 14 days may be distributed as under: i)

1 to 14 days

ii)

15 to 28 days

iii) 29 days and upto 3 months iv) Over 3 months and upto 6 months v)

Over 6 months and upto 12 months

vi) Over 1 year and upto 2 years vii) Over 2 years and upto 5 years viii) Over 5 years Within each time bucket there could be mismatches depending on cash inflows and outflows. While the mismatches upto one year would be relevant since these provide early warning signals of impending liquidity problems, the main focus should be on the short-term mismatches viz., 1-14 days and 15-28 days. Banks, however, are expected to monitor their cumulative mismatches (running total) across all time buckets by establishing internal prudential limits with the approval of the Board/Management Committee.

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190 Financial Engineering, Risk Management & Financial Institutions The mismatch during 1-14 days and 15-28 days should not in any case exceed 20% of the cash outflows in each time bucket. If a bank in view of its asset -liability profile needs higher tolerance level, it could operate with higherlimit sanctioned by its Board/Management Committee giving reasons on the need for such higher limit. A copy of the note approved by Board/ Management Committee may be forwarded to the Department of Banking Supervision, RBI. The discretion to allow a higher tolerance level is intended for a temporary period, till the system stabilises and the bank is able to restructure its asset -liability pattern. The Statement of Structural Liquidity (Annexure I) may be prepared by placing all cash inflows and outflows in the maturity ladder according to the expected timing of cash flows. A maturing liability will be a cash outflow while a maturing asset will be a cash inflow. It would be necessary to take into account the rupee inflows and outflows on account of forex operations including the readily available forex resources (FCNR (B) funds, etc) which can be deployed for augmenting rupee resources. While determining the likely cash inflows/outflows, banks have to make a number of assumptions according to their asset-liability profiles. For instance, Indian banks with large branch network can (on the stability of their deposit base as most deposits are renewed) afford to have larger tolerance levels in mismatches if their term deposit base is quite high. While determining the tolerance levels the banks may take into account all relevant factors based on their asset-liability base, nature of business, future strategy etc. The RBI is interested in ensuring that the tolerance levels are determined keeping all necessary factors in view and further refined with experience gained in Liquidity Management. In order to enable the banks to monitor their short-term liquidity on a dynamic basis over a time horizon spanning from 1-90 days, banks may estimate their short-term liquidity profiles on the basis of business projections and other commitments.

Currency Risk ‘Currency Risk’ indicates fluctuations in foreign exchange rates.

Dealing in different currencies brings opportunities as also risks. If the liabilities in one currency exceed the level of assets in the same currency, then the currency mismatch can add value or erode value depending upon the currency movements. The simplest way to avoid currency risk is to ensure that mismatches, if any, are reduced to zero or near zero. Banks undertake

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operations in foreign exchange like accepting deposits, making loans and advances and quoting prices for foreign exchange transactions. Irrespective of the strategies adopted, it may not be possible to eliminate currency mismatches altogether. Besides, some of the institutions may take proprietary trading positions as a conscious business strategy. Managing Currency Risk is one more dimension of Asset- Liability Management. Mismatched currency position besides exposing the balance sheet to movements in exchange rate also exposes it to country risk and settlement risk. Ever since the RBI (Exchange Control Department) introduced the concept of end of the day near square position in 1978, banks have been setting up overnight limits and selectively undertaking active day time trading. Following the introduction of “Guidelines for Internal Control over Foreign Exchange Business” in 1981, maturity mismatches (gaps) are also subject to control. Following the recommendations of Expert Group on Foreign Exchange Markets in India (Sodhani Committee) the calculation of exchange position has been redefined and banks have been given the discretion to set up overnight limits linked to maintenance of additional Tier I capital to the extent of 5 per cent of open position limit. Presently, the banks are also free to set gap limits with RBI’s approval but are required to adopt Value at Risk (VaR) approach to measure the risk associated with forward exposures. Thus the open position limits together with the gap limits form the risk management approach to forex operations.

Interest Rate Risk (IRR) Interest rate risk is the risk where changes in market interest rates might adversely affect a bank’s financial condition. Changes in interest rates affect both the current earnings (earnings perspective) as also the net worth of the bank (economic value perspective). The risk from the earnings’ perspective can be measured as changes in the Net Interest Income (Nil) or Net Interest Margin (NIM). In the context of poor MIS, slow pace of computerisation in banks and the absence of total deregulation, the traditional Gap analysis is considered as a suitable method to measure the Interest Rate Risk. It is the intention of RBI to move over to modern techniques of Interest Rate Risk measurement like Duration Gap Analysis, Simulation and Value at Risk at a later date when banks acquire sufficient expertise and sophistication in MIS. The Gap or Mismatch risk can be measured by calculating Gaps over different

‘Interest Rate Risk’ indicates the effect of changes on interest rates.

192 Financial Engineering, Risk Management & Financial Institutions ALM can be rate sensitive also.

time intervals as at a given date. Gap analysis measures mismatches between rate sensitive liabilities and rate sensitive assets (including off-balance sheet positions). An asset or liability is normally classified as rate sensitive if: i) Within the time interval under consideration, there is a cash flow; ii) The interest rate resets/reprices contractually during the interval; iii) RBI changes the interest rates (i.e. interest rates on Savings Bank Deposits, advances upto Rs.2 lakhs, DRI advances, Export credit, Refinance, CRR balance, etc.) in cases where interest rates are administered; and iv) It is contractually pre-payable or withdrawable before the stated maturities. The Gap Report should be generated by grouping rate sensitive liabilities, assets and offbalance sheet positions into time buckets according to residual maturity or next repricing period, whichever is earlier. The difficult task in Gap analysis is determining rate sensitivity. All investments, advances, deposits, borrowings, purchased funds etc. that mature/reprice within a specified timeframe are interest rate sensitive. Similarly, any principal repayment of loan is also rate sensitive if the bank expects to receive it within the time horizon. This includes final principal payment and interim instalments. Certain assets and liabilities receive/pay rates that vary with a reference rate. These assets and liabilities are repriced at pre-determined intervals and are rate sensitive at the time of repricing. While the interest rates on term deposits are fixed during their currency, the advances portfolio of the banking system is basically floating. The interest rates on advances could be repriced any number of occasions, corresponding to the changes in PLR.

GAPs can be identified according to time buckets.

The Gaps may be identified in the following time buckets: i) Upto 1 month ii) Over one month and upto 3 months iii) Over 3 months and upto 6 months iv) Over 6 months and upto 12 months v) Over 1 year and upto 3 years vi) Over 3 years and upto 5 years vii) Over 5 years viii)Non-sensitive

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The various items of rate sensitive assets and liabilities in the Balance Sheet may be classified as explained in Appendix - II and the Reporting Format for interest rate sensitive assets and liabilities is given in Annexure II. The Gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL) for each time bucket. The positive Gap indicates that it has more RSAs than RSLs whereas the negative Gap indicates that it has more RSLs. The Gap reports indicate whether the institution is in a position to benefit from rising interest rates by having a positive Gap (RSA > RSL) or whether it is in a position to benefit from declining interest rates by a negative Gap (RSL >RSA). The Gap can, therefore, be used as a measure of interest rate sensitivity. Each bank should set prudential limits on individual Gaps with the approval of the Board/Management Committee. The prudential limits should have a bearing on the total assets, earning assets or equity. The banks may work out earnings at risk, based on their views on interest rate movements and fix a prudent level with the approval of the Board/Management Committee. RBI will also introduce capital adequacy for market risks in due course.

Classification of Components of Assets and Liabilities The classification of various components of assets and liabilities into different time buckets for preparation of Gap reports (Liquidity and Interest Rate Sensitivity) as indicated in Appendices I & II is the benchmark. Banks which are better equipped to reasonably estimate the behavioural pattern, embedded options, rolls-in and rolls-out, etc of various components of assets and liabilities on the basis of past data/empirical studies could classify them in the appropriate time buckets, subject to approval from the ALCO/Board. A copy of the note approved by the ALCO/Board may be sent to the Department of Banking Supervision.

Quality of Assets Quality of assets is determined on the basis of the following two categories: 1. Liquidity, 2. Risk,

The Gap reports indicate whether the institution is in a position to benefit from rising interest rates.

194 Financial Engineering, Risk Management & Financial Institutions 1. Liquidity Liquid Assets can be divided into four groups.

Degree of liquidity of assets depends on their destination. Assets of the bank, located in monetary form, are designed to perform billing functions. Loans can meet the short and long term needs of clients. In this regard, the degree of liquidity of bank assets are divided into four groups: First Group: The first group consists of first-rate liquid assets, which include: a) Direct cash bank in his or her office or correspondent accounts; b) Government securities held in the portfolio of the bank, to the realization that he may have recourse in the event of insufficient cash to meet obligations to creditors. Second Group: The second group of assets by the degree of liquidity are short-term loans to businesses and individuals, interbank loans, factoring, commercial paper corporations. They have a longer period of transformation in cash. Third Group: The third group includes long-term investment assets and investment bank, including long-term loans, leases, investment securities. Fourth Group: The fourth group of bank assets, which includes illiquid assets in the form of overdue loans, some types of securities, buildings and structures.

2. Risk ‘Riskiness’ criterion indicates the quality of assets.

Classification of assets according to risk and the risk of each asset group is mixed in different countries and for different purposes.

Riskiness as a criterion for the quality of assets means the potential loss of their transformation into money. The degree of risk assets is dependent on many factors specific to certain of their kind. For example, the risk of loans due to the financial condition of the borrower, the contents of an object credit, loan volume, the order of issuance and redemption, etc. Risk of investing in a security depends on the financial stability of the issuer, the mechanism of production and sales of securities, the ability to be quoted on the stock exchange, etc. Classification of assets according to risk and the risk of each asset group is mixed in different countries and for different purposes. To assess the adequacy of capital used in international practice recommendations of the Basel Agreement, under which there are four groups of assets. Current practice for this purpose involves the division into five groups. To assess the quality of the loan portfolio of the Central Bank recommends the allocation of the four groups of loans with

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the definition of different levels of risk. Analysis of the status of various types of deposits held by foreign researchers, showed that the most stable have deposits. This kind of deposits does not depend on the level of interest rates. It belongs to a particular bank to a greater extent due to factors such as quality and speed of service, reliability of the bank, a variety of services offered to depositors, the proximity of the bank from the customer.

Conclusion This chapter deals with “Asset Liability Management” is nothing but maintaining liabilities with sufficient assets. Excess of assets over liabilities will lead to under utilization, otherwise excess of liabilities over assets leads to deficit financing. Asset liability management is an approach that provides institutions with protection that makes such risk acceptable. Asset-liability management models enable institutions to measure and monitor risk, and provide suitable strategies for their management.

Keywords

Keywords

Asset Liability Management: Asset Liability Management is nothing but maintaining liabilities with sufficient assets. Goal of ALM: The goal of asset/liability management (ALM) is to properly manage the risk related to changes in interest rates, the mix of balance sheet assets and liabilities, the holding of foreign currencies, and the use of derivatives. Liquidity Risk Management: Liquidity risk refers to the risk that the institution might not be able to generate sufficient cash flow to meet its financial obligations. Interest Rate Risk Management: The uncertainty associated with the effects of changes in market interest rates. There are two types of interest rate risk identified; price risk and reinvestment rate risk. Currency Risks Management: Uncertainty that is associated with potential changes in the foreign exchange value of a currency. There are two major types: translation risk and transaction risks. Assets: ‘Assets’ of any corporate entity can be classified into two categories viz., a) Fixed Assets and b) Current Assets. Capital Structure: Capital structure can be divided into two categories i.e. 1) Fixed Capital and 2) Working Capital.

196 Financial Engineering, Risk Management & Financial Institutions Gross Working Capital: It refers to the funds invested in current assets, i.e., investment in stock, sundry debtors, cash and other current assets. Net Working Capital: This is the difference between an organisation’s current assets and its current liabilities. Permanent Working Capital: It refers to that minimum level of investment in the current asset that is carried by the business at all times to carry out minimum level of its activities. Temporary Working Capital: It refers to that part of total working capital, which is required by a business over and above permanent working capital. Gap Analysis: Gap analysis is a technique of asset-liability management that can be used to assess interest rate risk or liquidity risk. Value at Risk: Value at Risk measures the probability that the value of an asset or portfolio will drop below a specified value in a particular time period. Simulation: Simulation models help to introduce a dynamic element in the analysis of interest rate risk. Management of Cash: A sound cash management scheme, maintains the balance between the twin objectives of liquidity and cost. Transaction Motive: A firm’s enters in to a variety of business transactions resulting in both inflows and outflows. In order to meet the business obligations in such situation, it is necessary to maintain adequate cash balance. Precautionary Motive: A firm cash balance to meet unexpected contingencies such as flood, strikes, presentment of bill for payment earlier than the expected date. Speculative Motive: A firm also keeps cash balance to take advantage of unexpected opportunities typically outside the normal course of the business. Compensation Motive: Banks provide certain services to their client’s free of charge. They, therefore, usually require clients to keep minimum cash balance with them, which help them to earn interest and thus compensate them for the free services so provided. Bank Liquidity: Bank liquidity is the ability to promptly and without loss to meet their obligations to depositors and creditors. Risk: Riskiness as a criterion for the quality of assets means the potential loss of their transformation into money. Capital: It is that part of wealth which is used for further production. Thus, capital consists of all current assets and fixed assets. Bills Receivable: A bill of exchange or a promissory note receivable by the business. Liabilities: ‘Liabilities’, of any corporate entity can be classified into two categories viz., a) Long term-liabilities and 2) Current liabilities.

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Current Liabilities: Liabilities payable within a year are termed as current liabilities. The value of these liabilities goes on changing. Creditors, bills payable and outstanding expenses etc., are current liabilities. Earnings Per Share: A widely used indicator of the return on equity investments. Any figure quoted represents the total amount of a company’s earnings (after deductions) divided by the number of ordinary shares it has issued. EBIT: Earnings before interest and taxes. EBIT is calculated by subtracting costs of sales and operating expenses from revenues. The figures are often used to gauge the financial performance of companies with high levels of debt and interest expenses. Working Capital: It is the capital available with the firm for day-to-day working of the business.

Review Questions

Review Questions

1. Discuss meaning and objectives of asset liability management.

4. Define management of cash and motives of holding cash.

2. What are the different types of Assets and Liabilities?

5. What do you understand by Value at Risk?

3. Discuss the three-tier organizational setup for ALM Implementation.

6. What is earning before tax? How is it calculated?

References

References

1. Deloof M (2003), ‘Does Working Capital Management Affect Profitability of Belgian Firms? Journal of business Finance & Accounting, 30 (3) & (4), p.585, Blackwell Publishing. 2. Hathome Nobanee, ‘Optimizing Working Capital management’, http://ssrn.com/abstract=1528894

3. Vaidyanathan, Asset-liability management: Issues and trends in Indian context, ASCI Journal of Managment, 29(1).39-48

198 Financial Engineering, Risk Management & Financial Institutions

Case Study

Case Study

Case - 1 Note: Students are required to go through the following recent guidelines issued by IRDA and make a comparative study with RBI-asset liability management policy with respect to banking sector.

IRDA Introduces Uniform Asset-Liability Management Regulations SME News, Thursday, Jan 05, 2012. NEW DELHI: The Insurance Regulatory and Development Authority (IRDA) has unveiled uniform asset-liability management regulations for market players with the aim to ensure their solvency. The regulator has also directed the companies to take up stress tests to find out their ability to fulfill financial obligations during crisis. The asset-liability management guidelines are scheduled to become effective from April 1, 2012. It means that it is compulsory for the insurance firms to prepare an ALM policy and get it approved by the IRDA by the end of March. On examination of the extant norms being followed by insurance companies, IRDA found they were “incomplete and inconsistent. As the mandate by the authority was very broad, each insurer had adopted their own measures in reporting such details”. “The Asset-Liability Management (ALM) is relevant to and critical for the sound management of the finances of the insurers that invest to meet their future cash flow needs and capital requirements,” IRDA said in a circular. The guidelines, which would come into effect from April 1, make it mandatory for insurance companies to prepare an ALM policy and have it approved by the Insurance Regulatory and Development Authority (IRDA) by March-end. Moreover, IRDA has urged the insurance firms to check their ability to fulfill financial liabilities after taking into account factors such as 30% decline in equity values and one percentage point dip in yields on fixed investments. IRDA has issued these norms to get uniformity in the ALM guidelines being followed by both life and non-life insurance companies. The ALM policy needs to ensure the insurers to understand the risks they are exposed to and also develop ALM policies for managing them effectively. The ALM can be used to determine the interest rate risk faced by the insurers.

EFFECTIVE PROCEDURES 1. IRDA has asked the insurance companies to determine their ability to meet financial liabilities after taking into account factors like a 30 per cent fall in equity values and a one percentage point decline in yields on fixed investments, among others. 2. IRDA has issued these guidelines to bring about uniformity in the ALM norms being followed by both life and non-life insurance companies. 3. IRDA has said that insurers would have to put in place effective procedures for monitoring and managing their asset-liability positions to ensure that their investment activities and

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asset positions are appropriate to their liability, risk profiles and solvency positions and it should be used to measure the interest rate risk faced by insurers. 4. The ALM policy should enable the insurers to understand the risks they are exposed to and develop ALM policies to manage them effectively.

Case - 2 1. Calculate the re-pricing gap and the impact on net interest income of a 1 percent increase in interest rates for each of the following positions: a. Rate-sensitive assets = 200 million. Rate-sensitive liabilities = Rs.100 million. b. Rate-sensitive assets = Rs.100 million. Rate-sensitive liabilities = Rs.150 million. c. Rate-sensitive assets = Rs.150 million. Rate-sensitive liabilities = Rs.140 million. Solution: a. Re-pricing gap =

RSA RSL = Rs.200 Rs.100 million = +Rs.100 million.

DNII = (Rs.100 million)(.01) = +Rs.1.0 million, or Rs.1,000,000. b. Repricing gap =

RSA RSL = Rs.100 Rs.150 million = -Rs.50 million.

DNII = (-Rs.50 million)(.01) = -Rs.0.5 million, or -Rs.500,000. c. Repricing gap =

RSA RSL = Rs.150 Rs.140 million = +Rs.10 million.

DNII = (Rs.10 million)(.01) = +Rs.0.1 million, or Rs.100,000. 2. A bank has a portfolio of bonds with a market value of Rs.200 million. The bonds have an estimated price volatility of 0.95 percent. What are the DEAR and the 10-day VAR for these bonds? Daily earnings at risk (DEAR) = (Rs. Value of position) x (Price volatility) = Rs.200 million x .0095 = Rs.1,900,000 Value at risk (VAR)

= DEAR x ÖN = Rs.1,900,000 x Ö10

= Rs.1,900,000 x 3.1623 = Rs.6,008,328 3. ABC Bank’s stock portfolio has a market value of Rs.10 million. The beta of the portfolio approximates the market portfolio, whose standard deviation (sm) has been estimated at 1.5 percent. What is the 5-day VAR of this portfolio, using adverse rate changes in the 99th percentile? DEAR = (Rs. Value of portfolio) x (2.33 x sm ) = Rs.10m x (2.33 x .015) = Rs.10m x .03495 = Rs.349,500 VAR = Rs.349,500 x Ö5 = Rs.349,500 x 2.2361 = Rs.781,506

200 Financial Engineering, Risk Management & Financial Institutions 4. PQR Ltd., a publicly traded manufacturing firm has provided the following financial information in its application for a loan. (‘Rs.’cr) Assets

Liabilities and Equity

Cash

Rs. 20

Accounts payable

Rs. 30

Accounts receivables

90

Notes payable

90

Inventory

90

Accruals

30

Long-term debt

150

Plant and equipment

500

Equity (ret. earnings = Rs.0) 400

Total assets

Rs.700

Total liabilities and equity

Rs.700

Also assume sales = Rs.500, cost of goods sold = Rs.360, taxes = Rs.56, interest payments = Rs.40, net income = Rs.44, the dividend payout ratio is 50 percent, and the market value of equity is equal to the book value. What is the Altman discriminant function value.? Should the bank approve application for a Rs.500crore capital expansion loan? Solution: Net working capital = Current assets - Current liabilities. Current assets = Cash + Accounts receivable + Inventories. Current liabilities = Accounts payable + Accruals + Notes payable. EBIT = Revenues Cost of goods sold Depreciation. Net income = EBIT interest taxes. Retained earnings = Net income (1 Dividend payout ratio) Altman’s discriminant function is given by: Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5 X1 = (20+90+90 30 30-90)/ 700 = .0714

X1 = Working capital/total assets (TA)

X2 = 44(1-.5) / 700 = .0314

X2 = Retained earnings/TA

X3 = (500-360) / 700 = .20

X3 = EBIT/TA

X4 = 400 / 150 = 2.67

X4 = Market value of equity/long term debt

X5 = 500 / 700 = .7143

X5 = Sales/TA

Z = 1.2(0.07) + 1.4(0.03) + 3.3(0.20) + 0.6(2.67) + 1.0(0.71) = 3.104 =

.0857

+ .044

+

.66

+

1.6

+

.7143 = 3.104

Since the Z-score of 3.104 is greater than 2.99, application for a capital expansion loan should be approved.

CHAPTER 9 Asset Liability Management

Appendix

Appendix

Appendix - 1 List of Working Capital Accounts Current Liabilities

Current Assets

1. Bills payable

1. Cash in hand

2. Sundry creditors/accounts payable

2. Cash at bank

3. Accrued or outstanding expenses

3. Bills receivable

4. Dividends payable

4. Sundry debtors/accounts receivable

5. Bank overdrafts

5. Short-term loans and advances

6. Provision against current assets

6. Temporary/marketable investments

7. Short-term loans advances and deposits

7. Inventories or stocks such as: (a) raw materials (b) work-in-progress (c) stores and spares (d) finished goods

8. Provision for taxation, if it does not

8. Prepaid expenses amount to appropriation of profits.

9. Proposed dividend (may be current or a non-current liability)

9. Accrued incomes

201

202 Financial Engineering, Risk Management & Financial Institutions Appendix-2 List of Non-current Permanent Capital Accounts Non-current/Permanent Liabilities

Non-current/Permanent Assets

1. Equity share capital

1. Goodwill

2. Preference share capital

2. Land

3. Redeemable preference capital

3. Building

4. Debentures

4. Plant & Machinery

5. Long-term loans

5. Furniture & Fittings

6. Share premium account

6. Trade Marks

7. Share forfeited account

7. Patent rights

8. Profit & Loss A/c (credit balance)

8. Long-term investments

9. Capital reserve

9. Debit balance of P&L A/c

10. Capital redemption reserve

10. Discount on issue of shares

11. Provision for depreciation against

11. Discount on issue of debentures fixed assets

12. Appropriation profits:

12. Preliminary expenses

(a) General reserve (b) Dividend equalisation fund (c) Insurance fund (d) Compensation fund (e) Sinking fund (f) Investment fluctuation fund (g) Provision for taxation (h) Proposed dividend 13. Other deferred expenses

CHAPTER 9 Asset Liability Management

Appendix-3 Maturity Profile - Liquidity Heads of Accounts

Classification into Time Buckets

A. Outflows 1. Capital, Reserves and Surplus

Over 5 years bucket.

2. Demand Deposits (Current and Savings Bank Deposits)

Demand Deposits may be classified into volatile and core portions. 25% of deposits are generally withdrawable on demand. This portion may be treated as volatile. While volatile portion can be placed in the first time bucket i.e., 1-14 days, the core portion may be placed in 1 - 2 years bucket.

3. Term Deposits

Respective maturity buckets.

4. Certificates of Deposit, Borrowings and

Respective maturity buckets.

Bonds (including Sub-Ordinated Debt) 5. Other Liabilities and Provisions: (i) Bills Payable

(i) 1-14 days bucket.

(ii) Inter-office Adjustment

(ii) As per trend analysis. Items not representing cash payables, may be placed in over 5 years bucket.

(iii) Provisions for NPAs:

(iii)

a) Sub-standard

a) 2-5 years bucket.

b) Doubtful and Loss

b) Over 5 years bucket.

(iv) Provisions for depreciation in

(iv) Over 5 years bucket.

investments (v) Provisions for NPAs in investments:

(v)

a) Sub-standard

a) 2-5 years bucket.

b) Doubtful and Loss

b) Over 5 years bucket.

203

204 Financial Engineering, Risk Management & Financial Institutions (vi) Provisions for other purposes

(vi) Respective buckets depending on the purpose.

(vii) Other Liabilities

(vii) Respective maturity buckets. Items not representing cash payables (i.e. income received in advances etc.) may be placed in over 5 years bucket.

B. Inflows 1. Cash

1-14 days bucket

2. Balances with RBI

While the excess balance over the required CRR/SLR may be shown under 1-14 days bucket, the Statutory Balances may be distributed amongst various time buckets corresponding to the maturity profile of DTL with a time-lag of 14 days.

3. Balances with other Banks: (i) Current Account

(i) Non-withdrawable portion on account of stipulations of minimum balances may be shown under 1-2 years bucket and the remaining balances may be shown under 1-14 days bucket.

(ii) Money at Call and Short Notice, (ii) Respective maturity buckets. Term Deposits and other placements. 4. Investments: (i) Approved securities

(i) Respective maturity buckets excluding the amount required to be reinvested to maintain SLR corresponding to the DTL profile in various time buckets.

(ii) Corporate debentures and bonds, PSU bonds, CDs and CPs, Redeemable preference Shares,Units of Mutual Funds (close ended), etc.

(ii) Respective maturity buckets. Investments classified as NPAs should be shown under 2-5 years bucket (sub-standard) or over 5 years bucket (doubtful and loss).

CHAPTER 9 Asset Liability Management (iii) Shares/Units of Mutual Funds (open ended)

(iii) Over 5 years bucket.

(iv) Investments in Subsidiaries/Joint Ventures

(iv) Over 5 years bucket.

5. Advances (Performing): (i) Bills Purchased and Discounted (including bills under DUPN)

(i) Respective maturity buckets.

(ii) Cash Credit/Overdraft (including TOD) and Demand Loan component of Working Capital.

(ii) Banks should undertake a study of behavioural and seasonal pattern of availments based on outstandings and the core and volatile portion should be identified. While the volatile portion could be shown in the respective maturity buckets, the core portion may be shown under 1-2 years bucket.

(iii) Term Loans

(iii) Interim cash flows may be shown under respective maturity buckets.

6. NPAs: (i) Sub-standard (ii) Doubtful and Loss

(i) 2-5 years bucket. (ii) Over 5 years bucket.

7. Fixed Assets

Over 5 years bucket

8. Other Assets: (i) Inter-office Adjustment

(ii) Others

(i) As per trend analysis. Intangible items or items not representing cash receivables may be shown in over 5 years bucket. (ii) Respective maturity buckets. Intangible assets and assets not representing cash receivables may be shown in over 5 years bucket.

205

206 Financial Engineering, Risk Management & Financial Institutions C. Contingent Liabilities/Lines of Credit committed/available other and Inflows/Outflows 1. (i) Lines of Credit committed to Institutions (outflow).

(i) 1-14 days bucket.

(ii) Unavailed portion of Cash Credit/ Overdraft/Demand loan component of Working Capital limits (outflow).

(ii) Banks should undertake a study of the behavioural and seasonal pattern of potential availments from the accounts and the amounts so arrived at may be shown under relevant maturity buckets upto 12 months.

2. Letters of Credit/Guarantees (outflow).

Historical trend analysis ought to be conducted on the devolvements and the amounts so arrived at in respect of outstanding Letters of Credit/Guarantees (net of margins) should be distributed amongst various time buckets.

3. Repos/Bills Rediscounted (DUPN)/ Swaps INR/USD, maturing forex forward contracts etc. (outflow/inflow)

Respective maturity buckets.

4. Interest payable/receivable (outflow/inflow)

Respective maturity buckets.

Note (i) Liability on account of any other contingency may be shown under respective maturity buckets. (ii) All overdue liabilities may be placed in the 1-14 days bucket. (iii) Interest and instalments from advances and investments, which are overdue for less than one month may be placed in the 3-6 months, bucket. Further, interest and instalments due (before classification as NPAs) may be placed in the 6-12 months bucket without the grace period of one month if the earlier receivables remain uncollected.

Financing of Gap In case the negative gap exceeds the prudential limit of 20% of outflows, the bank may show by way of a foot note as to how it proposes to finance the gap to bring the mismatch within the prescribed limits. The gap can be financed from market borrowings (call/term), Bills Rediscounting, Refinance from RBI/others, Repos and deployment of foreign currency resources after conversion into rupees (unswapped foreign currency funds) etc.

CHAPTER 9 Asset Liability Management

Appendix - 4 Interest Rate Sensitivity Heads of Accounts

Rate Sensitivity and Time Bucket

Liabilities 1. Capital, Reserves and Surplus

Non-sensitive.

2. Current Deposits

Non-sensitive.

3. Savings Bank Deposits

Sensitive to the extent of interest payin (core) portion. This may be included in the 3-6 months bucket. The non-interest paying portion may be shown in non-sensitive bucket.

4. Term Deposits and Certificates of Deposit

Sensitive and reprices on maturity. The amounts should be distributed to different buckets on the basis of remaining maturity. However, in case of floating term deposits, the amounts may be shown under the time bucket when deposits contractually become due for repricing.

5. Borrowings - Fixed

Sensitive and reprices on maturity. The amounts should be distributed to different buckets on the basis of remaining maturity.

6. Borrowings - Floating

Sensitive and reprices when interest rate is reset. The amounts should be distributed to the appropriate bucket which refers to the repricing date.

7. Borrowings - Zero Coupon

Sensitive and reprices on maturity. The amounts should be distributed to the respective maturity buckets.

8. Borrowings from RBI

Upto 1 month bucket.

9. Refinances from other agencies.

(a) Fixed rate: As per respective maturity. (b) Floating rate: Reprices when interest rate is reset.

207

208 Financial Engineering, Risk Management & Financial Institutions 10. Other Liabilities and Provisions (i) Bills Payable (ii) Inter-office Adjustment (iii) Provisions (iv) Others

(i) Non-sensitive. (ii) Non-sensitive. (iii) Non-sensitive. (iv) Non-sensitive.

11. Repos/Bills Re-discounted (DUPN), Swaps (Buy/Sell) etc.

Reprices only on maturity and should be distributed to the respective maturity buckets.

Assets 1. Cash

Non-sensitive.

2. Balances with

RBI Interest earning portion may be shown in 3 - 6 months bucket. The balance amount is nonsensitive.

3. Balances with other Banks (i) Current Account (ii) Money at Call and Short Notice, Term Deposits and other placements.

(i) Non-sensitive. (ii) Sensitive on maturity. The amounts should be distributed to the respective maturity buckets.

4. Investments (Performing) (i) Fixed Rate/Zero Coupon (ii) Floating Rate

(i) Sensitive on maturity. (ii) Sensitive at the next repricing date

5. Shares/Units of Mutual Funds

Non-sensitive.

6. Advances (Performing) (i) Bills Purchased and Discounted (including bills under DUPN) (ii) Cash Credits/Overdrafts (including TODs)/Loans repayable on demand and Term Loans

(i) Sensitive on maturity (ii) Sensitive only when PLR/risk premium changed. Of late, frequent changes in PLR have been noticed. Thus, each bank should foresee the direction of interest rate movements and capture the amounts in the respective maturity buckets by which time PLR would be revised.

CHAPTER 9 Asset Liability Management 7. NPAs (Advances and Investments)* (i) Sub-Standard (ii) Doubtful and Loss

(i) 2-5 years bucket. (ii) Over 5 years bucket.

8. Fixed Assets

Non-sensitive.

9. Other Assets. (i) Inter-office Adjustment (ii) Others

(i) Non-sensitive. (ii) Non-sensitive.

10. Reverse Repos, Swaps (Sell/Buy) and Bills Rediscounted (DUPN)

Sensitive on maturity.

11. Other products (Interest Rate) (i) Swaps (ii) Other Derivatives *Amounts to be shown net of provisions.

(i) Sensitive and should be distributed under different buckets with reference to maturity. (ii) Should be suitably classified as and when introduced.

209

210 Financial Engineering, Risk Management & Financial Institutions Annexure - I Name of the Bank .................................................................... Statement of Structural Liquidity as on ........................................... (Amounts in Crores of Rupees)

RESIDUAL MATURITY 1-14 15-28 Days days

29 days to 3 months

3-6 months

6-12 1-2 2-5 Over 5 Total months years years years

Outflows 1. Capital 2. Reserves & Surplus 3. Deposits

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

(i) Current Deposits (ii) Savings Bank Deposits (iii) Term Deposits (iv) Certificates of Deposit 4. Borrowings (i) Call and Short Notice (ii) Inter-Bank (Term) (iii) Refinances (iv) Others (specify) 5. Other Liabilities & Provisions (i) Bills Payable (ii) Inter-office Adjustment (iii) Provisions (iv) Others 6. Lines of Credit committed to (i) Institutions (ii) Customers 7. Unavailed portion of Cash Credit / Overdraft / Demand Loan component of Working Capital 8. Letters of Credit / Guarantees 9. Repos 10. Bills Rediscounted (DUPN) 11. Swaps (Buy/Sell) / maturing forwards

CHAPTER 9 Asset Liability Management

211

12. Interest payable 13. Others (specify) A. Total Outflows Inflows 1. Cash 2. Balances with RBI 3. Balances with other Banks

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

(i) Current Account (ii) Money at Call and Short Notice, Term Deposits and other placements 4. Investments (including those under Repos but excluding Reverse Repos) 5. Advances(Performing) XXX

XXX

(i) Bills Purchased and Discounted (including bills under DUPN) (ii) Cash Credits, Overdrafts and Loans repayable on demand (iii) Term Loans 6. NPAs (Advances and Investments) 7. Fixed Assets 8. Other Assets

XXX

XXX

(i) Inter-office Adjustment (ii) Others 9. Reverse Repos 10. Swaps (Sell / Buy)/ maturing forwards 11. Bills Rediscounted (DUPN) 12. Interest receivable 13. Committed Lines of Credit 14. Others (specify).

B. Total Inflows C. Mismatch ( B-A ) D. Cumulative Mismatch E. C as % To A

212 Financial Engineering, Risk Management & Financial Institutions Annexure - II Name of the Bank ....................................................................

Statement of Short-term Dynamic Liquidity as on ........................................... (Amounts in Crores of Rupees)

A. Outflows 1 - 14 days 15-28 29-90 days days 1. Net increase in loans and advances 2. Net increase in investments: i) Approved securities ii) Money market instruments (other than Treasury bills) iii) Bonds/Debentures/shares iv) Others 3. Inter-bank obligations 4. Off-balance sheet items (Repos, swaps, bills discounted, etc.) 5. Others

Total Outflows B. Inflows 1. Net cash position 2. Net increase in deposits (less CRR obligations) 3. Interest on investments 4. Inter-bank claims 5. Refinance eligibility (Export credit) 6. Off-balance sheet items (Reverse repos, swaps, bills discounted, etc.) 7. Others

Total Inflows C. Mismatch (B - A) D. Cumulative mismatch E. C as a % to total outflows

PORTFOLIO CONSIDERATIONS IN RISK MANAGEMENT Introduction Definition of Portfolio Diversification of Risk Risk Free Asset Risky Asset- Tobin’s Separation Theorem Portfolio Optimization in Practice Conclusion Practice Problems Keywords Review Questions References Case Study

214 Financial Engineering, Risk Management & Financial Institutions

Chapter Objectives

Chapter Objectives

After studying this chapter the student will be able to: Understanding concepts of portfolio considerations and diversification of risk. Define covariance and calculate correlation and risk reduction. Discuss the importance of portfolio diversification and risk reduction. Define models of measuring the portfolio variance and diversification.

Introduction Any corporate entity or individual may opt to invest resources available with them according to the various avenues available and their willingness to take risk.

This chapter deals with ‘portfolio considerations’ while dealing with risk management. It also discusses with various issues relating to risk free asset, risk premium asset and risk aversion strategies. Any corporate entity or individual may opt to invest resources available with them according to the various avenues available and their willingness to take risk. However the investments can be classified in to risk premium assets and risk less assets. A small story by Ron Bird, Hary Lien and susan1, narrated as “a hare ridicules a slow-moving tortoise and is challenged by him to a race. The hare soon leaves the tortoise behind and, confident of winning, decides to take a nap midway through the course. When he awakes, however, he finds that his competitor, crawling slowly but steadily, has finished before him” In their study they compared two methods of portfolio diversification that have recently attracted interest. Investors increasingly allocate away from traditional investments, such as equity and bonds, into alternative investments, with the promise of higher, less volatile returns. It was found that 15 to 20 percent of global institutionally managed portfolios are already invested in alternative assets with some U.S. endowments allocating up to 80 percent to alternative assets. Yet, like the erratic hare, alternative investments carry certain risks as a

Ron Bird, Hary Lien and Susan, The Tortoise and the Hare: Risk Premium versus Alternative Asset Portfolios, The Paul Woolley Centre for the Study of Capital Market Dysfunctionality, UTS Working Paper Series 16 1

CHAPTER 10 Portfolio Considerations in Risk Management

215

tradeoff to the promise of higher returns. Recent academic evidence suggests that the majority of returns come from exposure to risk premia (beta), as market timing and security selection is notoriously hard to consistently execute. Risk Premia2 encourages investors to allocate capital to areas they might otherwise avoid. Any investor has the choice of remaining uninvested or buying an asset with an uncertain future payout. There is no incentive to do the latter unless, on balance, the investor expects to profit from this allocation away from cash. In theory, there should be a positive reward for accepting the risk of some capital loss in the long term. Another category of persistent returns are those due to structural distortions in markets or the behaviour of market participants.

Risk Premia encourages to allocate capital.

For example, momentum has been shown to have a pervasive effect, partly due to behavioural biases of market participants. Assets that have recently shown strongly positive growth have a tendency to continue doing so while assets which have been trending downwards tend to persist in losing value. In each case, when the trend does break, it can do it sharply, so strong risk management is required when exploiting this anomaly. Within an individual asset class, those securities that are most sensitive to movements in that asset class tend to underperform relatively less sensitive securities. This may be because market participants who are unable to lever their exposure favour sensitive (‘high beta’) securities to increase their exposure, bidding prices beyond fair value and thereby damaging subsequent returns. In any event, both this effect and momentum can be exploited within the portfolio to generate reliable long-term returns, provided investors are alert to the changing institutional behaviours within markets. The Investec Asset Management Company finds that a key characteristic of risk premia and persistent market anomalies is that they have a fundamental driver such as economic growth or rising profit margins which is broadly available to all. There will be relative ‘losers’ as well as ‘winners’ but in aggregate everyone is better off. We believe therefore that risk premia should be a more dependable source of long2 Marc Abrahams (2012), Head of Multi-Asset Research, Diversified Growth Portfolios: Beyond Naïve Diversification, published by Investec Asset Management (is a specialist provider of active investment products and services to institutional and individual investors. Established in South Africa in 1991), Aug, 2012.

High beta indicates high risk.

216 Financial Engineering, Risk Management & Financial Institutions term returns than relative skill and it is clear that exposure to a collection of different risk premia should be the foundation of any long-term investment portfolio.

Definition of Portfolio Portfolio is a combination of various investment avenues.

‘Portfolio’ is a combination of various investment avenues to achieve an expected return subject to the risk exposure of each investment. Hence, the expected return of portfolio is dependent on proportion and probability of the return of respective investments of selected portfolio.

Diversification of Risk Risk comes from sources unique to each asset.

Risk may arise due to common sources, like the economy. But, risk comes from sources unique to each asset. This means that some kinds of risk can be diversified. However, expected return of portfolio is dependent on the weight or proportion of investment made in the particular asset, the following formula is used to find expected return of portfolio: Expected return on a portfolio E(rp) = Siw i *E(ri) = wi *E(r1)+w2 *E(r 2)+...+* E(rn)

Markowitz Theorem3 Investors with different risk/return goals can use leverage to increase the ratio of the market return to the risk-free return in their portfolios

Markowitz (1959) developed the mean-variance portfolio selection theory, which suggests that investors should fully broaden their horizons and their portfolios should be a mixture of the “market” and a risk-free investment. Investors with different risk/return goals can use leverage to increase the ratio of the market return to the risk-free return in their portfolios. This is based on Capital Market Line (CML) equation as mentioned below: R P = IRF + (RM - IRF)óP/óM Where, RP = Expected Return of Portfolio

Markowitz H. M., (1959). Portfolio Selection: Efficient Diversification of Investments, Yale University Press, Wiley 3

CHAPTER 10 Portfolio Considerations in Risk Management

217

RM = Return on the Market Portfolio IRF = Risk-Free rate of interest óM = Standard Deviation of the market portfolio óP = Standard Deviation of portfolio

Measuring Risk As stated in earlier chapter, portfolio standard deviation depends on covariance and or correlation between each pair of assets within the portfolio. This indicates how much the movements between each pair of assets offset each other. However, portfolio standard deviation will be less than the weighted average of the standard deviations of the individual assets within the portfolio. Covariance =: σ i,j COV (r 1,r2) = σ1,2 = Σpr(s)[r 1(s) - E(r 1)][r2(s) - E(r 2)] Prob

1

2

Good

.3

.2

.1

Average

.5

.1

.2

Poor

.2

-.05

.4

σ1,2 = .3 ∗(.2−.1)∗(.1−.21) + .5∗(.1−.1)∗(.2−.21) + .2*(-.05-.1)*(.4-.21) = -.0033 + 0 + -.0057 = -.009

Calculation of Correlation between Two Assets The correlation coefficient “standardizes” covariance – puts it into a form that tells you how much two assets actually move together. Correlation coefficients are scaled between –1 and +1:

ρij =

σ ij σ iσ j

Risk can be measured using standard deviation & covariance.

218 Financial Engineering, Risk Management & Financial Institutions Measuring Variance of a Portfolio N

N

σ = ∑∑ wi w jσ i , j 2 P

i =1 j =1

If N=2,

σ 2p = w21σ21+w 22σ 22+2w1w2σ 1,2

If N=3,

σ 2 p = w 2σ 2 1+w 22σ 22 + w 2 3σ 23 + 2w 1w 2σ 1,2 + 2w 1 w 3S 1,3 + 2w 2w 3S2,3

Nature of Concave Curve The nature of the curve will be depending on extent of correlation between assets making up the portfolio. If we assume that there are two assets (1 and 2), and the extreme cases of perfect positive ( ρ1,2=1.0) and perfect negative (ρ1,2=-1.0) correlation: Assume, E(r p)>E(r1),s2>s1 E(rp)

Assets 2

f

ρ1,2=-1.0

f ρ1,2=+1.0

f Weightings of f the Assets results in these Portfolios.

ρ1,2=-1.0

f Assets 1

Measuring the Portfolio Variance and Diversification Using : σ2P=W21σ 21+W22σ 22+2W1W2P1,2σ 1σ2 Suppose that σ 1=σ 2=0.05 and W1=W2=0.50 2

2

σ 2p=.502(0.05)+.502(0.05)+2(.50)(.50)P1,2 .05 .05 = .025 + r1,2(.025)

CHAPTER 10 Portfolio Considerations in Risk Management

Optimal Risky Portfolios in Case of Two Risky Assets and a Risk-Free Asset If there are two risky assets, we know that various portfolios curve to the left in an expected return. However, in case of combining any risky asset with a risk-free asset results in a straight line in the same graph. For instance, we can combine the risk-free asset together with any combination of the two risky assets, the best combination will be at the tangency portfolio (P*), which has the steepest CAL. CAL (P*) A less risk averse investor chooses this mix of P* and the risk free asset (is a borrower)

E (r)

Without a risk-free asset, a less risk P* averse investor chooses this portfolio

f

f

Without a risk-free asset, a more risk averse investor might choose this portfolio

f f

A more risk averse investor would instead choose this mix of P* and the risk-free asset (is a lender) rF

One should remember that risk averse investors are better off mixing the risky portfolio P* with the risk-free asset. Without the risk-free asset, each investor type chooses a unique risky portfolio along the curve. With the risk-free asset, all investors choose the same risky portfolio P* in combination with the risk-free asset on the CAL. Example: Investment A is better than B if … E(rA)>E(rB) and σA