CSP 2015 Indian Economy Key Test 2 dt. 15.12.2014

CSP 2015 Indian Economy Key Test 2 dt. 15.12.2014

1.	b	21.	b	41.	b	61.	a	81	a
2.	a	22.	c	42.	d	62.	d	82	c
3.	d	23.	a	43.	b	63.	a	83	a
4.	a	24.	c	44.	c	64.	b	84	c
5.	c	25.	d	45.	b	65.	a	85	c
6.	c	26.	d	46.	c	66.	b	86	d
7.	a	27.	a	47.	c	67.	a	87	a
8.	d	28.	a	48.	d	68.	c	88	a
9.	c	29.	d	49.	b	69.	a	89	c
10.	a	30.	d	50.	d	70.	b	90	a
11.	c	31.	c	51.	b	71	a	91	c
12.	c	32.	b	52.	d	72	a	92	a
13.	d	33.	c	53.	a	73	c	93	d
14.	c	34.	c	54.	a	74	d	94	b
15.	b	35.	d	55.	c	75	b	95	a
16.	b	36.	a	56.	c	76	d	96	a
17.	d	37.	c	57.	d	77	b	97	b
18.	d	38.	d	58.	d	78	d	98	c
19.	c	39.	a	59.	c	79	b	99	c
20.	b	40.	c	60.	a	80	b	100	b

Dear Friends,

1.    Perusal of CSP 2013 and 2014 question papers, it is found that about 6 questions are asked from this syllabus of this test. That indicates the importance of this area. Simple and in-depth answers are provided to equip you with knowledge and latest events in this area. You must know each and every term used in this test. If you are not able to any of these terms/concepts, read twice or discuss amongst yourselves or call me for clarification. But, you must have clarity on these topics.

2.    No question from the syllabus what is given to you in Indian Economy Test 3 was appeared in the CSP 2013 and 14. Therefore, I will try to find out some latest events on agriculture, Industry and services and set questions on them. But the questions would be minimal from CSP point of view. However, certain potential areas such as different first generation revolutions [Green, Yellow, white and others], Second green Revolution and GM crops and their trials which are important for mains point of view would be covered for understanding as well as writing correct and nice answers in the CSM. 

3.    Budget 2014-15 may throw up certain issues which will be covered in last and fifth Economy Test.

                                                                                          Yours friendly,

                                                                                            

                                                                                           B. YADAGIRI, IRS.,

                                               

Explanation:

1. The RBI has defined “Willful defaulter”. According to RBI, a “willful default" is deemed to have occurred in if any of the following events is noted:-

1.    Default in repayment of loans deliberately, in spite of having capacity to oblige payments

2.    The defaulter, has diverted the loan to some other purpose, other than for which it was sanctioned  by the bank

3.    The defaulter, has siphoned off the funds and neither used the funds for the specific purpose, nor the funds available with the unit in the form of others assets

4.    The defaulter has disposed-off the movable or immovable assets by pledging which a term loan was secured without the knowledge of the lender/bank.  

[I have simplified the original RBI definition as above, without change of the content and make easy to remember and reproduce. This is imp both for CSP and CSM]

2 & 3. Insider trading is the trading activity [Purchase or sale of shares a particular company] in a stock exchange with specific inside information which is not available to public at large. Such information is called “Un-published price sensitive information”. The insider is a person who knows the affairs of the company very deeply or in simple words, a person who is involved in day to day affairs of the company or the company management. For example in M/s. Satyam Computers case, the management knows that company is showing very huge cash in the balance sheet artificially and thereby satyam shares were valued high and people were accumulating the stock. Having known this information, the directors and their relatives sold shares of the company at very high prices, before Mr. Ramalinga Raju, declared the non-existence of cash in the company to World.  Thus insider trading violates the concept of “level playing field”. The SEBI has recently finalized insider trading norms based on the recommendations of NK Sodhi committee. [I have already forwarded Sodhi committee recommendations in Economy notes and one of the editorials contains the SEBI regulations. Imp for CSP as well as CSM] 

4 and 25.

MSF: Marginal Standing Facility is a special window for banks to borrow from RBI against approved government securities in an emergency situation like an acute cash shortage. MSF rate is higher than Repo rate.  At present, repo rate is 7.75% and MSF rate is 8.75%.

NDTL means Net Demand and Time Liabilities.

As the English meaning, Demand liability is one which has to pay by the bank on demand from the customers and time liabilities are those which are paid as pre-scheduled on particular dates. The bank has to pay or make available money which is their in SB Account and Current Account. [Banks are obliged to offer a minimum of 4% interest on SB A/c, with certain limits of withdrawals per day and in Current Account no limit of withdrawals and banks need not pay interest]. The Time Liabilities as the name indicates which the banks have to pay as per pre-scheduled maturity dates, i.e., Fixed Deposits etc. Once, the FD matures, the bank has to pay the money to the customer along with the interest.  The specific items in each category are given as under.

Demand Liabilities: The liabilities which bank have to pay on demand. Current deposits, demand liabilities portion of savings bank deposits, margins held against letters of credit/guarantees, balances in overdue fixed deposits, cash certificates and cumulative/recurring deposits, outstanding Telegraphic Transfers (TTs), Mail Transfer (MTs), Demand Drafts (DDs), unclaimed deposits, credit balances in the Cash Credit account and deposits held as security for advances which are payable on demand come under Demand Liabilities.

Time Liabilities: The liabilities which bank have to pay after specific time period. Fixed deposits, cash certificates, cumulative and recurring deposits, time liabilities portion of savings bank deposits, staff security deposits, margin held against letters of credit if not payable on demand, deposits held as securities for advances which are not payable on demand and Gold Deposits come under Time Liabilities.

The meaning of net liabilities has to be seen from the functioning of the bank. Banks receive various deposits from the customers or on behalf of the customers. The money received such is used to pay its liabilities. Thus net liability is the total payments made by the bank minus the deposits received on any particular day. It is to be noted that banks have to maintain CRR with RBI on certain percentage of its NDTL.

[Additional information: 1. CASA Ratio: This is one of the very important ratios, determining the financial health and profitability of a bank. It means Current Account and Saving Account ratio to total deposits received by the bank. It is to be noted that deposits in CA is interest-free and deposits in SA are low cost debt which the bank use to lend at higher of interest ranging from  10 to 20% of to the customers. In other words, the CASA deposits are the cheapest source of credit to the banks when compared time deposits like FDs and loans obtained from RBI @ 7.75 under repo and 8.75 under MSF. Those banks with higher CASA ratio will make higher net interest margins [NIM] and therefore more profitable when compared to banks with low CASA ratio.]

2. High lights of 6^th bimonthly policy of RBI: Reserve Bank of India (RBI) has cut down repo rate by 25 basis points to 7.75 percent from 8 percent, with immediate effect. It was announced ahead of the scheduled date of monetary policy announcement on 3rd February 2015 as part of RBI’s 6th bi-monthly monetary policy statement.

RBI’s 6^th bi-monthly monetary policy statement says that

Repo rate: RBI has reduced the policy repo rate under the liquidity adjustment facility (LAF) by 25 basis points from 8.0 per cent to 7.75 per cent.

Cash reserve ratio (CRR): RBI has unchanged CRR and kept it at 4.0 per cent of net demand and time liabilities (NDTL).

Reverse repo rate: RBI has adjusted reverse repo rate under the LAF to 6.75 per cent.

While, RBI has adjusted Marginal standing facility (MSF) rate and the Bank Rate to 8.75 per cent with immediate effect.]

5. The NBFCs are not required to maintain CRR deposits with RBI and RBI would not pay interest on CRR deposits made by the SCBs with RBI. Rationing of the credit means fixing the specific sector wise quotas granted by the banks to the customers. This is one of the qualitative credit control used by RBI to reduce money supply in the market. Hence, rationing of credit by RBI decrease the liquidity in the market. Hence all the three statements are wrong.

6 and 8. The nominal interest rate refers to the rate of interest what a person gets from bank or from any other debtor. For example, if a person saved Rs.1 lakh in bank as FDs @ 8% rate of interest. He would get Rs. 8000/- as interest at the end of the year. This is called “nominal interest”, amounting to Rs.8000/- or 8% interest. If this return or interest is adjusted against the inflation, the real interest can be arrived. For example if the inflation [or the continuous rise in prices of goods] is growing @ 9%, the real interest earned is negative by Rs.1000/- [Nominal interest minus inflation 8000-9000= (-) 1000]. In the same example if the nominal interest earned is same @ 8% and inflation grows @ 7%, then the real interest earned is Rs.1000/- @ 1% on the investment in the FD made. In other words, the RBI and Government have successfully managed to bring down inflation below the nominal interest offered in the banks and thereby people are earning positive gain.

7. Base Rate is the minimum rate of interest that an individual bank is allowed to charge from its customers. Unless mandated by the government, RBI rule stipulates that no bank can offer loans at a rate lower than Base Rate to any of its customers. Your home loan will always be equal to or more than the Base Rate but never lower than Base Rate.

[Base rate has replaced the Prime Lending Rate, PLR, at which the banks were lending to their most trust worthy customer. Now there is no concept like PLR]

9. Change in Money supply in the Economy

	Activity of RBI/Govt.	Change in money supply in the Economy
1	Purchase of government securities from public by central bank	When Central bank purchases Govt. Securities from public, it pays money and the money supply with public would go up.
2	Deposit of currency in commercial banks by the public	Money supply in market would go down
3	Borrowing by government from the central bank	The Govt. borrows money, basically for spending in the Economy. The Govt. may spend on administration such as salaries; on social sector, including subsidies or investment or employment schemes. This action of Govt. would enhance money supply in the Economy.
4	Sale of government securities to the public by central bank	When Central bank sell Govt. Securities to public, it receives money from public and the money supply with public would go down in the Economy

Hence, the measures mentioned in serial numbers 1 and 3 would increase money supply in the Economy and in other two instances, the money supply in the Economy would go down.

11. The effect of interest decrease on the Economic activity

	Statement in the question	Correctness of the statement
a	Decrease the consumption expenditure in the economy	When interest rates on the loans offered by the banks go down, people tend to spend more as credit is cheaper. If interest rate goes up, they postpone the expenditure. Hence this statement is wrong
b	Increase the tax collection of the Government	There is no direct correlation between the decrease in interest rates and increase in tax collection.
c	Increase the investment expenditure in the economy	When the interest rates are low, Individuals, business persons and companies take loans and invest in the business/investment in properties
d	Increase the total savings in the economy	When interest rates are low, people would not save much as the interest rates offered are not attractive. Hence, this statement is not correct.

Hence, the option “c” correct.

13. The bank branches are divided into 4 types, on the basis of the location of the branch and the population of the area as per the latest census. They are 1. Rural branch, if the population is less than 10,000; 2. Semi-urban branch, if the population is above 10,000 and below 1 lakh; Urban branch, if the population is above 1 lakh and below 10 lakh and Metropolitan branch, if the population is 10 lakh and above.   

16. Hedging:

Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract. 

An example of a hedge would be if you owned a stock, then sold a futures contract stating that you will sell your stock at a set price, therefore avoiding market fluctuations. Investors use this strategy when they are unsure of what the market will do. A perfect hedge reduces your risk to nothing (except for the cost of the hedge, losing the premium or margin paid). 

PINAKA explains:

Ø  Hedging means reducing or controlling risk. This is done by taking a position in the futures market with the objective of reducing or limiting risks in the “Cash Market” associated with price changes.

Ø  Hedging is a two-step process. A gain or loss in the cash position due to changes in price levels will be countered by changes in the value of a futures position. For instance, a wheat farmer can buy wheat futures to protect the glut in the wheat prices after the crop harvest. If there is a fall in price, the loss in the value in physical market will be countered by a gain in futures market.  

How hedging is done 

In this type of transaction, the hedger tries to fix the price at a certain level with the objective of ensuring certainty in the cost of production or revenue of sale.

The futures market also has substantial participation by speculators who take positions based on the price movement and bet upon it. Also, there are arbitrageurs who use this market to pocket profits whenever there are inefficiencies in the prices. However, they ensure that the prices of spot and futures remain correlated.

Example - case of steel 

An automobile manufacturer purchases huge quantities of steel as raw material for automobile production. The automobile manufacturer enters into a contractual agreement to export automobiles three months hence to dealers in the East European market.

This presupposes that the contractual obligation has been fixed at the time of signing the contractual agreement for exports. The automobile manufacturer is now exposed to risk in the form of increasing steel prices. In order to hedge against price risk, the automobile manufacturer can buy steel futures contracts, which would mature three months hence. In case of increasing or decreasing steel prices, the automobile manufacturer is protected. Let us analyse the different scenarios: 

Increasing steel prices 

If steel prices increase, this would result in increase in the value of the futures contracts, which the automobile manufacturer has bought. Hence, he makes profit in the futures transaction. But the automobile manufacturer needs to buy steel in the physical market to meet his export obligation. This means that he faces a corresponding loss in the physical market.

But this loss is offset by his gains in the futures market. Finally, at the time of purchasing steel in the physical market, the automobile manufacturer can square off his position in the futures market by selling the steel futures contract, for which he has an open position.

Decreasing steel prices

If steel prices decrease, this would result in a decrease in the value of the futures contracts, which the automobile manufacturer has bought. Hence, he makes losses in the futures transaction. But the automobile manufacturer needs to buy steel in the physical market to meet his export obligation.

This means that he faces a corresponding gain in the physical market. The loss in the futures market is offset by his gains in the physical market. Finally, at the time of purchasing steel in the physical market, the automobile manufacturer can square off his position in the futures market by selling the steel futures contract, for which he has an open position. 

This results in a perfect hedge to lock the profits and protect from increase or decrease in raw material prices. It also provides the added advantage of just-in time inventory management for the automobile manufacturer. 

29. In 1948, the Government of India set up Industrial Finance Corporation of India (I.F.C.I) with a view of providing medium and long term finance to industries.

36, 90 and 91. ARCs and latest guidelines:

It is better to know about SARFAESI Act, before going into ARCs and SRs and recovery mechanism. This area is very imp both for CSP and CSM as the biggest problem faced by Indian banking industry, especially PSU banks is the NPAs and their recovery.

SARFAESI Act:

The full form of SARFAESI Act as we know is Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002. Banks utilize this act as an effective tool for bad loans (NPA) recovery. It is possible where non-performing assets are backed by securities charged to the Bank by way of hypothecation or mortgage or assignment. Upon loan default, banks can seize the securities (except agricultural land) without intervention of the court. SARFAESI is effective only for secured loans where bank can enforce the underlying security, eg hypothecation, pledges and mortgages. In such cases, court intervention is not necessary, unless the security is invalid or fraudulent. However, if the asset in question is an unsecured asset, the bank would have to move the court to file civil case against the defaulters.

How it works?

The SARFAESI Act, 2002 gives powers of "seize and desist" to banks. Banks can give a notice in writing to the defaulting borrower requiring it to discharge its liabilities within 60 days. If the borrower fails to comply with the notice, the Bank may take recourse to one or more of the following measures:

Ø  Take possession of the security for the loan Sale or lease or assign the right over the security Manage the same or appoint any person to manage the same

Ø  The SARFAESI Act also provides for the establishment of Asset Reconstruction Companies (ARCs) regulated by RBI to acquire assets from banks and financial institutions.

Ø  The Act provides for sale of financial assets by banks and financial institutions to asset reconstruction companies (ARCs). RBI has issued guidelines to banks on the process to be followed for sales of financial assets to ARCs.

Ø  This act had created the forums such as Debt Recovery Tribunals [DRTs]  and Debt Recovery Appellate Tribunals [DRAT] for expeditious adjudication of disputes with regard to ever increasing non-recovered dues

Asset Reconstruction Companies [ARCs]

ARCs are the NBFCs registered with the RBI and are established on the basis of recommendations of Narasimham committee-II to deal with the ever increasing problem of NPAs with the banking sector. They are established under the SRFAESI Act, 2002. ARC has been set up to provide a focused approach to Non-Performing Loans resolution issue by:-

(a)  Isolating Non Performing Loans (NPLs) from the Financial System (FS), 

(b)  Freeing the financial system to focus on their core activities and 

(c)  Facilitating development of market for distressed assets.

 Functions of ARC:

As per RBI Notification No. DNBS.2/CGM (CSM)-2003, dated April 23, 2003, ARC performs the following functions:-

ü  Acquisition of financial assets (as defined u/s 2(L) of SRFAESI Act, 2002) 

ü  Change or takeover of Management / Sale or Lease of Business of the Borrower 

ü  Rescheduling of Debts

ü  Enforcement of Security Interest (as per section 13(4) of SRFAESI Act, 2002) 

ü  Settlement of dues payable by the borrower

How Does ARC actually Works:

ARC functions more or less like a Mutual Fund. It takes NPAs from banks/FIs at a determined price by paying 15% [it was 5% earlier and RBI made it 15% for the year 2014-15] upfront money and transfers the acquired assets to one or more trusts at the price at which the financial assets were acquired from the originator (Banks/FIs). Then, the trusts issues Security Receipts to Qualified Institutional Buyers [as defined u/s 2(u) of SRFAESI Act, 2002]. The trusteeship of such trusts shall vest with the ARC. ARC will get only management fee from the trusts. Any upside in between acquired price and realized price will be shared with the beneficiary of the trusts (Banks/FIs) and ARC. Any downside in between acquired price and realized price will be borne by the beneficiary of the trusts (Banks/FIs).

 RBI has tightens the rules for ARCs during August, 2014.

Ø  The ARCs will henceforth have to mandatorily invest and hold minimum 15 per cent (against 5 per cent earlier) of the Security Receipts issued by them against the assets acquired from banks on an ongoing basis till the redemption of all the receipts. [Now the ARCs have to make 15% upfront money to banks on the value of NPA brought as against 5% earlier]

Ø  The time allowed for ARCs to formulate a plan for realization of non-performing assets of the selling bank acquired for the purpose of reconstruction has been reduced to 6 months from 1year

Ø  Before bidding for the stressed assets, the ARCs can ask the auctioning banks to give adequate time, not less than 2 weeks, to conduct a meaningful due diligence of the account by verifying the underlying assets.

Ø  Before bidding for the stressed assets, the ARCs can ask the auctioning banks to give adequate time, not less than 2 weeks, to conduct a meaningful due diligence of the account by verifying the underlying assets.

Ø  The ARCs should also be members of Joint Lenders’ Forum and should be a part of the process involving the JLF with reference to such stressed assets.

Other relevant facts:

ü  The trusts referred above are to be set up u/s 7(1) and 7(2) of SRFAESI Act, 2002. QIBs are as defined in the SRFAESI Act, 2002.

ü  Asset Reconstruction Company of India Ltd is the first ARC in India.

What are Security Receipts?

SRs means a receipt or other security, issued by a securitisation company or reconstruction company to any qualified institutional buyer pursuant to a scheme, evidencing the purchase or acquisition by the holder thereof, of an undivided right, title or interest in the financial asset involved in securitisation.

37. CIBIL’s aim is to fulfill the need of credit granting institutions for comprehensive credit information by collecting, collating and disseminating credit information pertaining to both commercial and consumer borrowers, to a closed user group of Members. Banks, Financial Institutions, Non-Banking Financial Companies, Housing Finance Companies and Credit Card Companies use CIBIL’s services.  Data sharing is based on the Principle of Reciprocity, which means that only Members who have submitted all their credit data, may access Credit Information Reports from CIBIL. The relationship between CIBIL and its Members is that of close interdependence.

CIBIL's equity was held by State Bank of India, Housing Development Finance Corporation Limited, Dun & Bradstreet Information Services India Private Limited and Trans Union International Inc. The shareholding pattern was in the proportion of 40:40:10:10 respectively.

The shareholding pattern has now been diversified to include the number of other banks and financial institutions representing varied categories of credit grantors

A Credit Information Report (CIR) is a factual record of a borrower's credit payment history compiled from information received from different credit grantors. Its purpose is to help credit grantors make informed lending decisions - quickly and objectively. An individual’s Credit Score provides a lender with an indication of the “probability of default” by the individual based on their credit history.

Credit Information Bureau (India) Limited is India’s first Credit Information Company (CIC) founded in August 2000. CIBIL collects and maintains records of an individual’s payments pertaining to loans and credit cards. These records are submitted to CIBIL by member banks and credit institutions, on a monthly basis. This information is then used to create Credit Information Reports (CIR) and credit scores which are provided to credit institutions in order to help evaluate and approve loan applications. CIBIL was created to play a critical role in India’s financial system, helping loan providers manage their business and helping consumers secure credit quicker and on better terms. The CIR and Credit Score not only help loan providers identify consumers who are likely to be able to pay back their loans, but also help them to do this more quickly and economically. This translates into faster loan approvals for consumers. An individual with a higher credit score can bargain with the credit institution for better lending terms, since he is perceived as a responsible borrower. Since consumers can now access their Credit Scores and CIRs directly from CIBIL, they can see for themselves how they are perceived by loan providers before taking a loan. Hence, CIBIL empowers both loan providers and individuals to see their financial and credit history more clearly and hence, take better and more informed decisions.

An individual’s Credit Score provides a lender with an indication of the “probability of default” by the individual based on their credit history. What this means in simple English is that the Score tells a lender how likely you are, to pay back a loan (should the lender choose to sanction your loan) based on your past pattern of credit usage and loan repayment behavior. The closer you are to 900, the more confidence the lender will have in your ability to repay the loan and hence, the better the chances of your application getting approved.

38. The Reserve Bank of India (RBI) has reduced the number of free monthly transactions from automated teller machines (ATMs) of other banks to three from five in the metros.

The Central bank has also allowed banks to levy ATM charges beyond five transactions (both financial and non-financial) for their own account holders. A customer will be required to pay a fees of up to Rs.20 for using ATMs beyond the permitted number of free transactions in Delhi, Mumbai, Chennai, Bangalore, Kolkata and Hyderabad. The new guidelines will come into effect from November 1, 2014. The reduction in the number of transactions will, however, not be applicable to customers having basic or small savings bank accounts.

45. Dual Currency Bonds, as the name indicates, pay interest coupons [interest payment as per currency bond] in one currency and principal redemption for a fixed sum in a second currency, often the dollar. The bonds are called single or dual currency bonds, based on the mode of payment at the maturity period. In  the case of single currency bond,  the total capital and interest is paid in single currency, say in rupees or $ or Euro and in the case of dual currency bonds, the principal and interest would be paid in two currencies, say Euro and US $. 

As you are aware, the exchange rate of a currency would keep on fluctuating, based on the supply demand factors and stability or soundness of the Government or Economy of a country. The currency fluctuation would have a bearing on the quantum of amount to be paid or received on a fixed date of future payment. For example, a US citizen has purchased a corporate bond of M/s. Bharti Airtel, an Indian company on January 30^th, 2015 with a maturity period of 10 years, interest payable @ 5%. The company will pay in US $ to the said investor both capital and interest on 30^th January, 2025 in US $. On that date, if the exchange rate of US $ would be less due to certain factors, the gain of the investor would get reduced and alternatively, if the $ exchange rate is more, he will gain more. In the same example, if the investor has an option to received capital in Euros and interest in US $, there is likelihood that he may gain as the chances for two currencies be a at low level are less and therefore dual currency bonds are popular than single currency bonds. 

A company may prefer issuing a dual currency bond to hedge any foreign exchange flows from its operations, or take a speculative view on currencies in order to get a lower cost of capital. Investors generally get an above-market coupon, but run the risk that, in this example, the dollar could plunge below the exchange rate used when the amount was fixed. Such bonds are enticing to borrowers who operate in the redemption currency because they have no long-term exchange rate risk. The example of Bharti Airtel is point in this case.

Bharti Airtel raises about $2 billion in Dual Currency Bond sale

India’s largest telecom company Bharti Airtel raised around $2 billion in a dual currency international bond sale. It is the largest debt issuance by a domestic company till date. Bharti sold dual currency dollar and euro bonds to raise the money which will be used for repayment and refinancing of existing foreign currency debt.  It is a first dual currency issuance by an Indian issuer and also largest fund raising exercise at a single time by an Indian issuer.

47. Whenever, Saving schemes are attractive, the people tend to put more and more money in to the schemes, thus reducing money circulation in the public. If the return is not attractive, people won’t invest, instead spend. In the instant question, the Budget 2014-15 has increased the investment limit under section 80C of the Income Tax Act from Rs.1 lakh to Rs.1.5 lakh. Similarly the investment limit in Public Provident Fund [PPF] has been enhanced from Rs.1.0 lakh to Rs.1.5 lakh. This result into more savings and to that extent their tax liability would go down and by this way, money is sucked up into the savings schemes. Hence the answer is “c”.

51. Providing jobs to poor people and providing vocational training to poor people has nothing to do with the financial inclusion. The FI is bringing people into the banking system and provide the facilities of credit, other financial products such as saving mechanism, insurance etc.

55, 85 and 86. What are Tier I and Tier II Capital?

The Basel-I defined two tiers of the Capital in the banks to provide a point of view to the regulators. The Tier-I Capital is the core capital while the Tier-II capital can be said to be subordinate capitals. The following info shows the 2 tiers of the Capital Fund under the Basel II.

Tier-I capital:

Paid up capital

Statutory Reserves

Other disclosed free reserves

Capital reserves which represent surplus arising out of sale proceeds of the assets

Investment Fluctuation reserves

Innovative Perpetual Debt Instruments (IPDIs)

Perpetual Noncumulative Preference Shares

Tier II capital

Undisclosed reserves and Cumulative perpetual preference shares

Revaluation reserves

General Provisions and loss reserves

Hybrid debt capital instruments such as bonds.

Long term unsecured loans

Debt Capital Instruments.

Redeemable cumulative Preference shares

Perpetual cumulative preference shares

Other Definitions:

	Term	Meaning or Description
1	Equity	The ownership interest in a company of holders of its common and preferred stock
2	Intangible assets	An item of value whose true worth is hard or almost impossible to determine such as goodwill reputation, patents and so on
3	Paid up capital	The amount of capital, both equity and preference, paid up by the shareholders against the capital subscribed to by them
4	Hybrid	Any security which has the character of more than one type of security, including their derivatives [An instrument with both debt and security features]
5	Cumulative preference shares	A type of preference shares on which dividend accumulates if not paid. All arrears of preference dividend have to be paid out before paying dividend on equity shares
6	Sub-ordinated debt	A loan (or security) that ranks below other loans (or securities) with regard to claims on assets or earnings.
7	Core capital	The main money which comes from its shareholders and   from any profit it has made and kept [retained earnings] is called “Core capital”.

58. Pradhan Mantri Jan Dhan Yojana features into Guinness book of World Records

NDA government’s flagship scheme Pradhan Mantri Jan Dhan Yojana (PMJDY) has entered into Guinness book of World Records. Guinness book of World Records has given certificate stating it as most bank accounts opened in one week. In one week, 18,096,130 bank accounts were opened as part of the financial inclusion campaign from 23rd to 29th August, 2014. It was achieved by the Department of Financial Services (Government of India).

Pradhan Mantri Jan Dhan Yojana (PMJDY)

ü  It was launched by Prime Minister Narendra Modi with the goal of eradicating financial untouchability of the poor by opening at least one bank account for every family in the country in less than six months.

ü  It seeks to financially empower the poor by providing them access to formal banking system.

ü  It also seeks to provide platform for Direct Benefits Transfer (DBT) which will curb leakages in government subsidies and thus saving government exchequer.

ü  Initially, after its launch the scheme had a target of opening 7.5 crore bank accounts by 26 January, 2015, but later it was revised and raised to 10 crore bank accounts.

ü  As on 17th January 2015, PMJDY has achieved feat of opening of 11.50 crore bank accounts under it in the short span of 5 months since it was launched.

65. Angle Investors: An angel Investor or angel (also known as a business angel or informal investor) is an affluent individual who provides capital for a business start-up, usually in exchange for convertible debt or ownership equity. A small but increasing number of angel investors, generally family members and friends organize themselves into angel groups or angel networks to share research and pool their investment capital, as well as to provide advice to their portfolio companies. The focus of angel investors is to support the business rather than reaping a huge profit from the investment. 

66. Arbitrage:

Arbitrage is a process of leveraging the price differential in different markets such as cash and derivatives market to generate returns. The returns are dependent on the volatility of the asset. These funds are hybrid in nature as they have the provision of investing a sizeable portion of the portfolio in debt markets. The simplest example can be making profit by arbitrage, due to price difference in the two stock exchanges. During certain times trade, a stock may be available few rupees less in NSE, the arbitrager buy it and sell immediately in BSE and make a profit.

Description: Arbitrage funds are like mutual funds. This is one of the avenues low risk taking investors. In a situation of high and persistent volatility, arbitrage funds provide investors a safe avenue to park their hard earned money. These funds capitalize on the market inefficiencies and generate profits for the investors. As these funds invest predominantly in equities, their tax treatment is at par with equity funds. [See note on derivative market also, given at the end]

67. Providing tax incentives, Government Spending, taxation [GST legislation] etc. is a part of Fiscal Policy. Dilution of green laws to promote investment and nothing to do with Monetary policy. The monetary policy is related to measure which increase or reduce money supply in the market. Hence the correct choice is option “a”. 

68. The “Open Market Operations” of RBI includes 1. Buying of Govt. securities from the public and Sale of Govt. securities to mop up money from the market. This is done as an exercise under monetary policy by the RBI. The sale of the shares of Public sector undertakings is part of Disinvestment, nothing to do with OMOs/Monetary Policy.

70. Merchant banking:

Merchant banking is a combination of banking and consultancy services. It provides consultancy to its clients for financial, marketing, managerial and legal matters. Consultancy means to provide advice, guidance and service for a fee. It helps a businessman to start a business. It helps to raise finance. It helps to revive sick business units. It also helps companies to register, buy and sell shares at the stock exchange. In short, merchant banking provides a wide range of services for starting until running a business. It acts as a financial engineer for a business.

Functions of Merchant Banks:

The basic function of a merchant banker is marketing corporate and other securities. Now they are required to take up some allied functions also.

A merchant bank now takes up the following functions:

ü  Promotional Activities:

A merchant bank functions as a promoter of industrial enterprises in India He helps the entrepreneur in conceiving an idea, identification of projects, preparing feasibility reports, obtaining Government approvals and incentives, etc. Some of the merchant banks also provide assistance for technical and financial collaborations and joint ventures

ü  Issue Management:

In the past, the function of a merchant banker had been mainly confined to the management of new public issues of corporate securities by the newly formed companies, existing companies (further issues) and the foreign companies in dilution of equity as required under FERA In this capacity the merchant banks usually act as sponsor of issues.

They obtain consent of the Controller of Capital Issues (now, the Securities and Exchange Board of India) and provide a number of other services to ensure success in the marketing of securities. The services provided by them include, the preparation of the prospectus, underwriting arrangements, appointment of registrars, brokers and bankers to the issue, advertising and arranging publicity and compliance of listing requirements of the stock-exchanges, etc.

They act as experts of the type, timing and terms of issues of corporate securities and make them acceptable for the investors on the one hand and also provide flexibility and freedom to the issuing companies.

ü  Credit Syndication:

Merchant banks provide specialized services in preparation of project, loan applications for raising short-term as well as long- term credit from various bank and financial institutions, etc. They also manage Euro-issues and help in raising funds abroad.

ü  Portfolio Management:

Merchant banks offer services not only to the companies issuing the securities but also to the investors. They advise their clients, mostly institutional investors, regarding investment decisions. Merchant bankers even undertake the function of purchase and sale of securities for their clients so as to provide them portfolio management services. Some merchant bankers are operating mutual funds and off shore funds also.

ü  Leasing and Finance:

Many merchant bankers provide leasing and finance facilities to their customers. Some of them even maintain venture capital funds to assist the entrepreneurs. They also help companies in raising finance by way of public deposits.

ü  Servicing of Issues:

Merchant banks have also started to act as paying agents for the service of debt- securities and to act as registrars and transfer agents. Thus, they maintain even the registers of shareholders and debenture holders and arrange to pay dividend or interest due to them

ü  Other Specialized Services:

In addition to the basic activities involving marketing of securities, merchant banks also provide corporate advisory services on issues like mergers and amalgamations, tax matters, recruitment of executives and cost and management audit, etc. Many merchant bankers have also started making of bought out deals of shares and debentures. The activities of the merchant bankers are increasing with the change in the money market.

74. FDI in banking

These include 100% foreign investment in asset reconstruction companies [ARCs], 74 per cent in private banks, 20 per cent in public-sector banks and 49 per cent in power exchanges. The above mentioned composite cap will include FDI, portfolio investments, investments by NRIs and foreign venture capital investors in a bank.

78. The Basel Committee is the primary global standard-setter for the prudential regulation of banks and provides a forum for cooperation on banking supervisory matters. Its mandate is to strengthen the regulation, supervision and practices of banks worldwide with the purpose of enhancing financial stability. The current norms are classified as Basel III which is being implemented in phases starting from 2012 and finally to be implemented from 1^st April, 2019. [Please see explanation to Q.No. 82]

79. Risk Weighted assets [RWA]:

The idea of risk-weighted assets is a move away from having a static requirement for capital. Instead, it is based on the riskiness of a bank's assets. For example, loans that are secured by a letter of credit would be weighted riskier than a mortgage loan that is secured with collateral.

For banks, risk-weighted assets are assets with special risks, especially loans to customers and other financial institutions or governments, weighted according to different levels of possible default. As risk is calculated differently for each type of loan, Basel II set out a procedure of determining the different risk levels. For example, government bonds with a rating over AA – are weighted as zero percent, whereas corporate loans with the same ratings are weighted at twenty percent. These rules also take into account the credit risk, operational risk and market risk of the loans.

Why they are important: Risk-weighted assets are used to calculate a bank’s minimum capital requirements. When each of the risk-weighted assets is evaluated, a bank or regulatory body can determine the bank’s exposure to potential losses. Basel III stipulates that banks must have top quality (Tier 1) capital which is equivalent to at least 4.5 to 7% of their risk-weighted assets or they face possible restrictions on paying bonuses to top management and dividends to shareholders. Because of the current situation of defaults and potential defaults, maintaining trust in financial markets is vital to the continuation of global financial stability.

The degree of risk expressed % weights assigned by the RBI. The following table shows the Risk weights for some important assets assigned by RBI in an increasing order.

	Asset	Weighted risk
1	Cash	0
2	Balances with RBI	0%
3	Central/State Govt. guaranteed advances/Govt. securities	0%
4	SSI advances up to CGF guarantee	0%
5	Loan against FD, LIC policy	0%
6	Government approved Securities	2.5%
7	Balance with Banks other than RBI which maintain the 9% CRAR	20%
8	Secured Loan to the Staff Members	20%
9	Housing Loans <Rs. 30 Lakh	50%
10	Housing Loans >Rs. 30 Lakhs	75%
11	Loans against Gold and Jewellery <Rs. 1 Lakh	50%
12	Retail Lending up to Rs. 5 crore	75%
13	Loans Guaranteed by DGCGC / ECGC	50%
14	Loans to Public Sector Undertakings	100%
15	Foreign Exchange and Gold in Open Position	100%
16	Claims on unrated corporates	100%
17	Commercial Real estate	100%
18	Consumer Credit	125%
19	Credit Cards	125%
20	Exposure to Capital Markets	125%
21	Venture Capital Investment as a part of Capital Market exposure	150%

In the above table we can have a broad idea that the assets which are in the form of Cash, Government Guaranteed securities, loans granted against FDs, LIC policies etc. are safest assets with 0% Risk weighted assigned to them. On the other hand, the venture Capital Investment as a part of Capital Market exposure has the maximum risk weight assigned to them. From these figures, Capital Adequacy Ratio [CAR] is calculated.

82. The Basel III rules, 2010 prescribes that the banks are  required to hold a minimum capital of 10.5% of "risk weighted assets" (RWAs), including a 4.5% of common equity and 6% of Tier I capital, when compared to 8% under Basel II. Further, Basel III introduced two additional "capital buffers"—a "mandatory capital conservation buffer" of 2.5% and a "discretionary counter cyclical buffer" to allow national regulators to require up to an additional 2.5% of capital during periods of high credit growth and leverage ratio of 3%. The same is summed up in the following table.

Comparison of Capital Requirements under Basel II and Basel III:

	Type of Capital Requirements	Under Basel II	Under Basel III
1	Minimum Ratio of Total Capital To RWAs	8%	10.50%
2	Minimum Ratio of Common Equity to RWAs	2%	4.50% to 7.00%
3	Tier I capital to RWAs	4%	6.00%
4	Core Tier I capital to RWAs	2%	5.00%
5	Capital Conservation Buffers to RWAs	None	2.50%
6	Leverage Ratio	None	3.00%
7	Countercyclical Buffer	None	0% to 2.50%

[Note: Items in Sl.Nos. 2, 3 and 4 are sub-category targets which are part and parcel of Sl.No. 1. The minimum capital of 10.50% of RWA is made up of 4.5 plus 6.0. Core capital is one of the items in tier-1 capital]

Leverage Ratio:

A leverage ratio is meant to evaluate a company’s debt levels. The most common leverage ratios are the debt ratio and the debt-to-equity ratio.

A debt ratio is simply a company's total debt divided by its total assets. The formula is:

Debt Ratio = Total Debt / Total Assets

For example, if Company XYZ had $10 million of debt on its balance sheet and $15 million of assets, then Company XYZ's debt ratio is: 0.67 or 67% [$10,000,000 / $15,000,000]

This means that for every dollar of Company XYZ assets, Company XYZ had $0.67 of debt. A ratio above 1.0 indicates that the company has more debt than assets.

The debt-to-equity ratio is a measure of the relationship between the capital contributed by creditors and the capital contributed by owners. It also shows the extent to which shareholders' equity can fulfill a company's obligations to creditors in the event of liquidation.

Here is the formula for the debt-to-equity ratio:

Debt-to-Equity Ratio = Total Debt/Total Equity

For example, if Company XYZ had $10 million of debt on its balance sheet and $10 million of total equity, then Company XYZ's debt-to-equity ratio is: 1.0 times or 100% [$10,000,000/$10,000,000]

[RWA, core capital are already explained elsewhere in the same key]

83. The RBI uses different instruments of monetary policy to control and maintain money supply in the market or Economy. These instruments are called Credit controls which are of two types, Quantitative and Qualitative credit controls.

The Quantitative controls are,

       1. Bank rate,

       2. Cash Reserve Ratio [CRR]

       3. Statutory Liquidity Ration [SLR] and

       4. Open Market Operations [OMOs]

The Qualitative credit controls are,

       1. Marginal requirements    [Margin is down payment requirement]

       2. Credit rationing               [Sector wise Credit limits]

       3. Moral suasion                 [Circulars and persuasion]

       4. Direct action    [such as levying penalties on banks for not following the rules of RBI]                                     

84. There would be convergence of capital providers [or owners] and loan seekers in the

Co-operative banks in India. These banks run on “co-operative lines”. In co-operative banks, a group of people contribute capital and they themselves take loan from the bank. The capital contributed by each member is called “Share capital”. The Scheduled Commercial Banks [SCBs], run on commercial lines. They give loans for earning profit, as against the principle of co-operation in co-operative banks. Thus, there is no such convergence of capital provides and loans seekers in SCBs.

85. Capital Adequacy Ratio [CAR] or "Capital to Risk Weighted Assets Ratio (CRAR) is very important concept the financial world, which is used to protect depositors and promote the stability and efficiency of financial systems. It is a measure of a bank's capital. It is expressed as a percentage of a bank's risk weighted credit exposures to its capital, both Tier 1 and Tier 2.

It is true that Tier 1 capital can absorb losses [suffered by bank] without a bank being required to cease trading. It provides highest degree of safety to the investors/depositors in the bank. On the other hand, if the total tier-1 capital is exhausted in paying up the debts and debt still persists, the company has to be wound up its business. The Tier 2 capital is used to absorb losses in the case of winding up of the banking company and therefore provides a lesser degree of protection to depositors.

87. In India, the operations different entities are regulated by various regulatory authorities, based on their activities. Hence, if any concern deals in more than one activity, there is always possibility that its activities are regulated by more than one regulatory authority. For example, those companies and concerns engaged in banking activities, finance, lease-finance etc. are regulated by RBI; those engage in capital markets such as Depositories, Depository participants, concerns helping the start-ups such as Merchant banks, angel investors, Venture capitalists etc., Mutual Funds, Exchange Traded funds, futures other than commodities, Options, Swaps etc., are regulated by SEBI; The Forward Markets Commission (FMC) is the chief regulator of commodity futures markets in India. The Nidhi companies are regulated by Department of Companies Affairs (DCA) and chit funds by the State Governments. Contrastingly, there is no controller for Microfinance Institutions. The merchant banking companies, which are involved both in banking and activities related to start-up of the business activities/consultancy services, are controlled both by RBI and SEBI in their respective domains.   

	Nature of the companies	Regulator
1	Merchant Banking Companies	Banking operations by RBI and business startup and other activities by SEBI
2	Venture Capital Companies, Stock Broking companies and Mutual Funds; Futures and Options and Swaps in the stock exchanges [other than in Commodity futures, which are regulated by FMC]	SEBI
3	Nidhi companies	Department of Companies Affairs (DCA)
4	Chit Fund Companies	State Governments

The other regulators are Insurance Regulatory Development Agency [IRDA] for insurance companies and National Housing Bank (NHB) for housing finance companies. The Microfinance sector has no regulator in India.

[This area is imp. for CSP due to Sharda scam in West Bengal which was happened with chit fund companies and scan done by Financial Technologies Ltd. Group in spot exchange. You may be aware of purchase of shares of FTL by Kotak Mahindra bank as SEBI declared FTL as unfit to deal with Commodities and banned the company and their directors from operation in commodity markets for 10 years]

88 and 89. NBFCs and the recent RBI guidelines

     What is a NBFC?

A non-banking financial company (NBFC) is a company registered under the Companies Act, 1956 and is engaged in the business of giving Loans and Advances, acquisition of shares/ stock/bonds/debentures/securities issued by government, but does not include any institution whose principal business is that of agriculture activity, industrial activity, Sale, purchase and Construction of immovable property.

The nature of business NBFCs is akin to that of banks, but there are marked differences as stated below.

ü  A NBFC cannot accept demand deposits

[Demand deposits are funds deposited at a depository institution that are payable on demand -- immediately or within a very short period -- like your current or savings accounts or FDs]. But some of the NBFCs, called “Deposit accepting NBFCs”, can accept deposits from public, by issuing money market instruments such as Commercial Paper or Certificate of Deposits/Corporate bonds.  This is to be done with the permission of RBI.

ü  It is not a part of the payment and settlement system and as such cannot issue cheques to its customers; and

ü  Deposit insurance facility of DICGC [Deposit Insurance and Credit Guarantee Corporation and is a subsidiary of RBI]. is not available for NBFC depositors unlike in case of banks.

Types of NBFCs

    1.  Asset Finance Companies [AFCs]

    2.  Loan companies [LCs]

    3. Investment Companies [ICs] and

    4. “Infrastructure Finance Companies” [IFCs]

NBFCs are categorized on the basis of different parameters; a. Types of liability, b. Strategic significance to Economy and c. By the nature of business

a.    In terms of the type of liabilities into Deposit and Non-Deposit accepting NBFCs,

b.    Non deposit taking NBFCs by their size into systemically important and other non-deposit holding companies (NBFC-NDSI and NBFC-ND) and

c.    By the kind of activity they conduct. Within this broad categorization the different types of NBFCs are as follows:

1. Asset Finance Company (AFC):

An AFC is a company which is a financial institution carrying on as its principal business the financing of physical assets supporting productive/economic activity, such as automobiles, tractors, lathe machines, generator sets, earth moving and material handling equipments, moving on own power and general purpose industrial machines. Principal business for this purpose is defined as aggregate of financing real/physical assets supporting economic activity and income arising therefrom is not less than 60% of its total assets and total income respectively.

2. Investment Company (IC):

IC means any company which is a financial institution carrying on as its principal business the acquisition of securities,

3. Loan Company (LC): 

LC means any company which is a financial institution carrying on as its principal business the providing of finance whether by making loans or advances or otherwise for any activity other than its own but does not include an Asset Finance Company.

4. Infrastructure Finance Company (IFC): 

IFC is a non-banking finance company a) which deploys at least 75 per cent of its total assets in infrastructure loans, b) has a minimum Net Owned Funds of Rs.300 crore, c) has a minimum credit rating of ‘A ‘or equivalent  d) and a CRAR of 15%.

5. Systemically Important Core Investment Company (CIC-ND-SI): 

CIC-ND-SI is an NBFC carrying on the business of acquisition of shares and securities which satisfies the following conditions:-
(a) it holds not less than 90% of its Total Assets in the form of investment in equity shares, preference shares, debt or loans in group companies;
(b) its investments in the equity shares (including instruments compulsorily convertible into equity shares within a period not exceeding 10 years from the date of issue) in group companies constitutes not less than 60% of its Total Assets;
(c) it does not trade in its investments in shares, debt or loans in group companies except through block sale for the purpose of dilution or disinvestment;
(d) it does not carry on any other financial activity referred to in Section 45I(c) and 45I(f) of the RBI act, 1934 except investment in bank deposits, money market instruments, government securities, loans to and investments in debt issuances of group companies or guarantees issued on behalf of group companies.
(e) Its asset size is Rs.100 crore or above and
(f) It accepts public funds

6. Infrastructure Debt Fund: Non- Banking Financial Company (IDF-NBFC): IDF-NBFC is a company registered as NBFC to facilitate the flow of long term debt into infrastructure projects. IDF-NBFC raise resources through issue of Rupee or Dollar denominated bonds of minimum 5 year maturity. Only Infrastructure Finance Companies (IFC) can sponsor IDF-NBFCs.
7. Non-Banking Financial Company - Micro Finance Institution (NBFC-MFI): NBFC-MFI is a non-deposit taking NBFC having not less than 85%of its assets in the nature of qualifying assets which satisfy the following criteria:
   a. loan disbursed by an NBFC-MFI to a borrower with a rural household annual income not exceeding Rs. 60,000 or urban and semi-urban household income not exceeding Rs. 1,20,000;
   b. loan amount does not exceed Rs. 35,000 in the first cycle and Rs. 50,000 in subsequent cycles;
   c. total indebtedness of the borrower does not exceed Rs. 50,000;
   d. tenure of the loan not to be less than 24 months for loan amount in excess of Rs. 15,000 with prepayment without penalty;
   e. loan to be extended without collateral;
   f. aggregate amount of loans, given for income generation, is not less than 75 per cent of the total loans given by the MFIs;
   g. loan is repayable on weekly, fortnightly or monthly instalments at the choice of the borrower
8. Non-Banking Financial Company – Factors (NBFC-Factors): NBFC-Factor is a non-deposit taking NBFC engaged in the principal business of factoring. The financial assets in the factoring business should constitute at least 75 percent of its total assets and its income derived from factoring business should not be less than 75 percent of its gross income.

 92, 93, 94, 95, 96, 97 and 98: Derivatives

Derivative is a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.

Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Derivatives are contracts and can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region.

The derivatives can be better understood if you see their differences with the trade in the Cash market or trading in capital market.

	Issue	Cash Market or normal trading	Derivative market or derivative trading
1	Nature of transaction	Actual stock/s are purchased or sold by paying/receiving market determined value of an asset	No asset is purchased. It is a mere contract or betting on a movement of price in a particular asset in a future date
2	Leverage	Low leverage. The full value as  determined by the market has to be paid for buying the asset Eg. 1 SBI share can be purchased @ Rs.350 per share	High leverage. A small amount of margin money/ premium is paid for the contract, disregarding the value of the asset. Hence, trading can be done in higher volumes than in cash market. Eg.Rs.350/- will buy 10 SBI derivatives by paying margin money @ Rs.35 per derivative unit.
3	Profitability	Profitable in bull markets and have to lose in bear markets	Profit both in bull and bear markets, provided the movements in the prices of an asset predicted correctly.
4	Transaction cost	Very high. As a percentage to the value of transaction [About 0.9% to 1%]	Very low [0.1% to 0.2%]
5	Liquidity	Relatively low liquid	High liquid
6	Forms of trade	IPO, FPO, Rights Issue and transactions in stock exchanges	Futures; Options, Call and Put; Swaps
7	Regulator	SEBI	SEBI and FMC

 The concept of Futures, Forward contracts, Options and Swaps are explained as under.

1. Futures:

A futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price/strike price. The price of the underlying asset on the delivery date is called the settlement price.
A futures contract gives the holder the obligation to buy or sell, which differs from an options contract, which gives the holder the right, but not the obligation. In other words, the owner of an options contract may or may not exercise the contract. Whereas in a futures contract, both parties of a "futures contract" must fulfill the contract on the settlement date. 

Illustration:

In a futures contract the seller delivers the shares/commodity to the buyer, or, if it is a cash-settled future, as in the case of stock futures in India, cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit or close your position in an existing futures contract prior to the settlement date, the holder of a futures position has to offset his position by either selling a long position or buying back a short position, effectively closing out the futures position and its contract obligations.

Let us a commodity example.  Both A and B are the contractees of a Future Contract. As per the contract, A predicted the price of 10 grarms of Gold will go up and the Mr. B predicted that gold rate would go down. Accordingly A greed to buy 10 grams of gold at Rs.30,000/- on   10^th May, 2015 and B would sell for the same price on the same date. Mr.A and B paid a premium or margin money of around Rs.3000/-.

ü  For instance, if the value of the 10 grams of gold is Rs.32,000/- on the settlement date of 10^th May, 2015, the prediction of Mr.B went wrong and prediction of Mr. A proven correct. In this case, Mr. B has to supply 10 grams of gold to Mr. A at Rs.30,000/-. In this way, A makes a quantitative profit of Rs.2000/- and B would lose that extent, besides losing his premium paid.

ü  For instance, if the value of the 10 grams of gold is Rs.28,000/- on the settlement date of 10^th May, 2015, the prediction of Mr.B went correct and prediction of Mr. A proven wrong. In this case, Mr. A has to buy 10 grams of gold from Mr.B  at Rs.30,000/-, though the gold is available at lesser rate in the market. In this way, B makes a quantitative profit of Rs.2000/- and A would lose that extent, besides losing his premium paid

How does Futures Trading Work?

There are two basic categories of futures participants: hedgers and speculators.

In general, hedgers use futures for protection against adverse future price movements in the underlying cash commodity. The rationale of hedging is based upon the demonstrated tendency of cash prices and futures values to move in tandem.

Hedgers are very often businesses, or individuals, who at one point or another deal in the underlying cash commodity. Take, for instance, a major food processor who cans corn. If corn prices go up, he must pay the farmer or corn dealer more. For protection against higher corn prices, the processor can "hedge" his risk exposure by buying enough corn futures contracts to cover the amount of corn he expects to buy. Since cash and futures prices do tend to move in tandem, the futures position will profit if corn prices raise enough to offset cash corn losses.

Speculators are the second major group of futures players. These participants include independent traders and investors. For speculators, futures have important advantages over other investments:

If the trader's judgment is good. he can make more money in the futures market faster because futures prices tend, on average, to change more quickly than real estate or stock prices, for example. On the other hand, bad trading judgment in futures markets can cause greater losses than might be the case with other investments.

Futures are highly leveraged investments. The trader puts up a small fraction of the value of the underlying contract (usually 10%-25% and sometimes less) as margin, yet he can ride on the full value of the contract as it moves up and down. The money he puts up is not a down payment on the underlying contract, but a performance bond. The actual value of the contract is only exchanged on those rare occasions when delivery takes place. (Compare this to the stock investor who generally has to put up 100% of the value of his stocks.) Moreover the futures investor is not charged interest on the difference between the margin and the full contract value.

Settling Futures Contracts in India

Futures contracts are usually not settled with physical delivery. The purchase or sale of an offsetting position can be used to settle an existing position, allowing the speculator or hedger to realize profits or losses from the original contract. At this point the margin balance is returned to the holder along with any additional gains, or the margin balance plus profit as a credit toward the holder's loss. Cash settlement is used for contracts like stock or index futures that obviously cannot result in delivery.

The purpose of the delivery option is to insure that the futures price and the cash price of good converge at the expiration date. If this were not true, the good would be available at two different prices at the same time. Traders could then make a risk-free profit by purchasing stocks in the market with the lower price and selling in the futures market with the higher price. That strategy is called arbitrage. It allows some traders to profit from very small differences in price at the time of expiration.

2. Options: 

What is a 'Call' option?

Call option gives the buyer the right but not the obligation to buy a given quantity of the underlying asset at a given price on or before a given future date.
For e.g.: Buying 1 call option of ONGC 1250 30Dec2010 comprising 250 equity shares for Rs. 80 per call will give the buyer the right to buy 250 ONGC shares on or before 30th December 2010 at Rs. 1,250 per share, irrespective of the share price (in cash market). Since it is only a right and no obligation to buy, the buyer can let this right lapse, which will be the case when ONGC share price is less than Rs. 1,250 in cash market. In the above case, loss is limited to Rs. 80 while the gains are unlimited to the buyer.

Rs. 80 paid is termed as option premium or the cost of purchasing 1 call option containing the pre-determined quantity of the underlying.

Selling a call option gives the seller the obligation to sell a given quantity of the underlying asset at a given price on or before a given future date, when the right is exercised by the buyer. For a seller of call option, profit is limited to the premium earned while loss it unlimited, as the buyer can exercise his call option anytime till the expiry of contract.

What is a 'Put' option?

Put option gives the buyer the right but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given future date.

For e.g.: Buying 1 put option of ONGC 1250 30Dec2010 comprising 250 equity shares for Rs. 15 per put, will give the buyer the right to sell 250 ONGC shares on or before 30th December 2010 at Rs. 1,250 per share, irrespective of the share price (in cash market). Since it is only a right and no obligation to sell, the buyer can let this right lapse, which will be the case when ONGC share price is more than Rs. 1,250 in cash market. In the above case, loss is limited to Rs. 15 while the gains are unlimited to the buyer.

Rs. 15 paid is termed as option premium or the cost of purchasing 1 put option containing the pre-determined quantity of the underlying i.e. 250 ONGC equity shares.

Selling a put option gives the seller the obligation to buy a given quantity of the underlying asset at a given price on or before a given future date, when the right is exercised by the buyer. For a seller of put option, profit is limited to the premium earned while loss it unlimited, as the buyer can exercise his put option anytime till the expiry of contract.

3. Interest Rate Swaps:

Interest Rate Swap is basically a contractual arrangement between two parties which are called “Counterparties”. Commonly the counterparties are a Financial Institution and an issuer. These counterparties agree to exchange the payments which are actually based upon a Principal amount. This Principal amount is NOT exchanged between the counterparties but the payments are based upon this principal are exchanged. .

Interest Rate Swaps don’t generate the new sources of funding themselves. Rather, they convert one Interest Rate Basis to another Interest Rate Basis. For example floating to fixed interest rate or Fixed Interest rate to Floating.

The Floating Interest Rate is benchmarked to some interest rates such as MIBOR in India.

SWAP is not a lending facility. It’s an interest rate management tool which can be used in conjunction with any viable rate lending facility.

Interest Rates Swaps were originally created to allow the multinational companies to evade the exchange controls. However, now, they are used to hedge against / speculate in the changes in the interest rates.

In an interest rate swap, each counter party agrees to pay either a fixed or floating rate denominated in a particular currency to the other counter party. The fixed or floating rate is multiplied by a notional principal amount (say Rupees 2 Crore).

How Interest Rate Swaps Work?

In SWAP the parties agree to pay the “the difference between a fixed interest Rate and a series of variable interest rates over an agreed period of time”.Fixed rate is a fixed rate such as 5%, 6% as the case may be. Variable rate is a rate that is linked to a variable rate such as MIBOR or LIBOR (London Interbank Offer Rate )

The agreement can be as follows:

ü  Fixed for Floating Swap Transaction

ü  Floating for Fixed Swap Transaction

We assume that a Party A is a borrower with a 3 year ` 2 crore Variable Rate MIBOR based facility, which rolls over on a quarterly basis at the prevailing 3 month MIBOR Rate. This party, in the current economic environment feels that the Interest rates may rise in near future and feels that the interest rate may go up than the current 5% rates. The party would seek an opportunity to lock in the borrowing cost at 5% rate. But since the party has a Variable Rate based facility , he/ she cannot change it and is exposed to the assumed interest rate hikes in the future.

Here, party A has an option. He/ she enters into an agreement with Party B for a period of 3 years for ` 2 Crore and pay the interest rate of 5% on quarterly settlement dates.

Now, we assume that the MIBOR linked interest rate hikes as party A assumed and itbecomes 6%. But since party A has a contract with party B that it will pay only 5% interest rate as per the swap agreement. So, now the party B will have to compensate party A by 1% of ` 2 crore. This amount will be used by party A to offset the interest rates hiked by 1%. So party A is saved from this hike in interest rate.

Now if the MIBOR linked interest rate decreases and becomes 4%. Party A will pay 4% for his ` 2 Crore loan which is a Variable Rate MIBOR based facility. Here it saves 1% , but since with party B it has an agreement to pay 5%, party A will compensate the party B for this balance.

The interest rate swap is a hedging in which if there is NO variation in the interest rates, it is a zero sum game but if the rates vary, one wins at the cost of another.

Additional information:

1. Advantages of Futures Trading in India:

There are many inherent advantages of trading futures over other investment alternatives such as savings accounts, stocks, bonds, options, real estate and collectibles.

1. High Leverage. The primary attraction, of course, is the potential for large profits in a short period of time. The reason that futures trading can be so profitable is the high leverage. To ‘own’ a futures contract an investor only has to put up a small fraction of the value of the contract (usually around 10-20%) as ‘margin’. In other words, the investor can trade a much larger amount of the security than if he bought it outright, so if he has predicted the market movement correctly, his profits will be multiplied (ten-fold on a 10% deposit). This is an excellent return compared to buying and taking physical delivery in stocks.

2. Profit in both bull & bear markets. In futures trading, it is as easy to sell (also referred to as going short) as it is to buy (also referred to as going long). By choosing correctly, you can make money whether prices go up or down.

3. Lower transaction cost. Another advantage of futures trading is much lower relative commissions. Your commission for trading a futures contract is one tenth of a percent (0.10-0.20%). Commissions on individual stocks are typically as much as one percent for both buying and selling.

4. High liquidity. Most futures markets are very liquid, i.e. there are huge amounts of contracts traded every day. This ensures that market orders can be placed very quickly as there are always buyers and sellers for most contracts

Trading in futures is regulated by the Securities & Exchange Board of India (SEBI). SEBI exists to guard against traders controlling the market in an illegal or unethical manner, and to prevent fraud in the futures market.

2. What is the difference between forward and futures contracts?

Fundamentally, forward and futures contracts have the same function: both types of contracts allow people to buy or sell a specific type of asset at a specific time at a given price.

However, it is in the specific details that these contracts differ. First of all, futures contracts are exchange-traded and, therefore, are standardized contracts. Forward contracts, on the other hand, are private agreements between two parties and are not as rigid in their stated terms and conditions. Because forward contracts are private agreements, there is always a chance that a party may default on its side of the agreement. Futures contracts have clearing houses that guarantee the transactions, which drastically lowers the probability of default to almost never.

Secondly, the specific details concerning settlement and delivery are quite distinct. For forward contracts, settlement of the contract occurs at the end of the contract. Futures contracts are market-to-market daily, which means that daily changes are settled day by day until the end of the contract. Furthermore, settlement for futures contracts can occur over a range of dates. Forward contracts, on the other hand, only possess one settlement date.

Lastly, because futures contracts are quite frequently employed by speculators, who bet on the direction in which an asset's price will move, they are usually closed out prior to maturity and delivery usually never happens. On the other hand, forward contracts are mostly used by hedgers that want to eliminate the volatility of an asset's price, and delivery of the asset or  cash settlement will usually take place.

3. An example of Hedging and Speculation:

Derivatives are generally used as an instrument to hedge risk, but can also be used for speculative purposes. A cotton trader, Mr. Venkat has a trade agreement with a manufacturer of cotton jeans, M/s. Jeans Makers pvt. Ltd.,  to supply 1000 bales [Each bale is 170 kgs] of cotton to during the year 2014-15  @ 21,000/-. Mr. Venkat has to supply at the same price whether price of cotton in the market goes up to Rs.25,000/- per bale or goes down to Rs.18,000/-. Hence there is always a possibility of making losses [in the event of rate goes up] to venkat in the physical or cash market. To avoid this situation of making losses, Mr.Venkat purchases Futures/options of cotton in derivative market with a contract to buy cotton on specific dates of year  2014-15 @ 20,000/- per bale by paying a very small premium, normally would be around Rs.50/- per bale of cotton. For instance, in the year 2014-15, the rate in the physical market the rate never went above Rs.20,000/-, he would lose his premium of Rs.20 paid in the derivative market. But, without losing his profit, he could supply the cotton to the Jeans Company and thereby ensured stability in the supply cost of the material and thereby his profit.  Alternatively, the rate of cotton per base goes up to Rs.25,000/-, he will purchase the cotton @ Rs.20,000/- from the futures contractee and supply it to M/s. Jeans @ Rs.20,000/- and so that avoid making loses. This kind of investment in the futures or options, to fight the fluctuation of prices in the cash or physical market is called “Hedging” and Venkat is called as “Hedger’.

If we take the example as above and Venkat does not have any supply commitments and he simply purchased to futures or options, just to make profit out of the volatility in the prices of goods, that activity is called “Speculation” and the Mr. Venkat [or other persons] as “Speculators”. In this case, correct prediction of price would fetch huge profits and wrong prediction may end up in making huge losses by the speculators.

The hedging or speculation can be done on different commodities such as metals [gold, silver, copper etc.] Minerals [ coal, manganese etc.], Cereals [paddy, wheat, Ragi etc.], Pulses, Oil seeds etc. stocks of various companies, weather data etc. The speculation is like pure betting on the movement of a price of a metal, stock, commodity etc. 

The hedgers and speculators can use Options, call option and put option also for the purpose of hedging as well as speculation as the case may be.   

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