Financial Institution Notes

8/3/2019 Financial Institution Notes

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CORPORATE FINANCE:Corporate finance is that part of finance that deals with the financial

problems of corporate enterprises. These problems include the financialaspects of the promotion of new enterprises and their administration duringearly development, the accounting problems connected with the distinctionbetween capital and income, the administrative questions created bygrowth and expansion; and finally, the financial adjustments required for the

bolstering up or rehabilitation of a corporation which has come into financialdifficulties.

SCOPE OF CORPORATE FINANCE:

It studies the financial operation carried on by a corporation.

It analyses the financial implications involved in the promotion ofcorporate enterprises.

It assists in scanning the financial plans of new and establishedbusiness units.

It examines the nature, extent and form of the capital required bycorporations.

It scrutinizes the practices and policies of administering corporateincome.

It looks into the propriety of dividend, depreciation and reserve policyadopted by various business companies.

It studies the nature and importance of financial assistance renderedto business enterprises by the different financial institutions.

It examines the roles of the state in regulating and controlling thefinancial practices and policies of corporations.

FINANCIAL INSTITUTION:

Financial institution is an establishment that focuses on dealing withfinancial transaction such as investment loans and deposits.

A financial institution is one that facilitates allocation of financialresources from its source to potential users.

Agencies that purvey credit in the financial system of a country arecollectively known as financial institution.

CHARACTERISTICS OF FI:

Savings and investment agencies.

Professional skills

Safety, liquidity and profitability

Financing

Role in money market

National importance.CLASSIFGICATIONS OF FINANCIAL INSTITUTION:


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MONEY MARKET INSTITUTIONS:Money market institutions is concerned with the supply of and

demand for investible fundsfor a short term period.

CAPITAL MARKET INSTITUTIONS:The market where medium term and long term funds are

borrowed and lent is known as Capital Market Institutions.

INDIAN FINANCIAL INSTITUTIONS:(1) INDUSTRIAL FINANCE CORPORATION OF INDIA (IFCI):

GENESIS:

First financial institution set up in india in 1948 for financingdevelopment projects.

AIM to provide medium and long term finance to industrialconcerns.

OBJECTIVES:

To make available medium and long term credit.

To provide financial accommodation where the normal bankingaccommodation is inappropriate or recourse to capital issuechannels is impracticable.

MANAGEMENT:

Board of Directors one- full time chairman appointed by centralgovt


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The board consists of 12 members- 2 nominated by central govt,4 by IDBI, 2 by scheduled commercial banks, 2 by cooperativebanks & remaining 2 by shareholder institutions.

FUNCTIONS:

Granting loans and advances

Subscribing directly to the shares

Subscribing to the issue of debentures

Guaranteeing loans

Underwriting of shares

Acting as an agent

FINANCIAL RESOURCES:

The corporation had an original authorized capital of Rs. 100 cr,later increased to Rs. 259 Cr.

They are authorized to issue & sell bonds and debentures forraising its working capital. The limit has been fixed & not toexceed 10 times the amount of IFCIs paid up share capital andretained earnings.

The corporation is also authorized to borrow from central govt,RBI, IDBI and to accept deposits from the public, State govt andlocal authorities for a period of less than 5 yrs. The relevant limithas been fixed not to exceed Rs. 10 Cr.

It is also empowered to raise money from foreign FinancialInstitution in the respective foreign currency.

CRITICISM

Failure to develop industries in backward region. Neglecting the interest of small and medium size industries

within the framework of the % yr plan

Failure to maintain supervision over the utilization of sanctionedassistance

Not providing equity capital

More attention to well established concerns which otherwisecould raise loans in the market.

Incompatibility of efficiency of the corporation due to highestablishment and other expenses.

(2) INDUSTRIAL DEVELOPMENT BANK OF INDIA (IDBI):

GENESIS:

Established in 1964 as apex institution of industrial finance inindia.

It functioned as a segment of RBI till 1976 feb 16 and it wasdelinked from the RBI and made autonomous corporation fullyowned by the central govt.

GOAL Reorganising and integrating the structure of existingfinancial institution in the country so as to gear them upto caterto the demands of rapid industrialization


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It plays an important role in the process of industrializationthrough planning, promoting and developing new industries to fillup the gaps in the industrial structure of the country

MANAGEMENT:

Board of Directors 22 members (Central Govt)

BOD given representation to RBI, other financial institutions.

It consists different committees in order to assists in itsoperation.

OBJECTIVES:

To coordinate, supplement and integrate the activities of otherexisting Financial Institutions including commercial banks.

To provide term-finance to industry To protect direct financial assistance to industrial concerns.

FUNCTIONS:FINANCIAL FUNCTIONS PROMOTIONAL FUNCTIONS

Provide financial assistance toindustrial concerns directly in

the form of loans Provide indirect financial

assistance by way of discounting and rediscountingof commercial papers.

underwriting or purchase orshares and debentures

guarantee deferred paymentsand loans raised from the otherfinancial institution byextending refinancing facilitites

guarantee underwritingobligations of institutions

marketing and investmentresearch

techno-economic studies andsurveys

technical and administrativeassistance to industrialconcerns for promotionmanagement or expansion


Authorized capital is Rs 500 cr.

Borrowings from the central govt and RBI

Sale of its bond and debentures

Accept public deposits for not less than 12 months

Borrowings on long term basis from national indian credit fundsestablished by RBI

Resources by way of receipts of gifts grants donations .etc. fromgovt and non govt sources

Making foreign currency loans with govt approval

MODE OF ASSISTANCE:

Financial assistance

Soft loan scheme

Refinance assistance


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Assistance to small sector

Technical development fund

Equipment finance scheme

Change agent

Regional development

Technology adaptation, industry studies and setting up ofscience and technology parks.

(3) INDUSTRIAL CREDIT AND INVESTMENT CORPORATION OFINDIA (ICICI):

GENESIS:

established on jan 5, 1995 as public ltd company

OBJECTIVES:

To assist creation, expansion and modernization of industrialenterprises in private sector

To encourage and promote the participaqtion of private capitalboth internal and external in such enterprises

To encourage and promote private ownership of industrial

investment and the expansion of investment markets MANAGEMENT:

BOD both indian and foreign

BOD is assisted by a number of committees in day to dayoperations of the corporation

FUNCTIONS:

Granting medium and long term loans in rupees and foreigncurrencies

Subscribes new issues of shares and debentures

Sponsor and underwrites new issue of shares and debentures

Guaranteeing loans raised by industrial concerns from otherprivate investment sources

Guarantee deferred payment for purchase of capital goods withinindia and payment

Making funds available for reinvestment by revolving investmentas rapidly as prudent

Securing and furnishing managerial, technical andadfministrative services to Indian industries


Authorized capital- Rs100 Cr

Paid up capital indian and foreign private institution LIC,scheduled commercial bank, joint stock companies andindividuals.

Augmentation of resources issue of debentures and borrowingsfrom the government of india, world bank, UK govt and agencyfor International Development

ACHEIVEMENTS:

Important institution


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Investment center

Housing finance

Sponser IFMR

Capital market

CRITICISM:Paying attention to projects in the backward areas sanctions obtainedby complex procedures.

(4) EXPORT IMPORT BANK OF INDIA (EXIM) :

GENESIS:

Wholly owned by govt of india on jan 1 1982as a statuatorycorporation

Commencement of operation PURPOSE to promote foreign trade in india

FUNCTIONS: Providing finance to export oriented industries by way of pre-

shipment finance and guarantees as well as rediscountingfacilities.

Conducting export feasibility studies Providing international merchant banking services

Assisting overseas Indian joint venture and turn-key constructionprojects

Assisting exporters of capital goods, software and consultancyservices.

Conducting forfeiting operations in order to enable Indianexporters to have the advantage of access to quick financialassistance

FINANCIAL RESOURCES:Authorized share capital 200 crs

WORKING: Exporting market fund 1986 june

Fund created with World Bank loan of 10 million U.S.dollars

The program covers activities like desk research, overseastravel, product adaptation and inspection services, training.etc.

It operates 14 lending schemes at present to help Indianexporters

Non funded assistance is provided mainly for constructionof project which accounted for about 88% of sanction and77% issues.

Agency line of credit -

Through an agency credit line of US $15 million withIFC[International Finance Corporation] ,EXIM bank providesfinancial assistance by way of foreign currency term loans


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to private sector and small and medium enterprises in thecountry

Assistance is provided for investment in plant andmachinery and product and process know how to createand enhance export capabilities

EXIM bank provides rupee term loans on matching basis toassisted enterprises

Eligible for financial assistance are new projects, expansionor modernization of projects and equipment imports

First agency line of credit from IFC to financial institution(5) SMALL SCALE INDUSTRIES DEVELOPMENT BANK OF INDIA

(SIDBI):

GENESIS:

It was set up in Oct 1989 as a wholly owned subsidiary of IDBI. Its authorized capital is Rs 250 cr with an enabling provision to

increase it to Rs 1000 cr

It is the central or apex institution which oversees, coordinates

and further strenghthens various arrangements for providingfinancial and non-financial assistance to small scale,tiny andcottage industries

OBJECTIVES: To initiate steps for technological upgradation and modernization

of existing units

To expand channels for marketing of SSI sector products in Indiaand abroad

To promote employment oriented industries in semi urban areasand to check migration of population to big cities

FINANCIAL ASSISTANCE:

Channeled thro the existing credit delivery system comprising ofNSIC, SFCs, SIDCs SSIDC, commercial banks, cooperative banksand RRBs.

Total no. of institution eligible for assistance from SIDBI is 869

It discounts and rediscounts bills arising from the sale ofmachinery to small units; extends seed capital, soft loan V thronational equity fund and thro seed capital schemes of specializedlending institutions refinances loans and provides services likefactoring, leasing and so on.

DIVIDENDS:They are defined as the Taxable payment declared by a companys

BOD and given to its shareholders out of the companys current or retainedearnings, usually quarterly.DIVIDEND POLICY:

it is that policy that a company uses to decide how much it will payoutto its shareholders.FACTORS DETERMINING DIVIDEND POLICY:

Types of business


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Stability of earnings

Age of corporation

Liquidity of funds

Extent of share distribution

Needs for additional capital

Trade/business cycles

Govt policies Taxation policy

Legal requirements

Post dividend rates

Ability to borrow

Policy of control

Repayment of loan

Time for payment of dividendTHEORIES OF DIVIDEND POLICY:

RELEVANCE THEORY IRRELEVANCE THEORYDefinition Theory hold that the dividend of a

firm has a direct effect on theposition of the firm in the stockexchange

Theory tht hold tht the

dividend policy has noeffect on the share pricesof the firm

Modelsunder thetheory

Walters model Gordons model Modigliani-Miller approach

Walters model Gordons model Modigliani-Miller

Assumptions

Retainedearningsrepresent onlythe source offinancing of thefirm

The firm is anequity firm. Noexternal financingis used andinvestmentprogrammes arefinancedexclusively byretained earnings

Capital markets areperfect. Investors are wellinformed about the risk andreturn of all types ofsecurities.they are free tobuy and sell securities

The return onthe firmsinvestmentremains

constant

The internal rateof return andappropriatediscount rate (k)

for the firm areconstant.

There are no transactioncost. They can borrow withno restrictions on the sameterms as firms do.

Cost of capitalfor the firmremainsconstant.

The firm hasperpetual life andits stream ofearnings areperpetual

No corporate and personaltaxes ,the tax rates aresame for dividend andcapital gains

The firm has No corporate tax The firm has fixed


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infinite life investment policy underwhich at each yr end itinvests a specific amountas capital expenditure

All the earningsare distributedor re invested in

the firm

The retentionratio oncedecided upon is

constant. Thusthe growth rate isalso constant

Investors are able topredict the future dividendsand market prices and only

one discount rate for theentire period.

EPS anddividendremainsconstant indetermining agiven value

Cost of capital>growth rate

All investments are fundedeither by equityor byretained earnings

Formula

Where ,p marketprice /shared dividend/sharer rate of returnon investmentby firmk cost of

capitale earning /share

Where,p marketprice /shared dividend/sharer rate of returnon investment byfirm

k cost of capitale earning /shareb retention ratiog growthrate(br)

Where, = present +market

value ofprice of

dividendsthe share

atthe end of speriod

Where ,

= market price / share atthe end of period

= current market price

= cost of equity capital

= dividend / share at theend of the periodDetermination of no ofnew sharesInvestment proposed- xxx(-)Retained earnings


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net income xxx(-) distributed

Dividends - xxx - xxxAmount to be raised byIssue of new shares (a) _ xxx

No of new shares =a_______

Issueprice /share

Inference /implications

Optimalpayment ratiofor a growthfirm is nil

Payout ratio

for a normalfirm isirrelevant

Optimalpayout ratiofor a decliningfirm is 100%

Higher theretention ratio,higher is thevalue of firmand viceversa.

Optimal payoutratio for agrowth firm isnil.

Payout ratio for

a normal firmis irrelevant

The optimalpayout ratio fora declining firmis 100%

Higher the retention ratiohigher is the capitalappreciation enjoyed bythe share holders. Thecapital appreciation is

equal to the amount ofearnings retained.

If the firm distributedearnings by way ofdividends the shareholders enjoy dividends=the amount of capitalappreciation if the firmhad retained the amountof dividends.

Criticism No externalfinancing.

Constant rateof return

Constantopportunitycost

Assumption of100% equityfunding defeatthe objective ofmaximization ofwealth byleveragingagainst a lower

cost of debt. Constant ROR &

currentopportunity costare not in tunewith realities.

Assumption of perfectcapital market istheoretical.

Following propositions ondividend areimpracticable:

1. Investors can switchbetween capital

gains & dividend.2.Dividend are

irrelevant3. Dividends do not

determine the firmvalue

The situation of zero taxesis not possible.


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The assumptions of nostock floatation/time lag &no taxation costs areimpossible.

UNIT2Risk and Return Analysis

Return expresses the amount which an investor actually earned on aninvestment during a certain period. Return includes the interest, dividendand capital gains; while risk represents the uncertainty associated with aparticular task. In financial terms, risk is the chance or probability that acertain investment may or may not deliver the actual/expected returns.

The risk and return trade off says that the potential return rises with anincrease in risk. It is important for an investor to decide on a balancebetween the desire for the lowest possible risk and highest possible return.Risk Analysis

Risk in investment exists because of the inability to make perfect or accurateforecasts. Risk in investment is defined as the variability that is likely tooccur in future cash flows from an investment. The greater variability ofthese cash flows indicates greater risk.

Variance or standard deviation measures the deviation about expected cashflows of each of the possible cash flows and is known as the absolutemeasure of risk; while co-efficient of variation is a relative measure of risk.

For carrying out risk analysis, following methods are used-

Payback [How long will it take to recover the investment] Certainty equivalent [The amount that will certainly come to you] Risk adjusted discount rate [Present value i.e. PV of future inflows with

discount rate]

However in practice, sensitivity analysis and conservative forecasttechniques being simpler and easier to handle, are used for risk analysis.Sensitivity analysis [a variation of break even analysis] allows estimating theimpact of change in the behavior of critical variables on the investment cashflows. Conservative forecasts include using short payback or higher discountrates for discounting cash flows.Investment Risks

Investment risk is related to the probability of earning a low or negativeactual return as compared to the return that is estimated. There are 2 typesof investments risks:

1. Stand-alone risk


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This risk is associated with a single asset, meaning that the risk willcease to exist if that particular asset is not held. The impact of standalone risk can be mitigated by diversifying the portfolio.

Stand-alone risk = Market risk + Firm specific risk

Where,

o Market risk is a portion of the security's stand-alone risk thatcannot be eliminated trough diversification and it is measured bybeta

o Firm risk is a portion of a security's stand-alone risk that can beeliminated through proper diversification

2. Portfolio risk

This is the risk involved in a certain combination of assets in a portfoliowhich fails to deliver the overall objective of the portfolio. Risk can beminimized but cannot be eliminated, whether the portfolio is balanced

or not. A balanced portfolio reduces risk while a non-balanced portfolioincreases risk.

Sources of risks

o Inflationo Business cycleo Interest rateso Managemento Business risko Financial risk

Return Analysis

An investment is the current commitment of funds done in the expectation ofearning greater amount in future. Returns are subject to uncertainty orvariance Longer the period of investment, greater will be the returns sought.An investor will also like to ensure that the returns are greater than the rateof inflation.

An investor will look forward to getting compensated by way of an expectedreturn based on 3 factors -

Risk involved Duration of investment [Time value of money] Expected price levels [Inflation]

The basic rate or time value of money is the real risk free rate [RRFR] whichis free of any risk premium and inflation. This rate generally remains stable;but in the long run there could be gradual changes in the RRFR depending


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upon factors such as consumption trends, economic growth and openness ofthe economy.

If we include the component of inflation into the RRFR without the riskpremium, such a return will be known as nominal risk free rate [NRFR]

NRFR = ( 1 + RRFR ) * ( 1 + expected rate of inflation ) - 1

Third component is the risk premium that represents all kinds ofuncertainties and is calculated as follows -

Expected return = NRFR + Risk premium

Risk and return trade off

Investors make investment with the objective of earning some tangiblebenefit. This benefit in financial terminology is termed as return and is areward for taking a specified amount of risk.

Risk is defined as the possibility of the actual return being different from theexpected return on an investment over the period of investment. Low riskleads to low returns. For instance, incase of government securities, while therate of return is low, the risk of defaulting is also low. High risks lead tohigher potential returns, but may also lead to higher losses. Long-termreturns on stocks are much higher than the returns on Governmentsecurities, but the risk of losing money is also higher.

Rate of return on an investment cal be calculated using the followingformula-

Return = (Amount received - Amount invested) / Amount invested

He risk and return trade off says that the potential rises with an increase inrisk. An investor must decide a balance between the desire for the lowestpossible risk and highest possible return.


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Types of Risk

Systematic Risk- Systematic risk influences a large number ofassets. A significant political event, for example, could affect several ofthe assets in your portfolio. It is virtually impossible to protect yourselfagainst this type of risk.

Unsystematic Risk- Unsystematic risk is sometimes referred to as"specific risk". This kind of risk affects a very small number of assets.

An example is news that affects a specific stock such as a suddenstrike by employees. Diversification is the only way to protect yourselffrom unsystematic risk.

Credit or Default Risk- Credit risk is the risk that a company orindividual will be unable to pay the contractual interest or principal onits debt obligations. This type of risk is of particular concern toinvestors who hold bonds in their portfolios. Government bonds,especially those issued by the federal government, have the leastamount of default risk and the lowest returns, while corporate bondstend to have the highest amount of default risk but also higher interest

rates. Bonds with a lower chance of default are considered to beinvestment grade, while bonds with higher chances are considered tobejunk bonds.

Country Risk- Country risk refers to the risk that a country won't beable to honor its financial commitments. When a country defaults on itsobligations, this can harm the performance of all other financialinstruments in that country as well as other countries it has relations
http://www.investopedia.com/terms/s/systematicrisk.asphttp://www.investopedia.com/terms/u/unsystematicrisk.asphttp://www.investopedia.com/terms/d/diversification.asphttp://www.investopedia.com/terms/c/creditrisk.asphttp://www.investopedia.com/terms/g/governmentsecurity.asphttp://www.investopedia.com/terms/c/corporatebond.asphttp://www.investopedia.com/terms/i/investmentgrade.asphttp://www.investopedia.com/terms/j/junkbond.asphttp://www.investopedia.com/terms/c/countryrisk.asphttp://www.investopedia.com/terms/d/default2.asphttp://www.investopedia.com/terms/u/unsystematicrisk.asphttp://www.investopedia.com/terms/d/diversification.asphttp://www.investopedia.com/terms/c/creditrisk.asphttp://www.investopedia.com/terms/g/governmentsecurity.asphttp://www.investopedia.com/terms/c/corporatebond.asphttp://www.investopedia.com/terms/i/investmentgrade.asphttp://www.investopedia.com/terms/j/junkbond.asphttp://www.investopedia.com/terms/c/countryrisk.asphttp://www.investopedia.com/terms/d/default2.asphttp://www.investopedia.com/terms/s/systematicrisk.asp


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with. Country risk applies to stocks, bonds, mutual funds, options andfutures that are issued within a particular country.

Foreign-Exchange Risk- When investing in foreign countries youmust consider the fact that currency exchange rates can change theprice of the asset as well. Foreign-exchange risk applies to all financialinstruments that are in a currency other than your domestic currency.

Interest Rate Risk- Interest rate risk is the risk that an investment'svalue will change as a result of a change in interest rates. This riskaffects the value of bonds more directly than stocks.

Political Risk- Political risk represents the financial risk that acountry's government will suddenly change its policies. This is a majorreason why developing countries lack foreign investment.

Market Risk- This is the most familiar of all risks. Also referred to asvolatility, market risk is the 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 abear market - volatility is not so much a cause but an effect of certainmarket forces. Volatility is a measure of risk because it refers to thebehavior, or "temperament", of your investment rather than the reasonfor this behavior.

DiversificationDiversification is a risk-management technique that mixes a wide

variety of investments within a portfolio in order to minimize the impact that

any one security will have on the overall performance of the portfolio.Diversification lowers the risk of your portfolio.

CAPITAL ASSET PRICING MODELIn finance, the capital asset pricing model (CAPM) is used to determine

a theoretically appropriate required rate of return of an asset, if that asset isto 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), oftenrepresented by the quantity beta () in the financial industry, as well as the

expected return of the market and the expected return of a theoretical risk-free asset.The formula
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The CAPM is a model for pricing an individual security or a portfolio. Forindividual securities, we make use of the security market line (SML) and itsrelation to expected return and systematic risk(beta) to show how the marketmust price individual securities in relation to their security risk class. TheSML enables us to calculate the reward-to-risk ratio for any security inrelation to that of the overall market. Therefore, when the expected rate ofreturn for any security is deflated by its beta coefficient, the reward-to-risk

ratio for any individual security in the market is equal to the market reward-to-risk ratio, thus:

The market reward-to-risk ratio is effectively the market risk premium and byrearranging the above equation and solving for E(Ri), we obtain the CAPM.

where:

is the expected return on the capital asset

is the risk-free rate of interest such as interest arising fromgovernment bonds

(the beta) is the sensitivity of the expected excess asset returns to

the expected excess market returns, or also ,

is the expected return of the market

is sometimes known as the market premium(thedifference between the expected market rate of return and the risk-free rate of return).

is also known as the risk premium

Restated, in terms of risk premium, we find that:

The Security Market Line, seen here in a graph, describes a relation between

the beta and the asset's expected rate of return.
http://en.wikipedia.org/wiki/Security_market_linehttp://en.wikipedia.org/wiki/Systematic_riskhttp://en.wikipedia.org/wiki/Beta_(finance)http://en.wikipedia.org/wiki/Sensitivity_and_specificityhttp://en.wikipedia.org/wiki/File:SecMktLine.pnghttp://en.wikipedia.org/wiki/File:SecMktLine.pnghttp://en.wikipedia.org/wiki/Security_market_linehttp://en.wikipedia.org/wiki/Systematic_riskhttp://en.wikipedia.org/wiki/Beta_(finance)http://en.wikipedia.org/wiki/Sensitivity_and_specificity


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which states that the individual risk premium equals the market premiumtimes.

Security market line

The SML essentially graphs the results from the capital asset pricingmodel (CAPM) formula. Thex-axis represents the risk (beta), and they-axis

represents the expected return. The market risk premium is determined fromthe slope of the SML.

The relationship between and required return is plotted on thesecurities market line (SML) which shows expected return as a function of .The intercept is the nominal risk-free rate available for the market, while theslope is the market premium, E(Rm) Rf. The securities market line can beregarded as representing a single-factor model of the asset price, whereBeta is exposure to changes in value of the Market. The equation of the SMLis thus:

It is a useful tool in determining if an asset being considered for a portfoliooffers a reasonable expected return for risk. Individual securities are plottedon the SML graph. If the security's expected return versus risk is plottedabove the SML, it is undervalued since the investor can expect a greaterreturn for the inherent risk. And a security plotted below the SML isovervalued since the investor would be accepting less return for the amountof risk assumed.

Asset pricing

Once the expected/required rate of return, E(Ri), is calculated using CAPM,we can compare this required rate of return to the asset's estimated rate ofreturn over a specific investment horizon to determine whether it would bean appropriate investment. To make this comparison, you need anindependent estimate of the return outlook for the security based on eitherfundamental or technical analysis techniques, including P/E, M/B etc.

Assuming that the CAPM is correct, an asset is correctly priced when itsestimated price is the same as the present value of future cash flows of theasset, discounted at the rate suggested by CAPM. If the observed price ishigher than the CAPM valuation, then the asset is undervalued (andovervalued when the estimated price is below the CAPM valuation) When theasset does not lie on the SML, this could also suggest mis-pricing. Since the

expected return of the asset at time tis , a higherexpected return than what CAPM suggests indicates that Pt is too low (theasset is currently undervalued), assuming that at time t+ 1 the assetreturns to the CAPM suggested price.The asset price P0 using CAPM,
http://en.wikipedia.org/wiki/Security_market_linehttp://en.wikipedia.org/wiki/Security_market_line


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sometimes called the certainty equivalent pricing formula, is a linear relationshipgiven by

where PT is the payoff of the asset or portfolio.

Asset-specific required return

The CAPM returns the asset-appropriate required return or discountratei.e. the rate at which future cash flows produced by the asset shouldbe discounted given that asset's relative riskiness. Betas exceeding onesignify more than average "riskiness"; betas below one indicate lower thanaverage. Thus, a more risky stock will have a higher beta and will bediscounted at a higher rate; less sensitive stocks will have lower betas andbe discounted at a lower rate. Given the accepted concave utility function, theCAPM is consistent with intuitioninvestors (should) require a higher return

for holding a more risky asset.

Since beta reflects asset-specific sensitivity to non-diversifiable, i.e. marketrisk, the market as a whole, by definition, has a beta of one. Stock marketindices are frequently used as local proxies for the marketand in that case(by definition) have a beta of one. An investor in a large, diversified portfolio(such as a mutual fund), therefore, expects performance in line with themarket.

Risk and diversification

The risk of aportfolio comprises systematic risk, also known as undiversifiablerisk, and unsystematic riskwhich is also known as idiosyncratic risk ordiversifiable risk. Systematic risk refers to the risk common to all securitiesi.e. market risk. Unsystematic risk is the risk associated with individual assets.Unsystematic risk can be diversified away to smaller levels by including agreater number of assets in the portfolio (specific risks "average out"). Thesame is not possible for systematic risk within one market. Depending on themarket, a portfolio of approximately 30-40 securities in developed marketssuch as UK or US will render the portfolio sufficiently diversified such thatrisk exposure is limited to systematic risk only. In developing markets alarger number is required, due to the higher asset volatilities.

A rational investor should not take on any diversifiable risk, as only non-diversifiable risks are rewarded within the scope of this model. Therefore, therequired return on an asset, that is, the return that compensates for risktaken, must be linked to its riskiness in a portfolio context - i.e. itscontribution to overall portfolio riskiness - as opposed to its "stand aloneriskiness." In the CAPM context, portfolio risk is represented by higher variance
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i.e. less predictability. In other words the beta of the portfolio is the definingfactor in rewarding the systematic exposure taken by an investor.

The efficient frontier

The (Markowitz) efficient frontier. CAL stands for the capital allocation line.

The CAPM assumes that the risk-return profile of a portfolio can beoptimizedan optimal portfolio displays the lowest possible level of risk forits level of return. Additionally, since each additional asset introduced into aportfolio further diversifies the portfolio, the optimal portfolio must compriseevery asset, (assuming no trading costs) with each asset value-weighted toachieve the above (assuming that any asset is infinitely divisible). All suchoptimal portfolios, i.e., one for each level of return, comprise the efficientfrontier.Because the unsystematic risk is diversifiable, the total risk of aportfolio can be viewed as beta.

The market portfolio

An investor might choose to invest a proportion of his or her wealth in aportfolio of risky assets with the remainder in cashearning interest at therisk free rate (or indeed may borrow money to fund his or her purchase ofrisky assets in which case there is a negative cash weighting). Here, the ratioof risky assets to risk free asset does not determine overall returnthisrelationship is clearly linear. It is thus possible to achieve a particular returnin one of two ways:

1. By investing all of one's wealth in a risky portfolio,

2. or by investing a proportion in a risky portfolio and the remainder incash (either borrowed or invested).

For a given level of return, however, only one of these portfolios will beoptimal (in the sense of lowest risk). Since the risk free asset is, by definition,uncorrelated with any other asset, option 2 will generally have the lowervariance and hence be the more efficient of the two.
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This relationship also holds for portfolios along the efficient frontier: a higherreturn portfolio plus cash is more efficient than a lower return portfolio alonefor that lower level of return. For a given risk free rate, there is only oneoptimal portfolio which can be combined with cash to achieve the lowestlevel of risk for any possible return. This is the market portfolio.

Leverage (finance)

In finance, leverage (sometimes referred to as gearing in the United Kingdom)is a general term for any technique to multiply gains and losses.[1] Commonways to attain leverage are borrowing money, buying fixed assets and usingderivatives.[2] Important examples are:

A public corporation may leverage its equity by borrowing money. Themore it borrows, the less equity capital it needs, so any profits or lossesare shared among a smaller base and are proportionately larger as aresult.[3]

A business entity can leverage its revenue by buying fixed assets. This

will increase the proportion offixed, as opposed to variable, costs,meaning that a change in revenue will result in a larger change inoperating income.[4][5]

Hedge funds often leverage their assets by using derivatives. A fundmight get any gains or losses on $20 million worth of crude oil byposting $1 million of cash as margin

Type of leverage :-

1. Operating leverage:

It is % change in earning before interest and tax divided by %change in sale . If company is charging fixed cost , the operatingleverage tells the EBIT will greater than sale because due to increasingsale of fixed cost per unit will decrease and it will increase EBIT higherthan sale .

FormulaOperating Leverage = % change in EBIT / %

change in Sale

This leverage is very helpful for finance manager because , if operating

leverage is more than or suppose it is two then it means if sale willincrease 100% then earning will increase 200% . At this time , financemanager can get more loan for increasing the earning of shareholders .

2. Financial leverage

It is second type of leverage . Financial leverage is known as trading on
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equity . If any company's finance manager knows that company'sreturn on investment is more than interest on loan or borrowingobligation . At this time , if company needs more money , then financemanager gets its loan and bought the asset from same loan . So, anytechnique in which any asset is purchased with loan and trying toincrease EPS , then this is called financial leverage .

Formula for calculating financial leverage

= % change in Earning per share / % change in earning beforeinterest and tax= % change in EPS / % change in EBIT

This formula explains the relationship between % change in EPS and %change in EBIT and after deep study of this financial leverage , financemanager decides to get appropriate loan for buying assets .

3. Combined leverage

It is the product of operating leverage and financial leverage .

Combined leverage = Operating leverage X financial leverage

= % change in EBIT / % change in sale X % change in EPS / %change in EBIT

High operating leverage and high financial leverage combination ishigh risky for business . Good combination is that in which lower operating leverage with

high financial leverage

Major reasons for Business Failures

1. Starting a business just for the sake of starting it Well if youare really planning a new business launch, just because you want toearn more money or if you are bored of your job and a cranky boss ormay be you think that youll be able to spend some more time withyour family, if you have your own business, then you should definitelygive it a thought again. None of the above reason is going to get yousuccess in business. But yes if a person is passionate about some thing

and wants to take it a step ahead or if you are physically fit and readyfor any kind of challenge, are determined and strong willed and youare creative enough to tackle the competition then of course you canand should start your own business.

2. Lack of Leadership Quality This accounts for the number onereason of the business failures. A person who starts a new businessoften lacks a lot of management qualities which often lead to a bad


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financing, poor purchasing, reselling and even hiring. Which in turnobviously cause a lot of trouble to the business resulting in adisastrous failure. Also, a person who is a bad manager could lead toconflicts with employees, and potential lawsuits. Legal matters such asthe LightGroup lawsuit, Wal-Mart labor issues, and other employmentrelated problems could lead to failed businesses.

3. Less Investment People often start their business without evennoticing the amount of investment needed initially, this often causes abig disaster as either the whole company goes bankrupt or thebusiness itself faces big losses when the outgoing goes way above theincoming. That is why it is very much necessary to assess the amountof money that is needed and if possible have some extra funds in caseyou need them, as you never know when the costing can go out ofyour hand. If you plan on using loans or credit to fund your business,youll also want to keep a close eye on your personal and businesscredit reports to ensure youre eligible for the best terms possible.

4. Locality - Well of course you would never start a business in a placewhere it doesnt belong. A good location gives you a lot of benefits ifselected smartly. Things you should consider before selecting yourbusiness location:

a. Consider the niche of your businessb. Kind of customers according to your business typec. Quality of the locationd. Business Friendly environmente. Well equipped neighborhood

5. Poor Planning- Setting up a business or I should better be saying, a

successful business, one need a foolproof plan of its establishment. Aperson, who puts in a methodical effort and smart planning along withhard work, surely achieves a lot in his business. Things that should beconsidered in planning:

a. Goals and Future Targets or Plans of your businessb. The total Office set up Including the employees and

infrastructurec. Financial Back up and Managementd. Market analysise. Promotional Strategies

f. Ones strength and weaknesses6. Lack of Modernization techniques and methods In this fastpaced world with highly competitive market, a new businessman canjust not afford to have a successful business running on old andoutdated technology. So one must be fully aware and equipped withlatest technology. Like for e.g. these days it has become so muchnecessary to have your own website. A businessman cannot afford notto have a company website. As it gives you a brand name, a website


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works as your global recognition forum, people recognize you globallythrough internet and get to know who you are teaming up with some ofthe biggest clients of the industry.

The major weaknesses of businesses can be classified as

below:

Entrepreneurial:

1. Untrained (non professional) and in experienced entrepreneurs inparticular trade.2. Trading entrepreneurs entering manufacturing sector and now inservices sector3. Greed and Profiteering- Immediate profits and narrow vision.4. Unwillingness to buy technology and pay to skilled loyal workers.Poor HR functions.

5. Over growth or hasty growth without building systems andorganization with committed, trained and motivated work force (bothat worker level and at managerial level). I have seen many businessesfail when entrepreneurs tried to grow in size significantly and abruptlywithout gaining experience and adequate resources or capability,graduating from an SME to large or from a small to medium sizedoperations. Particularly Human resource and Marketing network areareas where they failed miserably.

Structural weaknesses:

1. Too small or too large capacity that is not right for a 3-5 yearsperiod horizon, only.2. Poor marketing network (By far the most difficult to develop especially for SMEs).Most SMEs are puppets in hands of majordistributors in the network.3. Wrong location causing dearth of good employees and/or rawmaterial or logistics support and thus increased cost of product andprocesses and training and development charges.4. Over financing by debt or over capitalization for long term assets, orlack of working capital ( due to several reasons like poor creditmanagement) or both

5. Poor technology that is already obsolete or not likely to becompetitive in next 3-5 years period horizon.6. Poor quality and completely lacking management systems includinglack of delegation.7. Poor internal employee training and development program andfailure to involve employees, particularly in services sector. Failure toinvolve them emotionally and create motivation.8. Lack of innovation culture in organization with customer need in


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focus.9. Lack of up gradation, modernization and introduction of newproducts and services regularly.10. Poor attitude towards consumer/customer and their needs andcomplaints (A major problem with Indian customer care executivesand owners alike)11. Lack of industry and regulatory norms being followed. In India

particularly entrepreneurs tend to overlook norms and regulationsfixed for business derisively and contemptuously. This leads towastage, poor productivity and poor quality.12. Unstable source of raw materials and its quality at Globallycompetitive prices)13. Failure to create Brand/ Brand experience or piggybacking onother brands far too much (More brands are dieing today thancreated).14. Relaxing standards or cutting costs under illusion of having arrived(success) by new businesses. It is only matter of time beforecompetition and consumers catch you on wrong and weak foot.

15. Lack of Documented and well laid out policy and proceduremanuals with quality check points. High rejection rates or poorproducts result that consumers don't value. Remember consumer buystill she has no option. It is not consumer loyalty. Consumer is loyal tono one for a few Cents off ( Kotler, Philip)

External (environmental) factors:

1. Non availability of logistics chain and too high cost of distribution(particularly in traditional channels) Hybrid channels are in thing withweb sites and emails as important channel. ( Ignoring this will result

loss of business to many good firms)2. Too high cost of interaction with government and regulatoryagencies (India- almost 10% -15% of sales turnover)3. Poor industrial and logistic infrastructure and lack of modernfacilities for shipment and handling.4. Global competition tending to make products obsolete and tendingto push prices down( particularly those made in countries like China,Taiwan, Korea, Mexico, and such countries)5. Poor labor productivity in India on account of several complexreasons6. Rising costs of doing business. High economic rents demanded by

all.7. Mergers and Acquisitions making competition and capabilities unfairto the firm.8. Political interventions and political instability9. High interest rates and cost of raising capital10. Poor Industry ROI11. Product of organization moving down the product Life cycle, if oneapplies.


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12. Exchange rate fluctuations or weak domestic currency or widearbitrage gaps in foreign currency markets.13. Educated and aware consumers with internet technology drivinghis/her factual knowledge about product and its availability andalternate channels of supply.14 High taxation in India with poor infrastructure and delayeddeliveries will result in markets flooded by cheaper and well made

goods like from China.15 New models are being thrust on market post WTO opening likeorganized retails, Malls and Multiplexes making traditional shop goingout of business. Volumes and comfort will matter except for dailynecessities purchases from corner shop.

Mergers and acquisitions

Mergers and acquisitions (abbreviated M&A) refers to the aspect ofcorporate strategy, corporate finance and management dealing with the buying,selling, dividing and combining of different companies and similar entities that

can aid, finance, or help an enterprise grow rapidly in its sector or location oforigin or a new field or new location without creating a subsidiary, other childentity or using a joint venture

Acquisition

An acquisition is the purchase of one business or company by anothercompany or other business entity. Consolidation occurs when two companiescombine together to form a new enterprise altogether, and neither of theprevious companies survives independently. Acquisitions are divided into"private" and "public" acquisitions, depending on whether the acquiree or

merging company (also termed a target) is or is not listed on public stock markets.

Acquisition" usually refers to a purchase of a smaller firm by a larger one.Sometimes, however, a smaller firm will acquire management control of alarger and/or longer-established company and retain the name of the latterfor the post-acquisition combined entity. This is known as a reversetakeover. Another type of acquisition is the reverse merger, a form oftransaction that enables a private company to be publicly listed in arelatively short time frame. A reverse merger occurs when a privately heldcompany (often one that has strong prospects and is eager to raisefinancing) buys a publicly listed shell company, usually one with no business

and limited assets.[4]

There are also a variety of structures used in securing control over the assetsof a company, which have different tax and regulatory implications:
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The buyer buys the shares, and therefore control, of the targetcompany being purchased. Ownership control of the company in turnconveys effective control over the assets of the company, but since thecompany is acquired intact as a going concern, this form of transactioncarries with it all of the liabilities accrued by that business over its pastand all of the risks that company faces in its commercial environment.

The buyer buys the assets of the target company. The cash the targetreceives from the sell-off is paid back to its shareholders by dividend orthrough liquidation. This type of transaction leaves the target companyas an empty shell, if the buyer buys out the entire assets. A buyeroften structures the transaction as an asset purchase to "cherry-pick"the assets that it wants and leave out the assets and liabilities that itdoes not. This can be particularly important where foreseeableliabilities may include future, unquantified damage awards such asthose that could arise from litigation over defective products,employee benefits or terminations, or environmental damage. Adisadvantage of this structure is the tax that many jurisdictions,

particularly outside the United States, impose on transfers of theindividual assets, whereas stock transactions can frequently bestructured as like-kind exchanges or other arrangements that are tax-free or tax-neutral, both to the buyer and to the seller's shareholders.

Based on the content analysis of seven interviews authors concluded fivefollowing components for their grounded model of acquisition:

1. Improper documentation and changing implicit knowledge makes it

difficult to share information during acquisition.2. For acquired firm symbolic and cultural independence which is the

base of technology and capabilities are more important thanadministrative independence.

3. Detailed knowledge exchange and integrations are difficult when theacquired firm is large and high performing.

4. Management of executives from acquired firm is critical in terms ofpromotions and pay incentives to utilize their talent and value theirexpertise.

5. Transfer of technologies and capabilities are most difficult task tomanage because of complications of acquisition implementation. The

risk of losing implicit knowledge is always associated with the fast paceacquisition.

Business valuation

The five most common ways to valuate a business are

asset valuation,
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historical earnings valuation, future maintainable earnings valuation, relative valuation (comparable company & comparable transactions), discounted cash flow (DCF) valuation

Motives behind M&A

The dominant rationale used to explain M&A activity is that acquiring firmsseek improved financial performance. The following motives are consideredto improve financial performance:

ECONOMYOFSCALE: This refers to the fact that the combined companycan often reduce its fixed costs by removing duplicate departments oroperations, lowering the costs of the company relative to the samerevenue stream, thus increasing profit margins.

ECONOMYOFSCOPE: This refers to the efficiencies primarily associatedwith demand-side changes, such as increasing or decreasing the scopeof marketing and distribution, of different types of products.

INCREASEDREVENUE ORMARKETSHARE:This assumes that the buyerwill be absorbing a major competitor and thus increase its marketpower (by capturing increased market share) to set prices.

CROSS-SELLING: For example, a bank buying a stock broker could thensell its banking products to the stock broker's customers, while thebroker can sign up the bank's customers for brokerage accounts. Or, amanufacturer can acquire and sell complementary products.

SYNERGY: For example, managerial economies such as the increasedopportunity of managerial specialization. Another example arepurchasing economies due to increased order size and associated bulk-

buying discounts. TAXATION: A profitable company can buy a loss maker to use the

target's loss as their advantage by reducing their tax liability. In theUnited States and many other countries, rules are in place to limit theability of profitable companies to "shop" for loss making companies,limiting the tax motive of an acquiring company.

GEOGRAPHICALOROTHERDIVERSIFICATION: This is designed to smooththe earnings results of a company, which over the long termsmoothens the stock price of a company, giving conservative investorsmore confidence in investing in the company. However, this does notalways deliver value to shareholders (see below).

RESOURCETRANSFER: resources are unevenly distributed across firms(Barney, 1991) and the interaction of target and acquiring firmresources can create value through either overcoming informationasymmetry or by combining scarce resources.[6]

VERTICALINTEGRATION: Vertical integration occurs when an upstreamand downstream firm merge (or one acquires the other). There areseveral reasons for this to occur. One reason is to internalise an
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externality problem. A common example is of such an externality isdouble marginalization. Double marginalization occurs when both theupstream and downstream firms have monopoly power, each firmreduces output from the competitive level to the monopoly level,creating two deadweight losses. By merging the vertically integratedfirm can collect one deadweight loss by setting the downstream firm'soutput to the competitive level. This increases profits and consumer

surplus. A merger that creates a vertically integrated firm can beprofitable.[7]

"ACQUI-HIRE": An "acq-hire" (or acquisition-by-hire) may occurespecially when the target is a small private company or is in thestartup phase. In this case, the acquiring company simply hires thestaff of the target private company, thereby acquiring its talent (if thatis its main asset and appeal). The target private company simplydissolves and little legal issues are involved. Acqui-hires have become avery popular type of transaction in recent years.[citation needed]

ABSORPTIONOFSIMILARBUSINESSESUNDERSINGLEMANAGEMENT:similar portfolio invested by two different mutual funds (Ahsan RazaKhan, 2009) namely united money market fund and united growth andincome fund, caused the management to absorb united money marketfund into united growth and income fund.

However, on average and across the most commonly studied variables,acquiring firms' financial performance does not positively change as afunction of their acquisition activity.Therefore, additional motives for mergerand acquisition that may not add shareholder value include:

DIVERSIFICATION: While this may hedge a company against a downturn

in an individual industry it fails to deliver value, since it is possible forindividual shareholders to achieve the same hedge by diversifying theirportfolios at a much lower cost than those associated with a merger.(In his book One Up on Wall Street, Peter Lynch memorably termed this"diworseification".)

MANAGER'SHUBRIS: manager's overconfidence about expectedsynergies from M&A which results in overpayment for the targetcompany.

EMPIRE-BUILDING: Managers have larger companies to manage andhence more power.

MANAGER'SCOMPENSATION: In the past, certain executivemanagement teams had their payout based on the total amount ofprofit of the company, instead of the profit per share, which would givethe team a perverse incentive to buy companies to increase the totalprofit while decreasing the profit per share (which hurts the owners ofthe company, the shareholders)
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UNIT3

Capital market

A capital market is a market for securities (debt or equity), where businessenterprises (companies) and governments can raise long-term funds. It is definedas a market in which money is provided for periods longer than a year,[1]

[dead link] as the raising of short-term funds takes place on other markets(e.g., the money market). The capital market includes the stock market (equitysecurities) and thebond market (debt). Financial regulators, such as the UK'sFinancial Services Authority (FSA) or the U.S. Securities and Exchange Commission (SEC),oversee the capital markets in their designated jurisdictions to ensure thatinvestors are protected against fraud, among other duties.

Capital markets may be classified as primary markets and secondary markets. Inprimary markets, new stock or bond issues are sold to investors via amechanism known as underwriting. In the secondary markets, existingsecurities are sold and bought among investors or traders, usually on a

securities exchange, over-the-counter, or elsewhere.

What Does Fiscal PolicyMean?Government spending policies that influence macroeconomic

conditions. These policies affect tax rates, interest rates and governmentspending, in an effort to control the economy.

fiscal policy is the use of government expenditure and revenue collection(taxation) to influence the economy.Fiscal policy can be contrasted with theother main type ofmacroeconomic policy, monetary policy, which attemptsto stabilize the economy by controlling interest rates and spending. The two

main instruments of fiscal policy are government expenditure and taxation.Changes in the level and composition of taxation and government spendingcan impact the following variables in the economy:

Aggregate demand and the level of economic activity; The pattern of resource allocation; The distribution of income.

Economic effects of fiscal policy

Governments use fiscal policy to influence the level of aggregate demand in

the economy, in an effort to achieve economic objectives of price stability,full employment, and economic growth. Keynesian economics suggests thatincreasing government spending and decreasing tax rates are the best waysto stimulate aggregate demand. This can be used in times of recession or loweconomic activity as an essential tool for building the framework for strongeconomic growth and working towards full employment. In theory, theresulting deficits would be paid for by an expanded economy during theboom that would follow; this was the reasoning behind theNew Deal.
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Governments can use a budget surplus to do two things: to slow the pace ofstrong economic growth, and to stabilize prices when inflation is too high.Keynesian theory posits that removing spending from the economy willreduce levels of aggregate demand and contract the economy, thusstabilizing prices.

Economists debate the effectiveness of fiscal stimulus. The argument mostly

centers on crowding out, a phenomenon where government borrowing leads tohigher interest rates that offset the stimulative impact of spending. Whenthe government runs a budget deficit, funds will need to come from publicborrowing (the issue of government bonds), overseas borrowing, or monetizingthe debt. When governments fund a deficit with the issuing of governmentbonds, interest rates can increase across the market, because governmentborrowing creates higher demand for credit in the financial markets. Thiscauses a lower aggregate demand for goods and services, contrary to theobjective of a fiscal stimulus. Neoclassical economists generally emphasizecrowding out while Keynesians argue that fiscal policy can still be effectiveespecially in a liquidity trap where, they argue, crowding out is minimal.

Some classical and neoclassical economists argue that crowding out completelynegates any fiscal stimulus; this is known as the Treasury View[citation needed],which Keynesian economics rejects. The Treasury View refers to thetheoretical positions of classical economists in the British Treasury, whoopposed Keynes' call in the 1930s for fiscal stimulus. The same generalargument has been repeated by some neoclassical economists up to thepresent.

In the classical view, the expansionary fiscal policy also decreases netexports, which has a mitigating effect on national output and income. When

government borrowing increases interest rates it attracts foreign capital fromforeign investors. This is because, all other things being equal, the bondsissued from a country executing expansionary fiscal policy now offer a higherrate of return. In other words, companies wanting to finance projects mustcompete with their government for capital so they offer higher rates ofreturn. To purchase bonds originating from a certain country, foreigninvestors must obtain that country's currency. Therefore, when foreigncapital flows into the country undergoing fiscal expansion, demand for thatcountry's currency increases. The increased demand causes that country'scurrency to appreciate. Once the currency appreciates, goods originatingfrom that country now cost more to foreigners than they did before and

foreign goods now cost less than they did before. Consequently, exportsdecrease and imports increase.[2]

Other possible problems with fiscal stimulus include the time lag betweenthe implementation of the policy and detectable effects in the economy, andinflationary effects driven by increased demand. In theory, fiscal stimulusdoes not cause inflation when it uses resources that would have otherwisebeen idle. For instance, if a fiscal stimulus employs a worker who otherwise
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would have been unemployed, there is no inflationary effect; however, if thestimulus employs a worker who otherwise would have had a job, the stimulusis increasing labor demand while labor supply remains fixed, leading to wageinflation and therefore price inflation.

ROLE OF SEBI:

SEBI's functions include:

Regulating the business in stock exchanges and any other securitiesmarkets

Registering and regulating the working of collective investmentschemes, including mutual funds.

Prohibiting fraudulent and unfair trade practices relating to securitiesmarkets.

Promoting investor's education and training of intermediaries ofsecurities markets.

Prohibiting insider trading in securities, with the imposition of

monetary penalties, on erring market intermediaries. Regulating substantial acquisition of shares and takeover of

companies. Calling for information from, carrying out inspection, conducting

inquiries and audits of the stock exchanges and intermediaries and selfregulatory organizations in the securities market.

Keeping this in view, SEBI has issued a new set of comprehensive guidelinesgoverning issue of shares and other financial instruments, and has laid downdetailed norms for stock-brokers and sub-brokers, merchant bankers,portfolio managers and mutual funds.

On the recommendations of the Patel Committee report, SEBI on 27 July1995, permitted carry forward deals. Some of the major features of therevised carry-forward transactions as directed by SEBI are:

Carry forward deals permitted only on stock exchanges which havescreen based trading system.

Transactions carried forward cannot exceed 25% of a broker's totaltransactions on any one day.

90-day limit for carry forward and squaring off allowed only till the 75thday (or the end of the fifth settlement).

Daily margins to rise progressively from 20% in the first settlement to50% in the fifth.

On 26 January1995, the government promulgated an ordinance amendingthe SEBI Act, 1992, and the Securities Contracts (Regulation) Act, 1956.

In accordance with the amendment adjudicating mechanism will be createdwithin SEBI and any appeal against this adjudicating authority will have to be
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made to the Securities Appellate Tribunal, which is to be separatelyconstituted. These appeals will be heard only at the High Courts.

The main features of the amendment to the Securities Contract (Regulation)Act, 1956, are:

The ban on the system of options in trading has been lifted.

The time limit of six months, by which stock exchanges could amendtheir bye-laws, has been reduced to two months.

Additional trading floors on the stock exchanges can be establishedonly with prior permission from SEBI.

Any company seeking listing on stock exchanges would have to complywith the listing agreements of stock exchanges, and the failure tocomply with these, or their violation, is punishable.

GOVERNMENT REGULATION AFFECTING CAPITAL MARKET:

How does the government influence the securities market?

Governments generally say they don't like to take an active role in thesecurities market (except for regulating it); however, there are methods andpolicies by which the government's actions may have an indirect influenceon the market.

Fiscal policies that affect the taxation ofcapital gains, dividends and interestgains may eventually have an effect on market activity. For example,favorable policies such as tax cuts could persuade investors to become moreactive in buying and selling securities, while unfavorable policies might

cause individuals to move to fixed-income securities or alternativeinvestments (such as real estate or other appreciable assets).

Furthermore, through monetary policies, governments can indirectly involvethemselves in the market by adjusting interest rates and taking part in open-market operations. In theory, cutting rates will discourage investors andcompanies from putting (or parking) their money into fixed-incomeinvestments - the lower rates instead may encourage borrowing forinvestment purposes.

The market is also affected by the bills and laws passed by the various levels

of government. This can occur for those laws directed specifically at thesecurities market or those that have an indirect affect.

On the indirect side, if the government reduces spending in areas such ashealth care or defense, companies in these sectors will likely sell off as theyrely in part on government funds.

Fiscal policy
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Fiscal policy is the means by which a government adjusts itslevels of spending in order to monitor and influence a nation's economy. It isthe sister strategy to monetary policy with which a central bank influences anation's money supply. These two policies are used in various combinationsin an effort to direct a country's economic goals. Here we take a look at howfiscal policy works, how it must be monitored and how its implementation

may affect different people in an economy.Before the Great Depression in the United States, the

government's approach to the economy was laissez faire. But following theSecond World War, it was determined that the government had to take aproactive role in the economy to regulate unemployment, business cycles,inflation and the cost of money. By using a mixture of both monetary andfiscal policies (depending on the political orientations and the philosophies ofthose in power at a particular time, one policy may dominate over another),governments are able to control economic phenomena.

How Fiscal Policy Works

Fiscal policy is based on the theories of British economist John MaynardKeynes. Also known as Keynesian economics, this theory basically states thatgovernments can influence macroeconomic productivity levels by increasingor decreasing tax levels and public spending. This influence, in turn, curbsinflation (generally considered to be healthy when at a level between 2-3%),increases employment and maintains a healthy value of money. (To readmore on this subject, see Can Keynesian Economics Reduce Boom-BustCycles? and How Influential Economists Changed Our History.)

Balancing Act

The idea, however, is to find a balance in exercising these influences.For example, stimulating a stagnant economy runs the risk of rising inflation.This is because an increase in the supply of money followed by an increasein consumer demand can result in a decrease in the value of money -meaning that it will take more money to buy something that has notchanged in value.

Let's say that an economy has slowed down. Unemployment levels are up,consumer spending is down and businesses are not making any money. Agovernment thus decides to fuel the economy's engine by decreasingtaxation, giving consumers more spending money while increasing

government spending in the form of buying services from the market (suchas building roads or schools). By paying for such services, the governmentcreates jobs and wages that are in turn pumped into the economy. Pumpingmoney into the economy is also known as "pump priming". In the meantime,overall unemployment levels will fall.

With more money in the economy and less taxes to pay,consumer demand for goods and services increases. This in turn rekindlesbusinesses and turns the cycle around from stagnant to active.
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If, however, there are no reins on this process, the increase in economicproductivity can cross over a very fine line and lead to too much money inthe market. This excess in supply decreases the value of money, whilepushing up prices (because of the increase in demand for consumerproducts). Hence, inflation occurs.

For this reason, fine tuning the economy through fiscal policy alone can be adifficult, if not improbable, means to reach economic goals. If not closel

Financial Institution Notes

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