> a ~e ‘* Aanujjindal.in my Notes Financial Market 1.0 Introduction & Structure of financial markets in India 11.1 What is a Financial Market? 1.2 Structure of Financial Market in india 2.0 Money Market 2.1 What is a Money Market? 2.2 Money Market Instruments 2.2.1 CalliNotice Money 2.2.2 Treasury Bill 2.2.3 Commercial Bill 2.2.4 Commercial Paper 2.2.5 Certificate of Deposit 2.2.6 Cash Management Bill 2.2.7 Money Market Mutual Funds Discount and Finance House of India (OFHI) 3.0 Capital Market 3.1 What is a Capital Market? 3.2 Primary Market 3.2.1 What is a Primary Market? 3.2.2 Funetions of Primary Market 3.2.3 Major Reforms in the Primary Market Post 1991. 3.2.4 Issue Mechanism in Primary Market 3.2.5 Public issue 3.2.6 Right Issue 3.2.6 Bonus Issue 3.2.7 Private Placement 3.3 Secondary Market 3.3.1 What is Secondary Market? 3.3.2 Functions of Secondary Market 3.3.3 Major Reforms in the Secondary Market Post 1991 3.3.4 Margin Trading 3.4 Stock Exchanges in India 3.4.1 National Stock Exchange3.4.2 Bombay Stock Exchange 3.5 Stock Indices 3.5.1 What is a Stock Index? 3.5.2 Types of Stock Indices 3.5.3 Importance of Stock Indices 3.5.4 Index Weighting Methods 3.5.5 Market Capitalization Weighting 3.5.6 Classification of Stocks 3.5.6 SENSEX Vs. NIFTY 3.5.7 Some Innovative Indices in India 3.6 Depository Receipts 3.6.1 What are Depository Receipts? 3.6.2 American Depository Receipt (ADR) 3.6.3 Global Depository Receipt (GDR) How are ADRs/GDRs Issued by an Indian Company? 3.6.4 Indian Depository Receipt (IDR) How are IDRs Issued by a Foreign Company? 3.7 Mutual Funds 3.7.4 What is a Mutual Fund? 3.7.2 History of Mutual Funds in india 3.7.3 Organizational Structure of Mutual Funds in India 3.7.4 Types of Mutual Funds Based on Maturity Period Based on Investment Objective Based on Risk Specialized Schemes 3.7.5 Exchange-traded Funds (ETFs) 3.7.6 Real Estate Investment Trusts (REITs) 3.7.7 Infrastructure Investment Trusts (InvITS) 3.7.8 Bharat 22 3.8 Participatory Notes 4.0 DEBT MARKET 4.1 What is a Debt Market? 4.2 Government Securities Market 4.3 Corporate Bond Market 4.3.1 Types of Bonds / Debentures 4.3.2 Deep Discount Bonds (DDB) 4.3.3 Junk Bonds 4.3.4 Municipal Bonds 4.3.5 Inflation-indexed Bonds 4.4 Masala Bonds 4.5 External Commercial Borrowings Notes Financial Market4.5.1 What is External Commercial Borrowing (ECB)? 4.5.2 Types of ECBs 5.3.3 Routes to access ECB 4.5.4 ECB Framework 4.5.6 Minimum Average Maturity Period (MAMP) 4.6 Foreign Currency Convertible Bonds 4.6.1 What is a Foreign Currency Convertible Bond (FCCB)? 4.6.2 Benefits Offered by FCCBs 4.6.3 Major Drawbacks of FCCBS 4.7 Foreign Currency Exchangeable Bonds 4.7.1 What is a Foreign Currency Exchangeable Bond (FCEB)? 4.7.2 Difference between FCCB and FCEB 4.8 Bond Indenture 4.9 Bond Yield 4.9.1 Types of Bond Yield 4.9.2 Yield Spread 4.9.3 Yield Curve 4.10 Types of Risks in Bonds 5.0 DERIVATIVES MARKET 5.1 What is a Derivative? 5.2 History of derivatives in India 5.3 Types of Derivative Contracts 5.3.1 Forwards 5.3.2 Futures 5.3.3 Options ‘Types of Options 5.3.4 Swaps 5.4 Margin in Derivatives Trading 6.0 COMMODITY MARKET 6.1 What is a Commodity Market? 6.2 History of Commodities Market 6.3 Types of Commodities 6.4 Commodity Exchanges in India 7.0 FOREIGN EXCHANGE MARKET 7.1 What is the Foreign Exchange Market? 7.2 Evolution of Forex Market in India 7.2.1 Regulation of Forex in India 7.2.2 Evolution of India’s Exchange Rate Policy 7.3 Foreign Exchange Management Act (FEMA), 1999 7.3.1 Introduction 7.3.2 Capital Account and Current Account Transactions, 7.3.3 Authorised Person under FEMA Notes Financial Market7.3.4 Liberalised Remittance Scheme (LRS) 7.4 What is an Exchange Rate? 7.4.1 Fixed Exchange Rate System 7.4.2 Advantages of a Fixed Exchange Rate System 7.4.3 Disadvantages of a Fixed Exchange Rate System 7.4.4 Floating Exchange Rate System 7.4.5 Advantages of a Floating Exchange Rate System 7.4.6 Disadvantages of a Floating Exchange Rate System 7.4.7 Managed Floating 7.5 Changes in the Value of Currency 7.5.1 Currency Appreciation 7.5.2 Currency Depreciation 7.5.3 Currency Devaluation 7.5.4 Currency Revaluation 7.6 Functions of Foreign Exchange Market 7.6.1 Transfer Function 7.6.2 Credit Function 7.6.3 Hedging Function 7.7 Purpose of Foreign Exchange Market 7.7.1 Currency Conversion 7.7.2 Currency Hedging 7.7.3 Currency Speculation 7.7.4 Currency Arbitrage 7.8 Currency Quotation 7.8.1 Base Currency and Quote Currency 7.8.2 Direct & Indirect Quotation 7.9 Spot Rate, Cross Rate, & Forward Rate 7.10 Instruments in the Forex Market 7.10.1 Spot Contracts 7.10.2 Forward Contracts 7.10.3 Options 7.10.4 Futures 7.10.5 Swaps 7.11 Foreign Exchange Risk/Exposure 7.12 Foreign Currency Accounts Held by Resident Individuals 7.12.1 What is a Foreign Currency Account? 7.12.2 Types of Foreign Currency Accounts 7.12.3 Foreign Currency Accounts Outside India 7.13 FX Retail 7.14 Foreign Exchange Operations in Commercial Banks 7.14.1 Foreign Exchange Department 7.14.2 Letter of Credit Notes Financial Market7.14.3 Nostro & Vostro Accounts 7.15 Currency Convertbility 7.15.1 What is Currency Convertibility 7.15.2 Current Account Convertibility 7.15.3 Capital Account Convertibility 7.16 Special Drawing Rights 7.16.1 What is are SDRs? 7.16.2 SDR Currency Basket 8.0 CREDIT RATING AGENCIES 8.1 What is Credit Rating? 8.2 What is a Credit Rating Agency? 8.3 Credit Rating Agencies in india 8.3.1 CRISIL 8.3.2 CARE Ratings 8.3.3 ICRA Limited 8.3.4 India Ratings & Research 8.3.5 SMERA 8.4 Credit Bureau 1.0 Introduction & Structure of financial markets in India 1.1 What is a Financial Market? + A financial market is an infrastructure that facilitates the trade of financial securities. + Financial securities include currency, bonds, stocks, derivatives, commodities, forex etc. — ° + Afinancial market consists of individual investors, financial institutions and other intermediaries who are linked by formal trading rules and a communication network for trading the various financial assets and credit instruments. 1.2 Structure of Financial Market in India + Afinancial market consists of two major segments: (a) Money Market; and (b) Capital Market.* While the money market deals in short-term credit, the capital market handles the medium term and long-term credit. + Apart from these two, the other types of financial markets operating in India are- © Forex Market © Bond Market © Derivatives Market © Commodities Market 2.0 Money Market 2.1 What is a Money Market? * The money market is a market for short-term funds, which deals in financial assets whose period of maturity is up to one year. + The money market does not deal in cash or money as such but simply provides ‘a market for credit instruments such as bills of exchange, promissory notes, commercial paper, treasury bills, etc. * These financial instruments are close substitute of money. 2.2 Money Market Instruments + In 1985, the Chakravarty Committee first underlined the need to develop money market instruments in India + In 1987, the Working Group on the Money Market (Chairman: Shri N. Vaghul) laid the blueprint for the institution of money markets. 2.2.1 CalliNotice Money + When money is borrowed/lent for a day, it is known as ealll (overnight) money. + When money is borrowed/lent for more than a day and up to 14 days, it is known as notice money. + It primarily serves the purpose of balancing the short-term liquidity position of banks. * No collateral money is required to cover these transactions.* Call money can be utilised by banks to meet their CRR requirements. 2.2.2 Treasury Bill * A treasury bill (T-bill) is a promissory note issued by the RBI on behalf of the Government, to meet the short-term requirement of funds. + T-bills are presently issued in three tenors, namely, 91 day, 182 day and 364 day. + T-bills are zero coupon securities and pay no interest. Instead, they are issued at a discount and redeemed at the face value at maturity + For example, a 91 day Treasury bill of 2100/- (face value) may be issued at say € 98.20, that is, at a discount of say, €1.80 and would be redeemed at the face value of 8100/- 2.2.3 Commercial Bill + Acommercial bill is a written instrument containing an unconditional order signed by the maker, directing to pay a certain amount of money to a particular person of to bearer of the instrument. * Itis drawn by the seller to the buyer for the value of goods delivered by him. * They are called trade bills until accepted by commercial banks after which they are called commercial bills. 2.2.4 Commercial Paper * Acommercial paper is a short-term, negotiable, unsecured debt instrument issued in the form of a promissory note + CPs were introduced in 1990 to enable corporate borrowers to raise short- term funds. + CPs can be issued by highly rated corporate borrowers, primary dealers (PDs) and satellite dealers (SDs), and all-India financial institutions (Fis). + ACP can be issued for period ranging from 7 days to one year. * CP can be issued in denominations of Rs.5 lakh or multiples thereof. 2.2.5 Certificate of Deposit * Acertificate of deposit (CD) is a negotiable, unsecured money market instrument issued by a bank as a Usance Promissory Note against fundsdeposited at the bank for a maturity period up to one year + CDs can be issued by scheduled commercial banks, RRBs, small finance banks, and Alll India Financial Institutions. * CDs shall be issued only in dematerialised form and held with a depository registered with SEBI. * CDs shall be issued in minimum denomination of Rs. 5 lakh and in multiples thereof. + The tenor of a CD at issuance shall not be less than 7 days and shall not exceed 1 year. 2.2.6 Cash Management Bill + The Government, in consultation with the RBI, introduced the CMB in 2010. + CMBs are short-term money market instruments that assist the government in meeting short-term cash flow mismatches. + CMBs have a maturity of less than 91 days. 2.2.7 Money Market Mutual Funds * Money Market Mutual Funds (MMMFs) were introduced in India in April 1991 to provide an additional short term investment avenue to investors and to bring money market instruments within the reach of individuals. + MMMEFs are allowed to invest in rated corporate bonds and debentures with a residual maturity of one year. + The minimum lock-in period for units of MMMFs was relaxed from 30 days to 15 days in May 1998. + MMMFs, which were regulated under the guidelines issued by the RBI, have been brought under the purview of SEBI regulations since March 2000. Discount and Finance House of India (DFHI) * Pursuant to the Vaghul Working Group recommendation for setting up an institution to provide enhanced liquidity to the money market instruments, the RBI set up the Discount and Finance House of India (DFHI) jointly with public ‘sector banks and the all-India financial institutions. + DFHI was incorporated in March 1988 and it commenced operation in April 1988,* The main objective of this money market institution is to facilitate smoothening of the short-term liquidity imbalances by developing an active secondary market for the money market instruments. + DFHI participates in transactions in all the market segments, it borrows and lends in the call, notice and term money market, purchases and sells treasury bills sold at auctions, commercial bills, CDs and CPs, 3.0 Capital Market 3.1 What is a Capital Market? -_ + Capital Market is a market dealing in long-term funds. * [tis an institutional arrangement for borrowing long-term funds and which provides facilities for marketing and trading of securities. * It constitutes all long-term borrowings from banks and financial institutions, borrowings from foreign markets and raising of capital by issue various securities such as shares debentures, bonds, etc. * It consists of two different segments namely primary and secondary market. Notes Financial Market+ The primary market deals with new or fresh issue of securities and is, therefore, also known as new issue market; whereas the secondary market provides a place for purchase and sale of existing securities and is often termed as stock market or stock exchange. 3.2 Primary Market 3.2.1 What is a Primary Market? PRIMARY MARKET TRADER COMPANY + Primary market is the market for dealing in new securities, that is, securities which were not issued previously and are offered to the investors for the first time. + It consists of arrangements, which facilitate the procurement of long-term funds by companies by making fresh issue of shares and debentures. 3.2.2 Functions of Primary Market The primary market performs a “triple service function” — 1. Origination - It refers to the work of investigation, analyzing and processing of new proposals by specialist agencies. 2. Underwriting - It is a process by which investment companies undertake guarantee that the issues would be sold by eliminating risk arising from uncertainty of public responses. 3. Distribution — Sale of securities to the ultimate investors is referred to as distribution. Success of an issue is determined by final issue to investing issue.3.2.3 Major Reforms in the Primary Market Post 1991 1. Fils Permitted to Operate in the Indian Market: Foreign institutional investors, including mutual funds and pension funds, were permitted to invest in both the equities and debt markets, including treasury bills and dated government securities. 2. Access to Global Funds Market: * Access to global finance market was allowed to Indian companies and they could benefit from the lower cost of funds. * They have been permitted to raise resources through issue of American Depository Receipts (ADRs), Global Depository Receipts (GDRs), Foreign Currency Convertible Bonds (FCCBs) and External Commercial Borrowings (ECBs) * Also, Indian companies can list their securities on foreign stock exchanges through ADR/GDR issues. 3. Abolition of Controller of Capital Issues: + The Capital Issues (Control) Act, 1947 governed capital issues in India. + The capital issues control was administered by the Controller of Capital Issues (CCI). + The Narasimham Committee (1991) had recommended the abolition of CC! and wanted SEB! to protect investors and take over the regulatory function of CCI. 4. Credit Rating Agencies: * Various credit rating agencies such as Credit Rating Information Services of India Ltd. (CRISIL - 1988), Investment Information and Credit Rating Agency of India Ltd. (|CRA— 1991), Credit Analysis and Research Ltd. (CARE — 1993) and so on were set up to meet the emerging needs of capital market. 5. Securities and Exchange Board of India (SEBI): + SEBI was set up as a non-statutory body in 1988 and was made a statutory body in January 1992. + SEBI has introduced various guidelines for capital issues in the primary market.* Merchant bankers, and other intermediaries such as mutual funds including UTI, portfolio managers, registrars to an issue, share transfer agents, underwriters, debenture trustees, bankers to an issue, custodian of securities, and venture capital funds — have been brought under the purview of SEBI. 3.2.4 Issue Mechanism in Primary Market it Pett) Peed PETC 3.2.5 Public IssueCrnvmtex, a stim Initial Public Offe: (Primary Market) Vw? @ eg < b > An issue is called a public issue when the company decides to raise funds from the public by issuing shares in the primary market to drive new investors for subscription. Types of Public Issue 1. Initial Public Offer (IPO): * IPO is a process where a private company decides to raise funds by issuing of shares to the general public for the first time. + IPO is issued by an unlisted company. 2. Follow-On Public Offer (FPO): * FPO is an additional offer that the company issues once it has already issued an IPO. * FPO is issued by a listed company. 3. Offer for Sale * Offer for sale (OFS) is a simpler method of share sale through the exchange platform for list ed companies + The mechanism was first introduced by SEBI in 2012, to make it easier for promoters of publicly-traded companies to cut their holdings and comply with the minimum public shareholding norms. * OFS is available to 200 top companies in terms of market capitalisation,Who are Anchor Investors? Anchor investor or cornerstone investor (as they are called globally) are institutional investors like sovereign wealth funds, mutual funds and pension funds, who are allotted shares a . This is done to boost the popularity of the issue and thus provide confidence to potential IPO investors. Types of IPO Issue 1. Fixed Price Issue: * Price at which the securities are offered and would be allotted is made known in advance to the investors. 2. Book Building Issue: + There is no fixed price, but a price band or range. + The lowest and the highest price is called ‘floor price’ and ‘cap price’ respectively. + The gap between the floor and cap price cannot be more than 20%. Types of Offer Documents. + Itis an offer document case of a public issue, which has all relevant details including price and number of shares or convertible securities being offered. + Itis registered with ROC before the issue opens in case of a fixed price issue and after the closure of the issue in case of a book-buil issue. Fi Prospectus + Itis an offer document used in case of a book built Red Herring public issue, It contains all the relevant details except Prospectus that of price or number of shares being offered. + Itis filed with RoC before the issue opens. 2. + Itis an abridged version of offer document in public, Abridged issue and is issued along with the application form of Prospectus a public issue. + It contains all the salient features from the prospectus. 3.2.6 Right Issue * Through this mode, the company makes an offer to existing shareholders to buy additional shares in the company at a discounted price (rights offer price) withina prescribed period. * [tis not an obligation on the existing shareholders to avail the offer of right issue, they can decline to accept the offer, or they can renounce their right in favor of any other person. 3.2.6 Bonus Issue Bonus Shares ets bonus issue will look like belo + Ordinary Shares 2,000,000 at $1 each = $2,000,000 4 Share Premium Account = $0, 4 Retained Profit = $1,000,000 P watstreerntojo * Bonus issue is one of the ways to raise capital, but it does not bring any fresh capital + Companies can distribute profit to existing shareholders by the way of fully paid bonus shares instead of paying them a dividend. * Itis a capitalization of free reserves. + For example, a company may give one bonus share for every five shares held. 3.2.7 Private Placement+ In private placement, the company issues its shares directly to a small selected group of investors. + Here, investors generally fall under the category of insurance companies, banks, pension funds, and mutual funds. Types of Private Placement 1. Preferential Allotment: * Itis a kind of private placement which can be made only for equity share or for securities convertible into equity shares. 2. Qualified Institutional Placement (QIP): + Itis a type of private placement where a listed company can issue shares to Qualified institutional Buyers (QIBs). * It was introduced in 2006 by SEBI. 3.3 Secondary Market 3.3.1 What is Secondary Market?SECONDARY MARKET a £ @ e aA aA TRADER OTHER TRADER + The secondary market is a market for existing securities, that is, those securities already issued and listed on the stock exchange. * Allsales after the initial sale of the security are sales in the secondary market. 3.3.2 Functions of Secondary Market 1. Nexus between Savings and Investments: + Stock exchange provides a platform to savers to invest their money in those sectors and units which are favoured by the community at large. 2. Liquidity to Investors: * It,provides liquidity to the investors whereby investors can buy and sell their securities immediately in the market. 3. Continuous Price Formation: + Acontinuous change in demand and supply conditions result in continuous revaluation of assets, which completes the function of “price formation” in the stock exchange. 3.3.3 Major Reforms in the Secondary Market Post 1991 1. Setting up of National Stock Exchange (NSE): + NSE was set up in November 1992 and started its operations in 1994; which has now developed into a sophisticated, electronic market, which rankedfourth in the world by equity trading volume 2. National Securities Clearing Corporation Ltd. (NSCL): + Itwas incorporated in August 1995. + Ithas started guaranteeing all trades in the NSE since July 1996. + The NSCL is responsible for post-trade activities of the NSE. * Clearing and settlement of trades and risk management are its central functions. 3. Over the Counter Exchange of India (OTCE!): + OTCEI was set in 1992. + Itwas promoted by a consortium of leading financial institutions of India including UTI, ICICI, IDBI, IFC, LIC and others. * Itis an electronic national stock exchange listing an entirely new set of companies which will not be listed on other stock exchanges. 4. Depository System: + Amajor reform in the Indian Stock Market has been the introduction of depository system since 1996. + Adepository is an organization which holds the securities of shareholders in electronic form, transfers securities between account holders, facilitates transfer of ownership without handling securities and facilitates their safekeeping. + 2 depositories were set up - National Security Depository Limited (NSDL) in 1996; and Central Depository services Limited (CDSL) in 1999. 5. Mutual Funds: + Emergence of diversified mutual funds is one of the most important developments of indian capital market. * Their main function is to mobilize the savings of general public and invest them in stock market securities. 6. Investor Protection: * Under the purview of the SEBI the Central Government of India set up the Investors Education and Protection Fund (lEPF) in 2001. + Itworks in educating and guiding investors.* It tries to protect the interest of the small investors from frauds and malpractices in the capital market. 7. T +2 Settlement: * From 2003 the settlement cycle has been further reduced to T+2. * The trades accumulate over a trading cycle of one day, at the end of the day club together and position are netted, payment of cash and delivery of securities settle the balance after two working days. 3.3.4 Margin Trading Margin Trading Buying Power Deposit Leverage + Margin trading refers to borrowing money from the broker to purchase stock. + The investor can buy stock by paying a margin on the actual value of investment. * The margin can be given in the form of cash or shares as collateral depending upon the availability with the respective investor.+ To avail this facility, one has to place a request with the broker to open a Margin Trading Facility (MTF) Account. * The broker specifies a minimum balance that needs to be maintained in the margin account, called minimum margin. + Before initiating a trade, an investor will have to deposit a certain percent of the total traded value and the remaining will be funded by the broker. Example X wants to buy shares worth Rs.1,00,000/-. Assuming that the margin is 25%, X will be required to pay 25%, i.e., Rs.25000/- and balance Rs.75000/- will be funded by the broker. This 25% can also be in the form of stocks collateral. 3.4 Stock Exchanges in India 3.4.1 National Stock Exchange NSE * The National Stock Exchange of India Limited (NSE) was established in 1992, based on the recommendations of the Pherwani Committee. + NSE is headquartered in Mumbai. + The exchange was incorporated in 1992 as a tax-paying company and was recognized as a stock exchange in 1993 under the Securities Contracts (Regulation) Act, 1956. + NSE was the first dematerialized electronic exchange in the country. + The derivatives segment in NSE commenced operations in June 2000. + NSE operates on the National Exchange for Automated Trading (NEAT) system, a fully automated screen based trading system, which adopts the principle of an order driven market. + NIFTY 50, launched in April 1996, is the benchmark index of NSE. + NSE launched NSE EMERGE in 2012, as an initiative for small and medium- sized enterprises and startup companies from India. These companies can getlisted on NSE without an IPO. + NSE Clearing Limited (formerly known as National Securities Clearing Corporation Limited), which is NSE’s clearing corporation, was the first clearing corporation in India 3.4.2 Bombay Stock Exchange + The Bombay Stock Exchange (BSE) was established in 1875, as the Native Share and Stock Brokers’ Association. + BSEis the oldest stock exchange in Asia. * BSE is headquartered in Mumbai. + In 1957, the BSE became the first stock exchange to be recognized by the Indian Government under the Securities Contracts (Regulation) Act. + BSE operates on the BSE On-Line Trading (BOLT), a screen-based automated trading platform. It was launched in 1995, * SENSEX, launched in 1986, is the benchmark index of BSE. + Indian Clearing Corporation Limited (ICCL) is BSE’s clearing corporation. It was launched in 2007. 3.5 Stock Indices 3.5.1 What is a Stock Index?+ An Index is used to give information about the price movements of products in the financial, commodities or any other markets. + Financial indexes are constructed to measure price movements of stocks, bonds, T-bills and other forms of investments. + Stock market indexes are meant to capture the overall behaviour of equity markets. » Astock market index is created by selecting a group of stocks that are representative of the whole market or a specified sector or segment of the market. * The values of the grouped stocks are used to calculate the value of the index. + Any change in the price of the stocks leads to a change in the index value. + An index is thus, indicative of the changes in the market. * An Index is calculated with reference to a base period and a base index value. 3.5.2 Types of Stock IndicesTypes of Indices Broad Market 1 Indices or Market- Cap Indices 2 Sectoral Indices 3. Thematic Indices 4. Strategy Indices * Consist of largest most liquid and financially ‘sound companies on stock exchanges based on market capitalization + E.g., NIFTY 50, NIFTY ‘SmallCap 250, S&P BSE SENSEX, SENSEX, S&P BSE LargeCap + Consist of companies of one particular sector like banking, IT, media, etc. + €.g., NIFTY Bank Index, S&P BSE Energy + Consist of companies that are tied to specific investment themes like social, economic, digital, etc. + E.g., NIFTY India Digital, S2P BSE PSU + Indices that are based upon a specified trading strategy + E.g., NIFTY Alpha 50 Index, S&P BSE IPO, S&P BSE Low Volatility Index 3.5.3 Importance of Stock Indices 1. Sorting: + Companies and their shares are classified into indices on the basis of key characteristics like size, industry, sector, etc. 2. Information Source: * Stock indices act as an important information source about market sentiment. * It gives a consolidated picture which gives an idea about broad outlook of the market. Notes Financial Market3. Representativ. + Broad market indices are representative of the entire market or economy which tells an investor how the market is performing. * Specialized sector indices give information about a particular sector/segment of the market. So, an index composed of only IT stocks will indicate how the IT industry is performing and investors sentiments regarding IT sector. 4, Benchmark for Comparison: + An index makes it easy for the investor to compare performance of a particular stock. * Investor can see whether his stock performed better than the benchmark index. 5. Reflect Investors’ Sentiment: * Indices refiect investors’ sentiment regarding the entire market as well as specific sectors/industries. * Understanding investors’ sentiment is very important as when investors’ sentiment is positive, stock market performs well and vice-versa. 6. Facilitates Passive Investment: * Many investors prefer to invest in portfolio of securities resembling an index as it saves time, cost and efforts + These investors can invest in index funds or ETFs (exchange-traded funds) which track a particular index. 3.5.4 Index Weighting Methods + Index weighting determines how much weight each security will be assigned in the index, thereby impacting the index value. + The most common weighting method is Market Capitalization Weighting. 3.5.5 Market Capitalization Weighting + Market capitalization is the total market value of a company's stock, * This is calculated by multiplying the share price of a stock with the total number of stocks floated by the company. * It thus takes into consideration both the size and the price of the stock.* Inan index using market-cap weightage, stocks are given weightage on the basis of their market capitalization in comparison with the total market capitalization of the index. + For example, if stock A has a market capitalization of Rs. 10,000 while the index that the stock is part of has a total m-cap of Rs. 1,00,000, then its weightage will be 10%. Similarly, another stock with a market-cap of Rs. 50,000, will have a weightage of 50%. + The market capitalization weightage method gives more importance to companies with higher market cap. + Free-Float Market Capitalization In India, most indices use free-float market capitalization. The free float method calculates market capitalization based on the number of shares available on the exchanges for public trading rather than the total shares outstanding. Free float refers to the shares that can be publicly traded and are not restricted. 3.5.6 Classification of Stocks Based on Market Capitalization ‘Small Cap Stocks Mid Cap Stocks Large Cap Stocks Notes Financial Market osThey represent small size companies. These stocks have potential to grow rapidly, The prices of these stocks tend to be volatile, They are stocks of medium-sized companies. They offer investors the twin benefits, of acquiring stocks with good growth potential as well as the stability of a larger company. Mid-cap stocks also include baby blue chip stocks which are stocks of companies showing steady growth backed by a good track record These are stocks of the largest companies in the market. They are also called blue- chip stocks. They are less volatile and show less growth as compared to small cap stocks. Based on Dividend Payment Income Stocks ‘These companies have high dividend-payout ratio as they have less reinvestment opportunities. ‘These stocks provide regular and stable income to investors. They are relatively low-risk stocks. Growth Stocks These are stocks that reinvest most of their earings in their business They provide long term capital gains to investors, They do not pay or pay very less dividend. They are usually preferred by conservative, old-age investors looking for a secondary source of income. Based on Fundamentals Overvalued Stocks These are stocks which are trading above their intrinsic value (or true value), ie., Share Price > Intrinsic Value. Generally, these shares have high PE Ratio (price earnings ratio). Based on Risk Blue-chip Stocks Blue-chip stocks are shares of very large and well-recognized companies with a long history of sound financial performance. They are comparatively risky stocks. Undervalued Stocks These are stocks which are trading below their intrinsic value (or true value), i.e,, Share Price < Intrinsic Value. Generally, these shares have low PE Ratio (rice earnings ratio). They are also called value stocks. High-beta Stocks High-beta stocks are supposed to be riskier but provide higher return; low-beta stocks pose less risk but also lower returns.Based on Price Trends Cyclical Stocks ‘These stocks move with the economic cycle, ie., they go up when the economy is doing good and perform poorly when the economy is down. These stocks tend to fluctuate more as economic conditions change. ‘These stocks are preferred when the economy is booming, Examples: stocks of companies belonging to cement, construction, steel, automobile sector. 3.5.6 SENSEX Vs. NIFTY Defensive stocks These stocks are relatively unaffected by changes in the economy. ‘They are comparatively resistant to ‘economic changes, ‘These stocks are preferred when the economic conditions are poor. Examples: stocks of companies belonging to food, beverages, pharmaceuticals, insurance sector. Basis ‘SENSEX NIFTY What is it? Sensitive Index National Fifty Meaning Represents top 30 stocks of BSE __ Represents top 50 stocks of NSE by market capitalization by market capitalization Founded 1986 1996 Method of Free-float market capitalization _Free-float market capitalization Weightage Weighted method weighted method Base Value 100 1000 Base Year 1978-79 1995 3.5.7 Some Innovative Indices in In 1. S&P BSE GREENEX * The S&P BSE GREENEX is designed to measure the performance of the top 25 “green” * companies in terms of greenhouse gas (GHG) emissions, market cap and liquidity. + No. of constituents: 25 * Launch date: 22 Feb, 2012 2. S&P BSE CARBONEX* The S&P BSE CARBONEX, the first index of its kind in India, tracks the performance of the companies within the S&P BSE 100 index based on their commitment to mitigating risks arising from climate change. + The index was created to address market demand for a sophisticated approach to portfolio management incorporating climate change risk and ‘opportunity. + No. of constituents: 100 + Launch date: 30 Nov, 2012 3. S&P BSE 500 SHARIAH * The S&P BSE 500 Shariah index is designed to track the performance of the Shariah-compliant companies in the S&P BSE 500 index. + No. of constituents: 271 + Launch date: 2 May, 2013 4, NIFTY100 ESG + ESG stands for Environmental, Social and Governance. + Ituses NIFTY 100 as its universe. + It includes securities that meet sustainability investing criteria. + Companies engaged in the business of tobacco, alcohol, controversial weapons and gambling operations shall be excluded. 5. S&P BSE Bharat 22 * Itis designed to measure the performance of 22 select companies disinvested by the central government of India + Number of Constituents: 22 + Launch date: 10 August, 2017 * India VIX Index + Itwas launched by NSE in 2008. * Itis a measure of market's expectation of volatility over the near term. * Itis a volatility index based on the NIFTY Index Option prices. * Ituses the computation methodology of CBOE (Chicago Board Options Exchange).6. CriSidEx + Itwas launched on 3rd February 2018 by the then Finance Minister, Mr. Arun Jaitley. * Itis India’s first sentimental index for small and micro enterprises (SMEs). + Itwas jointly developed by CRISIL and SIDBI, hence the name CriSidEx. Some Important Indices of Other Countries Country Major Indices 1 usa «gl ta vere NASDAQ Compcaks- 2. UK FTSE 100 3. Hong Kong Hang Seng 4. Japan Nikkei 225 5. South Korea + KOSPI * KOSDAQ (for small companies) 6. Germany DAX-30, 7. France CAC 40 8. China, SSE Composite Index. 3.6 Depository Receipts 3.6.1 What are Depository Receipts? + Adepository receipt is a negotiable certificate instrument issued by a bank representing shares in a foreign company traded on a local stock exchange. + Itis an instrument which allows companies to raise capital in foreign markets. + The depository receipt gives investors the opportunity to hold shares in the equity of foreign countries and gives them an alternative to trading on an international market. 3.6.2 American Depository Receipt (ADR) + AN ADRs a certified negotiable instrument issued by an American bank representing a number of shares of a foreign company which can be traded on an American stock exchange.* ADRs are priced in U.S. dollars. + The ADR was firstly created in 1927 by J.P. Morgan. + In order to begin offering ADRs, a U.S. bank must purchase shares on a foreign exchange. + The bank holds the stock as inventory and issues an ADR for domestic trading. + Types of ADRs: + Sponsored ADRs: The bank issues the sponsored ADRs on behalf of the foreign company where the legal arrangement exists between the two parties. + Unsponsored ADRs: Unsponsored ADRs are the shares that are traded on the over-the-counter market (OTC). 3.6.3 Global Depository Receipt (GDR) + Aglobal depositary receipt (GDR) is a certificate issued by a bank that, represents shares in a foreign stock on two or more global markets + GDRs helps foreign companies to trade in any country’s stock market, other than the U.S. stock market. + GDRs are priced in the local currency of the exchanges where the shares are traded. + Suppose an Indian company which has issued ADRs in the American market wishes to further extend it to other developed and advanced countries such as in Europe, then the company can sell these ADRs to the public of Europe and the same would be named as GDR. How are ADRs/GDRs Issued by an Indian Company?EA (% ADRs/GDRs Issued — © ® © ——__ ee agin Overseas Investors Overseas Depository + An Indian company issues equity shares in the name of the overseas bank. * These shares are deposited with a domestic custodian bank who acts as an agent of overseas depository bank. + The Indian custodian bank holds physical possession of equity shares. + The overseas depository bank issues ADRs/GDRs in foreign currency to foreign investors. 3.6.4 Indian Depository Receipt (IDR) + An IDR is in Indian rupees and is created by a domestic depository (custodian of securities registered with SEBI). * Its issued against the underlying equity of the company to enable foreign companies to raise funds from the Indian securities Markets. + The Ministry of Corporate Affairs had prescribed the Companies (Issue of Indian Depository Receipts) Rules in 2004. * The rules for IDRs were operationalized by SEBI in 2006. * IDRs opened at the Bombay Stock Exchange and National Stock Exchange on June 11, 2010.* Standard Chartered PLC became the first global company to file for an issue of IDRs in India in 2010. * The minimum size of an IDR issue should not be less than Rs. 50 crores. Eli lity Criteria The eligibility criteria given under IDR Rules and Guidelines are as under: + The foreign issuing company shall — + have pre-issue paid-up capital and free reserves of at least US$ 500 million and a minimum average market capitalization (during the last 3 years) in its home country of at least USS 100 million; + have a continuous trading record or history on a stock exchange in its home country for at least three immediately preceding years; + have a track record of distributable profits for at least three out of immediately preceding five years; + be listed in its home country and not been prohibited to issue securities by any Regulatory Body and has a good track record with respect to compliance with securities market regulations in its home country. How are IDRs Issued by a Foreign Company?IDRs Issued * The Issuing Company, which is incorporated outside India, delivers equity shares to the Overseas Custodian. + The Overseas Custodian Bank orders the Domestic Depository to issue depository receipts in respect of shares held. + The Domestic Depository issues depository receipts to investors in India. + Foreign shares begin trading in Indian exchanges in the form of IDRs. 3.7 Mutual Funds 3.7.1 What is a Mutual Fund?OEM Maile MW Passed T to the investors Pool their money —="" rT HOW MUTUAL ee FUNDS WORK a Securities such as stocks, bonds, gold, etc generate returns SECURITIES FUND MANAGERS Choose & invest in securities + A mutual fund is a financial intermediary in the capital market that pools collective investments in form of units from retail and corporate investors and maintains a portfolio of various schemes which invest those collective investments in equity and debt instruments on behalf of investors. + The purpose of mutual funds is to provide liquidity and higher returns with optimum degree of safety to investors at minimum risk. 3.7.2 History of Mutual Funds in India + The mutual fund industry was established in India in the year 1963 with the setting up of the Unit Trust of India (UT!) by an act of parliament. + The main objective of setting up of UTI was to attract small investors to invest in the stock market. The history of mutual funds in India can be divided into 4 phases: 1. Phase 1(1964-87): + The era of mutual funds began with the establishment of the Unit Trust of India (UT!) in 1963.* Unit Scheme 1964, more popularly known as US-64 was the first scheme launched by UTI. It was an open-ended scheme, 2. Phase 2(1987-92): * In this phase, other public sector mutual funds set up. * The first non-UT! mutual fund was SB! Mutual Fund, which was established in 1987. 3. Phase 3(1992-97): + This phase marked the entry of private sector mutual funds. + The first private sector MF was Kothari merged with Franklin Templeton). joneer, established in 1993 (now * The first mutual fund regulations came in 1993, which were replaced by ‘SEBI (Mutual Fund) Regulations 1996. 4. Phase 4(beyond 1997): * The UTI Act of 1963 was repealed in 2003 and UTI was divided into 2 separate entities: 1. Specified Undertaking of Unit Trust of India (SUUT!) 2. UTI Mutual Fund 3.7.3 Organizational Structure of Mutual Funds in Indiaaa tltiey The Mutual Fund Transfer Agent Custodian + A™mutual fund is set up in form of a trust, which has a Sponsor, trustees, Asset Management Company (AMC) and a Custodian. + The Trust is established by a sponsor who is like a promoter of a company. + The trustees of a mutual fund hold its property for the benefit of the unitholders. + The sponsor or, if so, authorized by the trust deed, shall appoint an AMC, which has been approved by SEBI. + The AMC approved by SEB! manages the funds by making investments in various types of securities. * The custodian, who is required to be registered with SEBI, holds the securities of various schemes of the fund in its custody. 3.7.4 Types of Mutual Funds Based on Maturity Period1. Open-ended Schemes: Open ended funds are always open to investment and redemptions, hence, the name open ended funds. Open ended funds are the most common form of investment in mutual funds in india. These funds do not have any lock-in period or maturities. 2. Closed-ended Schemes: * Aclosed ended mutual fund scheme is where your investment is locked in for a specified period of time. * You can subscribe to close ended schemes only during the new fund offer period (NFO) and redeem the units only after the lock in period or the tenure of the scheme is over. 3. Interval Schemes: * Interval schemes provide the features of both open-ended and closed-ended schemes. + They are open for sale or redemption during predetermined intervals. Based on Investment Objective Notes Financial Market a1. Growth Funds: * Growth funds are equity-oriented funds. + The main objective of growth funds is capital appreciation over the medium to long term. + These schemes are good for investors having a long-term outlook seeking appreciation over a period. 2. Income Funds: * Income funds are debt-oriented funds. * The purpose of income funds is to provide safety of investments along with regular incomes to investors. + These schemes invest largely in income-bearing instruments like bonds, debentures, government securities, and commercial papers. 3. Balanced Funds: * These are hybrid funds. + The aim of balanced scheme is to provide both capital appreciation and regular income. * They divide their investment between equity shares and fixed interest debt instruments in such a ratio that the portfolio is balanced. 4, Liquid Funds: * Liquid Funds are debt funds which invest in securities with a residual maturity up to 91 days. Notes Financial Market 38* Liquid funds invest in debt and money market instruments such as certificate of deposits, commercial papers, treasury bill, etc. + They aim at providing a high degree of liquidity to investors and are considered one of the safest funds among mutual fund categories. 5, Tax-saving Funds: * Tax-savings funds provide special tax benefits to investors. * These are closed-ended funds and investments have a lock-in-period of at least 3 years. 6. Capital Protection Funds: * Capital protection funds invest meticulously in fixed income options and equity. * These are closed-ended hybrid mutual fund schemes with a clear focus on debt to achieve capital protection * A significant portion of the corpus is invested in high-rated fixed-income securities to earn assured returns, and the rest of the money is invested in equity to earn additional returns. 7. Pension Funds: * Pension funds allow investors to save a certain portion of their income for their retirement. + These funds offer a regular source of finance after one retires. Based on Risk po 1. Low-risk Funds: Notes Financial MarketLow-risk mutual funds are those investment options that carry minimal risk and a stable return assurance. These funds are always a step ahead of inflation. They invest a major chunk of their assets in debt instruments. 2. Medium-risk Funds: Moderate risk mutual funds are funds that invest in equity and debt instruments. The hybrid portfolio construction helps the funds generate inflation-beating returns in the medium term. These funds are less risky than pure equity funds and slightly more risky than pure debt funds. 3. High-risk Funds: High-risk mutual funds refer to funds that have excellent potential and the ability to provide high retums. However, these funds are very volatile in nature and come with high risks. Hence, these funds are suitable for high-risk appetite individuals who are willing to invest in risky assets. Specialized Schemes Types of Specialized Mutual Funds a itis a scheme of a mutual fund which has been set up with the objective of investing exclusively in money market instruments Money Market or Liquid Schemes These funds invest in government securities which have negligible default risk. This ensures preservation of investors’ capital along with moderate return, Gilt Funds Itis a mutual fund scheme that invests in Index Funds securities in the same proportion as an index of securities. They are passive investments. Exchange-traded They are like index funds, but they are traded like Funds (ETFs) stocks on stock exchanges unlike index funds.9. 10. i. These are schemes which invest in the securities Sector Specific pe of only those sectors as specified in the offer schemes documents. It means a mutual fund that invests primarily in Fund of Funds ther securities of the same mutual funds or other Schemes ‘mutual funds, Gold Exchange- traded Funds (Gold ETFs) It means a mutual fund scheme that invests primarily in gold or gold related instruments. Real Estate It means a mutual fund that invests directly or Mutual Fund indirectly in real estate assets or other permissible Scheme assets in accordance with MF regulations 1996. Itis a mutual fund scheme that invests primarily in the debt securities or securitized debt instrument Infrastructure of infrastructure companies or infrastructure Debt Fund capital companies or infrastructure projects or Scheme special purposes or special purpose vehicles Which are created for the purpose of facilitating or promoting investment in infrastructure Equity Linked itis open-ended scheme with a statutory lock in Saving Scheme _period of 3 years. This scheme offers tax benefits (ELss) to the investors Offshore Funds They invest in foreign markets and corporations. 3.7.5 Exchange-traded Funds (ETFs) ‘An exchange-traded fund (ETF) is a type of pooled investment security that operates much like a mutual fund. Typically, ETFs will track a particular index, sector, commodity, or other asset, but unlike mutual funds, ETFs can be purchased or sold on a stock exchange the same way that a regular stock can. ‘An ETF is called an exchange-traded fund because it's traded on an exchange just like stocks are. The price of an ETF's shares will change throughout the trading day as the shares are bought and sold on the market. 3.7.6 Real Estate Investment Trusts (REITs)Investor purchase shares Buy income generating properties Lia Prt ASSETS rR KR INVESTORS REAL ESTATE FIRM has fund requires funds Investor earn dividend & Earns rental income price appreci + REITs are set up as trusts under the provisions of the indian Trusts Act, 1882. + REITs are mutual fund like institutions that enable investors to invest in the real estate sector by pooling small sums of money from multitude of individual investors for directly investing in real estate properties. + REIT companies listed on the Indian stock exchanges are monitored and regulated by SEBI. * AREIT is required to allocate 90% of its income as dividends to its investors. 3.7.7 Infrastructure Investment Trusts (InviTs) + An Infrastructure Investment Trust (InviTs) is like a mutual fund, which enables direct investment of small amounts of money from investors in infrastructure to earn a small portion of the income as return. * InviTs work like mutual funds or real estate investment trusts (REITs) in features. * InviTs can be treated as the modified version of REITs designed to suit the specific circumstances of the infrastructure sector. + InviTs can be established as trusts and registered with SEBI 3.7.8 Bharat 22 * Bharat 22 is an ETF that will track the performance of 22 stocks, including three private sector stocks and 19 public sector units (PSUs) listed in the S&P BSE Bharat 22 Index.+ The ETF unit represents a slice of the fund, issued units are listed on exchanges for anyone to buy or sell at the quoted price. + The Bharat-22 ETF spans six sectors, such as basic materials, energy, finance, FMCG, industrials and utilities. + Besides public sector banks, miners, construction companies, and energy majors, the ETF will also include some of the government's holdings in SUUTI (Specified Undertaking of Unit Trust of India). + The Bharat 22 ETF will be managed by ICICI Prudential AMC while Asia Index will be the index provider. + The scheme was launched by the Government of India to fultil its disinvestment target in PSUs. SEBI Classification of Mutual Fund Schemes Equity DEBT Solution-oriented Others * SEBI issued a circular on 6th October 2017, in which it categorized mutual fund schemes into 5 broad categories. * These 5 broad categories are further divided into 36 subcategories. + The schemes are broadly classified in the following groups: 1. Equity Schemes 2. Debt Schemes 3. Hybrid Schemes 4. Solution Oriented Schemes - For Retirement and Children5. Other Schemes — Index Funds & ETFs and Fund of Funds Association of Mutual Funds in India (AMFI) AMFI * AME is the association of all the Asset Management Companies of SEBI registered mutual funds in India + Itwas incorporated on August 22, 1996, as a non-profit organisation. + AMEI is dedicated to developing the Indian Mutual Fund Industry on professional, healthy and ethical lines and to enhance and maintain standards in all areas with a view to protecting and promoting the interests of mutual funds and their unit holders. 3.8 Participatory Notes What are Participatory Notes? + Participatory notes also referred to as P-Notes, are financial instruments required by investors or hedge funds to invest in Indian securities without having to register with SEBI. + SEBI permitted Foreign Institutional Investors (Fils) to register and participate in the Indian stock market in 1992. + P-Notes are a unique invention started in 2000 by SEBI to enable foreign corporates and high networth investors enter the Indian market without having to go through the process of registering as Fils. How do Participatory Notes Work? + Participatory notes are offshore derivative instruments with shares as underlying assets.+ Brokers and foreign institutional investors registered with the SEBI issue the participatory notes and invest on behalf of the foreign investors. + Brokers must report their participatory note issuance status to the regulatory board each quarter. Regulatory Issues + SEBI has no jurisdiction over participatory note trading. * Although Fils must register with SEBI, the participatory notes trading among Flls are not recorded. + This practice may lead to the P-Notes being used for money laundering or other illegal activity 4.0 DEBT MARKET 4.1 What is a Debt Market? + Debt market is a market for issuance, trading and settlement of different types of fixed income securities. + Investments in debt securities typically involve less risk than equity investments and offer a lower potential return on investment. + Bonds are the most common form of debt investment. + Bonds are issued by corporations or by the government to raise capital for their operations and generally carry a fixed interest rate 4.2 Government Securities Market * G-Sec market is the most dominant part of the Indian debt market. + It comprises securities issued by central government or state governments. + They can be short term (called treasury bills) or long term (called Government bonds or dated securities). + Central govt issues both T-Bills as well as dated securities (or bonds) whereas state governments issues only dated securities (or bonds) which are called State Development Loans (SDLs). + They carry practically zero default risk and hence are also called risk-free or gilt- edged securities.+ Dated G-Secs: They carry a fixed or floating coupon (interest rate) which is paid on the face value on half yearly basis. Their tenor (or term) ranges from 5 years to 40 years. 4.3 Corporate Bond Market * Acorporate bond is a debt instrument issued by a company, distinct from one issued by a government or government agency. * When companies want to expand operations or fund new business ventures, they often turn to the corporate bond market to borrow money. * Unlike equities, ownership of corporate bonds does not signify an ownership interest in the company that has issued the bond. * Instead, the company pays the investor a rate of interest over a period of time and repays the principal at the maturity date established at the time of the bond's issue ian Corporate Bond Market + Indian corporate bond market has been ‘small’ in size despite policy push through recommendations of various high-level committees, and many structural reforms. + Specifically, itis saddled with supply as well as demand side issues such as: © crowding out by issuance of G-Secs, © private placement, © persistent inflation © higher interest rates, © information asymmetry, © absence of broad investor base, etc. 4.3.1 Types of Bonds / Debentures Secured Vs Unsecured Bonds Secured Bonds Unsecured Bonds Bonds carrying a charge on the assets of —_ Unsecured bonds do not carry any specific the issuer company are called secured charge on the assets of the issuer companybonds. The help reduce the risk of debt but are secured by the general credit of the investors. company. Convertible Vs Non-convertible Bonds Convertible Bonds Non- convertible Bonds convertible bond is one whose full face value (i.e. fully- convertible bond) or a part of face value (ie. partly- Anon-convertible bond, on the convertible bond) is convertible into another type of other hand, does not provide security such as equity share at the option of the any such conversion option. bondholder. Convertible bonds are an attractive option for investors due _ It is redeemed by repayment as, to the possibility of realising long-term capital gain on per the terms and conditions conversion. specified in the issue document. Coupon Vs Zero Coupon Bonds Coupon Bonds Zero Coupon Bonds Coupon bonds pay interest periodically at the Zero coupon bonds are issued at a discount pre specified rate of interest. to its face value. The annual rate at which the interest is paid is A zero coupon bond fetches no periadic known as the coupon rate or simply the interest and is redeemed at the face value at coupon maturity The dates on which the interest payments are made, are known as the coupon due dates Callable Vs Putable Bonds Callable Bond Putable Bond callable bond is one which gives the issuer (or borrower) an option to redeem the bond at any time after a fixed initial period. Aputable bond, on the other hand, gives the investor or bondholder the option to redeem the bond at any time after a fixed initial period. Usually, the bondholder will exercise the option When market interest rate goes above the coupon rate so that he can reinvest his money somewhere else at a better rate, Usually, the borrower will redeem the bond when the market interest rate falls below the coupon rate. Fixed Rate Vs Floating Rate Bonds Fixed Rate Bond Floating Rate BondIn case of fixed rate bonds, they pay a fixed interest rate throughout their tenure, i.e, till maturity. Perpetual Vs Redeemable Bonds Perpetual Bond A perpetual bond is one which is irredeemable, i.e., which does not have a redemption. In case of floating rate bonds, the interest rates. are a certain rate above some benchmark or reference rate. Redeemable Bond Redeemable bonds, on the other hand, have a fixed life and are redeemed after that fixed period 4.3.2 Deep Discount Bonds (DDBs) * Adeep-discount bond is a bond that sells at a discount (or a value which is significantly lesser than par) * Also, the bond is zero-coupon or has a coupon rate significantly less than the prevailing rates of fixed-income securities with a similar risk profile. + Adeep discount bond will typically have a market price of 20% or more below its face value. 4.3.3 Junk Bonds + They are high risk high return bonds which offer a high coupon rate. + They have high credit or default risk and have a very low credit rating. + Generally, speculators like to trade in such bonds. 4.3.4 Municipal Bonds + Municipal bonds are issued by local bodies like municipal corporations to raise money for public projects, such as to construct roads, bridges, schools or other infrastructure, and are repaid from returns generated by such projects or tax revenue. + They are very popular in developed countries such as USA but are not very popular in India. * So far eight local bodies in India have raised Rs 3,390 crore via municipal bonds. + By 2024, fifty cities are expected to issue municipal bonds. 4.3.5 Inflation-indexed Bonds+ They are bonds in which the coupon payments and maturity payments are tied to a general price index. + In these types of bonds, the par value of the bond is adjusted in the light of price index (or rate of inflation) and then the coupon rate is calculated on the adjusted par value 4.4 Masala Bonds SHY iy + Masala bonds are bonds issued outside India but denominated in Indian Rupees, rather than the local currency. + They are debt instruments which help to raise money in local currency from foreign investors. + The rupee denominated bond is an attempt to shield issuers from currency risk and instead transfer the risk to investors buying these bonds. + Masala Bonds were introduced in India by the International Finance Corporation (IFC) in 2014. + The first Masala bond was issued by the IFC in November 2014, to fund infrastructure projects in India. * In July 2016 HDFC raised 3,000 crore rupees from Masala bonds and thereby became the first Indian company to issue masala bonds. + The maturity period is three years for the bonds raised to the rupee equivalent of 50 million dollars in a financial year, and five years for the bonds raised above the rupee equivalent of 50 million dollars in a financial year. + In 2019, Kerala Infrastructure Investment Fund Board (KIIFB) became the first entity in India to list Masala Bonds on the London Stock Exchange.4.5 External Commercial Borrowings 4.5.1 What is External Commercial Borrowing (ECB)? + External Commercial Borrowings (ECBs) are loans in india made by non- resident lenders in foreign currency to Indian borrowers. * They are used widely in India to facilitate access to foreign money by Indian corporations and PSUs (public sector undertakings). + ECBs include commercial bank loans, buyers’ credit, suppliers’ credit, securitised instruments such as floating rate notes and fixed rate bonds etc., credit from official export credit agencies and commercial borrowings from the private sector winclow of multilateral financial Institutions such as international Finance Corporation, Asian Development Bank, etc. + ECBs cannot be used for investment in stock market or speculation in real estate. + The DEA (Department of Economic Affairs), Ministry of Finance, Government of India along with Reserve Bank of India, monitors and regulates ECB guidelines and policies. + ECBs have a minimum average maturity of 3 years. 4.5.2 Types of ECBs Notes Financial Market 50ECBs can be raised in any of the following forms: Loans Issue of non-convertible, optionally convertible or partially convertible preference shares/debentures Buyers’ credit ‘Suppliers’ credit Foreign Currency Convertible Bonds (FCCBs) Foreign Currency Exchangeable Bonds (FCEBs) 5.3.3 Routes to access ECB ECB can be accessed under two routes, viz., (i) Automatic Route and (ji) Approval Route. ‘Automatic Route Approval Route + Under Automatic Route, the AD Category- Bank + Under Approval Route, prospective examines the case and gives the approval. » Entities borrowers send in their requests to the wanting to raise ECB under the automatic route RBI through their AD Category-1 Banks may approach an AD Category-| Bank with their _for examination. « Such cases are proposal along with a duly filled Form ECB. + Under considered based on macroeconomic Notes Financial Market stthe ECB Policy Liberalisation Measures, RBI has increased the automatic route limit from USD. situation and merits of the specific proposals, keeping in view the overall 750 million or equivalent to USD 15 billion or equivalent. 4.5.4 ECB Framework guidelines, Prior to 2019, the ECB framework comprised the following three tracks: Medium term foreign currency denominated ECB with Minimum Average Maturity (MAM) of 3/5 years. Track Track Il Track Il Indian Rupee denominated ECB with MAM of 3/5 years. Long term foreign currency denominated ECB with MAM of 10 years. In 2019, the RBI released the New ECB Framework. Some salient features of the new framework are as under: + Merging of Tracks: Merging of Tracks | and Il as “Foreign Currency denominated ECB" and merging of Track Ill and Rupee Denominated Bonds framework as “Rupee Denominated ECB". + Minimum Average Maturity Period (MAMP): MAMP will be 3 years for all ECBs. However, for ECB raised from foreign equity holder and utilised for specific purposes, the MAMP would be 5 years. EcB Framework Sr. No. Parameters Currency of Borrowing Wi Forms of ECB FCY denominated ECB Any freely convertible Foreign Currency Loans including bank loans; floating! fixed rate notes/ bonds! debentures (other than fully and compulsorily convertible instruments); Trade credits beyond 3 years; FCCBs; FCEBs and Financial Lease. INR denominated ECB Indian Rupee (INR) Loans including bank loans; floating! fixed rate notes/bonds! debentures! preference shares (other than fully and compulsorily convertible instruments); Trade creditsEligible Borrowers, Recognised Lenders beyond 3 years; and Financial Lease. Also, plain vanilla Rupee denominated bonds issued overseas, which can be either placed privately or listed on exchanges as per host country regulations. a) All entities eligible to raise FCY ECB; and b) Registered Allentities eligible to receive FDI. entities engaged Further, the following entities are in micro-finance also eligible to raise ECB are as__activities, viz., follows: * Port Trusts; * Units in _ registered Not for SEZ: + SIDBI; and + EXIM Bank of Profit companies, India registered societiesitrusts/ cooperatives and Non-Government Organisations. The lender should be resident of FATF or IOSCO compliant country, including on transfer of ECB. However, a) Multilateral and Regional Financial institutions where India is a member country will also be considered as recognised lenders; b) Individuals as lenders can only be permitted if they are foreign equity holders or for subscription to bonds/debentures listed abroad; and c) Foreign branches / subsidiaries of Indian banks are permitted as recognised lenders only for FCY ECB (except FCCBs4.5. @ (b) © @ e and FCEBs). Foreign branches / subsidiaries of Indian banks, subject to applicable prudential norms, can participate as arrangers/underwritersimarket- makersitraders for Rupee denominated Bonds issued overseas. However, underwriting by foreign branches/subsidiaries of indian banks for issuances by Indian banks will not be allowed. .6 Minimum Average Maturity Period (MAMP) Minimum Average Maturity Period (MAMP) is defined as weighted average of all disbursements taking each disbursement individually and its period of retention by the borrower for the purpose of ECBs. MAMP for ECB will be 3 years. Category ECB raised by manufacturing companies up to USD 50 mmillion or its equivalent per financial year. ECB raised from foreign equity holder for working capital purposes, general corporate purposes or for repayment of Rupee loans ECB raised for (i) working capital purposes or general corporate purposes (ii) on-lending by NBFCs for working capital purposes or general corporate purposes ECB raised for (i) repayment of Rupee loans availed domestically for capital expenditure (ji) on-lending by NBFCs for the same purpose ECB raised for (i) repayment of Rupee loans availed domestically for purposes other than capital expenditure (i) on-lending by NBFCs for the same purpose End-uses (Negative list) MaMP year 5 years 10 years 7 years 10 years The negative list, for which the ECB proceeds cannot be utilised, would include the following: Real estate activities+ Investment in capital market + Equity investment * Working capital purposes, except in case of ECB mentioned at (b) and (c) above + General corporate purposes, except in case of ECB mentioned at (b) and (c) above + Repayment of Rupee loans, except in case of ECB mentioned at (d) and (e) above + On-lending to entities for the above activities, except in case of ECB raised by NBFCs as given at (c), (d) and (e) above 4.6 Foreign Currency Convertible Bonds 4.6.1 What is a Foreign Currency Convertible Bond (FCCB)? * A foreign currency convertible bond (FCCB) is a type of convertible bond issued in a currency different than the issuer's domestic currency, * The money being raised by the issuing company is in the form of a foreign currency. + Aconvertible bond is a mix between a debt and equity instrument. It acts like a bond by making regular coupon and principal payments, but these bonds also give the bondholder the option to convert the bond into stock. * Itenables the firms to raise funds from the market. 4.6.2 Benefits Offered by FCCBs To the Issuer: + The coupon rates on FCCB's are generally lower than traditional bank interest rates, reducing the cost of debt financing. + If converted, the company is able to reduce its debt as a result of foreign currency convertible bonds and thus gains additional, much-needed equity capital + If there is a favourable move in the exchange rate, the company may benefit from a reduction in the cost of debt. To the bondholders: * Anassured minimum fixed rate of return.+ Investors can participate in any price appreciation in the issuer's stock upon conversion. + Flexibility in choosing to enter the capital market or receiving a stable stream of income through bond payments (coupons). © Itis a unique dual advantage of equity and debt that the investor gets through foreign currency convertible bonds. 4.6.3 Major Drawbacks of FCCBs + Ifthe stock market is in a negative cycle, the demand for foreign currency convertible bonds decreases. + Ifthe issuing company's currency does not perform well compared to the bondholder’s domestic currency, the principal and coupon payments will become more costly. * Foreign currency convertible bonds are subject to exchange rate risk and credit tisk. + The issuing company may bankrupt, following which the repayment of face value at maturity will no longer be plausible. 4.7 Foreign Currency Exchangeable Bonds 4.7.1 What is a Foreign Currency Exchangeable Bond (FCEB)? + A Foreign Currency Exchangeable Bond (FCEB) means a bond expressed in foreign currency. + The principal and interest in respect of FCEB is payable in foreign currency. * An FCEB involves three parties: © the issuer company © the offered company (OC) © investor + FCEBs carry an option for the investor to exchange the bonds into shares of OC, which are held by the issuer and are listed on a stock exchange. 4.7.2 Difference between FCCB and FCEB+ FCCBs are issued by a company to non-residents giving them the option to convert FCCBs into shares of the same company at a predetermined price. * On the other hand, FCEBs are issued by the investment or holding company of a group to non-residents which are exchangeable for the shares of the specified group company at a predetermined price. + Therefore, the key difference is that FCCB involves just one company, whereas FCEB involves at least two companies — the bonds are usually of the parent company while the shares are of the operating company which must be a listed company. 4.8 Bond Indenture * Abond indenture is a legal document or contract between the bond issuer and the bondholder that records the obligations of the bond issuer and benefits owed to the bondholder. + The bond indenture also includes the details of the rights of ownership as well as the rights of the bondholder to receive interest payments and principal payments in the future, * Itincludes all the terms and conditions related to issue of bonds, coupon payments, collateral available to bondholders, dividend policy, limits on further borrowings, debenture trustees, etc 4.9 Bond Yield + Bond yield refers to the percentage rate of return on the amount invested in buying one bond. + Itis different from coupon rate. A bond's coupon rate is the rate of interest it pays annually, while its yield is the rate of return it generates, 4.9.1 Types of Bond Yield 1. Current Yield (or Basic Yield): + Itis the ratio of coupon rate to current market price of the bond. * Current Yield = (Annual interest rate payment/Current market price) * 100 * Current yield changes with the change in the market price of the bond* When the bond is trading lower than its face value, the current yield is higher than the coupon rate. * When the bond is trading higher than its face value, the current yield is lower than the coupon rate. 2. Yield to Maturity (YTM): + YTM refers to the average annual rate of return that will be earned by an investor who buys a bond today at the current market price and holds the bond till maturity. * Abond’s YTM may be defined as the internal rate of return (IRR) for a given level of risk * Itis also referred to as "book yield" or "redemption yield”. © YTM=[C + (FV - PVyin}] / [(FV + PVY/2] where, C = Coupon Rate FV = Face Value PV = Present Value n= Years to maturity 3. Yield to Call (YTC): * YTC refers to the return a bondholder receives if the bond is held until the call date, which occurs sometime before it reaches maturity. + YTC can be calculated as the compound interest rate at which the present value of a bond's future coupon payments and call price is equal to the current market price of the bond. 4. Holding Period Return (HPR): + HPR is the total return earned on a bond during the time that it has been held. + Aholding period is the amount of time the investment is held by an investor, or the period between the purchase and sale of a security. + HPR = [Total Interest Income + (Ending Value — Initial Value)] / Initial Value 5. Effective Yield:* Effective yield is the return on a bond that has its interest payments (or coupons) reinvested at the same rate by the bondholder. * Itis the yearly rate of return at a periodic rate of interest on bonds. * Effective Yield = (1 + r/n)n—1 where, r= Interest Rate n= Number of Compounding Periods + For example, B purchases a bond of Company XYZ that has a 5% coupon. If the interest is paid semi-annually, then the effective yield will be: Effective Yield = (1 + 0.05/2)2 - 1 = 5.062% 4.9.2 Yield Spread * Yield spread is the difference between yields of two bonds (or debt instruments in general) which are different maturities, credit ratings or risk + This difference is most often expressed in basis points (bps) or percentage points. + For example, if one bond is yielding 7% and another is yielding 4%, the spread is 3 percentage points or 300 basis points. 4.9.3 Yield Curve * Ayield curve shows the relation between the interest rate (cost of borrowing) and the time to maturity. It is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. + Itis a way to measure bond investors’ feelings about risk, and can have a tremendous impact on the returns, + There are three main shapes of the yield curve: normal (upward sloping curve), inverted (downward sloping curve), and flat. Normal Yield Curveee Normal Yield Curve YIELD MATURITY Forbesapvisor The normal yield curve is a yield curve in which short-term debt instruments have a lower yield than long-term debt instruments of the same credit quality. ‘An upward sloping yield curve suggests an increase in interest rates in the future. A downward sloping yield curve predicts a decrease in future interest rates. Inverted Yield CurveInverted Yield Curve YIELD MATURITY Forbesapvisor * An inverted yield curve occurs when short-term debt instruments carry higher yields than long-term instruments of the same credit risk profile, * Inverted yield curves are unusual since longer-term debt should carry greater risk and higher interest rates, so when they occur there are implications for consumers and investors alike, Flat Yield CurveFlat Yield Curve YIELD MATURITY Forbesapvisor The flat yield curve is a yield curve in which there is litle difference between short-term and long-term rates for bonds of the same credit quality. This type of yield curve flattening is often seen during transitions between normal and inverted curves. The difference between a flat yield curve and a normal yield curve is that a normal yield curve slopes upward. Price-Yield CurvePrice Premium Par Discount Yield 10% 14% 18% + Price-Yield Curve can be defined as the relationship between yield (also called required rate of return or market interest rate) of a bond and the market price of that bond. * Abasic property of a bond is that its price varies inversely with yield. As the required yield decreases, the present value of the cash flow increases, hence the price increases + For example, if the coupon rate on a bond is 14% but required rate of return falls down to 10%, it means that investors would be willing to pay more for the same bond in order to get 14% return, which is higher than expected return of 10%. This would result in an increase in price of the bond. 4.10 Types of Risks in Bonds 1. Default Risk: * Itrefers to the risk that borrower company will default in the payment of interest or principal amount. * It can be calculated on the basis of credit rating given to the bond by credit rating agencies. * Allother things being equal, the lower a bond's credit quality, the higher its yield.* Lower-rated bonds tend to drop in value when the economy is in recession or when investors think the economy is likely to fall into a recession. 2. Market Interest Rate Risk: * It can be defined as the probability that bond prices will fall because of increase in general level of interest rates. It can also be called bond volatility or interest rate sensitivity. * The interest rate risk is higher in the following cases: + bonds of longer maturity period (everything else same, the bond with higher maturity will have higher interest rate risk) + bonds with lower coupon rates (everything else same, the bond with lower coupon rate will have higher interest rate risk) 3. Liquidity Risk: + Itrefers to the risk that the investor may not be able to sell the bond when he wants due to less liquidity (less trading) of that bond * Also, the price at the stock exchange may not show the true value of the bond which prevents the investor to sell the bond at will. 4. Inflation Risk: * If there is increase in inflation rate, then there is a decrease in purchasing power of the amount which the investor receives as interest or principal (except in case of inflation-indexed bonds). * Real interest rate = [(1 + coupon rate) + (1 + inflation rate)] — 1 5. Reinvestment Risk: * In YTM calculation, it is assumed that the investor will be able to reinvest interest income at the same rate (i.e., TM) * This may not always hold true in reality which gives rise to reinvestment risk. Also, longer the maturity of bond, higher is the reinvestment risk. 5.0 DERIVATIVES MARKET 5.1 What is a Derivative?* Aderivative is a financial security or contract between two parties whose value is derived from an underlying asset or a group of assets. + The underlying asset can be stocks, bonds, index, commodities, currencies, interest rates, etc. * Derivatives are defined in the Securities Contracts (Regulation) Act 1956. + Derivatives are traded over-the counter (OTC) as well as on exchanges. * OTC-trade derivatives can be customized but derivatives traded on an exchange are standardized + Derivatives do not have physical existence, but emerge out of a contract between two parties. Example A derivative/ security is issued, whose value is defined based on price of rice in the market. As price of rice increases or decreases, the value of derivative also goes up and down. if the asset (rice) underlying this derivative is removed, the value of derivative will become zero because this security has no value on its own. 5.2 History of derivatives in India Derivatives trading started in 1875 with the setting up of Bombay Cotton 1875 Trading Association. 1952 In 1952, government banned cash settlement and options trading In 1993, SEBI banned forward trading and “Badia” system. The “Bad trading is a mechanism of trade settlement in India. “Badla" is a Hindi term 1993 {or carryover transactions. It allowed traders to carry forward their positions to the next settlement cycle. There was no standard margin requirement in this system. ia In 1995, Securities Laws (Amendment) Ordinance was promulgated which removed the prohibition on options in securities In 1996, SEBI constituted a committee under the chairmanship of Mr. L.C. 1996 Gupta to develop appropriate regulatory framework of derivatives trading in India. 1999 ‘The SCRA was amended in December 1999 to include derivatives within the definition of ‘securities’ 2000 Finally, SEBI granted approval for derivatives trading in May 2000 and derivatives trading started in June 2000.5.3 Types of Derivative Contracts There are 4 types of derivative contracts: * Forwards » Futures: * Options + Swaps 5.3.1 Forwards * A forward contract is an agreement between parties to buy of sell an underlying asset on a specified date for a specified price. + The party who agrees to buy the underlying asset on a certain specified future date for a certain specified price is said to have taken a long position + The other party who agrees to sell the asset on the same date for the same price is said to have taken a short position. + Forward contracts are customized contracts. So, details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. + These contracts are traded over-the-counter (OTC) and not on an exchange. So, no initial margin or premium is payable. + Forward contracts are popular in the agriculture sector and foreign exchange market. 5.3.2 Futures + A future contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. * But unlike forward contracts, future contracts are standardized and are traded on an exchange. The contracts are standardized in terms of: + Standard underlying asset + Standard quantity and quality of the underlying asset that can be delivered + Standard timing of such settlement (date and month of delivery) + Standard tick (tick means minimum change in price)The exchange specifies certain standard features of the contract to enable liquidity in the contracts. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. In future contracts, the losses as well as profits for the buyer and the seller are unlimited, Terminology i Long 2. Short 3. Spot Price 4 Futures Price 5. Expiry Date 6. Margin te Basis 8 Spread A party is said to be long on an instrument when he or she purchases that particular instrument. A party is said to be short when he or she sells a contract, which he does not currently own The price at which an asset trades in the spot market is, called spot price. Also called as cash price or current price. The price at which the future contract trades in the futures market. The last day on which the contract will be traded, at the end of which it will cease to exist. The amount of money deposited by both buyers and sellers of futures contracts to ensure performance of terms of the contract is called margin money. The difference between spot price and futures price of an asset is called as basis. As a contract approaches maturity, the basis reduces and becomes zero on the date of maturity because the future price and spot price become the same on date of maturity The difference between two futures prices. Difference between Forwards and Futures Point of Forwards Difference y ves ot Customized Contract OTC/Exchange OTC-traded ity Less liquidity Futures Standardized Exchange-traded More liquidityItis not tradable. Contract Marked to market: this means that value of Tradable is settled on the settlement derivative changes everyday according to date only value of underlying asset - Traders are required to submit margin with Margin No margin requirement brokers This risk is eliminated because the clearing Counter-party house associated with exchanges becomes is pr Risk (tis present the counter-party to all trades and guarantees settlement 5.3.3 Options + An ‘Option’ is a type of security that can be bought or sold at a specified price within a specified period of time, in exchange for a non-refundable upfront deposit. * There are two parties: © Option buyer (or option holder) © Option seller (or option writer) + An options contract offers the option buyer the right to buy or sell, and not the obligation, at the specified price or date. But the option seller has the obligation to fulfil the contract in case buyer exercises the option. + Expiration Date: The specified future date is called maturity date or expiration date or exercise date of the contract. * Strike Price: The specified price is called the strike price or exercise price + Option Premium: The price of the option is called option premium. Option buyer needs to pay to the option seller a one-time non-refundable upfront amount to buy the right. Buyer will not get back the premium in case he does not exercise the option: * If the option holder does not exercise the option on the exercise date, then the option will lapse. + Popular models to determine value of an option: © Black Scholes Option Pricing Model © Binomial Model Types of Options1. American Options Vs European Options + American option: The option holder can exercise his right to buy or sell either on the maturity or expiration date or even before the maturity date, + European option: The option holder can exercise his right only on the expiration date. * Note: In India, all option contracts have to be European in nature. 2. Covered Options Vs Naked Options * Covered option: It is covered or backed by the asset which is owned by the option writer. So, if the option holder exercises the option, option writer can deliver the asset. + Naked option: It is not covered by any physical asset, 3. Call Options Vs Put Options * Call option: It provides the option holder the right to buy a specific asset at a specific price on or before the specific future date. * Put option: It provides the option holder the right to sell a specific asset at a specific price on or before the specific future date. Long position in Call Buying a Call Long position in Put Buying a Put Short position in Call Selling a Call Short position in Put Selling a Put * The relation between actual price (AP) and strike price (SP) can be depicted with the help of the table. Relation Call option Put option AP > SP Inthe Money Out of money AP < SP Out ofmoney _In the money AP = SP ‘Atthe money At the money 4. Exotic Options * Innovative option-like products are also developed which are called exotic options. + They are customized contracts and OTC-traded.+ Examples: Asian options, Look-back Options, Barrier Options, Binary Options. * Note: Futures and Options contracts expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts expire ‘on the previous trading day. All the Futures and Options contracts are settled in cash on a daily basis and at the expiry or exercise of the respective contracts as the case may be. Risk Profile Advance Payment Margin Obligation of Buyer Obligation of Seller 5.3.4 Swaps Futures symmetric No advance payment Both buyer as well as seller is, required to deposit margin with their broker There is obligation to execute the contract There is obligation to execute the contract Options Asymmetric Advance payment in the form of, premium Only seller (or option writer) is Tequired to deposit margin with his broker Buyer has a right and not obligation. There is obligation to execute the contract * Itis a derivative contract which allows exchange of cash flows between two parties. * Itusually involves exchange of a fixed cash flow for a floating cash flow. * They are traded over-the-counter (OTC) and not on an exchange. + Examples are currency swaps, interest rate swaps, commodity swaps, etc. 5.4 Margin in Derivatives Trading What is Margin? + When a trader trades in derivatives (futures & options), he is required to pay a proportion of the trade value as margin. + Full payment has to be done when the contract ends, = Traders submit margin with broker who further submit it with the exchange.+ Margin acts as a security against loss that can arise due to daily price changes. * Margin allows traders to take leverage as by depositing a small amount of money (some % of contract value) trader can take large exposure. Initial Margin * Itis the upfront margin which gets blocked in the trading account. It is calculated as a percentage of contract value. * Contract value = Futures Price * Lot size + Here, lot size is fixed but futures price may fluctuate daily. It means contract value can change daily and hence margins also vary every day. + There are two kinds of initial margins: © Standard Portfolio Analysis of Risk (SPAN) margin: this is the upfront margin blocked in the trading account of trader. © Exposure margin: this margin is over and above SPAN to cover M2M losses. M2M (Mark to Market) + Futures price fluctuate daily due to which trader makes profit or loss daily. + So, M2M is an accounting procedure which adjusts profit or loss on a daily basis in the trading account. Participants in Derivative Markets 1. Hedgers + Hedger is a person who holds the underlying asset and wish to cover the risk due to unfavorable movement in the price of the underlying asset. * So, hedgers have a risk exposure and they enter the derivatives market to mitigate or offset the risk and not to make gains. 2. Speculators + Speculators enter the derivatives market to make gains based on their belief about price movements in the asset. * They do not hold the underlying asset. 3. Arbitrageurs + Arbitrage refers to making riskless profit or gain by simultaneously entering into two transactions in two different markets and taking benefit of the pricedifferential in the same asset in the two markets. 6.0 COMMODITY MARKET 6.1 What is a Commodity Market? * Acommodity market is a market which facilitates trading (buying and selling) in various commodities. + Acommodity is any raw material or primary agricultural product that can be bought or sold, whether wheat, gold, or crude oil, among many others. + Commodities can be classified according to their uses: © Energy: E.g., coal and petroleum (crude oil) © Metal and nonmetals: E.g., tin and copper © Agricultural products: E.g., rice and sugar Terminology Itis the diference between futures price and spot Cost of Carry or . A er a becle price. Cost of carry constitutes interest rate, cost of transport and warehousing. When the spot price of a commodity is higher than 2 Backwardation pave iyis hi the futures price, itis called backwardation.6. When the spot price of a commodity is lower than Contar vontango the futures price, itis called Contango. itis a process for performing a futures contract by Cash Settlement payment of money difference rather than by delivering the physical commodity. The difference between spot and futures contract theoretically should have declining trend over the life of a contract and tend to become zero on the date on maturity Convergence Any warehouse which has been officially approved Approved (or by the exchange and from which actual deliveries of Certified) commodities can be made on the expiration of a Warehouse futures contract, itis a document issued by a warehouse indicating Warehouse ‘ownership of a stored commodity and specifying Receipt details in respect of particulars, like, quality, quantity and, sometimes, indicating the crop season. it means the total number of Commodity Derivatives of an underlying that have not yet been offset and Open interest closed by an opposite Commodity Derivatives transaction; nor fulfilled by delivery of the cash or underlying security or Exercise of the option. 6.2 History of Commodities Market Organised trading in commodities began in 1848 with the setting up of the Chicago Board of Trade (CBOT). In India, organised commodity trading began in the year 1875 with the establishment of the Bombay Cotton Trade Association Commodity derivatives were initially started to protect farmers from the risk of decline in price of their crops or produce. In 1952, the Forwards Contract (Regulation) Act was passed on the recommendation of Prof. A.D. Shroff Committee. Futures trading was banned in 1966 to control the price movements of agricultural and other important commodities. Since April 2003, Government has again allowed futures trading in all the commodities.* Options trading in commodities began in 2017. 6.3 Types of Commodities To Hard feet bed fest l= lu} + Commodities traded on the exchanges are broadly classified as: © Soft Commodities, which are agricultural produce (rice, wheat, com, soya, coffee, sugar etc.) & livestock (live & feeder cattle, pork etc.), and © Hard Commodities, which are natural resources (precious & base metals, natural gas, crude ete.) + In general, commodities are classified into four types: © Metals: aluminium, copper, brass, zinc, nickel, lead © Energy: crude oil, natural gas, gasoline, and heating oil © Agriculture: corn, beans, rice, wheat, cotton, cardamom, rubber, castor seed © Bullion: gold, silver, platinum 6.4 Commodity Exchanges in India 1. Multi Commodity Exchange - MCX + Itwas established in 2003.Itis India’s largest commodity derivative exchange. + Itis India’s first listed exchange — its listed on both BSE and NSE * Itis India’s first exchange to offer commodity option contracts. * Itoffers futures contracts on Bullion, Base Metals, Energy and Agri commodities. + iCOMDEX is the flagship index series of MCX which is developed jointly with Thomson Reuters. It gives information about market movement in key commodities traded on MCX. * MCX Clearing Corporation Limited (MCXCCL), a wholly-owned subsidiary of MCX, is the first clearing corporation in the commodity derivatives market. 2. National Commodity and Derivatives Exchange ~ NCDEX * Itwas established in 2003. Itis India’s second largest commodity exchange. It deals primarily in agricultural commodities. * Ibis a national-level demutualised commodity exchange. * Nkrishi: It is a value weighted index, computed in real time using the prices of the 10 most liquid commodity futures traded on the NCDEX platform. + National Commodity Clearing (NCCL) is the clearing corporation of NCDEX. It is a wholly owned subsidiary of NCDEX. 3. Indian Commodity Exchange - ICEX * National Multi Commodity Exchange (NMCE) has merged with ICEX. * Itis India’s third largest commodity exchange. + Itlaunched the world’s first ever diamond derivatives contract. * Itallows trade in derivatives of agricultural commodities and non-agri commodities like diamond and steel Regulatory Authority * Before 2015, Forward Market Commission (FMC), which was established in 1953, was the regulator of commodities market in India. * But on 28 September 2015, FMC merged with SEBI. So, since 28 September 2015, SEBI is the regulator of commodities market as well.+ SEBI has set up "The Commodity Derivatives Market Regulation Department” (CDMRD) which is responsible for supervising the functioning and operations of ‘commodity derivative exchanges. + The commodity derivative exchanges recognized under Forward Contracts (Regulation) Act, 1952 (FCRA) are now deemed to be recognized under Securities Contract (Regulation) Act, 1956 (SCRA). Futures Trading in Commodity Indices + Through a circular issued on June 18, 2019, SEBI has permitted recognized ‘stock exchanges with commodity derivative segment to introduce futures on commodity indices based on the recommendations of the “Commodity Derivatives Advisory Committee” (CDAC). * The recognized stock exchanges with commodity derivative segment willing to start trading in futures on commodity indices shall take prior approval of SEB! for launching such contracts + Exchanges will have to submit at least past 3 years data of the index constructed along with data on monthly volatility, roll over yield for the month and monthly return while seeking approval from SEBI. + On approval, exchanges shall also publish the above data on their website before launch of the products. 7.0 FOREIGN EXCHANGE MARKET 7.1 What is the Foreign Exchange Market?+ The foreign exchange market is an over-the-counter (OTC) global marketplace for trading of currencies. + The forex market determines the exchange rate for currencies around the world. + Participants in these markets can buy, sell, exchange, and speculate on the relative exchange rates of various currency pairs. 7.2 Evolution of Forex Market in India 7.2.1 Regulation of Forex in India + Fora long time, foreign exchange in India was treated as a controlled commodity because of its limited availability. + The early stages of foreign exchange management in the country focused on control of foreign exchange by regulating the demand due to limited supply. + The statutory power for exchange control was provided by the Foreign Exchange Regulation Act (FERA) of 1947, which was subsequently replaced by the more comprehensive Foreign Exchange Regulation Act (FERA), 1973* After the liberalization measures were introduced since 1991, FERA was amended and replaced by the new Foreign Exchange Regulation (Amendment) Act, 1993. + Finally, keeping in view the changed environment, the Foreign Exchange Management Act (FEMA) was enacted in 1999 to replace FERA with effect from June 1, 2000. 7.2.2 Evolution of India’s Exchange Rate Policy * India’s exchange rate policy has evolved in tandem with the domestic as well as international developments. + The period after independence was marked by a fixed exchange rate regime, which was in line with the Bretton Woods system prevalent then. + The Indian Rupee was pegged to the Pound Sterling on account of historic links with Britain. * After the breakdown of Bretton Woods System in the early seventies, most of the, countries moved towards a system of flexible/managed exchange rates. * With the decline in the share of Britain in India’s trade, the Indian Rupee was de- linked from the Pound Sterling in September 1975. + The exchange rate subsequently came to be determined with reference to the daily exchange rate movements of an undisclosed basket of currencies of India’s major trading partners. + In March 1992, the Liberalised Exchange Rate Management System (LERMS), involving a dual exchange rate was instituted. + Aunified single market-determined exchange rate system based on the demand for and supply of foreign exchange replaced the LERMS effective March 1, 1993. 7.3 Foreign Exchange Management Act (FEMA), 1999 7.3.1 Introduction + FEMAis an Act of the Parliament of India "to consolidate and amend the law relating to foreign exchange with the objective of facilitating external trade and payments and for promoting the orderly development and maintenance of foreign exchange market in India".+ Itwas passed in 1999, replacing the Foreign Exchange Regulation Act (FERA). FEMA came into effect on 1st June, 2000. * Itenabled a new foreign exchange management regime consistent with the emerging framework of the World Trade Organisation (WTO) + Itis a more liberal form of the erstwhile FERA Act and has removed many of the restrictions on withdrawal of foreign exchange. + FEMA has classified forex transactions into two categories: capital account and current account transactions. 7.3.2 Capital Account and Current Account Transactions Capital Account Transactions + Acapital account transaction means a transaction which alters © the assets or liabilities, including contingent liabilities, held outside India by persons resident in India or © assets or liabilities in India of persons resident outside India. * It includes transactions referred to in sub-section (3) of Section 6 of FEMA, such as— © transfer or issue of any foreign security by a person resident in Indi © transfer or issue of any security by a person resident outside India; © deposits between persons resident in India and persons resident outside India; © acquisition or transfer of immovable property in Indi outside India. by a person resident Current Account Transactions + Acurrent account transaction means a transaction other than a capital account transaction and includes — © payments due in connection with foreign trade, other current business, services, and short-term banking and credit facilities in the ordinary course of business; © payments due as interest on loans and as net income from investments; © remittances for living expenses of parents, spouse and children residing abroad, and© expenses in connection with foreign travel, education and medical care of parents, spouse and children. 7.3.3 Authorised Person under FEMA An" Authorized Person" under FEMA, is a person who is authorized by the Reserve Bank to deal in foreign exchange. Reserve Bank, currently, issues authorisation under Section 10(1) of the Foreign Exchange Management Act, 1999, to + select banks (as Authorised Dealers Category-I) to carry out all permissible current and capital account transactions as per directions issued from time-to- time + select entities (as Authorised Dealers Category-1) to carry out specified non- trade related current account transactions, all the activities permitted to Full Fledged Money Changers and any other activity as decided by the Reserve Bank + select financial and other institutions (as Authorised Dealers Category-III) to carry out specific foreign exchange transactions incidental to their business / activities + select registered companies as Full Fledged Money Changers (FFMC) to undertake purchase of foreign exchange and sale of foreign exchange for specified purposes viz. private and business travel abroad. 7.3.4 Liberalised Remittance Scheme (LRS) + Under the Liberalised Remittance Scheme, all resident individuals, including minors, are allowed to freely remit up to USD 2,50,000 per financial year (April — March) for any permissible current or capital account transaction or a combination of both. * The Scheme was introduced on February 4, 2004, with a limit of USD 25,000. * Incase of the remitter being a minor, the LRS declaration form must be countersigned by the minor's natural guardian, * The Scheme is not available to corporates, partnership firms, HUF, Trusts, etc. 7.4 What is an Exchange Rate?+ Anexchange rate is the price of a nation’s currency in terms of another currency. + Itis also regarded as the value of one country’s currency in relation to another currency. + For example, if the exchange rate between the U.S. Dollars (USD) and the Indian Rupee (INR) is Rs.80 per dollar, one U.S. dollar can be exchanged for Rs.80 in foreign currency markets. + The exchange rate affects trade and the movement of money between countries. + The exchange rate between two currencies is commonly determined by the economic activity, market interest rates, gross domestic product, and unemployment rate in each of the countries. + Exchange rates can be either fixed or floating. Fixed exchange rates are decided by central banks of respective countries, whereas floating exchange rates are decided by the mechanism of market demand and supply. 7.4.1 Fixed Exchange Rate SystemFixed Exchange Rate Pd Creu en regen Cer WA tg ers) F warsueeroie + Afixed exchange rate is a regime applied by a government or central bank that ties the country's official currency exchange rate to another country's currency or the price of gold. + Fixed rates provide greater certainty for exporters and importers. * Fixed rates also help the government maintain low inflation, which, in the long Tun, keep interest rates down and stimulates trade and investment. 7.4.2 Advantages of a Fixed Exchange Rate System + It ensures stability in exchange rate which encourages foreign trade. * Astable system allows importers, exporters, and investors to plan without worrying about currency moves. + Afixed exchange rate helps to ensure the smooth flow of money from one country to another. + Ithelps smaller and less developed countries to attract foreign investment. * Italso helps the smaller countries to avoid devaluation of their currency and keep inflation stable. 7.4.3 Disadvantages of a Fixed Exchange Rate System + A fixed-rate system limits a central bank's ability to adjust interest rates as needed for economic growth,* A fixed-rate system also prevents market adjustments when a currency becomes over or undervalued. 7.4.4 Floating Exchange Rate System + The system of exchange rate in which rate of exchange is determined by forces. of demand and supply of foreign exchange market is called a floating or flexible exchange rate system. + Here, value of currency is allowed to fluctuate or adjust freely according to change in demand and supply of foreign exchange. + There is no official intervention in foreign exchange market. 7.4.5 Advantages of a Floating Exchange Rate System + Adeficit or surplus in BOP is automatically corrected by market adjustments and changes in exchange rate (fall in exchange rate leads to rise in exports and vice- versa). * Government intervention is not required. + Ithelps in optimum resource allocation by allowing markets to adjust freely. 7.4.6 Disadvantages of a Floating Exchange Rate System + It encourages speculation leading to fluctuations in foreign exchange rate. * Wide fluctuation in exchange rate hampers foreign trade and capital movement between countries + It generates inflationary pressure when prices of imports go up due to depreciation of currency. 7.4.7 Managed Floating * Amanaged floating exchange rate system is an exchange rate regime in which the exchange rate is neither entirely floating nor fixed + Under managed floating, a country's central bank occasionally intervenes to change the direction or the pace of change of a country's currency value. * This system is also known as “dirty float” + The goal of a ditty float is to keep currency volatility low and promote economic stability.7.5 Changes in the Value of Currency 7.5.1 Currency Appreciation * Currency appreciation is the increase in the value of domestic currency in terms of foreign currency. It takes place in a floating exchange rate system + For example, a change from $1 = Rs.75 to $1 = Rs.72 indicates that there is an appreciation of Indian Rupee. + Currencies appreciate against each other for a variety of reasons, including government policy, interest rates, trade balances, and business cycles. + Currency appreciation leads to an increase in imports and a decrease in exports. 7.5.2 Currency Depreciation + Currency depreciation is the decrease in the value of domestic currency in terms of foreign currency. It takes place in a floating exchange rate system + For example, a change from $1 = Rs.75 to $1 = Rs.76 indicates that there is a depreciation of Indian Rupee. * Currency depreciation can occur due to factors such as economic fundamentals, interest rate differentials, political instability, or risk aversion among investors. + Countries with weak economic fundamentals, such as chronic current account deficits and high rates of inflation, generally have depreciating currencies. + Currency depreciation leads to an increase in exports and a decrease in imports. 7.5.3 Currency Devaluation + Devaluation is an official lowering of the value of a country's currency within a fixed exchange-rate system. + The government formally sets a lower exchange rate of the domestic currency in terms of foreign currency. + For example, a change from $1 = 70 to $1 = 75 indicates that the Rupee has been devalued. * Devaluing a currency reduces the cost of a country’s exports, enabling exporters to more easily compete in the foreign markets. It also makes imports more expensive, providing a disincentive for domestic consumers to purchase imported goods, leading to lower levels of imports.+ Devaluation tends to improve a country's balance of trade by improving the competitiveness of domestic goods in foreign markets. Devaluation Vs. Depreciation Devaluation Depreciation A devaluation occurs when a country makes a ‘A depreciation is when there is a fall in conscious decision to lower its exchange rate ina __the value of a currency in a floating fixed or semi-fixed exchange rate. exchange rate, Ittakes place due to official action taken by the government. It takes place due to market forces. 7.5.4 Currency Revaluation + Revaluation is an official rise of the value of a country's currency within a fixed exchange-rate system. + The government formally sets a higher exchange rate of the domestic currency in terms of foreign currency. + For example, a change from $1 = 76 to $1 = 75 indicates that the Rupee has been revalued. + Currency revaluation can be triggered by a variety of events, including changes in the interest rates between various countries or large-scale events that impact an economy. * Arevaluation of the domestic currency will make foreign goods less expensive, thus increasing imports. + Domestic producers, on the other hand, will be able to sell fewer export goods because foreign consumers wil find it more expensive to obtain domestic goods. * Thus, its balance of trade will move to a smaller surplus or to a deficit. 7.6 Functions of Foreign Exchange Market A forex market performs three main functions: * Transfer + Credit + Hedging7.6.1 Transfer Function * The basic and the most visible function of foreign exchange market is the transfer of funds (foreign currency) from one country to another. * It basically includes the conversion of one currency to another, wherein the role of forex is to transfer the purchasing power from one country to another. + The transfer function is performed through a use of credit instruments, such as bank drafts, bills of foreign exchange, and telephone transfers. 7.6.2 Credit Function + The forex market provides short-term credit to the importers so as to facilitate the ‘smooth flow of goods and services from country to county. + An importer can use credit to finance the foreign purchases. 7.6.3 Hedging Function + Hedging in a forex market means the avoidance of a foreign exchange tisk. * Parties in forex transactions are often afraid of the fluctuations in the exchange rates. + The forex market provides facilities for hedging anticipated or actual claims or liabilities through forward contracts in exchange. + A forward contract is a contract to buy or sell foreign exchange against another currency at some fixed date in the future at a price agreed upon now. Notes Financial Market 8%7.7 Purpose of Foreign Exchange Market — mae 7.7.1 Currency Conversion ‘Notes Financial Market* Currency conversion is the process that facilitates transactions where the issuer and acquirer use different currencies by exchanging one type of currency for another. + For example, Mr. X has a business in the United States that imports wines from around the world. He'll need to pay the French winemakers in euros, the ‘Australian wine suppliers in Australian dollars, and the Chilean vineyards in pesos. 7.7.2 Currency Hedging + Currency hedging refers to the technique of protecting against the potential losses that result from adverse changes in exchange rates. * A foreign exchange hedge is a method used by companies to eliminate or “hedge” their foreign exchange risk resulting from transactions in foreign currencies. + Companies use hedging as a way to protect themselves if there is a time lag between when they bill and receive payment from a customer. + For example, a retail store in Japan imports or buys shoes from Italy. The Japanese firm has 90 days to pay the Italian firm. To protect itself, the Japanese firm enters into a contract with its bank to exchange the payment in ninety days at the agreed-on exchange rate. This way, the Japanese firm is clear about the amount to pay and protects itself from a sudden depreciation of the yen. If the yen depreciates, more yen will be required to purchase the same euros, making the deal more expensive. By hedging, the company locks in the rate. 7.7.3 Currency Speculation* Currency speculating is the buying and selling of currencies for the purposes of profiting on the changes in exchange rates. 7.7.4 Currency Arbitrage Exchange ; )* Currency arbitrage is a strategy that allows a currency investor to make money from different rates offered by brokers in different currency markets for the same currency pair. + Acurrency trader benefits from the price difference in quotes by various brokers or in a different market to make a profit, + For example, there are two different brokers — A and B — for USD/EUR currency pair. Broker A sets the price at 1.5 dollars per euro, while Broker B sets the rate for the same currency pair as 1.33 dollars per euro. To execute a forex arbitrage, the trader would first convert one euro into dollars with Broker A. Then. The trader will go to Broker B and convert dollars into euros. First, when a trader tums one euro into a dollar, he gets 1.5 dollars. Then he converts 1.5 dollars into euros to get 1.33 euros. This way, the trader makes a profit of about 0.17 euros. 7.8 Currency Quotation 7.8.1 Base Currency and Quote Currency Quote Currency: US Dollar { EUR / USD Base Currency: EURO + Acurrency pair is a quotation of two different currencies, where one is quoted against the other. + When we quote currencies, we are indicating how much of one currency it takes to buy another currency. + The first listed currency within a currency pair is called the base, while the second currency that is the benchmark is called the quote. + The value of base currency is always assumed to be 1.* Acurrency pair's exchange rate reflects how much of the quote currency is needed to be sold/bought to buy/sell one unit of the base currency. * For example, the quotation EUR/USD = 1.25 means that one euro is exchanged for 1.25 U.S. dollars. in this case, EUR is the base currency and USD is the quote currency. This means that 1 euro can be exchanged for 1.25 U.S. dollars. Another way of looking at this is that it will cost you $1.25 to buy 1 euro. 7.8.2 Direct & Indirect Quotation Direct Quotation Amount of Domestic Currency Direct Quote ~7 feamicel Woreign Currency * Adirect quote is an exchange rate quotation in the foreign exchange market that quotes a fixed unit of a foreign currency against a variable amount of the domestic currency. * Adirect quote depicts the amount of domestic currency that can be bought for a certain unit of the foreign currency. * Adirect quote is also called a “price quotation”. + The price of one unit of foreign currency is expressed in terms of the domestic currency. + In adirect quote, the foreign currency is the base currency, while the domestic currency is the quote currency. + For example, USD/INR = 80 is a direct quote for a person living in India. It means that $1 = Rs. 80 Indirect Quotation 1 Direct Quote = ————_~_ Q Indirect Quote * An indirect quote expresses the quantity of foreign currency required to buy units of the domestic currency. * An indirect quote is also called “quantity quotation”.+ The price of one unit of domestic currency is expressed in terms of the foreign currency. + In an indirect quote, the domestic currency is the base currency, while the foreign currency is the quote currency. + For example, INR/USD = 0.0125 is an indirect quote for someone living in the USA. It means that INR 1 = $ 0.0125 (1/80 = 0.0125). 7.9 Spot Rate, Cross Rate, & Forward Rate Spot Rate * The spot exchange rate is the current amount one currency will trade for another currency at a specific point in time. + Itis the open market price that a trader will pay to buy another currency. + Spot rates are usually set through the global foreign exchange market (forex) where currency traders, institutions, and countries clear transactions and trades. * Cash delivery for spot currency transactions is usually the standard settlement date of two business days after the transaction date (T+2) Cross Rate * Across rate is a foreign currency exchange transaction between two currencies that are both valued against a third currency, * In the foreign currency exchange markets, the U.S. dollar is the currency that is usually used to establish the values of the pair being exchanged. + When a cross-cutrency pair is traded, two transactions are actually involved. The trader first trades one curreney for its equivalent in U.S. dollars. The U.S. dollars are then exchanged for another currency. + One of the most common cross currency pairs is the euro and the Japanese yen. Forward Rate + The forward exchange rate is the exchange rate at which a buyer and a seller agree to transact a currency at some date in the future. + Forward rates are really a reflection of the market’s expectation of the future spot rate for a currency. * In the forward markets, foreign exchange is always quoted against the U.S. dollar.+ This means that pricing is done in terms of how many U.S. dollars are needed to buy one unit of the other currency. 7.10 Instruments in the Forex Market 7.10.1 Spot Contracts * Spot contracts are the contract of exchanging currencies, securities, and commodities at the price of the settlement date. * Ifthe arrangement is conducted at the transaction date exchange rate, which is known as spot rate contracts. + Itinvolves the immediate purchase and sale of currencies, securities, and commodities. 7.10.2 Forward Contracts + A forward contract is an agreement of buying or selling of particular asset on a mentioned future date at the specified rate. + Here future dates may be longer-term (more than 12 months). + Forward contracts are foreign exchange derivatives. + They are utilized by traders to restrict the risk of exchange rate uncertainty. + Forward contracts take place over the counter, where two parties negotiate the quantity, quality, cost, and date of the transaction. Notes Financial Market 987.10.3 Options * Options are exactly like a forward contract, parties can exercise options on favorable terms. * Its also a type of forex derivative used to mitigate forex trading risks * It gives the purchaser the right, but not a responsibility to transfer any underlying asset, currencies, security, etc, at an agreed cost on a specified date. + Parties involved in the options are called: option holders (buyers), option writers (sellers) 7.10.4 Futures + Afutures contract is an arrangement between two agencies that make one agent purchase an asset, financial instruments, securities, currencies, and counterparty to sell an asset, financial instrument, securities, and currencies at a fixed future date. + Future contracts are a derivative instrument that is used by investors to make huge profits on their investments. 7.10.5 Swaps * A foreign exchange swap (also known as an FX swap) is an agreement to simultaneously borrow one currency and lend another at an initial date, then exchanging the amounts at maturity. + Foreign currency swaps can help companies borrow at a rate that's less expensive than that available from local financial institutions. + They can also be used to hedge (or protect) the value of an existing investment against the risk of exchange rate fluctuations 7.11 Foreign Exchange Risk/ExposureTransaction Risk * Itis the simplest kind of foreign exchange exposure. * This risk is faced by a company or business when it purchases a good or service from a company in a foreign country and price of that product/service is quoted in foreign currency. * So, if the selling company's currency appreciates against the buying company's currency, then the company doing the buying will have to make a larger payment in its domestic currency to meet the contracted price. Economic or Operating Risk + This exposure directly affects the value of the company or firm. * This type of exposure has a bearing on assets as well as operating cash flows of the firm which directly affects the value of the firm. + It is also called “forecast risk". * So, it can be defined as the situation where a company's market value is continuously affected by an unavoidable exposure to currency fluctuations. * Its also called “accounting exposure”. * Itrefers to the risk which arises when the financial statements of a foreign subsidiary of the parent company, which maintains its accounts in the foreign Notes Financial Marketcurrency, are converted into the home curreney for preparing consolidated financial statements. * So, due to conversion, parent company may have to suffer losses due to unavoidable currency movements 7.12 Foreign Currency Accounts Held by Resident Individuals 7.12.1 What is a Foreign Currency Account? A Foreign Currency Account is an account held or maintained in currency other than the currency of India or Nepal or Bhutan, 7.12.2 Types of Foreign Currency Accounts ‘Some of the foreign currency accounts that can be opened by resident individuals with an Authorised Dealer (AD) bank in india are: + Exchange Earners Foreign Currency (EEFC) Account + Resident Foreign Currency (Domestic) [RFC(D)] Account + Resident Foreign Currency (RFC) Account Exchange Earners Resident Foreign _Resident Foreign Particulars Foreign Currency Currency (Domestic) Currency (RFC) (EEFC) Account IRFC(D)] Account Account Who can open Exchange Eamers Individuals Individuals the account Jointly with eligible persons; or With Joint account resident relative(s) on former or survivor’ Jointly with any eligible persons Same as EEFC basis. ype of Current! savings! term Current only Current only * Account deposits De-regulated (As Interest Non-interest ea ming -Non-interest earning decided by the AD bank) Permitted 1, 100% of foreign 4. Foreign exchange 1. Foreign exchange Credits exchange received on received as payment! received by him as. account of export service gift superannuation/ othertransactions. 2. Advance remittance received by an exporter towards export of goods or services 3. Repayment of loans given to foreign importers 4. Disinvestment proceeds on conversion of ADR/ GOR 5. Professional earnings like director's! consultancy/ lecture fees, honorarium and similar other earnings received by a professional by rendering services in his individual capacity 6. Interest earned on the funds held in the account 7. Re-credit of unutilised foreign currency earlier withdrawn from the account 8. Payments received in foreign exchange by an Indian startup arising out of sales/ export made by the startup or its overseas subsidiaries 1, Any permissible current or capital account transaction 2. Cost of goods purchased 3. Customs duty 4, Trade related loans and advances Permitted Debits honorarium while on visit abroad or froma non-resident who is on a visit to India 2. Unspent amount of foreign exchange acquired from AD for travel abroad 3. Gift from close relative 4 Earning through export of goods! services, royalty 5. Disinvestment proceed on conversion of shares into ADR/ GOR 6 Foreign exchange received as earnings of LIC claimst maturity! surrendered value settled in forex from an indian insurance company Can be used for any permissible current’ capital account transactions. monetary benefits from overseas employer 2. Foreign exchange realised on conversion of the assets referred to in Sec 6(4) of FEMA 3. Gift/ inheritance received from a person referred to in Sec 6(4) of FEMA4, Foreign exchange acquired before the July 8, 1947 or any income arising on it held outside India with RBI permission 5. Foreign exchange received as earnings of LIC claims/ maturity? surrendered value settled in forex from an Indian insurance ‘company 6. Balances in NRE/ FCNR (8) accounts on change in residential status No restrictions on utilisation in/ outside India. 7.12.3 Foreign Currency Accounts Outside India A resident individual can open a foreign currency account with a bank outside India in the following cases:1. Aresident student who has gone abroad for studies for the period of stay abroad. 2. Aresident who is on a visit to a foreign country for the period of stay abroad. 3. Aperson going abroad to participate in an exhibition/ trade fair for crediting the sale proceeds of goods. 4. The following persons for remitting/ receiving their entire salary payable to them in India 5. A foreign citizen resident in India, who is an employee of a foreign company and is on deputation to the office/ branch/ subsidiary/ joint venture/ group company in India; 6. An Indian citizen who is an employee of a foreign company and is on deputation to the office/ branch’ subsidiary/ joint venture/ group company in India; and 7. A foreign citizen who is a resident in India and is employed with an Indian company. 8. For the purpose of sending remittances under the Liberalized Remittance Scheme. 7.13 FX-Retail + The Clearing Corporation of India Limited (CCIL) started FX-Retail, an electronic trading platform for buying/selling foreign exchange by retail customers of banks, in August, 2019. * The platform was launched to address the issue of transparent and fair pricing for retail users (individuals and Micro, Small and Medium Enterprises) in the foreign exchange market. + FX-Retail platform provides for an order driven dealing in the USD/INR currency pair for the customers of banks. * The FX-Retail platform can be accessed by any customer of a bank (through the website https://www.fxretail.co.in) who has a need to purchase or sell US Dollar against the Rupee for delivery on cash basis (same day), tom basis (next day) or spot basis (T+2), subject to the following: + There is no cap on the number of transactions per customer during a day. The total amount of transactions of a customer shall be subject to the limit assigned by its bank.* The size of a single transaction is not allowed to exceed $5 million. + Asa further facility for retail clients, no transaction charges shall be levied by the CCIL on transactions of customers if such transactions do not exceed USD 50,000 per day. * Atransaction charge of 0.0004% shall be charged by the CCIL for transactions in excess of USD 50,000 per day. 7.14 Foreign Exchange Operations in Commercial Banks 7.14.1 Foreign Exchange Department + The Foreign Exchange Department of a bank performs foreign exchange operations as well as transactions. * The principal function of a foreign exchange department is to handle foreign inward remittances as well as outward remittancvabnvaes; buying and selling of foreign currencies, handling and forwarding of import and export documents and giving the consultancy services to the exporters and importers * Besides this, the department also gives the financial assistance in relation to the foreign trade, ie., it gives assistance to the exporters by way of financing the exports and imports by giving them the financial assistance to clear the consignments or open a letter of credit. + The department issues letters of credit for their importer clients and handles letters of credit received from overseas correspondents in favor of exporters from India. 7.14.2 Letter of Credit * ALetter of Credit (LC) is a document that guarantees the buyer's payment to the sellers, + Itis issued by a bank and ensures timely and full payment to the seller. + Ifthe buyer is unable to make such a payment, the bank covers the full or the remaining amount on behalf of the buyer. * Aletter of credit is issued against a pledge of securities or cash. Banks typically collect a fee, i.e., a percentage of the size/amount of the letter of credit. Parties to a Letter of CreditSeller Buyer Sales contract a) Advice of letter Letter of credit of credit pplication » ee Request to advise and, if applicable, confirm letter of credit Advising / Issuing Bank Confirming Bank + Applicant: An applicant (buyer/importer) is a person who requests his bank to issue a letter of credit. + Beneficiary: A beneficiary (seller/exporter) is basically the seller who receives his payment under the process. * Issuing Bank: The issuing bank (also called an opening bank) is responsible for issuing the letter of credit at the request of the buyer. + Advising Bank: The advising bank is responsible for the transfer of documents to the issuing bank on behalf of the exporter and is generally located in the country of the exporter. 7.14.3 Nostro & Vostro Accounts Nostro and Vostro are terms used to differentiate between the two sets of accounting records kept by each bank. Nostro AccountIndian Bank Foreign Bank + Itrefers to an account that a domestic bank holds in a foreign currency in foreign bank. + Nostro comes from the Latin word for "ours," as in “our money that is on deposit at your bank." + For example, Axis Bank's (India) account in Citibank (USA), maintained in U.S. dollars. Vostro Account Foreign Bank Indian Bank + Itrefers to an account that a foreign bank holds in a domestic currency in domestic bank. * Vostro comes from the Latin word for "yours," as in "your money that is on deposit at our bank."+ For example, Citibank’s (USA) account in Axis Bank (India), maintained in Indian Rupees. 7.15 Currency Convertibility 7.15.1 What is Currency Convertibility + Currency convertibility refers to the freedom to convert domestic currency into other internationally accepted currencies and vice versa. + Aconvertible currency is any nation's legal tender that can be easily bought or sold on the foreign exchange market with little to no restrictions. + Aconvertible currency is a highly liquid instrument as compared with currencies that are tightly controlled by a government's central bank or other regulating authority. + Some common fully convertible currencies include the U.S. dollar, euro, Japanese yen, and the British pound. * Developing countries or those with more authoritative governments are more likely to place restrictions on the exchange of their currency with another. Currencies from these countries are typically less stable and may come from economies with high inflation rates.7.15.2 Current Account Convertibility + Current account convertibility means freedom to convert domestic currency into foreign currency and vice versa for trade in goods and invisibles (services, transfers or income from investment). + When there is current account convertibility for rupee, an exporter can sell U.S. Dollars (or other foreign currency) obtained from exporting a commodity at the market determined exchange rate in India. Similarly, when an importer buys foreign currency from India’s foreign exchange market by exchanging rupee, it is current account convertibility. * Since August 1994, India has had full current account convertibility. + It means that the full amount of the foreign exchange required by someone for current purposes will be made available to them at the official exchange rate. 7.15.3 Capital Account Convertibility + Capital account convertibility is the freedom to convert domestic financial assets into foreign financial assets and vice versa at market determined rates of exchange. + Countries prefer capital account convertibility to promote the inflow of foreign capital + India is still a country with partial capital account convertibility. * Following the recommendations of the S.S. Tarapore Committee on Capital Account Convertibility (1997), India has been moving toward full convertibility in this account, although with necessary safeguards. * The RBI, in consultation with the Government has set a limit of $250,000 per financial year, for capital account transactions for individuals. Advantages of Capital Account Convertibility + CAC attracts foreign investment. As the investors are able to take out investments at a market determined rate, economies with CAC are perceived as less risky. + There is generally a larger inflow of foreign capital into a country with full capital convertibility and macroeconomic stability. + Foreign investment helps create more business and employment opportunities.+ Government and Private sector can also access foreign capital, reducing the cost of capital. * Money can be borrowed from foreign countries at a lower rate and invested in domestic infrastructure. + Domestic financial institutions (like banks) can also borrow cheaper money from abroad and improve their capital base. Disadvantages of Capital Account Convertibility + Full convertibility on Capital Account makes the exchange market more volatile and consequently increases the risks. + A flight of capital (large outflow of foreign investment) may result in response to adverse domestic economic shock which can cause a large depreciation of domestic currency. * Asa consequence of the Impossible Trilemma, an open capital account demands a complete ‘let go’ of the exchange rate management and volatile capital flows and can therefore, lead to extreme volatility in the exchange rate Impossible Trinity/Trilemma In International Economics, Impossible Trinity or Trilemma refers to the hypothesis that itis impossible to achieve fixed exchange rate, free capital movement and independent monetary policy all together.l The policy trilemma Free capital mobility Pick one side of the triangle Exchange- ===> Monetary rate autonomy management 7.16 Special Drawing Rights 7.16.1 What is are SDRs?71 SDRs are international reserve assets created by the International Monetary Fund (IMF). Reserve assets are currencies or other assets, such as gold, that can be readily transferable and are used to balance international transactions and payments. SDRs are an artificial currency instrument, that can provide a country with liquidity. SDRs were created in 1969 to supplement a shortfall of preferred foreign exchange reserve assets, namely gold and U.S. dollars. SDRs are allocated by the IMF to countries, and cannot be held or used by private parties. The ISO 4217 currency code for special drawing rights is XDR and the numeric code is 960. SDR js also called “paper gold”. 6.2 SDR Currency Basket