Investment Decisions in Banking

Session-2: Investment Environment &

Derivatives

By
Dinesh G. Mahabal
 Recap of session 1 – Conceptual
framework for Investment
 An investment operation is one which
upon through analysis promises safety
of principle and an adequate return
commensurate with the embedded
risk.
 Investment is different from
speculation and gambling to the
extent of varying degree of acquired
risk vis-à-vis the returns

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 Recap of Session 1–Conceptual
framework for Investment
 The investment process involves five steps
viz. 1. Setting of policy, 2. Performing
Analysis, 3. Construction of portfolio,
4.Relook / Revision of portfolio and 5.
Evaluation of the performance
 There are two types of investors 1. Active
and 2. Passive
 The qualities of smart investor may be
derived from the investment process as
those who have a plan for investments,
invest consistently & patiently for gains, not
tied up emotionally to their investment
position but have a well planned exit policy.
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 Investment Environment &
Derivatives
 What is Investment Environment?
 In order to finance their operations as well as to expand,
business firms must invest capital in amounts that are
normally beyond their capacity to save in any reasonable
period of time and hence tap the “savers / providers”
 Governments are also required to borrow large amounts
of money to provide for administration and goods to
services to general public against the expected revenue
 The sources of funds for all “users” are financial
intermediates like 1. Banks/Insurance companies/FIs, 2.
Financial Markets, 3. Private placements
 Financial Intermediaries are intermediate between the
providers and users of financial capital

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 Financial Intermediaries
 Financial Intermediaries channelise the savings of
individuals, businesses and government into loans or
investments
 The key suppliers and demanders of funds are
individuals, businesses and government. In general.
Individuals are net suppliers of funds while businesses
and governments are net demanders of funds
 They enable the flow of capital from “savers”- people
and institutions to the “users” – the businesses
individuals and economy in general.
 There is information asymmetry between the provider
and the users of money & hence the presence of
financial intermediaries is essential for stability of
economy.

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 Investment Environment
 Financial Markets: It is a market for creation and
exchange of financial assets (securities). Most common
securities are stocks (also called shares), bonds or
money market instruments that represent an
obligation of the issuer to provide the purchaser an
expected return (e.g. dividend) or a stated return (e.g.
interest) on the investment
 The financial markets are segregated into following
ways
 1. Money Market and 2. Capital Market
 1. Primary market and 2. Secondary market
 1. Organised market and 2. OTC market

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 Money Market and Capital Market
 Money markets are markets for short-
term (364 days or less) funds.
 These securities carry little or no default
risk and have very little price risk due to
their short maturities
 Capital market is the market for long-
term securities
 These securities are subject to significant
price risk, default risk, purchasing power
risk etc due to longer maturities

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 Primary market and Secondary market
 Primary market is one in which the borrower issues
new securities in exchange for cash from an investor
(buyer)
 The issuer (generally government / corporations)
receives the proceeds from the securities sales
transaction directly from the investor. If the issuer
is selling securities for the first time it is referred to
as Initial Public Offers (IPO). In case some amount of
security is already outstanding before the new sale
occurs, then such sale is called Seasoned new issues.
 Secondary market facilitates the trade of already
issued securities thus providing liquidity to the
security
 The original issuer does not get any cash for
subsequent sales of security in the secondary market
but the seller of securities receives the proceeds

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Organised market and OTC market
 Organised market are those which have a
physical location where all trading takes
place
 E.g. BSE, NSE etc
 Over The Counter (OTC) markets do not
have physical presence instead they are
charecterised by network of dealers who
are connected by telephone or computer
networks
 OTCEI of India

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 Money Markets (MM) – features and
composition
 The term “Money market” is a misnomer. Money
(currency) is not actually traded in the money market
 The MM is a market for short-term financial assets
that are close substitutes of money
 The securities traded in MM are short term with high
liquidity and low risk & therefore being close to money
 MM transactions can be executed directly or through
an intermediary.
 Some of the important players (Lenders and
Borrowers) in MM are Central Government, PSUs,
Insurance Companies, Mutual Funds, Banks/ FIs and
Corporate Houses

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M M Players
 Central Govt: As a short term borrowing programme
borrows by issuing T bills (0 risk) through RBI
 PSU: Listed Companies issue CP for WC
 Insurance Companies: Invests short & long term
(Collateralized Borrowing & Lending Obligations
Market) of RBI
 Mutual Funds: invests
 Banks: Borrowers / Lenders
 Corporates: Lenders / Borrowers

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 Characteristics - MM Instruments
 Short term debt instruments (maturity of less than -1- year)
 Services immediate cash needs (Borrowers need short term “working
capital” Lenders need an interest earning “parking space” for excess funds)
 Instruments trade in an active secondary market (market liquidity provides
easy entry & exit for participants. Speed & efficiency of transactions allows
cash to be “active” even for a very short periods of time (overnight) - RTGS
 Large denominations (transaction costs are relatively low / individual
investor do not actively participate in this market)
 Low default risk (Only high quality borrowers participate. Short maturities
reduce the risk of “deterioration in borrower quality)
 Generally insensitive to the changes in market interest rates (Being with
low maturity)

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Common MM instruments in
India
 1. Treasury Bills: These are short term obligations
issued by the RBI on behalf of Government to borrow to
meet the short term financial needs. It looks like a
promissory note
 At present GOI issues -4- types of T-Bills i.e. -14- day,-
91- day -benchmark, -182- day and -364- day
 Banks maintain two types of A/c with RBI viz. Current
A/c for cash & Subsidiary General Ledger (SGL) for
securities
 T-Bills are issued for a minimum amount of Rs.25,000/-
and in multiples of Rs.25,000/-
 Liquidity very high (GOI). Used for SLR, Repo, refinance
with Discount & Finance House of India (DFHI)
 T-Bills are issued at discount rate and redeemed at par

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Common MM instruments in
India
 2. Call Money / Notice Money: These are short term
funds transferred between the eligible participant
Banks / FIs / PDs for a short period of -1- day
(“overnight money” or call money) and between 2 days and
-14- days under notice money See RBI Guidelines
CallNotice010708.pdf
 Day-to-day surplus funds are traded with prudential
limits on Screen-based negotiated quote-driven system
(NDS-Call)
 Indian call money market is mainly to even out short term
mismatches of assets and liabilities and to meet CRR
requirements
 Players are Com,Co-Op,Fgn Banks, DFHI, Securities
trading Corp, LIC, GICPrimary Dealers

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 Common MM instruments in India
 3. Repurchase Agreements or Ready Forward: It is an
agreement, which involves a sale of a security with an
undertaking to buy back the same security at a predetermined
price and at a future date
 A party sells T-Bills and agrees to buy back at a certain date
(usually 3 to 14 days) for a certain price
 The above transaction is called “Repo” from the point of view
of seller of the security whereas the same is viewed as
“Reverse-Repo” from the point of view of Buyer of the
security.
 In India RBI lends at Repo rate. Repo rate > Rev Repo rate
 Repo agreement is essentially a short term collaterised loan.
RBI sales Repo to reduce liquidity from market only through
SGL (Subsidiary General Ledger) account holders
 RBI introduced Liquidity Adjustment Facility from June5,
2005 to adjust short term liquidity in the market

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Common MM instruments in
India
 4. Negotiable Certificates of Deposits (CD): These
are Bank issued time deposits that specifies an
interest rate and maturity date, and it is negotiable
See RBI guideline CDs010708.pdf
 CDs are issued at a discount to face value when a
Bank receives a large deposit
 The discount rate determined by the issuing
(borrower) bank considering the prevailing call money
rate, T Bills rate, maturity and relation with the
customer etc
 The minimum size for the issue of CD is Rs.1 Lac
(face value) and thereafter in multiples of Re 1 lac
 Maturity normally between -3- months to -1- year

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Common MM instruments in
India
 5. Commercial Paper (CP): These are short term
unsecured promissory note issued by a company to raise
short term cash. They mature in no more than -270- days
see RBI GuidelinesCPs010708.pdf
 Only the Large Creditworthy Corporates issue CPs as a
source alternative to Bank finance for working capital
 Generally, Corporate prefer to issue CPs whenever they
find that the interest rate charged on working capital is
higher than the rate at which CPs can be raised from the
market
 Net worth of borrower (CP Issuer) company should be
minimum Rs4 Cr and the WC limits Rs.4 Cr Min
 Issued at discount to face value with Rs25 lacs & multiple
of Rs5lacs
 Maturity 15 days to 1 year
 Credit rating done by CRISIL, CARE etc

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Common MM instruments in
India
 6. Banker’s Acceptance
 These are time drafts payable to a seller of goods, with
payment guaranteed by a Bank as per RBI guidelines
 Is a bill of exchange drawn by an exporter (or seller in
domestic trade) on the bank of importer (buyer)
 Banker’s acceptance is essentially a post-dated check on which
a Bank has guaranteed payment
 These are commonly used to finance international trade
transactions
 Not popular as the denominations are not standard (represent
the bill amount). Also exporter normally discounts immediately
 7. Commercial Bills: Trade Bill of exchange. Not popular in
India

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 Capital Markets (CM) – features and
composition
 The term “Capital Market” denotes the nature of availability of
funds viz. for Capital Expenditure
 Thus CM is a market for meeting with Long-term expenditure
like buying technology, machinery, undertaking capacity
expansion / diversification strategic takeover of other
companies etc
 Capital Market is important for the economic development of a
country since it attracts domestic as also foreign entities both
as FDI and FII (portfolio investment
 CM transactions can be executed directly or through an
intermediary.
 Players in CM are classified as 1. Pure Borrowers, 2. Pure
Lenders (Investors) and 3. Both Borrowers & Lenders
 Some of the important players in CM are Pure Borrowers
( Central Government, PSUs) Pure Lenders (Insurance
Companies, Mutual Funds, NBFCs, PF and Pension Funds, others
like HNI, Trusts etc) and Both Borrowers / Lenders (Banks/
FIs and Corporate Houses)

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 Main Instruments of Capital Market in
India
 Stocks (Shares): A share of common
stock gives an investor a portion of
ownership in a company. Stocks are
owned for growth potential
 After allotment vide IPO and listing; the
shares are traded on the stock
exchanges / OTC
 Over long term stocks are found as the
best vehicle for overcoming inflation and
building wealth

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Instruments of Capital Market
in India
 Bonds: A Bond is a Loan from an Investor to a
Corporate or a Government
 In exchange the investor receives interest
payments (coupon) and a return of the initial loan
(the principal) amount at the end of the life of
the bond (the maturity date)
 The interest that different bonds pay (% of the
price) is known as the bond yield
 Some of the factors upon which bond yield
variations are dependent are the prevailing
market rate, yield of similar bonds, rate of
inflation, counterparty default risk and bond
attributes like Call options and Convertibility

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 Comparison of Stocks & Bonds
 Ownership: Owning a stock gives
ownership in the company while Bond
holders are Creditors (Loaners)
 Income: Stocks are owned for value
appreciation and dividend. Bonds are
steady income generating vehicles
(coupon / yield)
 Volatility: Bond prices are less volatile
compared to stocks. However, bonds do
not protect against the inflation risk

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 Financial Derivatives
 Derivatives are financial Instruments
that have no intrinsic value but
derive their value from the
underlying assets

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