MBA Semester IV MB0052- Strategic Management and Business Policy Assignment Set1

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Q1. What is meant by Strategy? What are the levels of strategy? Differentiate between goals and objectives. Answer: The word strategy is derived from the Geek word strategia, and conventionally used as a military term. It means a plan of action that is designed to achieve a particular goal. Earlier, the managers adopted the day-to-day planning method without concentrating on the future work. Later the managers tried to predict the future events using control system and budgets. These techniques could not calculate the future happenings accurately. Thus, an effective technique called strategy was introduced in business to deal with long term developments and new methods of production.

The different concepts of strategy are: It is defined as a plan to direct or guide a course of action It is a pattern to improve the performance over time It is a fundamental way to view an organisations performance It is a scheme to out-maneuver competitor

Levels of strategy Strategy exists at different business levels. The different levels of strategies are as follows: Corporate Strategy This is regarding the general function and scope of the business to meet the stakeholders expectations. As it is significantly influenced by the investors in the business, it is also called the critical level strategy. Business Strategy This is regarding how a business competes effectively in a particular market. It includes strategic decisions about the selection of products and meeting customer requirements. Operational Strategy This is regarding how each part of the business is organised and delivered to the corporate and business level. Operational strategy focuses on issues of resources and practices of an organisation.

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MBA Semester IV Difference between Goals and Objectives of Business

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Goals are statements that provide an overview about what the project should achieve. It should align with the business goals. Goals are long-term targets that should be achieved in a business. Goals are indefinable, and abstract. Goals are hard to measure and do not have definite timeline. Writing clear goals is an essential section of planning the strategy.

Example - One of the goals of a company helpdesk is to increase the customer satisfaction for customers calling for support.

Objectives are the targets that an organisation wants to achieve over a period of time. Example - The objective of a marketing company is to raise the sales by 20% by the end of the financial year.

Example - An automobile company has a Goal to become the leading manufacturer of a particular type of car with certain advanced technological features and the Objective is to manufacture 30,000 cars in 2011.

Both goals and objectives are the tools for achieving the target. The two concepts are different but related. Goals are high level statements that provide overall framework about the purpose of the project. Objectives are lower level statements that describe the tangible products and deliverables that the project will deliver.

Goals are indefinable and the achievement cannot be measured whereas the success of an objective can be easily measured. Goals cannot be put in a timeframe, but objectives are set with specific timelines. The difference between organisational goals and objectives is depicted in table. Table: Differences between Organisational Goals and Objectives Goals Are long term Are general intentions with broad outcome Cannot be validated Are intangible can be qualitative as well as quantitative Are abstract Objectives Are usually meant for short term Are precise statements with

specific outcome Can be validated Are tangible are usually

quantitative and measurable Are concrete

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Q2. Define the term Strategic Management. Explain the importance of strategic management?

Answer: Strategic Management Definition: Strategic management is a systematic approach of analysing, planning and implementing the strategy in an organisation to ensure a continued success. Strategic management is a long term procedure which helps the organisation in achieving a long term goal and its overall responsibility lies with the general management team. It focuses on building a solid foundation that will be subsequently achieved by the combined efforts of each and every employee of the organisation.

Importance of strategic management A rapidly changing environment in organisations requires a greater awareness of changes and their impact on the organisation. Hence strategic management plays an important role in an organisation. Strategic management helps in building a stable organisation. Strategic management controls the crises that are aroused due to rapid change in an organisation. Strategic management considers the opportunities and threats as the strengths and weaknesses of the organisation in the crucial environment for survival in a competitive market. Strategic management helps the top level management to examine the relevant factors before deciding their course of action that needs to be implemented in changing environment and thus aids them to better cope with uncertain situations. Changes rapidly happen in large organisations. Hence strategic management becomes necessary to develop appropriate responses to anticipate changes. The implementation of clear strategy enhances corporate harmony in the organisation. The employees will be able to analyse the organisations ethics and rules and can tailor their contribution accordingly. Systematically formulated business activities helps in providing consistent financial performance in the organisation. A well designed global strategy helps the organisation to gain competitive advantages. It increases the economies of scale in the global market, exploits other countries resources, broadens learning opportunities, and provides reputation and brand identification.

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MBA Semester IV Q3. Describe Porters five forces Model. Answer: Porters Five Force model

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Michael E. Porter developed the Five Force Model in his book, Competitive Strategy. Porter has identified five competitive forces that influence every industry and market. The level of these forces determines the intensity of competition in an industry. The objective of corporate strategy should be to revise these competitive forces in a way that improves the position of the organisation.

Figure below describes forces driving industry competitions.

Figure: Forces Driving Industry Competitions

Forces driving industry competitions are: Threat of new entrants New entrants to an industry generally bring new capacity; desire to gain market share and substantial resources. Therefore, they are threats to an established organisation. The threat of an entry depends on the presence of entry barriers and the reactions can be expected from existing competitors. An entry barrier is a hindrance that makes it difficult for a company to enter an industry. Suppliers Suppliers affect the industry by raising prices or reducing the quality of purchased goods and services.

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Rivalry among existing firms In most industries, organisations are mutually dependent. A competitive move by one organisation may result in a noticeable effect on its competitors and thus cause retaliation or counter efforts. Buyers Buyers affect an industry through their ability to reduce prices, bargain for higher quality or more services. Threat of substitute products and services Substitute products appear different but satisfy the same needs as the original product. Substitute products curb the potential returns of an industry by placing a ceiling on the prices firms can profitably charge. Other stakeholders - A sixth force should be included to Porters list to include a variety of stakeholder groups. Some of these groups include governments, local communities, trade association unions, and shareholders. The importance of stakeholders varies according to the industry.

Q4. What is strategic formulation and what are its processes?

Answer: Strategy Formulation Strategy formulation is the development of long term plans. It is used for the effective management of environmental opportunities and for the threats which weaken corporate management. Its objective is to express strategical information to achieve a definite goal.

The following are the features of strategy formulation: Defining the corporate mission and goals Specifying achievable objectives Developing strategies Setting company policy guidelines Process in Strategy Formulation The main processes involved in strategy formulation are as follows: Stimulate the identification - Identifying useful information like planning for strategic management, objectives to achieve the goals of the employees and the stakeholders.

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Utilisation and transfer of useful information as per the business strategies - A number of questions arising during utilisation and transfer of information have to be solved The questions that arise during utilisation and transfer of information are the following: Who has the requested information? What is the relationship between the partners who holds the requested information? What is the nature of the requested information? How can we transfer the information? Henry Mintzbergs contribution to strategic planning Henry Mintzberg is a well-known academician and generalist writer who has written about strategy and organisational management. His approach is broad, involving the study of the actions of a manager and the way the manager does it. He believes that management is about applying human skills to systems, but not systems to people. Mintzberg states certain factors as the reason for planning failure.

The factors are as follows: Processes - The elaborate processes used in the management such as creation of bureaucracy and suppression of innovation leads to strategic planning failure. Data - According to Mintzberg, hard data (the raw material of all strategists) provides information whereas soft data (the data gathered from experience) provides wisdom which means that soft data is more relevant than the hard data. Detachment Mintzberg says that effective strategists are people who do not distance themselves from the details of a business. They are the ones who immerse themselves into the details and are able to extract the strategic messages from it.

In 1993, Henry Mintzberg concluded that planning is a formalised procedure to produce a coherent result in the form of an integrated system of decisions. The objectives must be explicitly labeled by words after being carefully decomposed into strategies and substrategies.

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MBA Semester IV Q5. What is Strategic Business Unit? What are its features and advantages?

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Answer: SBU is a business tool whose main concept is to serve a clear and defined market segment with a defined strategy.

The features of SBU are as follows: SBU contains all the needs and corporate capabilities of its organisation. There is managerial and capital resource allocation for serving the overall interest of the organisation. SBU segments the activities of the company in a strategic manner and allocates resources competitively.

For an organisation to have an SBU, it must fulfill the following criteria:

Possess different missions Set up original plans Have a definable group of competitors Administer resources in key areas

Advantages Reduces problems associated with sharing resources across functional areas Responses quickly to the environmental changes Increases focus on products and markets

Benefits of SBU to parent company/MNCs An MNC realises parenting advantages in certain factors like global scale and scope efficiencies, regional differences, global risk diversification etc. The SBU adds value through parenting advantages by defining its roles and strategic priorities.

The benefits to the parent company are as follows: Optimisation of the competitive advantages lies within the companys global network of business units and people. Reforming the business model and achieving the objective Serving a defined external market where it can conduct strategic planning in relation to products and markets

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MBA Semester IV Q6. Define the term Business policy. Explain its importance.

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Answer: Business policies are the instructions laid by an organisation to manage its activities. It identifies the range within which the subordinates can take decisions in an organisation. It authorises the lower level management to resolve their issues and take decisions without consulting the top level management repeatedly. The limits within which the decisions are made are well defined. Business policy involves the acquirement of resources through which the organisational goals can be achieved. Business policy analyses roles and responsibilities of top level management and the decisions affecting the organisation in the long-run. It also deals with the major issues that affect the success of the organisation.

Features of business policy Following are the features of an effective business policy: Specific- Policy should be specific and identifiable. The implementation of policy is easier if it is precise. Clear - Policy should be clear and instantly recognisable. Usage of jargons and connotations should be avoided to prevent any misinterpretation in the policy. Uniform Policy should be uniform and consistent. It should ensure uniformity of operations at different levels in an organisation. Appropriate Policy should be appropriate and suitable to the organisational goal. It should be aimed at achieving the organisational objectives. Comprehensive Policy has a wide scope in an organisation. Hence, it should be comprehensive. Flexible Policy should be flexible to ensure that it is followed in the routine scenario. Written form To ensure uniformity of application at all times, the policy should be in writing. Stable Policy serves as a guidance to manage day to day activities. Thus, it should be stable.

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MBA Semester IV Importance of Business Policies

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A company operates consistently, both internally and externally when the policies are established. Business policies should be set up before hiring the first employee in the organisation. It deals with the constraints of real-life business.

It is important to formulate policies to achieve the organisational objectives. The policies are articulated by the management. Policies serve as a guidance to administer activities that are repetitive in nature. It channels the thinking and action in decision making. It is a mechanism adopted by the top management to ensure that the activities are performed in the desired way.

The complete process of management is organised by business policies. Business policies are important due to the following reasons: Coordination Reliable policies coordinate the purpose by focusing on organisational activities. This helps in ensuring uniformity of action throughout the organisation. Policies encourage cooperation and promote initiative. Quick decisions Policies help subordinates to take prompt action and quick decisions. They demarcate the section within which decisions are to be taken. They help subordinates to take decisions with confidence without consulting their superiors every time. Every policy is a guide to activities that should be followed in a particular situation. It saves time by predicting frequent problems and providing ways to solve them. Effective control Policies provide logical basis for assessing performance. They ensure that the activities are synchronised with the objectives of the organisation. It prevents divergence from the planned course of action. The management tends to deviate from the objective if policies are not defined precisely. This affects the overall efficiency of the organisation. Policies are derived objectives and provide the outline for procedures. Decentralisation Well defined policies help in decentralisation as the executive roles and responsibility are clearly identified. Authority is delegated to the executives who refer the policies to work efficiently. The required managerial procedures can be derived from the given policies. Policies provide guidelines to the executives to help them in determining the suitable actions which are within the limits of the stated policies. Policies contribute in building coordination in larger organisations.

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MBA Semester IV MB0052 Strategic Management and Business Policy

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Assignment Set- 2

Q1. What is meant by core competency? Explain with an example.

Answer: Core competencies are those skills that are critical for a business to achieve competitive advantage. These skills enable a business to deliver essential customer benefit like the selection of a product or service by a customer. Core competency is the key strength of business because it comprises the essential skills. These are the central areas of expertise of the company where maximum value is added to its services or products. Example - Infosys has a core competency in information technology.

It is a unique skill or technology that establishes a distinct customer value. As the organisation progresses and adapts to the new environment, the core competencies also adjust to the change. They are not rigid but flexible to advancing time. The organisation makes the maximum utilisation of the competencies and correlates them to new opportunities in the market. Resources and capabilities are the building blocks on which an organisation builds and executes a value-added strategy. The strategy is devised in a manner that an organisation can receive reasonable profit and attain strategic competitiveness.

Core Competencies are not fixed. They change in response to the transformation in the environment of the company. They are adaptable and advance over time. As an organisation progresses and adapts to new circumstances, the core competencies also adapt to the transformation.

The characteristics of core competencies are: To provide potential access to a wide range of market Should be difficult to imitate by competitors Should make considerable contribution to the customers

Example - Microsoft has expertise in IT-based innovations and technologies. Customers receive many benefits by purchasing and using Microsoft products. For many reasons including unique skills, it is difficult for competitors to imitate Microsoft's core competences.

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Resources are the key inputs of the organisations production process. These can be manpower, financial, technological, or services. For the organisation to have core competency the resources should be unique, beneficial and specialised in the particular field. Resources should be built on the strengths of the organisation and not on its weaknesses.

Organisational capabilities are the ability of the organisation to identify and integrate its resources so that it can be used in the most efficient manner. If an organisation lacks the capability to utilise these resources productively then the organisation cannot create its core competency. The organisation can devise strategies to either develop new resources and capabilities or improve the existing resources and capabilities to build core competencies of the organisation.

A company can continue to reinvest in its core competencies. When the core competencies are advanced to those of the competitors they are called distinctive competencies. The distinctive competencies should be unique and advanced to the competitor capacity. It should be used to develop new product or service. Core competencies of an organisation distinguish it from its competitors. They can help in deciding the future of the organisation. For the strategy to have the best probability of success, it should be built on core competencies. The competencies are enhanced continuously. They are developed through a continuous process of improvement and enhancement.

Critical Success Factors (CSFs) Critical success factors (CSFs) are used extensively to identify the key features that an organisation should focus on to be successful. The CSFs are important sections of activities that are performed perfectly to achieve the mission and objective of the business. It refers to the main areas which ensure successful competitive performance for an organisation. Identifying the CSFs is important as the organisation can focus on its efforts to develop its resources to meet the CSFs and measure the success of the business. It is important for the organisation to decide in building the essential requirements to meet the CSFs.

Critical Success Factors are associated with the strategic goals of an organisation. They also focus on the essential areas that affect the business. The chief areas that affect the business are:

Industry - These factors result from specific industry characteristics. The organisation should consider these factors to remain competitive. Page 11

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Environmental These are the factors that are the result of environmental influences on an organisation like the economy, competitors, and technological advancements. Strategic - These factors are the result of particular competitive strategy selected by the organisation. Temporal - These factors are the result of the organisation's internal influence like challenges and directions.

The CSFs are essential for the success of an organisation. Identifying CSFs helps to ensure that the business is focused and thus avoids wasting effort on insignificant areas. To keep the project on track towards common aims and goals, CSFs should be specific and should be communicated to everyone involved.

Q2. Describe the concept of SWOT analysis.

Answer: SWOT Analysis SWOT is an acronym for strength, weakness, opportunities and threats which are strategic factors of an organisation. SWOT analysis not only results in the identification of organisations distinctive competencies, but also identifies the opportunities that the organisations are unable to take advantage of, due to the lack of appropriate resources.

Strengths The strengths of an organisation are its resources and capabilities that can be used as a basis for developing a competitive advantage. Examples of such strengths are as follows: Patents Strong brand names Good reputation among customers Cost advantages from proprietary know-how Exclusive access to high grade natural resources Favourable access to distribution networks

Weaknesses The absence of certain strengths may be considered as weaknesses. Example - Lack of a patent can be considered as a weakness. Each of the following factors may be considered as a weakness:

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MBA Semester IV Lack of patent protection Weak brand name Poor reputation among customers High cost structure Lack of access to the best natural resources

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Opportunities The external environment analysis may disclose certain new opportunities for profit and growth. Few examples of such opportunities are as follows: Unfulfilled customer needs Arrival of new technologies Relaxing of regulations Removal of international trade barriers

Threats Alteration in the external environment may also present threats to the organisation. Some examples of such threats include the following: Shift in consumer choice, it takes them away from the organisations product Emergence of substitute products New regulations Increased trade barriers

Example - An opportunity to provide products like refrigerator or services like online ticket booking, that can improve consumers lifestyle increases the demand for the companys product. The Threat could be a new competitor in the market with advanced technology as it makes the existing product out-of-date.

The SWOT matrix - Organisations should concentrate to develop a strategic plan that fits in the organisations strength and upcoming opportunities. In rare cases, the organisation overcomes a weakness by planning itself for a compelling situation. The SWOT matrix is shown in the figure below. Strength Opportunities Threats S-O Strategies S-T Strategies Weakness W-O Strategies W-T Strategies

The SWOT matrix can be explained as follows: Page 13

MBA Semester IV S-O strategies follow the opportunities that suits the companys strength W-O strategies overcomes weakness to follow opportunities S-T strategies find ways to use the organisations strength to reduce external threats

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W-T strategies determines a defensive plan to prevent the organisations weakness from becoming liable to external forces .

Q3. What is strategic leadership? Explain the types of leadership.

Answer: Strategic leadership refers to the potential to express a strategic vision and to motivate others to acquire that vision. It is the ability to influence organisational members and to execute organisational change. Features of strategic leadership A strategic leader possesses the following qualities: Loyalty and compassion Effective leadership should be loyal and compassionate to vision of the team. Judicious use of power Strategic leaders utilise power wisely. They must push their ideas gradually along with the other members in the team. Wider perspective or outlook Strategic leader have a wider perspective of vision and they act accordingly. Motivation and reliability Strategic leader have motivating qualities and are also reliable. Skillful communication A leader shares views with the team members. Effective communication brings effective understanding among the team members. Quality of understanding the moods and emotions - A strategic leader must understand the moods and emotions of his team members. He must communicate his sentiments with the employees.

The following figure depicts the three types of leadership

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Types of Leadership Direct Leadership This is typically in organisations where subordinates are in direct contact with their leaders. Direct leaders are linked with their subordinates and influences organisation through the development of subordinates. An example of direct leadership is given in the following figure.

Figure: Direct Leadership Organisational Leadership In organisational leadership, the leaders reach out to far more people and can even influence several thousands of people. Unlike direct leaders, organisational leaders are not able to interact directly with their subordinates and need other staff to help them lead people. The hierarchy of organisational leadership is illustrated in below figure.

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Figure: Organisational Leadership Strategic Leadership These leaders usually lead large organisations and influence thousands of people. The role of a strategic leader is to establish organisational structure, allocate resources and communicate the strategic vision of the organisation.

Q4. Define the term Strategic Alliance. Differentiate between Joint ventures and Mergers.

Answer: Strategic alliance is the process of mutual agreement between the organisations to achieve objectives of common interest. They are obtained by the co-operation between the companies. Strategic alliance involves the individual organisations to modify its basic business activities and join in agreement with similar organisations to reduce duplication of manufacturing products and improve performance. It is stronger when the organisations involved have balancing strengths. Strategic alliances contribute in successful

implementation of strategic plan because it is strategic in nature. It provides relationship between organisations to plan various strategies in achieving a common goal.

The various characteristics of strategic alliances are: The two independent organisations involving in agreement have a similar idea of achieving objectives with respect to alliances. The organisations share the advantages and organise the management of alliance until the agreement lasts. To develop more areas in alliances, the organisations contribute their own resources like technology, production, R&D, marketing etc to increase the performance.

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According to Faulkner (1995) Strategic alliance is the inter-organisational relationship in which the partners make substantial investment in developing a long-term collaborative effort, and obtain common orientation. Joint Venture Joint venture is the most powerful business concept that has the ability to pool two or more organisations in one project to achieve a common goal. In a joint venture, both the organisations invest on the resources like money, time and skills to achieve the objectives. Joint venture has been the hallmark for most successful organisations in the world. An individual partner in joint venture may offer time and services whereas the other focuses on investments. This pools the resources among the organisations and helps each other in achieving the objectives. An agreement is formed between the two parties and the nature of agreement is truly beneficial with huge rewards such that the profits are shared by both the organisations.

The advantages of joint venture are: A long term relationship is built among the participating organisations It Increases integrity by teaming with other reputable and branded organisations Helps in gaining new customers It helps in investing little money or no money It provides the capability to compete in the market with other organisations Reduces production time as the organisations are into join venture More new products and services can be offered to the customers

The disadvantages of joint venture are: Sometimes the organisations deal with wrong people, thereby losing investments The organisations do not have the opportunity to take up decisions individually There are risks of disputes among the organisations that lead to poor performance If the organisation enters into joint venture agreement with unprofessional selfish organisation, then it increases the risk of hurting business reputation and devastating customers trust. Example The China Wireless Technologies, a mobile handset maker is getting into an agreement with the Reliance Communications Ltd (RCom) to launch its new mobile. The joint venture between the two companies is to gain profits and provide affordable mobile phones to the market that consists of advanced features and aims to earn eight billion

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dollars in the next five years. The new mobile consists of dual SIM smart phone with 3G technology at a cheaper rate. Mergers Merger is the process of combining two or more organisations to form a single organisation and achieve greater efficiencies of scale and productivity. The main reason to involve into mergers is to join with other company and reap the rewards obtained by the combined strengths of two organisations. A smart organisations merger helps to enter into new markets, acquire more customers, and excel among the competitors in the market. The participating organisation can help the active partner in acquiring products, distribution channel, technical knowledge, infrastructure to drive into new levels of success.

With the perception of the organisation structure, here are a few types of mergers. The different types of mergers are: Horizontal merger The horizontal merger takes place when two organisations competing in the same market join together. This type of merger either has a maximum or minimum effect on the market. The minimum effect could also be zero. They share the same product line and markets. The results of the mergers are less noticeable if the small organisations horizontally merge. Consider a small local drug store that horizontally merges with another small local drug store, then the effect of this merger on drug market would be minimal.

But when the large organisations set up horizontal merger, then higher profits are obtained in the market share providing advantages over its competitors. Consider two large organisations that merge with twenty percent share in the market. They achieve forty percent increase in the market share. This is an added advantage of the organisations over its competitors in the market. Vertical merger This involves the union of a customer with the vendor. It is the process of combining assets to capture a sector of the market that it fails to acquire as an individual organisation. The participating organisations determine the intentions of joining forces that will strengthen the current positions of both the organisations and lay basis for expanding into other areas. The purpose of a vertical merger is to build the strengths of the two organisations for an effective future growth. In order to explore new methods of using existing products to create a new product line for wider markets, it is also important to consider the assets like property, buildings, inventories and cash assets. The vertical merger involves careful planning. Page 18

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Market-extension merger It is the process of merging two organisations that sell same products in different geographical areas. The main purpose of this merger is to make the merging organisations to achieve higher positions in bigger markets and ensure a bigger base for client. Product-extension merger Most of the organisations execute product extension merger to sell different products of a related category. They serve the common market. This merger enables the new organisations to pool their products to serve a common market. Conglomerate merger This merger involves organisations alliance with unrelated type of business activities. The organisations under conglomerate merger are not related either horizontally or vertically. There are no important common factors among the organisations in terms of production, marketing, research, development and technology. It is the union of different kinds of businesses under one management organisation. The main purpose of this merger is to utilise financial resources; enlarge debt capacity and obtaining synergy of managerial functions. The organisations do not share the resources; instead it focuses on the process of acquiring stability and using resources in a better way to generate additional revenue.

Q5. What do you mean by innovation? What are the types of innovation?

Answer: There is no universally accepted definition of "product innovation" or "new product." Everett M Rogers (Diffusion of Innovation, 4th ed. Free Press, 1995) observes that some researchers have favoured a consumer-oriented approach in defining an innovation. According to Hubert Gatignon and Thomas S Robertson, an innovation is a product, service, attribute, or idea that consumers within a market segment perceive as new and that has an effect on existing consumption patterns. Types of Innovation A continuous innovation is, one that has a limited influence on consumption behaviour of consumers. Consumers would use a product representing continuous innovation in much the same way they used products that came before it. Product alteration is on a continuous basis. Adoption of such products requires minor changes in behaviour that are unimportant to consumers. Most of the new products that are introduced in the market represent continuous innovations such as newer models of computers and autos etc.

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A dynamically continuous innovation is, one that affects consumers consumption behaviour in a pronounced way. Adoption requires a moderate change in an important behaviour or a major change in an area of behaviour that is of low or moderate importance to the individual. The examples include Internet shopping, digital camera, notebook computers, electric cars and cordless phones. Real Jukebox is a dynamically continuous innovation because it requires changes in the way we acquire, use and dispose of music and may utilise other technologies such as CD and DVD writers.

A discontinuous innovation represents a product so new that consumers have never known anything like it before. According to Peter Waldman ("Great Idea If It Flies," Wall Street Journal, June 24, 1999), a former aeronautics professor has introduced a product called "skycar," which is a machine that flies through the air in the same manner as cars do in cartoon shows on TV. The "skycar" uses the principle of VTL (vertical take off and landing) and is capable of flying at speeds of up to 300 miles per hour. Products such as electric bulbs, aeroplanes, computers, television, photocopying machines, inkjet and laser printers, heart transplant and MRI scanning, etc. were all, at one time, discontinuous innovations. Such innovations herald radical changes in an area of consumer behaviour which has significant importance to the individual consumer.

Innovations can also be categorised by the benefits that products or services offer. Some services, attributes or ideas are functional innovationbecause they provide functional performance benefits to consumers over existing alternatives. For example, computer notebooks offer portability over stationary computers. Functional innovations often take advantage of new technology. For example, technological advances have offered consumers the advantage of downloading images from the Internet and conducting videoconferencing via their cellular phones. Figure : depicts the innovation continuum.

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MBA Semester IV Q6. Describe Corporate Social Responsibility.

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Answer: Corporate Social Responsibilities (CSR) Corporate Social Responsibility (CSR) is the continuing obligation of a business to behave ethically and contribute to the economic development of the organisation. It improves the quality of life of the organisation. The meaning of CSR has two folds. On one hand, it exhibits the ethical behaviour that an organisation exhibit towards its internal and external stakeholders. And on the other hand, it denotes the responsibility of an organisation towards the environment and society in which it operates. Thus CSR makes a significant contribution towards sustainability and competitiveness of the organisation.

CSR is effective in number of areas such as human rights, safety at work, consumer protection, climate protection, caring for the environment, sustainable management of natural resources, and such other issues. CSR also provides health and safety measures, preserves employee rights and discourages discrimination at workplace. CSR activities include commitment to product quality, fair pricing policies, providing correct information to the consumers, resorting to legal assistance in case of unresolved business problems, so on. Example TATA implemented social welfare provisions for its employees since 1945. Features of CSR CSR improves the customer satisfaction through its products and services. It also assists in environmental protection and contributes towards social activities. The following are the features of CSR: Improves the quality of an organisation in terms of economic, legal and ethical factors CSR improves the economic features of an organisation by earning profits for the owners. It also improves the legal and ethical features by fulfilling the law and implementing ethical standards. Builds an improved management system CSR improves the management system by providing products which meets the essential customer needs. It develops relevant regulations through the utilisation of innovative technologies in the organization Contributes to countries by improving the quality of management CSR contributes high quality product, environment conservation and occupational health safety to various regions and countries. Page 21

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Enhances information security systems and implementing effective security measures CSR enhances the information security measures by establishing improved information security system and distributing them to overseas business sites. The information system has improved by enhancing better responses to complex security accidents. Creates a new value in transportation CSR creates a new value in transportation for the greater safety of pedestrians and automobiles. This is done by utilising information and technology for automobiles. The information and technology helps in establishing a safety driving assistance system. Creates awareness towards environmental issues CSR serves in preventing global warming by reducing the harmful gases emitted into the atmosphere during the process of business activities.

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MBA Semester IV MB0053 International Business Management

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Assignment Set- 1

Q1. Define international business. What are the advantages of international business?

Answer: International business can be defined as any business that crosses the national borders of the country for its establishment. It includes importing and exporting; international movement of goods, services, employees, technology, licensing, and franchising of intellectual property (trademarks, patents, copyright and so on). International business includes the investment in financial and immovable assets in foreign countries. Contract manufacturing or assembly of products for local sale or for export to other countries, establishment of foreign warehousing and distribution systems, and import of goods from one foreign country to a second foreign country for subsequent local sale is part of international business.

There are various factors that affect international business. These factors include economic environment, culture, political environment, financial and banking systems, regulatory bodies, human capital, trade policies and so on, of the target country. Figure represents the various factors affecting international business.

Figure: Factors Effecting International Business Page 23

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International trade is growing at a rapid rate. Table, which is compiled by World Trade Organisation, gives us an understanding on the region-wise quantum of international trade. It illustrates the incremental value and volume of global trade in specified countries over a period of four years. This table gives us an insight into the dynamics and importance of international business.

Q2. Discuss in brief the absolute and comparative cost advantage theories.

Answer: Absolute advantage Adam Smith (a social philosopher and a pioneer of politicl economics) argued that nations differ in their ability to manufacture goods efficiently and he saw that a country gains by trading. If the two countries exchanged two goods at a ratio of 1:1, country I gets one unit of goods B by sacrificing only 10 units of labour, whereas it has to give up 20 units of labour if it produced the goods itself. In the same manner, country II gives up only 10 units of labour to get one unit of goods A, whereas it has to give up 20 units of labour if it was made by itself. Hence, it was understood that both countries had large amount of both goods by trading. Comparative advantage Ricardo (english political economist) questioned Smiths theory stating that if one country is more productive than the other in all lines of production and if country I can produce all goods with less labour costs, will there be a need for the countries to trade. The reply was affirmative.

He used England and Portugal as examples in his demonstration, the two goods they produced being wine and cloth. This case is explained using table below.

According to him, Portugal has an advantage in both areas of manufacture.

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To demonstrate that trade between both countries will lead to gains, the concept of opportunity cost (OC) is introduced. The OC for good X is the amount of other goods that have to be given up in order to produce one additional unit of X.

A country has a comparative advantage in producing goods if the OC is lower at home than in the other country. The table shows that Portugal has the lower OC of the 2 countries in wine-making while England has the lower OC in making cloth. Thus Portugal has the comparative advantage in the production of wine whereas England has one one in the production of cloth.

Q3. How is culture an integral part of international business. What are its elements?

Answer: Cultural differences affect the success or failure of multinational firms in many ways. The company must modify the product to meet the demand of the customers in a specific location and use different marketing strategy to advertise their product to the customers. Adaptations must be made to the product where there is demand or the message must be advertised by the company. The following are the factors which a company must consider while dealing with international business:

The consumers across the world do not use same products. This is due to varied preferences and tastes. Before manufacturing any product, the organisation has to be aware of the customer choice or preferences.

The organisation must manage and motivate people with broad different cultural values and attitudes. Hence the management style, practices, and systems must be modified.

The organisation must identify candidates and train them to work in other countries as the cultural and corporate environment differs. The training may include language

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training, corporate training, training them on the technology and so on, which help the candidate to work in a foreign environment.

The organisation must consider the concept of international business and construct guidelines that help them to take business decisions, and perform activities as they are different in different nations. The following are the two main tasks that a company must perform:

Product differentiation and marketing - As there are differences in consumer tastes and preferences across nations; product differentiation has become business strategy all over the world. The kinds of products and services that consumers can afford are determined by the level of per capita income. For example, in underdeveloped countries, the demand for luxury products is limited.

Manage employees - It is said that employees in Japan were normally not satisfied with their work as compared with employees of North America and European countries; however the production levels stayed high. To motivate employees in North America, they have come up with models. These models show that there is a relation between job satisfaction and production. This study showed the fact that it is tough for Japanese workers to change jobs. While this trend is changing, the fact that job turnover among Japanese workers is still lower than the American workers is true. Also, even if a worker can go to another Japanese entity, they know that the management style and practices will be quite alike to those found in their present firm. Thus, even if Japanese workers were not satisfied with the specific aspects of their work, they know that the conditions may not change considerably at another place. As such, discontent might not impact their level of production.

The following are the three mega trends in world cultures: The reverse culture influence on modern Western cultures from growing economies, particularly those with an ancient cultural heritage. The trend is Asia centric and not European or American centric, because of the growing economic and political power of China, India, South Korea, and Japan and also the ASEAN. The increased diversity within cultures and geographies. The following are the necessary implications in international business: Avoid self reference criterion such as, ones own upbringing, values and viewpoints.

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Follow a philosophical viewpoint that considers that many perspectives of a single observation or phenomenon can be true. Discover and identify global segments and global niche markets, as national markets are diverse with growing mobility of products, people, capital, and culture. Grow the total share market by innovating affordable products and services, and making them accessible so that, they are affordable for even subsistence level consumers rather than fighting for market share.

Organise global enterprises around global centres of excellence.

Cultural elements that relate business The most important cultural components of a country which relate business transactions are: Language. Religion. Conflicting attitudes.

Language Language is something more than just spoken and written words. Gestures, non-verbal communication, facial expressions, and body language all communicate a message. An interpreter is used when two people do not speak common language. Failure in understanding the cultural context when non-verbal communication takes place or failure in reading the person across the table results in sending a wrong signal.

Religion The dominant religious beliefs within a culture have a great impact on a persons approach to business than most people expect, even if that person is not a follower of a specific culture. Conflicting attitudes Cultural values have a massive effect on the way business is carried out. The cultural values that are evident in everyday life are not only shown in business but they are exaggerated. If the cultural basics are not understood, then there is possibility that a deal ends even before the negotiations start. Some of the additional cultural elements which must be known are the customs and manners, arts, education, humour, and social organisation of a society.

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Q4. What is country risk analysis? Describe the tools and methods of country risk analysis.

Answer: Country Risk Analysis Country risk analysis is the evaluation of possible risks and rewards from business experiences in a country. It is used to survey countries where the firm is engaged in international business, and avoids countries with excessive risk. With globalisation, country risk analysis has become essential for the international creditors and investors.

Country Risk Analysis (CRA) identifies imbalances that increase the risks in a cross-border investment. CRA represents the potentially adverse impact of a countrys environment on the multinational corporations cash flows and is the probability of loss due to exposure to the political, economic, and social upheavals in a foreign country. All business dealings involve risks. An increasing number of companies involving in external trade indicate huge business opportunities and promising markets. Since the 1980s, the financial markets are being refined with the introduction of new products.

When business transactions occur across international borders, they bring additional risks compared to those in domestic transactions. These additional risks are called country risks which include risks arising from national differences in socio-political institutions, economic structures, policies, currencies, and geography. The CRA monitors the potential for these risks to decrease the expected return of a cross-border investment. For example, a multinational enterprise (MNE) that sets up a plant in a foreign country faces different risks compared to bank lending to a foreign government. The MNE must consider the risks from a broader spectrum of country characteristics. Some categories relevant to a plant investment contain a much higher degree of risk because the MNE remains exposed to risk for a longer period of time.

Analysts have categorised country risk into following groups: Economic risk This type of risk is the important change in the economic structure that produces a change in the expected return of an investment. Risk arises from the negative changes in fundamental economic policy goals (fiscal, monetary, international, or wealth distribution or creation). Transfer risk Transfer risk arises from a decision by a foreign government to restrict capital movements. It is analysed as a function of a countrys ability to earn

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foreign currency. Therefore, it implies that effort in earning foreign currency increases the possibility of capital controls. Exchange risk This risk occurs due to an unfavourable movement in the exchange rate. Exchange risk can be defined as a form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged. Location risk This type of risk is also referred to as neighborhood risk. It includes effects caused by problems in a region or in countries with similar characteristics. Location risk includes effects caused by troubles in a region, in trading partner of a country, or in countries with similar perceived characteristics. Sovereign risk This risk is based on a governments inability to meet its loan obligations. Sovereign risk is closely linked to transfer risk in which a government may run out of foreign exchange due to adverse developments in its balance of payments. It also relates to political risk in which a government may decide not to honor its commitments for political reasons. Political risk This is the risk of loss that is caused due to change in the political structure or in the politics of country where the investment is made. For example, tax laws, expropriation of assets, tariffs, or restriction in repatriation of profits, war, corruption and bureaucracy also contribute to the element of political risk.

Risk assessment requires analysis of many factors, including the decision-making process in the government, relationships of various groups in a country and the history of the country. Country risk is due to unpredicted events in a foreign country affecting the value of international assets, investment projects and their cash flows. The analysis of country risks distinguishes between the ability to pay and the willingness to pay. It is essential to analyse the sustainable amount of funds a country can borrow. Country risk is determined by the costs and benefits of a countrys repayment and default strategies. The ways of evaluating country risks by different firms and financial institutions differ from each other. The international trade growth and the financial programs development demand periodical improvement of risk methodology and analysis of country risks.

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Country detailed risk refers to the unpredictability of returns on international business transactions in view of information associated with a particular country. The techniques used by the banks and other agencies for country risk analysis can be classified as qualitative or quantitative. Many agencies merge both qualitative and quantitative information into a single rating. A survey conducted by the US EXIM bank classified the various methods of country risk assessment used by the banks into four types. They are:

Fully qualitative method - The fully qualitative method involves a detailed analysis of a country. It includes general discussion of a countrys economic, political, and social conditions and prediction. Fully qualitative method can be adapted to the unique strengths and problems of the country undergoing evaluation.

Structured qualitative method The structured method uses a uniform format with predetermined scope. In structured qualitative method, it is easier to make comparisons between countries as it follows a specific format across countries. This technique was the most popular among the banks during the late seventies.

Checklist method - The checklist method involves scoring the country based on specific variables that can be either quantitative, in which the scoring does not need personal judgment of the country being scored or qualitative, in which the scoring needs subjective determinations. All items are scaled from the lowest to the highest score. The sum of scores is then used to determine the country risk.

Delphi technique The technique involves a set of independent opinions without group discussion. As applied to country risk analysis, the MNC can assess definite employees who have the capability to evaluate the risk characteristics of a particular country. The MNC gets responses from its evaluation and then may determine some opinions about the risk of the country.

Inspection visits Involves travelling to a country and conducting meeting with government officials, business executives, and consumers. These meetings clarify any vague opinions the firm has about the country. Other quantitative methods The quantitative models used in statistical studies of country risk analysis can be classified as discriminant analysis, principal component analysis, logit analysis and classification and regression tree method.

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MBA Semester IV Q5. Write short notes on Foreign exchange market.

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Answer: Foreign exchange market The Foreign exchange or the forex markets facilitates the participants to obtain, trade, exchange and speculate foreign currency. The foreign exchange market consists of banks, central banks, commercial companies, hedge funds, investment management firms and retail foreign exchange brokers and investors. It is considered to be the leading financial market in the world. It is vital to realise that the foreign exchange is not a single exchange, but is created from a global network of computers that connects the participants from all over the world.

The foreign exchange market is immense in size and survives to serve a number of functions ranging from the funding of cross-border investment, loans, trade in goods, trade in services and currency speculation. The participant in a foreign exchange market will normally ask for a price.

The trading in the foreign exchange market may take place in the following forms: Outright cash or ready foreign exchange currency deals that take place on the date of the deal. Next day - foreign exchange currency deals that take place on the next working day. Swap Simultaneous sale and purchase of identical amounts of currency for different maturities. Spot and Forward contracts - A Spot contract is a binding obligation to buy or sell a definite amount of foreign currency at the existing or spot market rate. A forward contract is a binding obligation to buy or sell a definite amount of foreign currency at the pre-agreed rate of exchange, on or before a certain date.

The advantage of spot dealing has resulted in a simplest way to deal with all foreign currency requirements. It carries the greatest risk of exchange rate fluctuations due to lack of certainty of the rate until the deal is carried out. The spot rate that is intended to receive will be set by current market conditions, the demand and supply of currency being traded and the amount to be dealt. In general, a better spot rate can be received if the amount of dealing is high. The spot deal will come to an end in two working days after the deal is struck.

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A forward market needs a more complex calculation. A forward rate is based on the existing spot rate plus a premium or discounts which are determined by the interest rate connecting the two currencies that are involved. For example, the interest rates of UK are higher than that of US and therefore a modification is made to the spot rate to reflect the financial effect of this differential over the period of the forward contract. The duration will be up to two years for a forward contract. A variation in foreign exchange markets can be affected to any company whether or not they are directly involved in the international trade or not. This is often referred to as Economic foreign exchange and most difficult to protect a business. The three ways of managing risks are as follows:

Choosing to manage risk by dealing with the spot market whenever the need of cash flow rises. This will result in a high risk and speculative strategy since one will not know the rate at which a transaction is dealt until the day and time it occurs. Managing the business becomes difficult if it depends on the selling or buying the currency in the spot market.

The decision must be made to book a foreign exchange contract with the bank whenever the foreign exchange risk is likely to occur. This will help to fix the exchange rate immediately and will give a clear idea of knowing the exact cost of foreign currency and the amount to be received at the time of settlement whenever this due occurs.

A currency option will prevent unfavourable exchange rate movements in the similar way as a forward contract does. It will permit gains if the markets move as per the expectations. For this base, a currency option is often demonstrated as a forward contract that can be left if it is not followed. Often banks provide currency options which will ensure protection and flexibility, but the likely problem to arise is the involvement of premium of particular kind. The premium involved might be a cash amount or it could also influence into the charge of the transaction.

Q6. Discuss the importance of transfer pricing for MNCs.

Answer: Transfer pricing is the process of setting a price that will be charged by a subsidiary (unit) of a multi-unit firm to another unit for goods and services, which are sold between such related units.

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Transfer pricing is a critical issue for a firm operating internationally. Transfer pricing is determined in three ways: market based pricing, transfer at cost and cost-plus pricing. The Arms Length pricing rule is used to establish the price to be charged to the subsidiary.

Transfer pricing can also be defined as the rates or prices that are utilised when selling goods or services between a parent company and a subsidiary or company divisions and departments that may be across many countries. The price that is set for the exchange in the process of transfer pricing may be a rate that is reduced due to internal depreciation or the original purchase price of the goods in question. When properly used, transfer pricing helps to efficiently manage the ratio of profit and loss within the company.

Transfer pricing is a relatively simple method of moving goods and services among the overall corporate family.

Many managers consider transfer pricing as non-market based. The reason for transfer pricing may be internal or external. Internal transfer pricing include motivating managers and monitoring performance. External factors include taxes, tariffs, and other charges.

Transfer Pricing Manipulation (TPM) is used to overcome these reasons. Governments usually discourage TPM since it is against transfer pricing, where transfer pricing is the act of pricing commodities or services. However, in common terminology, transfer pricing generally refers TPM. TPM assists in saving the organisations tax by shifting accounting profits from high tax to low tax jurisdictions. It also enables to fix transfer price on a non-market basis and thus enables to save tax. This method facilitates in moving the tax revenues of one country to another. A similar trend can be observed in domestic markets where different states try to attract investment by reducing the Sales tax rates, and this leads in an outflow from one state to another. Therefore, the Government is trying to implement a taxing system in order to curb tax evasion.

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MBA Semester IV MB0053 International Business Management

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Assignment Set- 2

Q1. What is globalisation and what are its benefits?

Answer: Globalisation Globalisation is a process where businesses are dealt in markets around the world, apart from the local and national markets. According to business terminologies, globalisation is defined as the worldwide trend of businesses expanding beyond their domestic boundaries. It is advantageous for the economy of countries because it promotes prosperity in the countries that embrace globalisation. Benefits of globalization The merits and demerits of globalisation are highly debatable. While globalisation creates employment opportunities in the host countries, it also exploits labour at a very low cost compared to the home country. Let us consider the benefits and ill-effects of globalisation.

Some of the benefits of globalisation are as follows: Promotes foreign trade and liberalisation of economies.

Increases the living standards of people in several developing countries through capital investments in developing countries by developed countries.

Benefits customers as companies outsource to low wage countries. Outsourcing helps the companies to be competitive by keeping the cost low, with increased productivity.

Promotes better education and jobs.

Leads to free flow of information and wide acceptance of foreign products, ideas, ethics, best practices, and culture.

Provides better quality of products, customer services, and standardised delivery models across countries.

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Increases business travel, which in turn leads to a flourishing travel and hospitality industry across the world.

Increases sales as the availability of cutting edge technologies and production techniques decrease the cost of production.

Provides several platforms for international dispute resolutions in business, which facilitates international trade.

Q2. Describe the theories of international business.

Answer: The importance of cross border commerce and the globalisation of production are well recognized and since MNCs conduct business in many new forms other than traditional importing and exporting, international trade theory has become too limited for explaining the current challenges to IB. Basis for trade Though the price difference remains the basic cause of trade, this explanation is not adequate. The two-way flow of goods must be traced to systematic international differences in the cost and pricing structure. Goods that are cheaper to produce at home will be exported and goods that are cheaper to produce abroad will be imported. The following trade theories explain the basics behind international trade:

1. Mercantilism This was the economic theory that prevailed in the 17th and 18th centuries. This theory was highly nationalistic, viewed national well-being to be of prime importance and favoured the regulation and planning of economic activity as a means of national advancement. According to this theory, the most important way for a nation to grow rich was by the acquisition of precious metals, especially gold. Exports were viewed as favourable as long as they brought in gold, but imports were viewed unfavourably as depriving the country of its true source of wealth and hence trade had to be regulated.

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Adam Smith (a social philosopher and a pioneer of politicl economics) argued that nations differ in their ability to manufacture goods efficiently and he saw that a country gains by trading. If the two countries exchanged two goods at a ratio of 1:1, country I gets one unit of goods B by sacrificing only 10 units of labour, whereas it has to give up 20 units of labour if it produced the goods itself. In the same manner, country II gives up only 10 units of labour to get one unit of goods A, whereas it has to give up 20 units of labour if it was made by itself. Hence, it was understood that both countries had large amount of both goods by trading. 3. Comparative advantage Ricardo (english political economist) questioned Smiths theory stating that if one country is more productive than the other in all lines of production and if country I can produce all goods with less labour costs, will there be a need for the countries to trade. The reply was affirmative.

4. Product lifecycle theory This theory was proposed by Raymond Vernon in the mid-1960s and was based on the observation that from most of the 20th century, a very large proportion of the worlds new products were developed by American firms and sold there first. He argued that the wealth and size of the market gave American firms a strong incentive to develop new consumer products and in addition, the high cost of labor was an incentive to develop cost-saving innovations. He did not agree with earlier theories and he placed emphasis on information, risk, and economies of scale, rather than on cost. He focused on the lifecycle of the product and came up with his theory which identified three distinct stages: New product stage - The need for a new product, in the domestic market, is identified and it is developed, manufactured and marketed in limited numbers. It is not exported, not in sizeable quantities, at any rate, since it is primarily for the national market.

Maturing product stage - Once the product has become popular in the domestic market, foreign demand increases and manufacturing facilites abroad may be set up to meet demand there. After success in the foreign markets and towards the end of the product maturity stage, the manufacturers try and produce it in the developing countries. Standardised product stage - In the last stage of the life-cycle theory, the product becomes a commodity, the price becomes optimised and the makers look for countries Page 36

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where it can be made with the least production costs. One of the results of this is the product being imported into the firms home country. Dell manufactures hardware in Asia, which is then transported to the US, its country of origin. 5. Porters diamond model In 1990, Michael Porter analysed the reason behind some nations success and others failurein international competition. His thesis outlined four broad attributes that shape the environment in which local firms compete and these attributes promote the creation of competitive advantage. They are explained as follows:

Factor endowments - Characteristics of production were analysed in detail. Heirarchies are recognised, as is distinguishing between basic factors like natural resources, climate, location and so on and advanced factors like communications infrastructure, research facilities.

Demand conditions - The role of home demand in improving competitive advantage is emphasised since firms are most sensitive about the needs of their closest customers. Example, the Japanese camera industry which caters to a sophisticated and knowledgeable local market.

Relating and supporting industries - The presence of suppliers or related industries is advantageous since the benefits of investment in advanced factors of production spill over to these supporting industries. Successful industries within a country tend to be grouped into clusters of industries.Example, Silicon Valley. related

Firm strategy, structure and rivalry Domestic rivalry creates pressure to innovate, improve quality, reduce costs which in turn helps create world-class competitors.

He said that these four attributes constituted the diamond and he argued that firms are most likely to succeed in industries where the diamond is most favourable. He also stated that the diamond is a mutually reinforcing system and the effect of one attribute depends on the state of others. For example, favourable demand conditions will not result in a competitive advantage unless the state of rivalry is enough to elicit a response from the firms. Figure gives you an illustration of Porters diamond model.

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Porters Diamond Model

Q3. Explain the importance of ethics in international business.

Answer: Most countries have similar ethical values, but are practiced differently. This section deals with the way individuals in different countries approach ethical issues, and their ethically acceptable behaviour. With the rise in global firms, issues related to ethical values and traditions become more common. These ethical issues create complications to MultiNational Companies (MNCs) while dealing with other countries for business. Hence, many companies have formulated well-designed codes of conduct to help their employees.

Two of the most prominent issues that managers in MNCs operating in foreign countries face are bribery and corruption and worker compensation.

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Bribery and corruption Bribery can be defined as the act of offering, accepting, or soliciting something of value for the purpose of influencing the action of officials in the discharge of their duties. Corruption is the abuse of public office for personal gain. The issue arises when there are differences in perception in different countries. For example, in the Middle East, it is perfectly acceptable to offer an official a gift. In Britain it is considered as an attempt to bribe the official, and hence, considered unlawful. Worker compensation Businesses invest in production facilities abroad because of the availability of low-cost labour, which enables them to offer goods and services at a lower price than their competitors. The issue arises when workers are exploited and are underpaid compared to the workers in the parent country who are paid more for the same job. The disparity arises due to the differences in the regulatory standards in the two countries. Managing ethics Earlier, we believed that ethics is a prerogative of individuals, but now this perception has immensely changed. Many companies use management techniques to encourage ethical behaviour at an organisational level. Various techniques of managing ethics like practicing ethics at the top level management, special training on ethics, forming committees to oversee ethical issues, and defining and implementing code of ethics are illustrated in the following figure.

Figure: Techniques of Managing Ethics

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Top management The senior management of a company must be committed to ensure that ethical standards are met. The chief executive of the company must not engage in business practices harmful to employees, or the society. The top management must focus on ethical practices while informing employees of their intention. Code of ethics One of the best practices for ethics is creating a corporate ethical statement and communicating it within the company. Such practices enhance the companys public image. Almost all Fortune 500 companies have such codes. Ethics committee There are ethics committees in many firms to help them deal with and advise on work related ethical issues. The Chief Executive Officer can head the committee that includes the Board of Directors. Such a committee answers employee queries, helps the company to establish policies in uncertain areas, advises the Board on ethical issues, and oversees the enforcement of the code of ethics. Ethics hotline A companys ethical hotline helps its employees report any ethical issues they face at work. The ethics committee then investigates these issues. Such hotline calls are treated confidential, where the callers identity is protected to encourage employees to report on ethical issues.

The act of reporting illegal, immoral, or illegitimate practices by former or current employees involving its employees is known as Whistle-blowing. Whistle-blowing is favourable to a company because employees can alert the management on possibly deviant behaviour rather than reporting it to the media, which adversely affects the company. A case of whistleblowing in Xerox corporation (a pioneer in copier machines), led its Chief Financial Officer to be fined $ 5.5 million and banned from practicing accountancy after reports of falsified financial statements emerged. Ethics training programs Most firms take ethics seriously and provide training for its managers and employees. Such training programs help the employees become familiar with the official policy on ethical issues. These programs demonstrate the use of these ethic policies in everyday decision-making. Ethics training is most effective when conducted by managers and when focused on work environment.

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Ethics and law Both law and ethics focus on defining the perfect human behaviour, but they are not the same. Law is the governments attempt to formalise rightful behaviour, but it is rarely possible to enforce written laws. It depends on individual or business ethics to reduce unlawful incidents. Ethical concepts are more complex than written rules since it deals with human dilemmas that go beyond the formal language of law.

Legal rules seek to promote ethical behaviour in companies. The following are some of the Acts which seek to ensure fair business practices in India:

Foreign Exchange Management Act (FEMA) of 1999 - FEMA regulates the cross border movement of foreign and local currencies. Companies Act of 1956 - Companies Act provides the complete legal framework for the formation, running, and winding up of a company. Consumer Protection Act of 1986 (CPA) - CPA provides and regulates the framework for the protection of consumer rights. Essential Commodities Act of 1955 - This act defines the goods and services that are essential for the people at all times and provides a legal framework for the uninterrupted supply of the same.

Free market ethics In this section, we will discuss the ethical aspects of competition used to explain free market ethics. Competition is an important element that differentiates free market from command market. Competition is a mechanism for free market production and distribution of goods and services that are in demand. Competition in business is seen as an essential cultural trait of a free market society. Most activities of the free market can be viewed as a competitive contest in which businesses engage to provide products and services for a profit.

In addition to the economic nature of the free market system, there are ethic- related issues as well. The three widely accepted factors of ethics in the free market are market ethics, the Protestant ethics, and the liberty ethics. These three ethics set the stage for the industrial revolution and the accompanying growth in business. During this period, industrial capitalists were allowed to freely operate businesses, build large organisations, exploit workers, and engage in fiercely competitive practices for profit and economic expansion.

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Market ethics Market ethics is the basic system of ethics followed by a business in a free market scenario. It covers the entire spectrum of business including sales, pricing, and competitor issues. The Protestant ethics The Protestant ethics considered ideology as an important factor along with the moral aspects in a capitalist scenario. As an ideology, this ethic served to legitimise the capitalistic system by providing a moral justification for the pursuit of profit and distribution of income. Liberty ethics Liberty ethics encourages a person to play a participatory role on government, encourages private property, and introduces more freedom and individualism in all spheres of life.

Q4. What do you understand by regional integration? List its types.

Answer: Regional integration can be defined as the unification of countries into a larger whole. Regional integration also reflects a countrys willingness to share or unify into a larger whole. The level of integration of a country with other countries is determined by what it shares and how it shares. Regional integration requires some compromise on the part of countries. It should aim to improve the general quality of life for the citizens of those countries.

In recent years, we have seen more and more countries moving towards regional integration to strengthen their ties and relationship with other countries. This tendency towards integration was activated by the European Union (EU) market integration. This trend has influenced both developed and developing countries to form customs unions and Free Trade Areas (FTA). The World Trade Organisation (WTO) terms these agreements of integration as Regional Trade Agreements (RTA).

Different types of regional integration are: 1. Preferential trading agreement Preferential trading agreement is a trade pact between countries. It is the weakest type of economic integration and aims to reduce the taxes on few products to the countries who sign the pact. The tariffs are not abolished completely but are lower than the tariffs charged to countries not party to the agreement. India is in PTA with countries like Afghanistan, Chile Page 42

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and South Common Market (MERCOSUR). The introduction of PTA has generated an increase in the market size, and resulted in the availability and variety of new products. 2. Free trade area Free Trade Area (FTA) is a type of trade bloc and can be considered as a second stage of economic integration. It is made up of all the countries that are willing to or agree to reduce preferences, tariffs and quotas on most of the services and goods traded between them. Countries choose this kind of economic integration if their economical structures are similar. If the countries compete among themselves, they are likely to choose customs union.

The importers must obtain product information from all the suppliers within the supply chain, in order to determine the eligibility for a Free Trade Agreement (FTA). After receiving the supplier documentation, the importer must evaluate the eligibility of the product depending on the rules surrounding the products. The importers product is qualified individually by the FTA. The basis on which the product will be qualified is that the finished product should have a minimum percentage of local content. 3. Common market Common market is a group formed by countries within a geographical area to promote duty free trade and free movement of labour and capital among its members. European community is an example of common market. Common markets levy common external tariff on imports from non-member countries. A single market is a type of trade bloc, comprising a free trade area with common policies on product regulation, and freedom of movement of goods, capital, labour and services, which are known as the four factors of production. This agreement aims at making the movement of four factors of production between the member countries easier. The technical, fiscal and physical barriers among the member countries are eliminated considerably as these barriers hinder the freedom of movement of the four factors of production. The member countries must come forward to eliminate the barriers, have a political will and formulate common economic policies.

A common market is a first step towards a single market. It may be initially limited to a FTA with moderate free movement of capital and services, but it is not capable of removing rest of the trade barriers.

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A single market has many advantages. The freedom of movement of goods, capital, labour and services between the member countries, results in the efficient allocation of these production factors and increases productivity.

A single market presents a challenging environment for businesses as well as for customers, making the existence of monopolies difficult. This affects the inefficient companies and hence, results in a loss of market share and the companies may have to close down. However, efficient companies can gain from the increased competitiveness, economies of scale and lower costs. Single market also benefits the consumers in a way that the competitive environment provides them with inexpensive products, more efficient providers of products and increased variety of products.

A country changing over to a single market may experience some short term negative effects on the national economy due to increased international competition. The national companies that earlier benefited from market protection and subsidies, may find it difficult to cope with their efficient peers. If the companies fail to improve their methods, they may have to close down leading to migration and unemployment. 4. Economic union Economic union is a type of trade bloc and is instituted through a trade pact. It comprises of a common market with a customs union. The countries that are part of an economic union have common policies on the freedom of movement of four factors of production, common product regulations and a common external trade policy. The purpose of an economic union is to promote closer cultural and political ties, while increasing the economic efficiency between the member countries.

Economic unions are established by means of a formal intergovernmental legal agreement, among independent countries with the intention of fostering greater economic integration. The members of an economic union share some elements associated with their national economic jurisdictions.

These include the free movements of: Goods and services within the union along with a common taxing method for imports from non-member countries. Capital within the economic union.

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Persons within the economic union. Some form of cooperation usually exists when framing fiscal and monetary policies.

5. Political union

A political union is a type of country, which consists of smaller countries/nations. Here, the individual nations share a common government and the union is acknowledged internationally as a single political entity. A political union can also be termed as a legislative union or state union.

Q5. What are the challenges faced by Indian businesses in global market?

Answer: The Challenges of E-Business: As the ebusiness is growing, there are many technical and business trends that are associated with it. Some important trends in e-business are explained below.

E-business is crucial to business success. Many companies come out with changes that are necessary for e-business to become profitable. The process of e-business is long lasting than that of the re-engineering. There are some important trends in the e-business that are described as follows: Technology focus is on e-business - The hardware, software, and network vendors, focus on providing the tools for e-business. The ebusiness is mainly the extension of the products and services. E-business produces cumulative effects - E-business is long lasting. The relationship with customers, suppliers, and employees changes as we implement e-business. E-business implementation effects success and failure of a business - There will be both the success and the failures that are associated with any kind of business. The failures become dramatic with e-business as it is more visible externally.

There are some major success factors for e-business. These factors include the strategic factors, structural factors and the management oriented factors. These factors are explained as follows:

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The technologies related to the internet are used as a complement for the existing technologies.

The basis of competition that is not shifted from traditional competitive advantages such as cost, profit, quality, service and features. The new competitors and market shares are tracked. The web centric marketing strategy. The strategic position of the company in the market has strengthened. The frequent review of the distribution and supply chain model is done in order to maximise the company's gain. The buyers behaviour and the customer personalisation. The first-mover advantage and quick time to start. The e-business offered good products and services. The innovation was allowed when risks are low. The customers and partner's expectations from the well managed.

Structural factors Correct digital infrastructure. Good e-business education and training to employees, management and customers. Current systems expanded to cover entire supply chain. Good cost control.

Management-oriented factors The organisation wide commitment to e-business leadership. The necessary support for e-business from the top management. The awareness and understanding of capabilities of technology by executives. The top management has to communicate about the value of ebusiness throughout the organisation.

The e-business is facing challenges mainly in the areas of technology, logistics, and legal issues. 1. Technology The technology plays a major role in the concept of new economy. The technology has two dimensions; one is the shift from manufacturing to services and second is the shift from physical resources to the knowledge resources. There are so many mechanisms for Page 46

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technology innovation and diffusion, both within and outside the countries. Many of the organisations will include different technologies both for quantitative and qualitative terms. Small scale enterprises play a vital role in the implementation of new technologies. They have added more value in terms of population, employment, and services that they are offering. Internet also plays a vital role as it helps the small and medium enterprises in providing the cost effective possibilities to advertise their products. Internet also provides the contacts to buyers and suppliers on a global basis. E-business is helps the radical transformation in the way that the business is done. The introduction of technologies like the common database, electronic networks and value added services are helpful for speeding up the transactions and these are fundamental at the industrial level. The e-business has to undergo lot of challenges in implementing the technologies that are helpful for the organisation since many of the people in the organisation will not be interested to shift to the new technology and learn the new skills.

2. Logistics The logistics is defined as the planning framework for maintaining the material, information, and capital flow. The logistics includes the complex information, communication and control systems required in the business environment. The logistics presents e-business with challenges that exceeds the expectations of the customers with a reasonable cost. Now aday, attempt has been made to reduce the inventory costs. In order to meet the high expectations of the customers, an e-business needs the special infrastructure for tuning and managing the interactions. The interactions can be in between the shippers, logistic providers, shipping companies, and also the customers.

3. Legal concerns As there is tremendous usage of internet, it is better to consider the legal concerns behind the internet. This is because whatever is printed on the net will be accessed by public throughout the world. We also have an option of going back and seeing the basics of that information. Now-a-day with the help of wireless phones, Personal Digital Assistants (PDAs), internet can be accessed from anywhere in the world. As a result the customers must be provided proper security and privacy to access internet. It becomes very difficult to trust the actual with the unethical, illegal, internet marketing and advertising frauds and ebusiness email scams and hence one must be careful while performing e-business. It is necessary to concern the privacy and legal matters while writing a copy and maintaining a client's e-business.

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There are uncertainties in e-business when compared with direct business. The uncertainties are related to the security, privacy, credit and debit card handling. The security is the primary concern in e-business. The PCI Data Security standard (PCI DSS) needs to be followed by one who handles the credit card information. E-business is all about the trust between buyer and the seller so one must be careful while dealing with the transactions which involve the handling of credit and debit cards.

There will also be copyright issues that is copying something from other sites and presenting the same content as their own. It is important to check for plagiarism when the company is publishing their own articles. When some concepts are copyright then it is necessary to credit the original authors. Disclaimer notice is required at the start of any business website. If the webmasters include some unethical information about the client then that can cause everlasting negative consequences for the client. The legal action is taken against the false advertisements also.

The risks associated with conducting e-business over the internet are explained as follows: Jurisdiction - Contracting over the cyberspace is a challenge for the website owners and the internet is the form of communication that rises above the spatial boundaries. There is a jurisdiction problem in the disputes between the buyer and seller regarding where the contract was formed and which state law applies for the contract. Contact validity - The emerging issue is the legal validity of web wrap or click on contracts. This type of contract is mainly found on the web site that offers goods and services for the sale. This e-business creates the legal relationship between the seller and buyer. Contract information - The advent of the e-business over the net is responsible for various legal issues regarding the formation of the electronic contracts. There is a need for matching both the e-customers and e-merchants with the legally responsible parties in the real world. There is a need for on cryptographic methods for reducing the risks associated with the identification and authentication. The cryptographic methods for eliminating the risks those are associated with the non repudiation and security.

Q6. Write short notes on WTO.

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growth and employment throughout the world. The WTO is the successor to the General Agreement of Tariffs and Trade (GATT). India is one of the founder members of WTO. WTO represents the latest attempts to create an organisational focal point for liberal trade management and to consolidate a global organisational structure to govern world affairs. WTO has attempted to create various organisational attentions for regulation of international trade. WTO created a qualitative change in international trade. It is the only international body that deals with the rules of trades between nations. Objectives and functions of WTO The key objective of WTO is to promote and ensure international trade in developing countries. The other major functions include:

Helping trade flows by encouraging nations to adopt discriminatory trade policies. Promoting employment, expanding productions and trade and raising standard of living and income and utilising the worlds resources. Ensuring that developing countries secure a better share of growth in world trade. Providing forum for trade negotiations. Resolving trade disputes.

The important functions of the WTO as stated in the WTO agreement are the following: Developing transitional economies Majority of the WTO members belong to developing countries. The developing countries such as India, China, Mexico, Brazil and others have an important role in the organisation. The WTO helps in solving the problems of developing economies. The developing states are provided with trade and tariff data. This depends on the countrys individual export interest and their participation in WTO -bodies. The new members benefit hugely from these services. Providing help for export promotion The WTO provides specialised help for export promotion to its members. The export promotion is done through the International Trade Center established by the GATT in 1964. It is operated by the WTO and the United Nations. The center accepts requests from member countries, usually developing countries for support in formulating and implementing export promotion programmes. The center provides information on export market and marketing techniques. The center also provides assistance in establishing export promotion and marketing services. Through this WTO proves its commitment in the upliftment of the world economy.

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Cooperating in global economic policy-making The main function of the WTO is to cooperate in global economic policy-making. In the Marrakesh Ministerial Meeting in April 1994, a separate declaration was adopted to achieve this objective. The declaration specifies the responsibility of WTO as, to improve and maintain the cooperation with international organisations such as the World Bank, International Monetary Fund (IMF) that are involved in monetary and financial matters. WTO analyses the impact of liberalisation on the growth and development of national economies which is the important factor in the success of the economy. Monitoring implementation of the agreement The WTO administers sixty different agreements that have the statue of international legal documents. The membergovernments sign and confirm all WTO agreements on attainment. Providing forum for negotiations The WTO provides a permanent forum for negotiations among members. The negotiations can be on matters already in the WTO agreements or matters not addressed in the WTO law. Administrating dispute settlement The important function of WTO is the administration of the WTO dispute settlement system. It helps in settling multilateral trading dispute. A dispute arises when a member country adopts a trade policy and other fellow members consider it as a violation of WTO agreements. The Dispute Settlement Body (DSB) is responsible for the settlement of disputes. The dispute settlement system is prohibited from adding or deleting the rights and obligations provided in the WTO agreements. The WTO dispute settlement system helps to: Preserve the rights and responsibilities of the members. Clarify the current provisions of the agreements.

Structure The structure of the WTO consists of the Ministerial Conference, which is the highest authority. This body consists of the representatives from all WTO members. The WTO members meet in every two years and take decisions on all matters under the multilateral trade agreements. The daily activities of the WTO are conducted by subsidiary bodies and principally by the General Council which is composed of WTO members. The members report to the Ministerial Conference. The General Council on behalf of the Ministerial Conference administers as the Dispute Settlement Body to manage the dispute settlement procedures. It also acts as the Trade Policy Review Body that conducts regular reviews of the trade policies of the individual WTO members. Page 50

MBA Semester IV The General Council delegates responsibility to other major bodies. They are:

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Council for Trade in Goods manages the implementation and functioning of all agreements covering trade in goods. Trade in Services and Trade of Intellectual Property Rights are the two councils that have responsibility for their respective WTO agreements and can establish their own subsidiary bodies if required.

The Committee on Trade and Development manages issues relating to the developing countries. The Committee on Balance of Payments conducts consultations between WTO members and countries that take trade-restrictive measures to handle balance-ofpayments difficulties.

Committee on Budget and Administration manages issues relating to financing and budget of WTO.

Principles The WTO principles of the trading system are: Trading without discrimination One aspect of nondiscrimination is that foreigners and people within the home country must be treated equally. This implies that imported goods that are in the market must not face discrimination. There is also a Most Favoured Nation (MFN) principle which requires the nations to treat all WTO members equally. In case one nation grants a special trade deal to another nation, the deal must be extended to all WTO members. Trade barriers negotiated downwards To lower trade barriers such as import tariffs, red tape and encourage trade growth. Predictable trading The predictability in business helps to know the real costs. The WTO operates with tariff bindings and agreements that restricts raising a specific tariff over a given time. This provides the business people with realistic data. Making trade rules clear and accessible helps the business people to anticipate stable future. Competitive trading The WTO works towards trade liberalisation and understands that trade relationships between nations can be very complex. The WTO agreements support healthy competition in services and intellectual property and discourage subsidies and dumping of products at prices below the cost of their manufacturer. Encourage development and economic reforms The majority of the WTO members are developing economies that are changing to market economies. The

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developed nations must give market access to goods from the under developed countries and provide technical assistance. Developed countries are allowing dutyfree and quota-free imports for all the products from the under developed countries.

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Assignment Set- 1

Q1. You are given the following information: Spot EUR/USD : 0.7940/0.8007 Spot USD/GBP: 1.8215/1.8240 Three months swap: 25/35 Calculate three month EUR/USD rate.

Answer: Forward Points = ((Spot * (1 + (OCR rate * n/360))) / (1 + (BCR rate * n/360))) - Spot OCR = Other Currency Rate BCR = Base Currency Rate Forward points = ((0.07940 * (1 + (0.018215 * 90/360))) / (1 + (0.08007 * 90/360))) 0.07940 SWAP = -0.00120 Forward rate = 0.07940 - 0.00120 = 0.0782 Customer sells EUR 3 Mio against USD at 0.0782 at 3 month (0.07940 - 0.00120). Customer wants to Buy EUR 3 Mio against USD 3 months forward.

Q2. Distinguish between Eurobond and foreign bonds. What are the unique characteristics of Eurobond markets?

Answer: A Eurobond is underwritten by an international syndicate of banks and other securities firms, and is sold exclusively in countries other than the country in whose currency the issue is denominated. For example, a bond issued by a U.S. corporation, denominated in U.S. dollars, but sold to investors in Europe and Japan (not to investors in the United States), would be a Eurobond. Eurobonds are issued by multinational corporations, large domestic corporations, sovereign governments, governmental enterprises, and international institutions. They are offered simultaneously in a number of different national capital markets, but not in the capital market of the country, nor to residents of the country, in whose currency the bond is denominated. Almost all Eurobonds are in bearer form with call provisions and sinking funds. Page 53

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A foreign bond is underwritten by a syndicate composed of members from a single country, sold principally within that country, and denominated in the currency of that country. The issuer, however, is from another country. A bond issued by a Swedish corporation, denominated in dollars, and sold in the U.S. to U.S. investors by U.S. investment bankers, would be a foreign bond. Foreign bonds have nicknames: foreign bonds sold in the U.S. are "Yankee bonds"; those sold in Japan are "Samurai bonds"; and foreign bonds sold in the United Kingdom are "Bulldogs." Figure 4 specifically reclassifies foreign bonds from a U.S. investor`s perspective.

FOREIGN BONDS TO U.S. INVESTORS Foreign currency bonds are issued by foreign governments and foreign corporations, denominated in their own currency. As with domestic bonds, such bonds are priced inversely to movements in the interest rate of the country in whose currency the issue is denominated. For example, the values of German bonds fall if German interest rates rise. In addition, values of bonds denominated in foreign currencies will fall (or rise) if the dollar appreciates (or depreciates) relative to the denominated currency. Indeed, investing in foreign currency bonds is really a play on the dollar. If the dollar and foreign interest rates fall, investors in foreign currency bonds could make a nice return. It should be pointed out, however, that if both the dollar and foreign interest rates rise, the investors will be hit with a double whammy.

Characteristics of Eurobond markets 1. Currency denomination: The generic, plain vanilla Eurobond pays an annual fixed interest and has a long-term maturity. There are a number of different currencies in which Eurobonds are sold. The major currency denominations are the U.S. dollar, yen, and euro. (70 to 75 percent of Eurobonds are denominated in the U.S. dollar.) The central bank of a

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country can protect its currency from being used. Japan, for example, prohibited the yen from being used for Eurobond issues of its corporations until 1984. 2. Non-registered: Eurobonds are usually issued in countries in which there is little regulation. As a result, many Eurobonds are unregistered, issued as bearer bonds. (Bearer form means that the bond is unregistered, there is no record to identify the owners, and these bonds are usually kept on deposit at depository institution). While this feature provides confidentiality, it has created some problems in countries such as the U.S., where regulations require that security owners be registered on the books of issuer. 3. Credit risk: Compared to domestic corporate bonds, Eurobonds have fewer protective covenants, making them an attractive financing instrument to corporations, but riskier to bond investors. Eurobonds differ in term of their default risk and are rated in terms of quality ratings.

4. Maturities: The maturities on Eurobonds vary. Many have intermediate terms (2 to 10 years), referred to as Euronotes, and long terms (10-30 years), and called Eurobonds. There are also short-term Europaper and Euro Medium-term notes. 5. Other features: Like many securities issued today, Eurobonds often are sold with many innovative features.

For example: a) Dual-currency Eurobonds pay coupon interest in one currency and principal in another. b) Option currency Eurobond offers investors a choice of currency. For instance, a sterling/Canadian dollar bond gives the holder the right to receive interest and principal in either currency.

1. A number of Eurobonds have special conversion features. One type of convertible Eurobond is a dual-currency bond that allows the holder to convert the bond into stock or another bond that is denominated in another currency. 2. A number of Eurobonds have special warrants attached to them. Some of the warrants sold with Eurobonds include those giving the holder the right to buy stock, additional bonds, currency, or gold.

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Q3. What is sub-prime lending? Explain the drivers of sub-prime lending? Explain briefly the different exchange rate regime that is prevalent today.

Answer: Subprime lending is the practice of extending credit to borrowers with certain credit characteristics e.g. a FICO score of less than 620 that disqualify them from loans at the prime rate (hence the term sub-prime). Sub-prime lending covers different types of credit, including mortgages, auto loans, and credit cards. Since sub-prime borrowers often have poor or limited credit histories, they are typically perceived as riskier than prime borrowers. To compensate for this increased risk, lenders charge sub-prime borrowers a premium. For mortgages and other fixed-term loans, this is usually a higher interest rate; for credit cards, higher over-the-limit or late fees are also common. Despite the higher costs associated with sub-prime lending, it does give access to credit to people who might otherwise be denied. For this reason, sub-prime lending is a common first step toward credit repair; by maintaining a good payment record on their sub-prime loans, borrowers can establish their creditworthiness and eventually refinance their loans at lower, prime rates. Sub-prime lending became popular in the U.S. in the mid-1990s, with outstanding debt increasing from $33 billion in 1993 to $332 billion in 2003. As of December 2007, there was an estimated $1.3 trillion in sub-prime mortgages outstanding.20% of all mortgages originated in 2006 were considered to be sub-prime, a rate unthinkable just ten years ago. This substantial increase is attributable to industry enthusiasm: banks and other lenders discovered that they could make hefty profits from origination fees, bundling mortgages into securities, and selling these securities to investors.

These banks and lenders believed that the risks of sub-prime loans could be managed, a belief that was fed by constantly rising home prices and the perceived stability of mortgagebacked securities. However, while this logic may have held for a brief period, the gradual decline of home prices in 2006 led to the possibility of real losses. As home values declined, many borrowers realized that the value of their home was exceeded by the amount they owed on their mortgage. These borrowers began to default on their loans, which drove home prices down further and ruined the value of mortgage-backed securities (forcing companies to take write downs and write-offs because the underlying assets behind the securities were now worth less).

This downward cycle created a mortgage market meltdown. The practice of sub-prime lending has widespread ramifications for many companies, with direct impact being on lenders, financial institutions and home-building concerns. In the U.S. Housing

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Market, property values have plummeted as the market is flooded with homes but bereft of buyers. The crisis has also had a major impact on the economy at large, as lenders are hoarding cash or investing in stable assets like Treasury securities rather than lending money for business growth and consumer spending; this has led to an overall credit crunch in 2007. The sub-prime crisis has also affected the commercial real estate market, but not as significantly as the residential market as properties used for business purposes have retained their long-term value.

The International Monetary Fund estimated that large U.S. and European banks lost more than $1 trillion on toxic assets and from bad loans from January 2007 to September 2009. These losses are expected to top $2.8 trillion from 2007-10. U.S. banks losses were forecast to hit $1 trillion and European bank losses will reach $1.6 trillion. The IMF estimated that U.S. banks were about 60 percent through their losses, but British and euro zone banks only 40 percent.

Drivers of sub-prime lending Home price appreciation Home price appreciation seemed an unstoppable trend from the mid-1990s through to today. This "assumption" that real estate would maintain its value in almost all circumstances provided a comfort level to lenders that offset the risk associated with lending in the subprime market. Home prices appeared to be growing at annualized rates of 5-10% from the mid-90s forward. In the event of default, a very large percentage of losses could be recouped through foreclosure as the actual value of the underlying asset (the home) would have since appreciated. Lax lending standards Outstanding mortgages and foreclosure starts in 1Q08, by loan type. The reduced rigor in lending standards can be seen as the product of many of the preceding themes. The increased acceptance of securitized products meant that lending institutions were less likely to actually hold on to the risk, thus reducing their incentive to maintain lending standards. Moreover, increasing appetite from investors not only fueled a boom in the lending industry, which had historically been capital constrained and thus unable to meet demand, but also led to increased investor demand for higher-yielding securities, which could only be created through the additional issuance of sub-prime loans. All of this was further enabled by the long-term home price appreciation trends and altered rating agency treatment, which seemed to indicate risk profiles were much lower than

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they actually were. As standards fell, lenders began to relax their requirements on key loan metrics. Loan-to-value ratios, an indicator of the amount of collateral backing loans, increased markedly, with many lenders even offering loans for 100% of the collateral value. More dangerously, some banks began lending to customers with little effort made to investigate their credit history or even income. Additionally, many of the largest sub-prime lenders in the recent boom were chartered by state, rather than federal, governments. States often have weaker regulations regarding lending practices and fewer resources with which to police lenders. This allowed banks relatively free rein to issue sub-prime mortgages to questionable borrowers. Adjustable-rate mortgages and interest rates Adjustable-rate mortgages (ARMs) became extremely popular in the U.S. mortgage market, particularly the sub-prime sector, toward the end of the 1990s and through the mid-2000s. Instead of having a fixed interest rate, ARMs feature a variable rate that is linked to current prevailing interest rates. In the recent sub-prime boom, lenders began heavily promoting ARMs as alternatives to traditional fixed-rate mortgages. Additionally, many lenders offered low introductory, or teaser, rates aimed at attracting new borrowers. These teaser rates attracted droves of sub-prime borrowers, who took out mortgages in record numbers. While ARMs can be beneficial for borrowers if prevailing interest rates fall after the loan origination, rising interest rates can substantially increase both loan rates and monthly payments. In the sub-prime bust, this is precisely what happened. The target federal funds rate (FFR) bottomed out at 1.0% in 2003, but it began hiking steadily upward in 2004. As of mid-2007, the FFR stood at 5.25%, where it had remained for over one year. This 4.25% increase in interest rates over a three-year period left borrowers with steadily rising payments, which many found to be unaffordable. The expiration of teaser rates didnt help either; as these artificially low rates are replaced by rates linked to prevailing interest rates, sub-prime borrowers are seeing their monthly payments jump by as much as 50%, further driving the increasing number of delinquencies and defaults. Between September of 2007 and January 2009, however, the U.S. Federal Reserve slashed rates from 5.25% to 0-.25% in hopes of curbing losses. Though many sub-prime mortgages continue to reset from fixed to floating, rates have fallen so much that in many circumstances the fully indexed reset rate is below the pre-existing fixed rate; thus, a boon for some sub-prime borrowers. The exchange rate is an important price in the economy and some governments like to control it, manage it or influence it. Others prefer to leave the exchange rate to be

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determined only by market forces. This decision is the choice of exchange rate regime. Many alternative regimes exist: Floating Exchange Rate (Flexible) Regimes: A flexible exchange rate system is one where the value of the currency is not officially fixed but varies according to the supply and demand for the currency in the foreign exchange market. In this system, currencies are allowed to: Appreciate when the currency becomes more valuable relative to others. Depreciate when the currency becomes less valuable relative to others.

Fixed Exchange Rate Regimes: A Fixed exchange rate system is one where the value of the currency is set by official government policy. The exchange rate is determined by government actions designed to keep rates the same over time. The currencies are altered by the government: Revaluation Government action to increase the value of domestic currency relative to others. Devaluation Government action to decrease the value of domestic currency. After the transition period of 1971-73, the major currencies started to float. Flexible exchange rates were declared acceptable to the IMF members. Gold was abandoned as an international reserve asset. Since 1973, most major exchange rates have been floating against each other. However, there are countries which have fixed exchange rate regimes.

Q4. Explain (a) Parallel Loans (b) Back to- Back loans

Answer: Parallel loan The forerunner of a swap; a method of raising capital in a foreign country to finance assets there without a cross-border movement of capital. For example, a $US loan would be made to an Australian company to finance its factory in the US; at the same time the US party which made the loan would borrow $A in Australia from the Australian company's parent to finance a project in Australia. Parallel loans enjoyed considerable popularity in the 1970s in the UK when they were frequently used to circumvent strict exchange controls.

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A type of foreign exchange loan agreement that was a precursor to currency swaps. A parallel loan involves two parent companies taking loans from their respective national financial institutions and then lending the resulting funds to the other company's subsidiary.

For example, ABC, a Canadian company, would borrow Canadian dollars from a Canadian bank and XYZ, a French company, would borrow euros from a French bank. Then ABC would lend the Canadian funds to XYZ's Canadian subsidiary and XYZ would lend the euros to ABC's French subsidiary.

The first parallel loans were implemented in the 1970s in the United Kingdom in order to bypass taxes that were imposed to make foreign investments more expensive.

Back-to-back loan A Back-to-back loan is a loan agreement between entities in two countries in which the currencies remain separate but the maturity dates remain fixed. The gross interest rates of the loan are separate as well and are set on the basis of the commercial rates in place when the agreement is signed.

Most back-to-back loans come due within 10 years, due to their inherent risks. Initiated as a way of avoiding currency regulations, the practice had, by the mid-1990s, largely been replaced by currency swaps.

A Back-to-back loan is a loan agreement between entities in two countries in which the currencies remain separate but the maturity dates remain fixed. The gross interest rates of the loan are separate as well and are set on the basis of the commercial rates in place when the agreement is signed.

Most back-to-back loans come due within 10 years, due to their inherent risks. Initiated as a way of avoiding currency regulations, the practice had, by the mid-1990s, largely been replaced by currency swaps.

One disadvantage of such agreements is asymmetrical liability - absent a specific agreement, when one party defaults on the loan, the other party may still be held responsible for repayment. Another disadvantage in comparison with currency swaps is that back-toback loan transactions are customarily recorded on banking institutions' records as liabilities and thereby increase their capitalization requirements, while currency swaps were, during the 2000s, widely exempted from this requirement. Page 60

MBA Semester IV Q5. Explain double taxation avoidance agreement in detail

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Answer: Double Taxation Avoidance Agreements Double Taxation Avoidance Agreements Double taxation relief Double taxation means taxation of same income of a person in more than one country. This results due to countries following different rules for income taxation. There are two main rules of income taxation (a) source of income rule and (b) residence rule. As per source of income rule, the income may be subject to tax in the country where the source of such income exists (i.e. where the business establishment is situated or where the asset/property is located) whether the income earner is a resident in that country or not. On the other hand, the income earner may be taxed on the basis of his residential status in that country. For example if a person is resident of a country, he may have to pay tax on any income earned outside that country as well. Further some countries may follow a mixture of the above two rules. Thus problem of double taxation arises if a person is taxed in respect of any income on the basis of source of income rule in one country and on the basis of residence in another country or on the basis of mixture of above two rules. Relief against such hardship can be provided mainly in two ways

(a) Bilateral relief (b) Unilateral relief.

Bilateral Relief The governments of two countries can enter into agreement to provide relief against double taxation, worked out on the basis of mutual agreement between the two concerned sovereign states. This may be called a scheme of bilateral relief as both concerned powers agree as to the basis of the relief to be granted by either of them. Unilateral Relief The above procedure for granting relief will not be sufficient to meet all cases. No country will be in a position to arrive at such agreement as envisaged above with all the countries of the world for all time. The hardship of the taxpayer, however, is a crippling one in all such cases. Some relief can be provided even in such cases by home country irrespective of whether the other country concerned has any agreement with India or has otherwise provided for any relief at all in respect of such double taxation. This relief is known as unilateral relief.

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Relief from double taxation is provided by abatement on the basis of mutual agreement between two states concerned where by the assessee is given relief by credit/refund in a particular manner even though he is taxed in both countries. Relief may be in the form of credit for tax payable in another country or by charging tax at lower rate. Various models of treaties Although treaties entered into by various countries cannot be exactly identical, a certain amount of uniformity is desirable in its framework; with this in view, tax treaties have been based on models such as: 1. OECD model (Organisation of Economic Co-operation and Development) 2. UN Models Double Taxation Convention between developed and developing countries, 1980. Most of Indias treaties are based on OECD models. Types of Agreements Agreements can be divided into two main categories: 1. Limited agreements 2. Comprehensive agreements Limited agreements are generally entered into to avoid double taxation relating to income derived from operation of aircraft, ships, carriage of cargo and freight. Comprehensive agreements, on the other hand, are very elaborate documents which lay down in detail how incomes under various heads may be dealt with. Countries with which no agreement exists [section 91] [unilateral relief] If any person who is resident in India in any previous year proves that, in respect of his income which accrued or arose during that previous year outside India (and which is not deemed to accrue or arise in India), he has paid in any country with which there is no agreement under section 90 for the relief or avoidance of double taxation, income-tax, by deduction or otherwise, under the law in force in that country, he shall be entitled to the deduction from the Indian income-tax payable by him of a sum calculated on such doubly taxed income at the Indian rate of tax or the rate of tax of the said country, whichever is the lower, or at the Indian rate of tax if both the rates are equal.

In other words, unilateral relief will be available, if the following conditions are satisfied: 1. The assessee in question must have been resident in the taxable territories. 2. That some income must have accrued or arisen to him outside the taxable territory during the previous year and it should also be received outside India. 3. In respect of that income, the assessee must have paid by deduction or otherwise tax under the law in force in the foreign country in question in which the income outside India has arisen. Page 62

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4. There should be no reciprocal arrangement for relief or avoidance from double taxation with the country where income has accrued or arisen. India has agreements for avoidance of double taxation with over 60 countries. If all the above conditions are satisfied, such person shall be entitled to deduction from the Indian income-tax payable by him of a sum calculated on such doubly taxed income (a) At the average Indian rate of tax or the average rate of tax of the said country, whichever is the lower, or (b) At the Indian rate of tax if both the rates are equal. Average rate of tax means the tax payable on total income divided by the total income. Steps for calculating relief under this section: Step I: Calculate tax on total income inclusive of the foreign income on which relief is available. Claim relief if available under sections 88, 88B and 88C. Step II: Calculate average rate of tax by dividing the tax computed under Step I with the total income (inclusive of such foreign income). Step III: Calculate average rate of tax of the foreign country by dividing income-tax actually paid in the said country after deduction of all relief due but before deduction of any relief due in the said country in respect of double taxation by the whole amount of the income as assessed in the said country. Step IV: Claim the relief from the tax payable in India at the rate calculated at Step II or Step III whichever is less

Q6. What do you mean by optimum capital structure? What factors affect cost of capital across nations?

Answer: The objective of capital structure management is to mix the permanent sources of funds in a manner that will maximise the companys common stock price. This will also minimise the firms composite cost of capital. This proper mix of fund sources is referred to as the optimal capital structure. Thus, for each firm, there is a combination of debt, equity and other forms(preferred stock) which maximises the value of the firm while simultaneously minimising the cost of capital. The financial manager is continuously trying to achieve an optimal proportion of debt and equity that will achieve this objective. Cost of Capital across Countries Just like technological or resource differences, there exist differences in the cost of capital across countries. Such differences can be advantageous to MNCs in the following ways: Page 63

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1. Increased competitive advantage results to the MNC as a result of using low cost capital obtained from international financial markets compared to domestic firms in the foreign country. This, in turn, results in lower costs that can then be translated into higher market shares. 2. MNCs have the ability to adjust international operations to capitalise on cost of capital differences among countries, something not possible for domestic firms. 3. Country differences in the use of debt or equity can be understood and capitalised on by MNCs. We now examine how the costs of each individual source of finance can differ across countries. Country differences in Cost of Debt Before tax cost of debt (Kd) = Rf + Risk Premium This is the prevailing risk free interest rate in the currency borrowed and the risk premium required by creditors. Thus the cost of debt in two countries may differ due to difference in the risk free rate or the risk premium. (a) Differences in risk free rate: Since the risk free rate is a function of supply and demand, any factors affecting the supply and demand will affect the risk free rate. These factors include: Tax laws: Incentives to save may influence the supply of savings and thus the interest rates. The corporate tax laws may also affect interest rates through effects on corporate demand for funds. Demographics: They affect the supply of savings available and the amount of loanable funds demanded depending on the culture and values of a given country. This may affect the interest rates in a country. Monetary policy: It affects interest rates through the supply of loanable funds. Thus a loose monetary policy results in lower interest rates if a low rate of inflation is maintained in the country. Economic conditions: A high expected rate of inflation results in the creditors expecting a high rate of interest which increases the risk free rate. (b) Differences in risk premium: The risk premium on the debt must be large enough to compensate the creditors for the risk of default by the borrowers. The risk varies with the following: Economic conditions: Stable economic conditions result in a low risk of recession. Thus there is a lower probability of default. Relationships between creditors and corporations: If the relationships are close

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and the creditors would support the firm in case of financial distress, the risk of illiquidity of the firm is very low. Thus a lower risk premium. Government intervention: If the government is willing to intervene and rescue a firm, the risk of bankruptcy and thus, default is very low, resulting in a low risk premium. Degree of financial leverage: All other factors being the same, highly leveraged firms would have to pay a higher risk premium.

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MBA Semester IV MF0015 International Financial Management

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Assignment Set- 2 Q1. Because of its broad global environment, a number of disciplines (geography, history, political science, etc.) are useful to help explain the conduct of International Business. Elucidate with examples.

Answer: International Finance is a distinct field of study and certain features set it apart from other fields. The important distinguishing features of international finance are discussed below: Foreign exchange risk: An understanding of foreign exchange risk is essential for managers and investors in the modern day environment of unforeseen changes in foreign exchange rates. In a domestic economy this risk is generally ignored because a single national currency serves as the main medium of exchange within a country. When different national currencies are exchanged for each other, there is a definite risk of volatility in foreign exchange rates. The present International Monetary System set up is characterized by a mix of floating and managed exchange rate policies adopted by each nation keeping in view its interests. In fact, this variability of exchange rates is widely regarded as the most serious international financial problem facing corporate managers and policy makers. Political risk: Another risk that firms may encounter in international finance is political risk. Political risk ranges from the risk of loss (or gain) from unforeseen government actions or other events of a political character such as acts of terrorism to outright expropriation of assets held by foreigners. MNCs must assess the political risk not only in countries where it is currently doing business but also where it expects to establish subsidiaries. The extreme form of political risk is when the sovereign country changes the rules of the game and the affected parties have no alternatives open to them. Expanded opportunity sets: When firms go global, they also tend to benefit from expanded opportunities which are available now. They can raise funds in capital markets where cost of capital is the lowest. In addition, firms can also gain from greater economies of scale when they operate on a global basis. Market imperfections: The final feature of international finance that distinguishes it from domestic finance is that world markets today are highly imperfect. There are profound differences among nations laws, tax systems, business practices and general cultural environments. Imperfections in the world financial markets tend to restrict the extent to

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which investors can diversify their portfolio. Though there are risks and costs in coping with these market imperfections, they also offer managers of international firms abundant opportunities.

Q2. What is a credit transaction and a debit transaction? Which are the broad categories of international transactions classified as credits and as debits?

Answer: Debits and credits Since the balance of payments statement is based on the principle of double entry bookkeeping, every credit in the account is balanced by a matching debit and vice versa. The following section now explains, with examples, the BOP accounting principles regarding debits and credits. These principles are logically consistent, though they may be a little confusing sometimes. A country earns foreign exchange on some transactions and expends foreign exchange on others when it deals with the rest of the world. Credit transactions are those that earn foreign exchange and are recorded in the balance of payments with a plus (+) sign. Selling either real or financial assets or services to nonresidents is a credit transaction. For example, the export of Indian made goods earns foreign exchange for us and is, hence, a credit transaction. Borrowing abroad also brings in foreign exchange and is recorded as a credit. An increase in accounts payable due to foreigners by Indian residents has the same BOP effect as more formal borrowing in the worlds capital market. The sale to a foreign resident of a service, such as an airline trip on Air India or hotel booking in an Indian hotel, also earns foreign exchange and is a credit transaction.

Transactions that expend or use up foreign exchange are recorded as debits and are entered with a minus () sign. The best example here is of import of goods and services from foreign countries. When Indian residents buy machinery from US or perfumes from France, foreign exchange is spent and the import is recorded as a debit. Similarly, when Indian residents purchase foreign services, foreign exchange is used and the entry is recorded as a debit. The BOPs accounting principles regarding debits and credits can be summarised as follows: 1. Credit Transactions (+) are those that involve the receipt of payment from foreigners. The following are some of the important credit transactions: (a) Exports of goods or services (b) Unilateral transfers (gifts) received from foreigners Page 67

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2. Debit Transactions () are those that involve the payment of foreign exchange i.e., transactions that expend foreign exchange. The following are some of the important debit transactions: (a) Import of goods and services (b) Unilateral transfers (or gifts) made to foreigners (c) Capital outflows Let us now analyse the two terms capital inflows and capital outflows in a little more detail. Capital Inflows can take either of the two forms: (a) An increase in foreign assets of the nation (b) A reduction in the nations assets abroad For example, you can better understand the debit and credit transaction from the examples given below: A US resident purchases an Indian stock. When a US resident acquires a stock in an Indian company, foreign assets in India go up. This is a capital inflow to India because it involves the receipt of a payment from a foreigner. When an Indian resident sells a foreign stock, Indian assets abroad decrease. This transaction is a capital inflow to India because it involves receipt of a payment from a foreigner.

Capital Outflows can also take any of the following forms: (a) An increase in the nations assets abroad (b) A reduction in the foreign assets of the nation

Both the above transactions involve a payment to foreigners and are capital outflows.

Q3. What is cross rates? Explain the two methods of quotations for exchange rates with examples.

Answer: Cross Rates: The exchange rate between any two non-dollar currencies is referred to as a cross rate. A relatively large number of cross rates would be required to trade every currency directly against every other currency. For example, N currencies would require N x (N-1)/2 separate cross rates. For this reason, most exchange rates are quoted in terms of dollars and by far the greatest volume of trading Page 68

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directly involves the dollar. This reduces the number of cross-currency quotes that dealers must keep track of and reduces the potential losses associated with mispricing currencies relative to one another (which permit Triangular Arbitrage). Exchange Rates Quotations

There are two methods of quotation for exchange rates between the dollar and the currency of another country. The two methods are referred to as the direct (American) and indirect (European) methods of quotation. The exchange rate between any two non-dollar currencies is referred to as a cross rate:

1. Direct/American Quotation: Direct quotation is the dollar price of one unit of foreign currency.

For example, a direct quotation of the exchange rate between dollar and the British pound (German mark) is $1.6000/1 ($0.6000/DM1), indicating that the dollar cost of one British pound (German mark) is $1.6000 ($0.6000). Direct exchange rate quotations are most frequently used by banks in dealing with their nonbank customers. In addition, the prices of currency futures contracts traded on the Chicago Mercantile exchange are quoted using the direct method.

2. Indirect/European Quotation: The number of units of a foreign currency that are required to purchase one dollar.

For example, an indirect quotation of the exchange rate between the dollar and the Japanese yen (German mark) is 125.00/$1 (DM 1.6667/$1), indicating that one dollar can be purchased for either 125.00 Japanese Yen or 1.6667 German Marks.

Q4. Explain covered and uncovered interest rate arbitrage.

Answer: Uncovered Interest Arbitrage The transfer of funds abroad to take advantage of higher interest rates in foreign monetary centres usually involves the conversion of the domestic currency to the foreign currency, to make the investment. At the time of maturity, the funds (plus the interest) are reconverted from the foreign currency to the domestic currency. During the period of investment, a foreign exchange risk is involved due to the possible depreciation of the foreign currency. If

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such a foreign exchange risk is covered, we have covered interest arbitrage, otherwise we have uncovered interest arbitrage.

Suppose that the interest rate on three-month treasury bills is 11 per cent at an annual basis in Germany and 15 per cent in London. It may then pay for a German investor to exchange marks for pounds at the current spot rate and purchase British treasury bills to earn the extra 1 per cent interest for the three months. When the British treasury bills mature, the German investor may want to exchange the pounds he invested plus the interest he earned back into marks. The situation is shown in Figure.

Covered Interest Arbitrage Interest arbitrage is usually covered as investors of short-term funds abroad generally want to avoid the foreign exchange risk. To do this, the investor exchanges the domestic currency for the foreign currency at the current spot rate so as to purchase the foreign treasury bills and at the same time he sells forward the amount of the foreign currency he is investing plus the interest he will earn so as to coincide with the maturity of his foreign investment. Thus, covered interest arbitrage refers to the spot purchase of the foreign currency to make the investment and offsetting the simultaneous forward sale (swap of the foreign currency) to cover the foreign exchange risk. When the treasury bills mature, the investor can then get the domestic currency equivalent of the foreign investment plus the interest earned without a foreign exchange risk. Since the currency with the higher interest rate is usually at a forward discount, the net return on the investment is roughly equal to the positive interest differential earned abroad minus the forward discount on the foreign currency. This reduction in earnings is the cost of insurance against the foreign exchange risk.

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Continuing with the earlier example where the interest rate on three-month treasury bills is 11 per cent per year in Germany and 15 per cent in London, let us also assume that the pound is at a three-month forward discount of 1 per cent per year. To engage in covered interest arbitrage, the German investor must exchange marks for pounds at the current exchange rate (to purchase the British treasury bills) and at the same time sell forward a quantity of pounds equal to the amount invested plus the interest he will earn at the prevailing forward rate. Since the pound is at a forward discount of 1 per cent per year, German investor loses 1 per cent on the foreign exchange transaction to cover his foreign exchange risk for the three month period. His net gain is thus the extra 1 per cent interest he earns for the three months minus th of the 1 per cent he loses on the foreign exchange transaction, or 3/4 of 1 per cent.

Covered interest arbitrage and interest parity theory Figure shows the relationship through Covered Interest Arbitrage (CIA) between the interest rate differentials between the two nations and the forward premium or discount on the foreign currency.

The horizontal axis in the diagram shows the forward premium (+) or forward discount on the foreign currency expressed in percentages per year. The vertical axis measures the interest differential in favour of the foreign country in per cent per annum. The solid line in the Figure depicts interest parity. Positive values indicate that interest rates are higher abroad. Negative values indicate that interest rates are higher domestically. And when the interest differential is zero, the foreign currency is neither at a forward discount nor at a forward premium (i.e., the forward rate on the foreign currency is equal to its spot rate).

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For example, when the positive interest differential is 1.5 per cent per year in favour of the foreign nation, the foreign currency is at a forward discount of 1.5 per cent per year. Similarly, a negative interest differential of 2.0 per cent is associated with a forward premium of 2.0 per cent.

The Figure shows that for all points above the interest parity line, there will be a net gain from an arbitrage outflow due to two reasons. First, the positive interest differential exceeds the forward discount and second, the forward premium exceeds the negative interest differential.

Q5. Explain briefly the mechanism of futures trading

Answer: Mechanism of Futures Trading The mechanics of futures trading consists of two parts. (a) Components of futures trade (b) Execution of futures trade Components of Futures Trade 1. Futures players: Futures trading, which represents a less than zero-sum game, can be considered beneficial if it results in utility gains. This is done by the transfer of risks between the market players. These players are: Hedgers Speculators Arbitrage

2. Clearing houses: Every organised futures exchange has a clearing house that guarantees performance to all of the participants in the market. It serves this role by adopting the position of buyer to every seller and seller to every buyer. Thus, every trading party in the futures markets has obligations only to the clearing house. Since the clearing house matches its long and short positions exactly, it is perfectly hedged, i.e., its net futures position is zero.

It is an independent corporation and its stockholders are its member clearing firms. All futures traders maintain an account with member clearing firms either directly or through a brokerage firm.

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3. Margin requirements: Each trader is required to post a margin to insure the clearing house against credit risk. This margin varies across markets, contracts and the type of trading strategy involved. Upon completion of the futures contract, the margin is returned.

4. Daily resettlement: For most futures contracts, the initial margins are 5% or less of the underlying commoditys value. These margins are marked to the market on a daily basis and the traders are required to realise any losses in cash on the day they occur. Whenever the margin deposit falls below minimum maintenance margin, the trader is called upon to make it up to the initial margin amount. This resettlement is also called marked-to-the-market.

Delivery terms. This includes: (a) Delivery date: Some contracts may be delivered on any business day of the delivery month while others permit delivery after the last trading day. (b) Manner of delivery: The possibilities are: - Physical exchange of underlying asset. - Cash settlement as in the case of stock index futures. (c) Reversing trade: This trade effectively makes a traders net futures position zero thus absolving him from further trading requirements. In futures markets, 99% of all futures positions are closed out via a reversing trade.

5. Types of orders: Besides placing a market order, the other types are: (a) Limit order: It stipulates to buy or sell at a specific price or better. (b) Fill-or-kill order: It instructs the commission broker to fill an order immediately at a specified price. (c) All-or-none-order: It allows the commission broker to fill part of an order at a specified price and remainder at another price. (d) On-the-open or on-the-close order: This represents orders to trade within a few minutes of operating or closing. (e) Stop order: Triggers a reversing trade when prices hit a prescribed limit.

6. Transaction costs: The costs incurred are: (a) Floor trading and clearing fees: These are small fees charged by the exchange and its associated clearing house. (b) Commissions: A commission broker charges a commission fees to transact a public order. (c) Bid: Ask spreads. (d) Delivery costs: Those are incurred in case of actual delivery. Page 73

MBA Semester IV 7. Tax rules: The regulations include:

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(a) Marketing-to-the-market: The gains/losses are considered at the end of the calendar year where futures contracts are marked-to-the-market. (b) Gains: The realised and unrealised gains are taxed at the ordinary personal income tax rate. (c) Losses: The realised and unrealised losses are made deductible by offsetting them against any other investment gains. (d) Commissions: Brokerage commissions are tax deductible. Execution of Futures Trade For a client who wants to assume a long position in, say, a July British pound futures contract, the following steps are undertaken: 1. Phone call to the agent. 2. The agent trades through an exchange member who may be a commission broker or a local. 3. The actual trading is conducted in a past for the particular futures contract involved. Trades are conducted through the use of sophisticated hand signals. 4. The commission broker confirms the trade with the agent who then notifies the client of the completed transaction and price. 5. The client then deposits the initial margin with a member firm of the clearing house. 6. The commission broker can transact in the pit with another commission broker representing another client or with a local.

Q6. Briefly explain the difference between functional currency and reporting currency. Identify the factors that help in selecting an appropriate functional currency that can be used by an organisation.

Answer: Functional Versus Reporting Currency Financial Accounting Standards Board Statement 52 (FASB 52) was issued in December 1981, and all US MNCs were required to adopt the statement for fiscal years beginning on or after December 15, 1982. According to FASB 52, firms must use the current rate method to translate foreign currency denominated assets and liabilities into dollars. All foreign currency revenue and expense items on the income statement must be translated at either the exchange rate in effect on the date these items were recognised or at an appropriate weighted average exchange rate for the period. The other important part about FASB 52 is that it requires translation gains and losses to be accumulated and shown in a separate Page 74

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equity account on the parents balance sheet. This account is known as the cumulative translation adjustment account. ASB 52 differentiates between a foreign affiliates functional and reporting currency.

Functional currency is defined as the currency of the primary economic environment in which the affiliate operates and in which it generates cash flows. Generally, this is the local currency of the country in which the entity conducts most of its business. Under certain circumstances the functional currency may be the parent firms home country currency or some third country currency.

The reporting currency is the currency in which the parent firm prepares its own financial statements. This currency is normally the home country currency, i.e., the currency of the country in which the parent is located and conducts most of its business. In general, if the foreign affiliates operations are relatively self -contained and integrated with a particular country, its functional currency will be the local currency of that country. Thus, for example, the German affiliates of Ford and General Motors, which do most of their manufacturing in Germany and sell most of their output for Deutschmarks, use the Deutschmark as their functional currency. If the foreign affiliates operations were an extension of the US parents operations, the functional currency could be the US dollar. If the foreign affiliates functional currency is deemed to be the parents currency, translation of the affiliates statements employs the temporal method of FAS # 8. Thus, many US multinationals continue to use the temporal method for those foreign affiliates that use the dollar as their functional currency, while using the current rate method for their other affiliates. Under FAS # 52, if the temporal method is used, translation gains or losses flow through the income statement as they did under FAS # 8; they are not charged to the CTA account.

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MBA Semester IV MF0016: Treasury Management

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ASSIGNMENT- Set 1

Q1. Write a note on the following: a. Call Money Market b. Money market

Answer: Call money market is an important segment in Indian money market. It is a shortterm market where financial institutions borrow and lend money. It is also known as interbank call money market as banks are major participants. The day to day surplus funds are traded in the call money market. The maturity of the loans in this market varies between one day and a fortnight. The loans are repaid on demand of either the borrower or the lender.

The loans in this market often help banks to meet the reserve requirements.

The characteristics of call money market are as follows: It is a market for short-term funds, also known as money on call. It is highly liquid as the funds are repayable on demand of the borrower or lender. It is a sensitive segment of financial system. It varies from country to country based on the institutional structure and the nature of the participants. It is used by RBI to conduct open market operations effectively. Changes in the demand and supply for short-term fund get quickly reflected in the financial system.

The participants of call money market in India are state, district and urban co-operative banks, scheduled and non-scheduled commercial banks, Discount and Finance House of India (DFHI), and Securities Trading Corporation of India (STCI). DFHI and STCI are permitted to operate like Primary Dealers (PDs) in call money market. Since 1970s, institutions like UTI, Life Insurance Corporation of India (LIC), and General Insurance Corporation (GIC) and term lending institutions such as Industrial Development Bank of India (IDBI), Industrial Credit and Investment Corporation of India (ICICI) and International Finance Corporation (IFC) started participating in it. Earlier, only foreign banks were allowed to conduct operations in call money market, but now the market is expanded to include small and non-scheduled banks.

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In India, call loans are unsecured. The call money market rates are subjected to seasonal fluctuations. The fluctuations are reflected in volume of money at call and short notice. The demand for call money is higher in March as the financial institutions withdraw funds to meet their year-end tax payments and statutory obligations.

Call rate is the rate of the interest paid on the call loans. The call rate in the market is highly variable. It varies on a daily basis and sometimes on hourly basis. The call rates in India are highly volatile and they are based on the following factors:

Mechanism of Cash Reserve Ratio (CRR) creates fluctuations in the call market. Huge borrowings by the banks to meet CRR requirements increase the demand of liquid resources, thereby increasing the call rate.

During the end of financial year, most of the business organisations have to pay advance tax which causes fluctuations in the market. Changes in forex market leads to volatility in the call market. Mismatch between assets and liabilities of the banks. Huge flow of funds and increase in deposits with banks decreases the call rate. Stock market conditions cause wide fluctuations in the call market. The opening of subscription to government loans increases the demand for call loans thus increasing the call rates. The business activities of Friday (end of business week) increases demand for call loans. RBI has tried to prevent call rate volatility through the following measures: Regulating the liquidity and volatility in market through repo - Repo auction provides a base for call money rates as a short-term opportunity for banks to park their surplus funds.

Increasing the number of participants - The non-bank entities like GIC and Unit Trust of India (UTI) are allowed to participate as lenders. Primary dealers (PDs) and DFHI have been permitted to act as lenders and borrowers.

Relieving inter-bank liabilities from reserve requirements - This helps to generate a smooth yield curve and thereby reduces the volatility in the call rate.

b. Money markets are a short-term market with a maturity period of up to one year. It meets the short-term requirements of borrowers and lenders. Money market provides funds to the trade and industry sectors. The characteristic features of Indian money market are as follows:
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The borrowers in money market are commercial banks, manufacturing firms and the government. Commercial banks and financial institutions act as fund suppliers in this market.

Objectives of money market The objectives of money market are as follows: It maintains equilibrium between demand and supply of short-term funds. It is a pivotal point of RBI intervention for influencing liquidity in the economy. It provides access to the users of short-term funds to fulfill their borrowing and investing requirements at an efficient market price. Structure of money market The Indian money market is classified as: Organised sector Unorganised sector

Organised sector - It consists of the RBI, State Bank of India (SBI) with its seven associates, 20 nationalised commercial banks, schedule and non-scheduled commercial banks, foreign banks, and regional rural banks. RBI controls the entire banking sector in India. The nonbanking financial institutions namely LIC, GIC and its subsidiaries, and UTI operate indirectly through banks in the market. The surplus funds of quasi-governmental and large organisations are available to the organised markets through banks. Unorganised sector This sector consists of unregulated non-bank financial intermediaries, indigenous bankers and money lenders who can exist even in small towns and big cities. The people who borrow from unorganised sectors include farmers, small traders, small scale producers and artisans.

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MBA Semester IV Q2. Analyse the significance and objectives of asset liability management.

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Answer : Asset liability management refers to the strategic balance involving risk caused due to the changes in interest rate, exchange rates and liquidity position in the organisation. The credit risk and contingency risk are the roots of ALM. During the post liberalisation period, India witnessed rapid industrial growth which has further inspired the growth of fund raising activities. The changes in the sources and features of funds were remarkable due to rise in demand for funds. Hence this reflected in the organisations profile and exposure limits in interest rate structure for deposits and advances etc. Significance The changing environment in assets and liabilities has brought the following significances of ALM in recent years: Volatility The globalisation scenario has led to increase in number of economies. This has paved way for market driven economies due to the changing dynamics of the financial markets. These changes are reflected in interest rate structures, money supply, and credit position of the market, exchange rates and price levels. Hence the organisation experiences low market value, net interest income etc. Product innovation The innovation in financial products has grown rapidly. Some of the innovations are repacked with existing products with slight modifications. These have major impact on the risk profile in the organisation enhancing the need for ALM. Regulatory environment The integration of domestic and international market has enabled the regulatory bodies of financial markets to initiate number of measures. These measures prevent major losses that occur due to market impulses. Management recognition The top management in the organisation realised that asset liability is neither a franchise for credit disbursement nor its a place for retail deposit base. It must be considered to relate and link the asset with liability. Hence the need for efficient asset liability management came into existence. Objectives The objective of ALM is to achieve perfect match in assets and liabilities. The match is related to the changes in the present value of assets and liabilities. The importance of ALM has led to the change in the functional environment. The ALM objectives are divided into micro and macro levels.

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The macro level objectives deal with formulation of critical business policies, efficient allocation of capital and designing of products with suitable pricing strategies. At macro level, the ALM aims at obtaining profits through price matching while ensuring liquidity by maturity matching. The process of price matching ensures deployment of liabilities which are greater than costs.

Q3. If you are the manager of a company describe the risks that you handle during the foreign currency trade?

Answer : Foreign exchange trading is very profitable but can be risky too. There are numerous foreign exchange risk management tactics that can be used to reduce the effect of risk and financial exposure.

Foreign Exchange Risk Management (FERM) and control procedures Each of the banks engaged in foreign exchange activities is responsible for evolving, applying and supervising procedures to manage and control foreign exchange risk based on the risk management policies. In devising a firms FERM policy, certain factors have to be taken into account the firms exposure, general attitude towards risk management, whether its risk-averse, risk-indifferent or risk-seeking, the firms ability to alter exposed positions i.e. the maximum exchange loss it can absorb without much impact, the competitors stance and most importantly regulatory requirements. Foreign exchange risk management procedures include the following: Systems to measure and monitor foreign exchange risk Management of foreign exchange risk involves a clear understanding of the amount of risk and the influence of exchange rate changes on the foreign currency exposure. In order to make these determinations, adequate information must be readily available to permit suitable action to be taken within the acceptable time period. Therefore, each of the banking organisations engaged in foreign exchange activities must have an operative accounting and management information system in place that records and measures the following accurately: - The risk exposures related to foreign exchange trading. - The impact of potential exchange rate changes on the bank. Control of foreign exchange activities Though the control of foreign activities vary widely among the banks depending upon the nature and extent of their foreign exchange activities, the main elements of any foreign exchange control plan are well-defined procedures governing:
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- Organisational controls To guarantee that there exists a clear and effective isolation of duties between those persons who initiate the foreign exchange transactions and are responsible for operational functions of foreign exchange activities. - Procedural controls To ensure that the transactions are completely recorded in the accounts of the banks, they are promptly and correctly settled and to identify unauthorised dealing instantly and reported to the management. - Other controls To make sure that the foreign exchange activities are supervised frequently against the banks foreign exchange risk, counterparty and other limits and those excesses are reported to the management. Independent inspections/audits Independent inspections/audits are an important factor for managing and controlling a banks foreign exchange risk management plan. Banks must use them to ensure compliance with, and the integrity of, the foreign exchange policies and procedures. Independent inspections/audits should examine the banks foreign exchange risk management activities in order to: - Ensure adherence to the foreign exchange management policies and procedures. - Ensure operative management controls over foreign exchange positions. - Verify the capability and accurateness of the management information reports regarding the institutions foreign exchange risk management activities. - Ensure that the foreign exchange hedging activities are consistent with the banks foreign exchange risk management policies and procedures. - Ensure that employees involved in foreign exchange risk management are given accurate and complete information about the institutions foreign exchange risk policies, risk limits and positions.

Q4. Describe liquidity management.

Answer : Liquidity management refers to the management of assets and liabilities (both onand off-balance sheets); so as to make them available when there is a cash inflow/outflow requirement. The management of an organisation should take care to ensure that sufficient cash is available whenever necessary.

Whenever a financial trade is taken into consideration, liquidity risk is represented in the form of an asset or a particular security, which would make it difficult for a financier to do any transaction that involves the security or asset when desired. The risk of liquidity may increase if principal and interest cash-flows related to assets, liabilities and off-balance sheet
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items mismatch. An effective liquidity management enables the organisation to fetch maximum gains at minimum expenses. The main objectives of an effective liquidity management are: Keeping track of cash outflow commitments (both on- and off-balance sheets) on a regular basis. Avoiding raising funds at market payments or through the forced sale of assets. Maintaining the statutory liquidity and reserve requirements.

Need for liquidity management Liquidity management plays an important role in the financial markets. It is needed during the following situations: When there is a difficulty in handling and synchronising multiple accounts held in various banks. When there is no stability in the positions of cash flow. When there is surplus cash in transit or float locked during the operational processes. The organisation is unable to predict the cash position for a group of companies situated in multiple places. When the number of reconciliation processes exceeds the limit and keeps the staff away from working on useful activities. When the organisation is unable to predict the short term and long term cash requirements. Inability to obtain finance from banks due to poor cash flow positions or too high leverage. Complex interfacing and group-wise cash management due to usage of different IT systems by entities. No fully leveraged technology. Inefficient procedures and policies for cash and risk management. Difficulty in centralising and outsourcing cash management decisions. Imbalanced cash flows Either too high or too low cash balances in relation to the working capital.

Liquidity risk arises when a party is interested in trading an asset but there is no buying party and this affects their trading ability.

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MBA Semester IV Sufficiency of liquidity

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It is essential for banks to calculate the liquidity level they need to maintain before the maturity period ends. Also it is required that banks and credit institutions fulfil the minimum liquidity requirement before the liquidity disposal or maturity period.

There are instances wherein even a stable economy might face problems, if the bank is unable to repay the funds as per their commitment. It is important that certain conditions have to be fulfilled by banks as far as liquidity risk management is concerned. Hence, banks must perform the liquidity check on a monthly basis to know about their liquidity requirements. Along with this, banks must use separate reporting systems for calculating the liquidity requirements.

Liquidity reporting system Usually, banks and other money lending institutions, compare their current liquidity with the required liquidity. In fact the actual liquidity is derived from the banks balance sheet and is calculated through aggregate of weighted liquidity values. The weighted liquidity value is derived from the available number of liquid assets and the cash inflow for the relevant period of time. Factors affecting liquidity The factors affecting liquidity risk are as follows: Delay in credit. Non Performing Assets (NPA) of high-level. Assets of lower quality. No proper management. Embedded option risk that is not recognised. Dependence on a few wholesale depositors. Large undrawn loan guarantees. Liquidity policy & contingent plans that are ineffective.

Sources of liquidity Few sources of liquidity risk management are: Unexpected change in capital charge. Usage of a number of assumptions. Irregular behaviour of financial markets. Improper judgement.
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MBA Semester IV Risk stimulation by secondary sources. Absence of financial setup. Failure of payments system. Macroeconomic imbalances. Contractual forms.

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Q5. What are factors which influence the market interest rates?

Answer : Factors Affecting Interest Rate Interest rate is a vital component in market assessments and so it is an important economic indicator. Interest rate is important to companies as well as governments because it is an important constituent of the capital cost.

The following are the factor that influences the level of market interest rate: Intensity of inflation Inflation is defined as an increase in the typical price level of goods and services in an economy over a period of time. Inflation reduces the procuring power of a currency. So people with excess funds claim higher interest rates, as they want to protect their investment returns against the unfavourable conditions of higher inflation. Fluctuation of monetary policy The central bank of a country controls the money supply in the economy through its monetary policy. In India, the monetary policy of RBI focuses at the price stability and economic growth. If RBI loosens its monetary policy then the interest rate gets reduced which leads to higher inflation. Whereas, if RBI strengthens its monetary policy then interest rate increases, this thereby limits the inflation. Repo rate is used by RBI to inject or remove liquidity from the monetary system. General economic conditions If the economic growth of an economy improves then the demand for money goes up. It ultimately compels the interest rates to move forward. Global liquidity If global liquidity is high then the domestic liquidity of a country will also be high which ultimately reduces the pressure on interest rates. Foreign exchange market activity Foreign investor demand for debt securities influences the interest rate. Higher inflows of foreign capital lead to increase in domestic money supply which in turn leads to higher liquidity and lower interest rates. Credit and payment history Making timely mortgage or rent payment is very important. Late payments on credit cards, car payments and other bills affect the interest rate.

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Debt to income ratio The higher the debt to income ratio, the higher will be the interest rate. Property type The interest rate depends upon the type of property owned by an individual. The less risky is the property, the better the interest rate proposed. Loan amount The amount of money the borrower borrows makes a difference in the interest rate. Reduced paperwork activities Many lenders offer reduced paperwork alternatives. These alternatives increase the suitability of getting a loan for the consumer. It also increases the risks for the lender.

Property state Varying property states have different regulations and requirements that results in fluctuating business costs. These costs are often passed to the consumer in the form of an interest rate for the lenders.

Budgetary deficit Budgetary deficit and increased borrowing programme of the Government will lead to increase in interest rates as the demand for funds increases. With increase in interest rates, costs go up and this will result in inflation.

Q6. If you are the CEO of a company, what treasury policies would you implement to handle financial risks?

Answer : Banks utilise various financial instruments and deal with a multitude of counterparties and securities organisations to fulfill the requirements of its borrowers, handle fluctuation exposures in market interest rates and currency exchange rates, and indulge in temporary investments of liquidity prior to disbursement. All these transactions include differing risk degrees that the counterparty in the trading may fail to meet its commitments to the bank.

Treasury risk management needs precise reporting of metrics that is associated to control the risks that would arise from trading and other treasury processes.

Practices Treasury management practices describe the method in which the company will achieve the policies and objectives summarised in its treasury management policy statement. These practices advise how the company should manage and govern its treasury activities.

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MBA Semester IV Treasury management practices consist of the following steps: Managing risks Analysing and decision making Approving instruments, methods and techniques

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Treasury management practices set out the approach in which the firm should seek to achieve those policies and objectives, and suggest the way to manage and govern those activities.

Policies The Investment Policy guidelines approved by the board will govern the investment activities of the Treasury. Formulating policies provides a framework to handle risks. It provides standard levels of exposures to protect cash flows in the organisation. Policy framing depends on organisations objectives and its risk tolerance levels. The objectives of formulations policies are as follows: o o o Managing the central management which raises finance and financial exposures while assigning specific responsibilities to appropriate business units. Diversifying funding sources through operating both banking finance and capital markets; and engaging limited or non-resource project finance when it is available. Arranging finance to balance each business features and cash flows to the possible extent.

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MBA Semester IV MF0016: TREASURY MANAGEMENT

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ASSIGNMENT- Set 2

Q1. Write a note on the following: a. Commercial papers (CPs) b. Certificate of deposits (CDs)

Answer: Commercial Papers (CPs) is a type of instrument in money market and it was introduced in Jan 1990. Commercial paper is a short-term unsecured promissory note issued by large corporations. They are issued in bearer forms on a discount to face value. It issued by the corporations to raise funds for a short-term. The maturity period ranges from 30 days to one year. CPs is negotiable by endorsement and delivery. They are highly liquid as they have buy-back facility.

The CPs is issued in denominations of Rs. 5 lakh or multiples of Rs. 5 lakh. Generally CPs is issued through banks, dealers or brokers. Sometimes they are issued directly to the investors. It is purchased mostly by the commercial banks, Non-Banking Finance Companies (NBFCs) and business organisations. CPs is issued in domestic as well as international financial markets. In international financial markets, they are known as Eurocommercial paper.

Features of commercial papers The salient features of CPs are as follows: CPs is an unsecured promissory note. CPs can be issued for a maturity period of 15 days to less than one year. CPs is issued in the denomination of Rs.5 lakh. The minimum size of the issue is Rs. 25 lakh. The ceiling amount of CPs should not exceed the working capital of the issuing company. The investors in CPs market are banks, individuals, business organisations and the corporate units registered in India and incorporated units. The interest rate of CPs depends on the prevailing interest rate on CPs market, forex market and call money market. The attractive rate of interest in any of these markets, affects the demand of CPs. The eligibility criteria for the companies to issue CPs are as follows:

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o The tangible worth of the issuing company should not be less than Rs. 4.5 Crores. o The company should have a minimum credit rating of P2 and A2 obtained from Credit Rating Information Services of India (CRISIL) and Investment Information and Credit Rating Agency of India Limited. (ICRA) respectively o The current ratio of the issuing company should be 1.33:1. o The issuing company has to be listed on stock exchange. Advantages of CPs CPs is like T-Bills and is close a competitor of T-Bills, but T-Bills have an edge over CPs because they are less risky and more easily marketable. The advantages of CPs are as follows: They are negotiable by endorsement and delivery. Highly safe and liquid instrument They are believed to be one of the highest quality investment instruments available in private sectors. CPs facilitates security for the loans. This results in creation of secondary market for CPs and there is efficient movement of funds providing surplus cash to cash deficit units. Flexible instrument It can be issued with varying maturities as insisted by the issuing company. High returns The CPs provide high returns when compared to the banks.

b. Certificate of deposit (CDs) is a short-term instrument issued by commercial banks and financial institutions. It is a document issued for the amount deposited in a bank for a specified period at a specified rate of interest. The concerned bank issues a receipt which is both marketable and transferable in the market. The receipts are in bearer or registered form. CDs are known as negotiable instruments and they are also known as Negotiable Certificates of Deposit. Basically they are a part of banks deposit; hence they are riskless in terms of payments and principal amount. CDs are interest-bearing, maturity-dated obligations of banks. CDs benefit both the banker and the investor. The bankers need not encash the deposit before the maturity and the investor can sell the CDs in the secondary market before the maturity. This contributes to the liquidity and ready marketability for the instrument. CDs can be issued only by the schedule banks. It is issued at discount to face value. The discount rate depends on the market conditions. CDs are issued in the multiples of Rs. 25 lakh and the minimum size of the issue is Rs.1 crore. The maturity period ranges from three months to one year.

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The introduction of CDs in Indian market was assessed in 1980. RBI appointed the Vaghul Working Group to study the Indian market for five years. Based on the suggestions of Vaghul committee; RBI formulated a scheme for the issue of CDs. As per the scheme, CDs can be issued only by the scheduled banks at a discount rate to face value. There is no restriction on the discount rate by the RBI.

Features of CDs in Indian market The characteristic features of CDs in Indian money market are as follows: Schedule banks are eligible to issue CDs Maturity period varies from three months to one year Banks are not permitted to buy back their CDs before the maturity CDs are subjected to CRR and Statutory Liquidity Ratio (SLR) requirements They are freely transferable by endorsement and delivery. They have no lock-in period. CDs have to bear stamp duty at the prevailing rate in the markets The NRIs can subscribe to CDs on repatriation basis

Q2. Explain the treasury organisation and risk management.

Answer: A more advanced treasury organisation has evolved in the past decade in which the focus on management activity has followed the economic factors which drive firm value with corporate wide cash flow. This modern treasury organisation concentrates on a different financial statement which is the statement of cash flows. Now, it is in the process of adapting to the complex environment and cash flow of the global business. Structure of treasury organisation has many dimensions. However, we focus mainly on the following dimensions: Range of services Extent of centralisation of management control Define resultant organisation models

We evaluate the relationship between organisation models and influencing factors that helps to choose the right model. The theme is to investigate the compatibility of the models with the organisational situations.

Organisations must select treasury organisation models based on their operations, irrespective of their underlying business. The most important dimensions of these choices

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are the range of activities covered by the treasury and the extent of centralisation of management control. Four main service models can be opted based on these models. They are full service global, full service local, limited service global and limited service local. Treasury implementation in an organisation gains profits in several aspects. The treasury activities focus on the financial strategy and decision making of the company, cash management, capital market funding, tax management and international financial activities of the firm. Multinational firms always possess large number of foreign subsidiaries and ensure that they are frequently managed on the regional level by the basic functions like cash management, foreign exchange.

Regional treasuries are always required as an intermediary step between the barely staffed foreign affiliate and its independence on other regional affiliates. However, there is a frequent overlapping in responsibilities and activities between the regional treasury offices and international treasury.

In banks, treasury is organised either as a department of the bank or as a specialised branch which is under the direct control of the banks head office. If treasury acts as a department of the bank, it has the advantage to coordinate easily with the other related departments like accounting and credit departments at head office. However, it is preferred if treasury acts as a specialised branch as the accounting books of treasury can be maintained independently. While the head office department of bank can only act through a branch, the specialised branch also has an additional advantage to act as an authorised dealer for forex business and can directly participate in clearing and settlement systems.

As treasury is a key activity of the bank, treasury should be headed by a member of the senior management like General Manager, Dy. General Manager, Vice-President and others, who could directly report to the Chief Executive of the bank. However, the level of reporting and delegating powers depends on the bank size and the importance of treasury activity within the bank.

Treasury might be divided into three main divisions. They are the front office (Dealing room), Middle office and Back office (Treasury administration). Front office (Dealing room) It is headed by the person who is in charge of the front office, that is Chief Dealer. Dealers working under him generally trade in the market. They are familiar with all the markets but specialise in one of the markets like forex market, money market or securities market.

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Middle office - It is created for providing information to the management. It monitors the limits of exposure and stops loss of treasury and reports the key parameters of performance to the management. It may also act as ALM Support Group in smaller banks. Back office (Treasury administration) It takes the responsibility of verifying and settling the deals concluded by the dealers. They are verified on the basis of deal slips prepared by the dealers. They take care of the book-keeping and periodic returns submission to RBI. Refer to unit 01 for detailed information on treasury management organisation.

Q3. What are the features of ADRs and GDRs?

Answer: ADRs and GDRs A Depository Receipt (DR) is a versatile financial security that is traded on a local stock exchange but it represents a security that is issued by a foreign publicly listed company. Two of the most common types of DRs are the American Depository Receipt (ADR) and Global Depository Receipt (GDR). ADR is a security issued by a non-U.S. company and is traded on U.S. stock exchanges. ADRs are issued to offer investment methods that avoid the unwieldy laws applied to the non-citizens who buy shares on local exchanges. ADRs are listed on NYSE, AMEX or NASDAQ.

Few advantages of ADRs are: ADRs are easy and cost efficient methods to buy shares in foreign companies. ADRs save money by reducing administration costs and avoiding foreign taxes on the transaction.

GDRs were developed on the basis of ADRs and are listed on stock exchanges outside US. GDRs are traded globally instead of the original shares on exchanges. The objective of GDR is to enable investors to gain economic exposure to a planned company in developed markets.

Features of GDRs are as follows: GDR holders do not have a voting right. It has less exchange risk as compared to foreign currency loan. GDR investors may cancel his receipt by advising the depository.

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ADRs and GDRs are excellent means of investment for NRIs and foreign nationals who want to invest in India. By buying these, they can invest directly in Indian companies without going through the harassment of understanding the rules in Indian financial market. Benefits of depository receipts The increasing demand for DRs is determined by the need of investors to diversify their portfolios, reduce risk and invest internationally. It allows the investors to achieve the benefits of global divergence without the added expense and complexities of investing directly in the local trading markets. Participatory notes International entrance to Indian capital market is limited to Foreign Institutional Investors (FIIs). The market has found a way to avoid the limitation by creating an instrument called Participatory Notes (PNs). PNs are basically contract notes. Indian traders buy securities and then issue PNs to foreign investors. Any dividends or capital gains collected from the primary securities are returned back to the investors. Any entity investing in PNs may not register with SEBI, whereas all FIIs have to register compulsorily. The benefits of PNs are as follows: Entities route their investment through PNs to extract advantage of the tax laws system. It provides a high degree of secrecy, which enables large funds to carry out their operations without revealing their identity. Investors use PNs to enter Indian market and shift to fully fledged FII structure when they are established.

Q4. Discuss the recommendations of Tarapore Committee for CAC Answer: Indias cautious approach towards capital account and assessing it as a liberalisation process based on certain pre conditions has held India in good state. But with the changes that have taken place over the last two decades, India felt the need to revisit the CAC and suggested a new map towards FCAC based on current situations. RBI, in consultation with the Government of India (GOI) appointed a committee on FCAC. S.S Tarapore was the chairman of committee. The committee suggested several

recommendations for the development of financial market in addition to addressing issues related to interaction of monetary policy and exchange rate management, regulation and
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supervision of banks, and the timing and sequencing of capital account liberalisation measures. The objectives of FCAC are as follows: Economic growth - It facilitates economic growth through higher capital investment .This will lead to growth in employment opportunities, infrastructure development and other areas. Improvement in financial sector - Huge capital flow into the system will lead to the improvement of financial sector which will enhance performance of the companies. This will enhance the liquidity in the system. Diversify the investment The diversification of investment will help ordinary people, to invest in foreign countries without restriction. This will help them to diversify their portfolio.

Risks involved in FCAC FCAC risk arises from inadequate preparedness before liberalisation in domestic and external sector of policy consolidation, strengthening of regulation and development of financials markets. A transparent financial consolidation is necessary to reduce risk of the currency crisis. The risks are as follows: Market risks - Markets risks like interest rate and foreign exchange risks become more complicated when financial institutions have access to new markets or securities. Participation of foreign investors in domestic market changes the working of the domestic market. For example, banks have to quote rates and take open positions in new and more volatile currencies. Likewise, the change in foreign interest rate, affects the banks interest rate and liabilities. Credit risk It includes a new dimension with cross border transaction. Cross border transactions introduces country risks to domestic market participants, the risk associated with economic, social, and political environment of the borrowers country. Risk in derivatives transaction It is very important with FCAC as derivatives transaction are main tools used in hedging risks .It includes both market and credit risk. Liquidity risk It includes risk in foreign currencies denominated assets and liabilities. Large flow of funds in different currencies will expose the banks to greater variations in their liquidity position and complicate their asset-liability management. Operational risk The difference between domestic and foreign legal rights and obligations and their enforcements is important with FCAC. Operational risk may increase with FCAC.

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MBA Semester IV Limitations of FCAC

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The effort of making the Indian rupee fully convertible has a number of difficulties involved in it. The limitations are as follows: Indian industries lack competitive strength. Lack of emphasis on the quality of labour and management practices. Inadequate technology for industrial economy. Absence of prudent fiscal management. Lack of resilient exchange rate mechanism at work. Inadequate attention on tariff reduction and the rationalisation of tax structure in the adjustment scheme. Inflationary pressure on the economy.

Consequences of FCAC India might face the following consequences if it implements full convertibility without adequate reform measures: It will have to face the danger of becoming vulnerable to free movement of foreign capital, which may further worsen the macro-economic imbalances. Though the banks and financial institutions are fully capitalized, they are not fully prepared to handle the intricacies of the fuller convertibility. Hence it is desirable to further strengthen their financial base. The prevailing high interest rates in the economy will attract capital inflow. This will result in rupee appreciation which will affect Indian exporters.

Q5. If you are the CEO of an MNC, how would you implement and maintain effective liquidity practices in your firm for the benefit of the company? Answer : Launching the overall policy framework Before processing any funding, market operations or risk management activities; policies are elected by the top management.

These policies administer the treasury functions and indicate the principles motivating the asset liability management of the balance sheet. Market operation activities Banks alter the term of their obligations to different maturities on the asset side of the balance sheet. The actual flow of funds need not mandatorily reflect in the contractual terms. This flow of funds differs as per the market conditions. The key
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aspect of liquidity management is the structure of a banks funding. The bank without a deposit base is likely to be more exposed to liquidity problems when compared to a stable, large and diverse deposit base bank. Risk evaluation and compliance Risk measurement and management concentrates on providing a systematic approach to control risk in portfolio management. It provides an independent evaluation of the market risks considered across several treasury businesses.

This evaluation is for the benefit of traders and management. Periodic computation of risk measurement like measuring risks on a daily, monthly or quarterly basis is important. A good compliance is very important to ensure that the treasury functions act appropriately and in the best interests of the respective traders and management. Treasury operations Handling treasury operational functions has become more complicated due to the changes in the financial markets, regulatory requirement and technological upgrades. These functions focus on the risks of market operations such as electronic inputs and a greater concentration over the payment approval/release functions, improving control on the transaction confirmations and the settlement of bank accounts at nostro accounts. Features of treasury functions A successful treasury function has the same attributes as any other functions that are considered successful in the organisation. The features of treasury functions are as follows: Teamwork Respect towards the firm Broad and positive thinking Global thinking Technologically advanced Customer oriented Knowledge in finance Knowledge in legal issues Trustworthy

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MBA Semester IV Q6. Evaluate various options available in foreign exchange market?

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Answer: Various tools and techniques are used for measuring foreign exchange risk management. Some of the foreign exchange management tools used are as follows: Forward contracts Currency futures Currency options Currency swaps

Forward contracts Foreign exchange forward contracts are the most common resources for hedging transactions in foreign currencies. A forward contract is an agreement to buy or sell foreign exchange for an amount determined in advance, at a specified exchange rate at a designated date in future. The specified rate is called the forward rate, the designated date the settlement date or delivery date. The difference between forward contract and other sales contracts is that the delivery and payment of the commodity occurs at a specified future date in case of forward contracts. Forward contracts are privately exchanged and are not standardized. This gives rise to counterparty risk or default risk arising out of failure of the other party to honour its commitment. For such situations currency futures are more suitable.

Currency futures Currency futures are forward contracts in which two parties agree between them to exchange something in the future. As futures contracts are traded on exchange with appropriate controls, counter party risk as prevalent in Forward contracts is prevented. The major currency futures market is the EUR futures market, based upon the Euro to US Dollar exchange rate. The most popular currency futures are provided by the Chicago Mercantile Exchange group, and include the following futures markets: EUR - It is the Euro to US Dollar futures market. GBP - It is the British Pound (Sterling) to US Dollar futures market. CAD - It is the Canadian Dollar to US Dollar futures market. CHF - It is the Swiss Franc to US Dollar futures market. Currency options A currency option is an alternative tool for managing forex risk. A foreign exchange option is an agreement for future supply of a currency interchanged with another, where the owner of

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the option has the right to buy (or sell) the currency at a settled price. The right to buy is a call; the right to sell is called as put. For such a right the holder pays a price called the option premium. The option seller receives the premium and is indebted to make (or take) delivery at the agreed-upon price if the buyer exercises his option.

Currency swaps Currency swaps deal with the exchange of payments in different currencies between two trading partners. For productivity currency swaps feature netting, in which the winning party obtains payment at the end of the swap term.

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MBA Semester IV MF0017 Merchant Banking and Financial Services - 4 Credits

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Assignment Set- 1 (60 Marks)

Q1. Discuss the proportionate allotment procedure followed by the lead banker to allot shares.

Allotment procedure The Executive Director or Managing Director of the Regional Stock Exchange consults with the post-issue lead merchant banker and the registrars regarding public issue of securities. This method ensures that the basis of allotment is done fairly according to the following guidelines: Proportionate allotment procedure The lead banker must ensure that the allotment is made on a proportionate basis as explained below:

The applicants are divided into separate category based on the number of shares they have applied for. The total number of shares to be allotted to each category is done on a proportionate basis. This is based on the product of the total number of shares applied for in that category and the inverse of the oversubscription ratio.

Example 1: Total number of applicants in category of 100s = 2,000 Total number of shares applied for = 2, 00,000 Number of times oversubscribed = 5 Proportionate allotment to category = 2, 00,000 x 1/5 = 40,000 The number of the shares to be allotted to the successful allottees is done on a proportionate basis. This is the product of the total number of shares applied by each applicant in that category and the inverse of the oversubscription ratio. This is shown below with an example: Example 2: Number of shares applied for by each applicant = 300 Number of times oversubscribed = 3 Proportionate allotment to each successful applicant = 300 x 1/3 =100
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In the applications where the proportionate allotment is less than 100 shares per applicant, the allotment is carried out as follows:

- Each successful applicant is allotted a minimum of 100 securities. - The successful applicants for that category are determined by drawl of lots in such a way that the total number of shares allotted in that category corresponds to the number of shares as shown in Example 2. The proportionate allotment to an applicant is more than 100 but not a multiple of 100. In such a case, the number in excess of the multiple of 100 is rounded off to the higher multiple of 100, only if that number is 50 or higher. But if the number is lower than 50, it is rounded off to the lower multiple of 100. Example 3: If the proportionate allotment works out to 350, the applicant is allotted 400 shares. However, the proportionate allotment works out to 140, the applicant is allotted 100 shares. If the shares allocated on a proportionate basis to any category exceed the shares allotted to the applicants in that category, the balance available shares for allotment are first adjusted against any other category. This condition arises when the allocated shares are not enough for proportionate allotment to the successful applicants in that category. The remaining shares after such adjustment are added to the category in which the applicants have applied for minimum number of shares. The process of rounding off to the nearest multiple of 100 may result in a higher allocation of shares than the shares offered. Therefore, it is necessary to permit a 10% margin. This means, the final allotment may be higher by 10 % of the net offer to the public.

Reservation for small individual applicants

The proportionate allotment of securities in an issue, when oversubscribed, is subjected to the reservation for small individual applicants as explained below:

A minimum 50% of the net offer of securities to the public is first made available for allotment to individual applicants, who have applied for allotment of equal to or less than 10 marketable lots of shares or debentures or the securities offered.

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MBA Semester IV The balance net offer of securities to the public is made available for allotment to the

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individual applicants, who have applied for allotment of more than 10 marketable lots of shares or debentures or the securities offered.

Q2. What is the provision of green shoe option and how is it used by companies to stabilize prices?

Answer: Green shoe option Green Shoe Option (GSO) is an option where a company can retain a part of the oversubscribed capital by issuing additional shares. Oversubscription is a situation when a new stock issue has more buyers than shares to meet their orders. This excess demand over supply increases the share price. There is another situation called undersubscription. In undersubscription, a new stock issue has fewer buyers than the shares available. An issuing company appoints a stabilizing agent, which is usually an underwriter or a lead manager, to purchase shares from the open market using the funds collected from the over-subscription of shares. The stabilizing agent stabilizes the price for a period of 30 days from the date of listing as authorised by the SEBI. Green shoe option agreement allows the underwriters to sell 15 percent more shares to the investors than planned by the issuer in an underwriting. Some issuers do not include green shoe options in their underwriting contracts under certain circumstances where the issuer funds a particular project with a fixed amount of price and does not require more funds than quoted earlier. The green shoe option is also known as over-allotment option. The over-allotment refers to allocation of shares in excess of the size of the public issue made by the stabilizing agent out of shares borrowed from the promoters in pursuance of a GSO exercised by the issuing company.

The mechanism by which the greenshoe option works to provide stability and liquidity to a public offering is described in the following example: A company intends to sell 1 million shares of its stock in a public offering through an investment banking firm (or group of firms which are known as the syndicate) whom the company has chosen to be the offering's underwriter(s). When the stock offering is the first time the stock is available for public trading, it is called an IPO (initial public offering). When there is already an established market and the company is simply selling more of their non-publicly traded stock, it is called a follow-on offering.

The underwriters function as the broker of these shares and find buyers among their clients. A price for the shares is determined by agreement between the company and the buyers.
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One responsibility of the lead underwriter in a successful offering is to help ensure that once the shares begin to publicly trade, they do not trade below the offering price.

When a public offering trades below its offering price, the offering is said to have "broke issue" or "broke syndicate bid". This creates the perception of an unstable or undesirable offering, which can lead to further selling and hesitant buying of the shares. To manage this possible situation, the underwriter initially oversells ("shorts") to their clients the offering by an additional 15% of the offering size. In this example the underwriter would sell 1.15 million shares of stock to its clients. When the offering is priced and those 1.15 million shares are "effective" (become eligible for public trading), the underwriter is able to support and stabilize the offering price bid (which is also known as the "syndicate bid") by buying back the extra 15% of shares (150,000 shares in this example) in the market at or below the offer price. They can do this without the market risk of being "long" this extra 15% of shares in their own account, as they are simply "covering" (closing out) their 15% oversell short.

If the offering is successful and in strong demand such that the price of the stock immediately goes up and stays above the offering price, then the underwriter has oversold the offering by 15% and is now technically short those shares. If they were to go into the open market to buy back that 15% of shares, the underwriter would be buying back those shares at a higher price than it sold them at, and would incur a loss on the transaction.

This is where the over-allotment (greenshoe) option comes into play: the company grants the underwriters the option to take from the company up to 15% more shares than the original offering size at the offering price. If the underwriters were able to buy back all of its oversold shares at the offering price in support of the deal, they would not need to exercise any of the greenshoe. But if they were only able to buy back some of the shares before the stock went higher, then they would exercise a partial greenshoe for the rest of the shares. If they were not able to buy back any of the oversold 15% of shares at the offering price ("syndicate bid") because the stock immediately went and stayed up, then they would be able to completely cover their 15% short position by exercising the full green shoe

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MBA Semester IV Q3. What do you understand by insider trading? What are the SEBI rules and regulations to prevent insider trading?

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Answer: An insider is a person who is connected with a company and who is expected to have access to unpublished sensitive information with respect to securities of the company. A person who has access to unpublished information which deals in securities and is involved in violations of the provisions will be guilty of insider trading. Insiders have access to confidential information of a company due to the position occupied by them in the company. They are in a position to manipulate the share prices to their own advantage and make huge profits. These actions cause major fluctuations in the prices of the securities. Considering the fact that the actions of insiders cause devastating effects on the functioning of stock exchange, SEBI has issued regulations to control such practices. Another problem that the stock market faces is unofficial trading in shares before listing of new companies. The company is not guilty of insider trading if the acquisition of shares was as per SEBI Substantial Acquisition of Shares and Takeover Regulations. If SEBI suspects that any person has violated the regulations of prohibition of insider trading, it can initiate an inquiry. For the prevention of insider trading, SEBI has introduced a policy on disclosure and internal procedure. According to this policy:

All listed companies and organisations associated with the securities markets have to frame a code of conduct for internal procedure as per the specified model. Any person holding more than five per cent shares in any listed company has to disclose the number of shares held by him to the company, within 54 working days. Every listed company must disclose the information received about the initial and continual disclosures within five days to all the respective stock exchanges.

Any person other than a company violating the disclosure provisions would be liable for action under the SEBI Act. SEBI has prescribed a model code of conduct for prevention of insider trading for listed companies. According to this model, the listed company appoints a compliance officer who reports to the managing director and is responsible for setting the policies and procedures, monitoring adherence to the rules for the preservation of price sensitive information, pre-clearance of designated employees trade, monitoring of trades and implementation of the code of conduct. Preservation of price sensitive information is done by the employees and directors. They have to maintain confidentiality of all price sensitive information. The information must not be passed to any person directly or indirectly.

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Merchant bankers are administered by the SEBI (Merchant Bankers) Rules and Regulations, 1992. According to the rules and regulations, a merchant banker is a person who is engaged in the business of issue management either by buying, subscribing to securities as manager, consulting or rendering corporate advisory service in relation to issue management. The regulatory framework is designed to ensure that the merchant bankers have sufficient competence and follow diligence in their work so that the issuers comply with the statutory requirements concerning the issue. SEBI has emphasised on ensuring that all merchant bankers fulfil the eligibility criteria. As stated earlier, all merchant bankers must have a valid registration certificate. Merchant bankers must follow the general obligations, responsibility, code of conduct prescribed under the SEBI regulations. Under the regulations, the merchant bankers must submit periodical returns and other additional information to SEBI regularly. SEBI has the authority to conduct inspection of the accounts, records and documents of the merchant banker at any time if necessary.

Q4. What are the advantages of leasing to a company?

Answer: Advantages of leasing Leasing has many advantages for the lessee as well as for the lessor. Lease financing offers the following benefits to the lessee: One hundred percent finance without immediate down payment for huge investments, except for his margin money investment. Facilitates the availability and use of equipments without the necessary blocking of capital funds. Acts as a less costly financing alternative as compared to other source of finance. Offers restriction free financing without any unduly restrictive covenants. Enhances the working capital position. Provides finance without diluting the ownership or control of the lessor. Offers tax benefits which depend on the structure of the lease. Enables lessee to pay rentals from the funds generated from operations as lease structure can be made flexible to suit the cash flow. When compared to term loan and institutional financing, lease finance can be arranged fast and documentation is simple and without much formalities.

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The lessor being the owner of the asset bears the risk of obsolescence and the lessee is free on this score. This gives the option to the lessee to replace the equipment with latest technology

The following are the benefits offered by lease financing to the lessor: The lessors ownership is fully secured as he is the owner and can always take possession in case of default by the lessee. Tax benefits are provided on the depreciation value and there is a scope for him to avail more depreciation benefits by tax planning. High profit is expected as the rate of return increases Return on equity is elevated by leveraging results in low equity base which enhance the earnings per share. High growth potential is maintained even during periods of depression.

Limitations of leasing The following are some of the limitations of leasing: Lessee is not capable of adding or altering anything to the leased asset because of the restrictive conditions of the lease agreement. Financial lease can bring about higher payout accountability if machinery is not found useful, and the lessee is planning to cancel the lease agreement or opts for premature termination of the lease contract. Termination of the lease happens when lessee fails to continue with the terms and conditions of the lease and the lessor can take possession of the leased asset, In case of financial lease, the lessee may be made liable for damages and compelled to make payment of his lease rental in an accelerated manner. Double sales tax can be charged once at the time of purchase of the asset by the lessor and again when it is leased out to the lessee.

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MBA Semester IV Q5. Discuss Accounting standard 19 for lease based on operating lease.

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Answer: Accounting Standard 19 as Applicable for Leases Accounting Standard (AS)-19, Leases, is issued by the Council of the Institute of Chartered Accountants of India. This standard comes into force with respect of all assets leased during accounting periods commencing on or after 1.4.2001 and is mandatory in nature from that date. Accordingly, the Guidance Note on Accounting for Leases issued by the Institute in 1995, is not applicable in respect of such assets. Earlier application of this Standard is, however, encouraged. Scope The right accounting policies and disclosures in relation to finance leases and operating leases should be applied in accounting for all leases other than the following:

Lease agreements to explore or to use natural resources, such as oil, gas , timber, metals and other mineral rights; and Licensing agreements for items such as motion picture films, video recordings, plays, manuscripts, patents and copyrights; and Lease agreements to use property such as lands.

This applies to agreements that transfer the right to utilize assets even though significant services by the lessor called for in connection with the operation or maintenance of such assets. Besides, this Statement does not apply to agreements that are contracts and do not transfer the right to use assets from one contracting party to the other. Related definitions The following terms are used in this statement: Lease A lease is an agreement calling for the lessee (user) to pay the lessor (owner) for use of an asset for an agreed period of time. A rental agreement is a lease in which the asset is a substantial property. Finance lease A lease which transfers all the risks and rewards incident to ownership of an asset. Operating lease A lease for which the lessee acquires the property for only a small portion of its useful life.

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Non-cancellable lease A non-cancellable lease is a lease that can be abandoned only: Upon the occurrence of some remote contingency. With the permission of the lessor. If the lessee enters into a new lease for the same or an equivalent asset with the same lessor. Upon payment by the lessee of an additional amount such that, at the beginning, continuation of the lease is reasonably certain.

Inception of lease The inception of lease is the former date of the lease agreement and the commitment date by the parties to the principal provisions of the lease.

Lease term The lease term is the non cancellable period for which the lessee has agreed to take on lease asset together with future periods. Minimum lease payments It is the regular rental payments excluding executory costs to be paid by the lessee to the lessor in a capital lease. The lessee informs that an asset and liability at the discounted value of the future minimum lease payments.

Fair value The expected value of all assets and liabilities of a owned company used to combine the financial statements of both companies. Economic life The outstanding period of time for which real estate improvements are expected to generate more income than operating expenses cost. Useful life Useful life of a leased asset is either the period over which leased asset is expected to be useful by the lessee or the number of production units expected to be gained from the use of the asset by the lessee.

Residual value The value of a leased asset is the estimated fair value of the asset at the end of the lease term. Guaranteed residual value It is guaranteed by the lessee or by a party on behalf of the lessee to pay the maximum amount of the guarantee; and in the case of the lessor, the part of the residual value which is guaranteed by the lessee or on behalf of the lessee, or an independent third party who is financially able of discharging the obligations under the guarantee.

Unguaranteed residual valued of a lease asset It is the value of a leased asset that is the total amount by which the residual value of the asset exceeds its guaranteed residual value.

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Gross investment in the lease It is the sum of the minimum lease payments within a finance lease from the lessors view and any unguaranteed residual value accumulating to the lessor.

Unearned finance income Any income that comes from investments and other sources unrelated to employment services. Net investment in the lease Net investment in the lease is the gross investment in the lease less unearned finance income. Implicit interest An interest rate that is not explicitly stated, but the implicit rate can be determined by use of present value factors. Contingent rent It is the portion of the lease payments that is not permanent in amount but is based on a factor other than just the passage of time. For example, percentage of sales.

Q6. Given the various types of mutual funds, take any two schemes and discuss the performance of the schemes.

Answer:Types of Mutual Funds It is important to remember that mutual funds offer risks and rewards the higher the potential returns, the greater the possible loss prospects. Therefore, it is important to understand the kinds of mutual funds available in the market. Mutual funds are classified on the basis of structure and investment objective. Figure illustrates the classifications of mutual funds.

On the basis of structure The following are the structures of mutual funds: Open ended funds This scheme of mutual funds is available for subscription throughout the year. Such funds do not have a fixed maturity date, and therefore, can

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be sold or purchased any time. The prices are based on the net asset value (NAV). This scheme is convenient for those investors who need investments that have a high level of liquidity. Close ended funds Unlike open ended funds, close ended funds have a specific maturity period. An investor can purchase these funds at the time of initial issue. There are two exit options in case the investor wants to buy or sell these funds after the initial offer period closes. One option is to buy or sell the units at the stock exchanges where they are listed. The NAV may vary based on the demand or supply of the units. The other option is to directly sell the units to the Mutual Fund. In this case, the company repurchases the units at NAV. Interval funds This scheme is a combination of open ended and close ended mutual funds. An investor may purchase or sell these funds at the stock exchange. These may be for sale or redemption at specific periods. The interval funds are transacted at NAV prices. On the basis of investment objective Mutual funds are also classified based on the objectives of the fund. The investor can invest in mutual funds based on these objectives: Growth funds This scheme is also referred to as equity schemes. The objective is to provide capital appreciation over medium to long term. A large portion of the fund is invested in equities for long term. Income funds This scheme is also referred to as debt schemes. The objective is to provide investors a regular income. Therefore, investments are made in fixed income securities such as corporate debentures and bonds. Unlike the growth scheme, the capital appreciation is limited. Balanced schemes This scheme provides appreciation and income. The company periodically distributes a part of the capital gains earned. This scheme invests in shares and fixed income securities. The proportion specified in the offer documents is usually 50:50. Money market funds The objective of this scheme is to provide the investor income, preserve capital and easy liquidity. In this scheme, the investors money is safer since investments are made in short term financial instruments. These are also called liquid funds. Load funds This scheme is also referred to as sales load. The investor pays the sum (known as front end load) at the time of purchase which is used to compensate an intermediary such as brokers, investment advisers, and financial planners. Recently the SEBI has slashed the entry load and funds should not charge entry load

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if you go directly to a fund. In another directive it has issued instructions that no distinction should be made among unit holders on the amount of subscription while charging exit loads (back end load). Some mutual funds do not charge any exit load. No load funds This scheme does not have a front end load or back end sales charge. No sales charges are applied to any load funds. However, they do have costs. The objective is to reduce the expense on the investors bank or brokerage statement. This is because the fees are paid from the funds assets to the investment advisers instead of the broker who sells the funds. Gilt funds These funds invest completely in government securities. Government securities do not have any default risk. NAVs of these schemes also vary due to alteration in interest rates and supplementary economic factors as is the case with income or debt oriented schemes. Index funds Index funds imitate the portfolio of a selected index such as the BSE Sensitive Index, S&P NSE, Index (Nifty) etc, These schemes invest in the securities in the same weightage comprising of an index. NAVs of such schemes would rise or fall in accordance with the risk or fall in the index, though not exactly by the same percentage. There are also exchange traded index funds launched by the mutual funds which are traded on the stock exchanges.

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MBA Semester IV MF0017 Merchant Banking and Financial Services - 4 Credits

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Assignment Set- 2 (60 Marks)

Q1. What are the provisions for prevention of fraudulent and unfair trade practices by SEBI regulations?

Answer: Prohibition of Fraudulent and Unfair Trade Practices Relating to the Securities The SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to the Securities Market) Regulations, 2003 authorises SEBI to investigate into cases of market fraudulent and unfair trade practices. The regulations prohibit market manipulation, misleading statements to increase sale or purchase of securities, unfair trade practices relating to securities. The SEBI can conduct investigation by an investigating officer regarding conduct and affairs of any person dealing, buying, and selling securities. The investigating officer prepares a report based on this information. The SEBI can take action for cancellation or suspension of registration of an intermediary based on this report. Fraud is any act, expression or concealment committed by a person or his agent while dealing with securities in order to prompt the deal in securities. The regulations prohibit the dealing in securities in fraudulent method, it prohibits market manipulation, misleading statements that promote sale of securities and unfair trade practice related to securities. Any dealing in securities shall be considered to be fraudulent or an unfair trade practice if it involves fraud. The following are considered as fraudulent or an unfair trade practice if it:

Indulges in an act which creates misleading or false impression of trading in securities market. Advances or agrees to advance any money to any person to induce other person to buy any security in any issue with an intention of securing the minimum subscription to such issue.

Pays, offers, or agrees to pay directly or indirectly to any person, any money for inducing such person for dealing in any security with the object of depression or causing fluctuation in the price of such security.

Acts to manipulate the price of security. Publishes reports, dealing in securities which are not true. Sells and deals with stolen security whether in physical or dematerialised form.

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Advertises misleading or containing information in a distorted manner which can influence the decision of the investors. Spread false or misleading news which induces sale or purchase of securities.

For restricting unethical trading practices, SEBI propagated the SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to the Securities Market).

Q.2 Discuss the method of price discovery using the book building process. [10]

Answer: Price discovery through book building process The following are the steps involved in the book building process: 1. The issuer company proposing an IPO appoints a lead merchant banker as a Book Running Lead Manager (BRLM). 2. Primarily, the issuer company consults with the BRLM in drawing up an offer document which does not mention the price of the issues, but consists of other details about the size of the issue, companies past history, and a price band. The securities which are available to the public, separately identified as net offer to the public. 3. The draft prospectus is filed with SEBI to provide a legal standing. 4. A definite period is set as the bid period and BRLM conducts awareness campaigns like advertisement, road shows and so on. 5. To underwrite the issues similar to the net offer to the public, the BRLM selects a syndicate member, a SEBI registered intermediary. 6. The BRLM is allowed to remuneration for conducting the book building process. 7. The BLRM may circulate the copy of the draft prospectus to the institutional investors and to the syndicate members. 8. The syndicate members build demand and ask each investor for the number of shares and the offer price. 9. Syndicate members send the feedback about the investors bids to the BRLM. 10. During the bid period the prospective investors are allowed to revise their bids. 11. The BRLM has to build up an order book after getting the feedback from the syndicate members about the bid price and the quantity of shares applied. The order book must show the demand for the shares of the company at various prices. The syndicate members must also have a record book for the orders they have received from institutional investors for subscribing to the issue out of the placement portion.

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12. The BRLM and the issuer company decide the issue price after getting all the information and this issue price is called the market-clearing price. 13. The BRLM then consult with the issuer company and close the book. After that they decide the issue size of placement portion and public offer portion. 14. After deciding the final price, the BLRM must make the allocation of securities based on the prior commitment, investors quality, price aggression, earliness of bids and so on. 15. Within two days from determining the issue price and receipts of acknowledgement card from SEBI, the final prospectus is filed with the registrar of companies. 16. Two different accounts for collection of application money within which first one for the private placement portion and the other for the public subscription must be opened by the issuer company. 17. The placement portion is closed one day prior the opening of the public issue through fixed price method. The BRLM must have the application money from the institutional buyers along with the application forms and the underwriters to the private placement portion. 18. On the second day from the closure of the issue, the allotment for the private placement portion will be made and the private placement portion will ready to be listed. 19. The allotment and listing of issues under the fixed price portion must be as per the existing statutory requirements. 20. Finally, the SEBI has the right to examine such records and books which are handled by the BRLM and other intermediaries involved in the Book Building process. A demand for the securities which is proposed to be issued by a body corporate is determined by book building process. The bids, obtained for the quantum of securities and offered by the issuer for subscription, are used to determine the price of the securities. Book building method gives an opportunity to the market to find out the price for securities.

Q3. Discuss the role of a custodian of shares.

Answer:Custodial services refer to the safeguarding of securities of a client. The activities relating to custodial services involve collecting the rights benefiting the client in respect to securities, maintaining the securities account of the client, informing the clients about the actions taken or to be taken, and maintaining records of the services. Custodian of services is a person who proposes or carries on the business of providing custodial services. The custodian provides the services to a client. To receive custodial services, the client enters into an agreement with the custodian of securities. The custodian of securities must be registered with the SEBI. The person proposing to carry on business as custodian of securities after the commencement of the SEBI regulations has to send an
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application to the Board to grant a certificate. The applicant has to provide the necessary information to the Board to receive the certificate of registration. The application without complete information is rejected. However, before rejecting any application, the Board gives an opportunity to the applicant to remove the objection within a specified time. Custodial services is a new method of services provided to Foreign Institutional Investors (FIIs) and Mutual Funds (MFs) to protect their assets such as security certificates and documents of ownership. Every custodian should have adequate facilities, sufficient capital and financial strength to manage the custodial services. Roles and responsibilities of custodians The SEBI regulations prescribe the roles and responsibilities of the custodians. According to the SEBI the roles and responsibilities of the custodians are to: Administrate and protect the assets of the clients. Open a separate custody account and deposit account in the name of each client. Record assets. Conduct registration of securities. Segregate securities and cash belonging of each client from others including custodian himself. Take adequate insurance of risks. Maintain records manually or in machine readable form. State clearly the method and system of receiving instructions from the client regarding collection, receipt, reporting and delivery of securities. Conduct verification of securities and to follow the stated control mechanism. Mention specifically the fees charged in the agreement. Conduct audit annually.

The custodian should have an adequate internal control system to prevent the manipulation of records and documents, which includes audit for securities and entitlements arising from securities, and held on behalf of the clients. To ensure that securities are protected from theft and natural hazards, the custodian must have appropriate safekeeping measures. On behalf of the client, the custodians have to maintain records and documents such as details of securities, money received and released registration of securities, and all reports submitted to the SEBI.

To monitor the compliance to the SEBI Act, every custodian of securities appoints a compliance officer. The SEBI can ask for any information with respect to any matter relating
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to the activities of the custodian. The SEBI is authorised to conduct inspection or investigation of accounts, documents or records of the custodians to ensure that the provisions of the SEBI Act and regulations are followed. In case of default, the SEBI can suspend or cancel registration of a custodian.

Every registered custodian must follow the code of conduct prescribed by SEBI. The following are the code of conduct prescribed by SEBI: Integrity The custodian of securities must maintain high standards of integrity and professionalism while discharging duties. Prompt distribution The custodian of securities must be prompt in distributing interests and dividends collected by him, on behalf of his clients on the securities held in custody. Infrastructure The custodian of securities must establish and maintain suitable infrastructure to discharge custodial services to the satisfaction of the clients. The operating procedures and systems of the custodian of securities need to be well documented. Accountability The custodian of securities is responsible for the movement of securities. The movement of securities can be from custody account, deposit and withdrawal of cash from the clients account. Whenever demanded by SEBI or the client, the custodian of securities must provide the complete audit trail. Confidentiality The custodian of securities has to maintain confidentiality regarding the client. Precautions The custodian of securities must take necessary precautions to ensure that continuity in custodial records is not lost or destroyed. To maintain sufficient backup records, the custodial records are kept electronically. Records The custodian of securities must create and maintain records of securities held in custody appropriately. This must be done to locate securities or obtain duplicate documents easily if the original records are lost due to any reason. Cooperation The custodian of securities must cooperate with other custodial entities and depositories which are necessary for the conduct of business, especially in the areas of inter custodial settlements and transfer of securities and funds. Diligence The custodian of securities must exercise diligence in administrating and safekeeping the clients assets which are in his custody.

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Q4. A company wishes to take machinery on lease. Study the lease options available to the company.

Answer: The lease options available to the company are as following: Finance lease In finance lease, the transfer of risks takes place. All the risks and secondary rewards incidental to the ownership of the asset are transferred to the lessee by the lessor, whether or not the title is eventually transferred. It involves payment of rentals over a compulsory, non-cancellable lease period which must be sufficient to repay the capital outlay of the lessor and leave some profit. Such a lease is also known as full payout lease. The lessor is essentially interested in the transaction as a financier and has no interest in the asset which is essentially required for the lessee for his business. Assets included under finance lease are ships, aircraft, land, buildings, heavy machinery, and so on.

Operating lease In an operating lease, transfer of all the risks and the rewards associated therewith does not take place and the cost of the asset is not fully recovered during the primary lease period. The lessor does not depend on a single lessee for recovering the cost of the asset. Services such as maintenance, repair and technical advice are provided by the lessor to the lessee. It is also known as service lease.

Sale and lease back and direct lease Sale and lease back Sale and lease back is an indirect form of leasing. The owner of an asset sells the asset to a lessor and the lessor leases it back to the owner who acts like the lessee. The sale and lease back of safe deposits vaults by banks is a good example of this type of leasing. The lease back arrangement in sale and lease back type of leasing can either be in the form of a finance lease or operating lease. Direct lease In direct lease, the lessee and the owner are two different bodies. A direct lease is of two types: bipartite and tripartite lease. Bipartite lease It consists of two parties the equipment supplier being the lessor. This lease is typically structured as an operating lease with inbuilt facilities, like upgradation of the equipment. The lessor maintains the asset and, if needed, replaces it with similar equipment.

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Tripartite lease This lease involves three parties, the equipment supplier, the lessor and the lessee.

Single investors lease and leveraged lease Single investor lease In single investors lease, there are only two parties, the lessor and the lessee. The leasing company manages the fund of the entire investment by an appropriate mix of debt and equity funds. The lender is not entitled to payment from the lessee when there is a default in servicing. The debt raised by the leasing company to finance the asset is without recourse to the lessee.

Leveraged lease In leveraged lease, there are three parties - the lessor, lender and the lessee. In such a lease, the leasing company buys the asset through considerable borrowing according to the requirement of the lessee. The lender obtains an obligation of the lease and the lessee has to pay rentals. The deal is routed through a trustee who looks after the interest of the lender and lessor. After receiving the receipt of the rentals from the lessee, the trustee sends the debt service component of the rental to the loan participant and the balance to the lessor. Domestic lease and international lease Domestic lease In domestic lease, all parties mentioned in the agreement are the residents of the same country. The party consists of the equipment supplier, lessor and the lessee. This lease is less prone to risks. International lease In international lease, the parties to the lease transaction reside in different countries. Import lease and cross-border lease are the sub classifications of international lease. This lease is affected by two types of risks - country and currency risk. Import lease The lessor and the lessee are resident of the same country but the equipment provider is located in a different country Cross-Border lease The lessor and the lessee are resident of different countries and the residence of the supplier is not at all important.

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Q5. Give examples of various venture capital funds that are present and examples of some business ventures that have been successful with venture capital financing.

Answer: Indian Venture Capital Scenario In India, the emergence of venture capital companies is a relatively new phenomenon. Until 1985, individual investors and Development Finance Institutions (DFIs) have played the role of venture capitalists in the absence of an organised venture capital industry. During that time entrepreneurs have largely depended on private placements, public offerings and lending by financial institutions. The venture capital phenomenon has arrived at a take-off stage in India with the easy availability of risk capital in all forms. In the earlier stage, it was easy to raise only growth capital but financing of ideas or seed capital is now available after the introduction of venture capital phenomenon. The number of players offering growth capital and the number of investors is rising rapidly.

In India, the concept of venture capital was initiated by the Industrial Finance Corporation of India (IFCI) when it established the Risk Capital Foundation (RCF) to provide seed capital to small and risky projects. However, the concept of venture capital financing first time got statutory recognition in the fiscal budget for the year 1986 to 1987.

The venture capital companies operating at present in India can be divided into four categories based on their mode of promotion. Let us read about each mode.

Promoted by All-India Development Financial Institution (IDFI) The ICICI provided the required impetus to venture capital activities in India. In 1986 it started providing venture capital finance. In 1998, it promoted with the Unit Trust of India (UTI) and Technology Development and Information Company of India (TDICI) as the first venture capital company registered under the Companies Act, 1956.

The risk capital foundation established by the IFCI in 1975 was converted to Risk Capital and Technology Finance Company (RCTC). The RCTC was established as a subsidiary company of IFCI to provide assistance in form of conventional loans and to give financial support to high technology projects.

Promoted by state level finance institution In India, the state level financial institutions in some states like Gujarat, Uttar Pradesh have done an excellent job by providing venture capital finance to small scale enterprises.

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Venture capital funds have been established by their corresponding commercial banks to undertake venture capital financing activity. Examples of these funds are Canbank venture capital fund, State bank venture capital fund, and Grindlays bank.

Private venture capital funds In India, several venture capital funds have been established to provide funding to various small scale enterprises. Examples of these funds established in India are 20th Century Venture Capital Corporation and Indus venture capital fund.

Q6. Mutual fund schemes can be identified by investment objective, List one scheme within each category.

Answer: Mutual Fund Schemes or Products Broad range of Mutual Fund Schemes exists to cater to the needs such as financial position, risk tolerance and return expectations and so on. The schemes are as follows: Open ended and close ended schemes An open-end fund is accessible for subscription throughout the year. These are not subjected to a fixed maturity. Investors can easily buy and sell units at Net Asset Value (NAV) related prices. The key quality of openend schemes is liquidity.

Close ended schemes have a pre-defined maturity period. At the time of the initial issue one can invest directly in the scheme. Depending on the arrangement of the scheme there are two exit options on hand to an investor after the preliminary offer period closes. Investors can buy or sell the units of the scheme on the stock exchanges where they are listed. Investment objective schemes Mutual funds are also classified based on the objectives of the fund. The investor can invest in mutual funds based on these objectives. The types of investment objective schemes are as follows: - Pure growth schemes Pure growth schemes are also acknowledged as equity schemes. The intention of these schemes is to offer capital approval over medium to long term. These schemes usually invest a main part of their fund in equities and are keen to bear short-term turn down in value for possible future appreciation.

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- Pure income schemes Pure income schemes are also identified as debt schemes. The target of these schemes is to supply regular and steady income to investors. These schemes normally invest in fixed income securities such as bonds. Capital appreciation in such schemes possibly will be limited. - Taxes saving schemes Tax-saving schemes recommend tax rebates to the investors under tax laws approved from time to time. Under Sec.88 of the Income Tax Act, contributions made to any Equity Linked Savings Scheme (ELSS) are eligible for rebate. - Balanced schemes Balanced schemes aim to give both growth and income by occasionally distributing a part of the income and capital gains they earn. These schemes put in in both shares and fixed income securities. Miscellaneous schemes The miscellaneous schemes include the following: - Sector funds These are the funds which put in the securities of only those sectors as specified in the offer documents. Examples of such funds are pharmaceuticals, software, fast moving consumer goods, and petroleum stocks and so on. The returns in these funds are reliant on the performance of the respective sectors. These funds have the potential to give higher returns but they are more risky compared to diversified funds. Investors need to keep a watch on the performance of those sectors and must exit at an appropriate time. - Money market mutual funds Money market mutual funds aim to present easy liquidity, conservation of capital and moderate income. These schemes commonly invest in safer, short-term instruments, such as bills of treasury, commercial paper, deposit certificates, and inter-bank call money.

Mutual Funds are always a good investment option in the financial portfolio. The returns are always more in these funds when compared to risk free investment options in banks. Also the risk in these investments is much less as compared to direct investments in shares.

Mutual funds can be called as diversified methods to invest our money and they offer numerous benefits to invest our hard earned money. But, before investing we should analyse the entire document provided by the concern mutual fund company as various risks are involved. Taxes and entry fees are also a part of mutual fund investments that reduces the returns on investments. The risk of losing the principal amount invested in a mutual fund is always there as the mutual funds are not guaranteed by the government. At the same time
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mutual funds present several advantages which made people to start investing in them. The first advantage is affordability which facilitates any kind of investor even without a huge capital to start investing in mutual funds to gain benefits for themselves. There are quite a lot of mutual funds schemes such as monthly payments, systematic investment plans and so on that can be customised based on the individual needs of the investor. The liquidity that mutual funds offer to the investors is more when compared to others. The investor can recover possession of the mutual funds whenever they want in the form of the current NAV per unit at that time but there will be a deduction of the charges from the net amount.

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MBA Semester IV MF0018: Insurance and Risk Management

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ASSIGNMENT- Set 1 (Marks 60)

Q1. Write a note on the following: a. endowment assurance b. Investment banking

Answer: Term products are life insurance plans that offers financial cover equivalent to the face value of the policy in case the policy holders dies during the policy period. They do not carry any cash value. According to the plan, policy holders pay a certain premium to protect their dependants against their sudden death. But if the insured person lives upto the specified period of the policy, the insured will not get any benefits from this plan.

Endowment products are plans that combine risk cover with financial savings. Endowment plans are the most popular products in the world of life insurance. In this plan, the sum assured is payable even if the insured survives the policy term. But when the insured dies during the specified period, the amount is paid to the sum assured. The insured who remain alive upto the specified period of the plan get back the sum assured with some other investment benefits. It also offers offer various benefits such as double endowment and marriage/ education endowment plan. The cost of this plan is slightly higher but is worth its value.

The following are the features of term and endowment products: Term and endowment products provide death benefits ensuring the security of those important persons of the insured. They provide disability protection ensuring the insured that their insurance will remain in force if they are disabled and unable to work. They provide retirement planning and funds to the insured for the future retirement needs. They cover other risks of the life of the insured such as accidents, hospitalisation and business loss.

Term and endowment products have been in the market for a long time and are very popular. Hence many insurance companies while designing products offer these. They incorporate the basic features of these plans and try to provide product differentiation by providing marginal benefits to attract more customers.

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Features of Endowment Assurance Policy The previous section discussed the role of term and endowment policies in product design. This section discusses the features of endowment assurance policy.

Endowment assurance policy is a fixed term life assurance policy in which provisions are made for premiums to pay for life cover and to save or invest. The policy pays out a sum of money (the sum assured) on the death of the policyholder or at the maturity date if the policyholder is alive till the term of completion. If an endowment policy is claimed prior to its maturity period, then the amount returnable to the policyholder will normally be below the value of the premiums paid up to cancellation.

The important features of the endowment assurance policy are: Moderate premiums. High bonus. High liquidity. Savings oriented. Sum assured is payable to the policyholder either on survival to the term or on death occurring within the term. Under this policy with Profit and a without Profit plans are available. Bonus for the full term is payable to the policyholder on the date of maturity or in the occasion of death, whichever is earlier. Premiums can be limited to smaller term or can be paid as single premium. Premiums come to an end on expiry of term or on death whichever is earlier. This policy provides provisions for the family of policyholder, in event of his death, and also assures an amount at a desired age. The amount can be reinvested, to provide an annuity during rest of his life or in any other way. Premiums are payable for specified number of years. Endowment assurance policy is affordable for people of all ages and social groups, who wish to protect their family members from a financial risk that might occur in future. If the policy holder becomes permanently disabled on account of an accident, before reaching the age of 70 and the policy is in full force, then it is not compulsory for him to pay the remaining premiums; and the policy will be unaffected. b. Corporate finance is the traditional aspect of investment banks which also involves helping customers raise funds in capital markets and giving advice on mergers and acquisitions (M&A). This may involve subscribing investors to a security issuance,
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coordinating with bidders, or negotiating with a merger target. Another term for the investment banking division is corporate finance, and its advisory group is often termed mergers and acquisitions. A pitch book of financial information is generated to market the bank to a potential M&A client; if the pitch is successful, the bank arranges the deal for the client. The investment banking division (IBD) is generally divided into industry coverage and product coverage groups. Industry coverage groups focus on a specific industry, such as healthcare, industrials, or technology, and maintain relationships with corporations within the industry to bring in business for a bank. Product coverage groups focus on financial products, such as mergers and acquisitions, leveraged finance, public finance, asset finance and leasing, structured finance, restructuring, equity, and high-grade debt and generally work and collaborate with industry groups on the more intricate and specialized needs of a client.

Q2. Discuss the various risk management strategies to handle risk.

Answer : Risk Management Strategies Tthe various risk management strategies used to handle both pure and speculative risk. 1. Risk avoidance Risk avoidance is where a certain loss exposure is never acquired or the existing one is totally removed. This is one of the strongest methods to deal with risks. The major advantage of this method is that it reduces the chance of loss to zero. The two ways by which risk can be avoided are proactive avoidance and abandonment avoidance. In the first case, the person does not assume any risk and therefore any project which brings in risk is not taken up.

For example a company which has chances of nuclear radiation will not set up the company, due to the perils which it can bring up.

In the case of abandonment avoidance, the existing loss exposure is abandoned. All activities with a certain degree of risk are abandoned. The case of abandonment avoidance is very few. If a firm abandons risky activities, then it faces difficulties in remaining in the market. The firm in the process of abandoning might take up new activities which exposes to another type of risk.

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This strategy aims to decrease the number of losses by reducing the occurrence of loss, which can be done in two ways namely loss prevention and loss control. Loss prevention is a desirable way of dealing with risks. It eliminates the possibility of loss and hence risk is also removed. The examples of this are safety programs like medical care, security guards, and burglar alarms.

Loss control refers to measures that reduce the severity of a loss after it occurs. For example segregation of exposure units by having warehouses with inventories at different locations. Insurance companies provide guidance and incentives to the company which has taken the policy to avoid the occurrence of loss.

3. Risk retention Retention simply means that the firm retains part or all the losses incurred from a given loss. Risks may be knowingly or unknowingly retained by the organisation. They are hence classified as active and passive based on this. Active risk retention is when the firm knows of the loss exposure and plans to retain it without making any attempt to transfer it or reduce it. Passive retention is the failure to identify the loss exposure and retaining it unknowingly. Retention can be used only under the following circumstances:

When insurers are unwilling to write coverage or if the coverage is too expensive. If the exposure cannot be insured or transferred. If the worst possible loss is not serious. When losses are highly predictable.

Based on past experience if most losses fall within the probable range of frequency, they can be budgeted out of the companys income. 4. Risk combination In this strategy, risks are retained in a proportion that reduces the overall risk combination to a minimum level. In order to minimise the overall risk, one risk is added to another existing risk instead of transferring a risk. This strategy is mostly used in management of financial risk. The risk is distributed over a number of issuers instead of putting it on a single issuer. This reduces the chances of default. For example it is better to have multiple suppliers instead of relying on a single supplier.

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If the risk is being borne by another party other than the one who is primarily exposed to risk then it is termed as risk transfer. In this case, transfer of asset does not take place but only the risk involved is transferred. The two parties involved in this strategy are the transferor (party transferring the risk) and the transferee (party to whom the risk is transferred). The contracts made in this strategy are grouped as exculpatory contracts.

In this contract the transferor is not liable if the event of risk takes place. But if the transferor is supposed to pay for the risk incurred then it cannot be termed as risk transfer. 6. Risk sharing This is an arrangement made by which the loss incurred is shared. For example in a corporation, a large number of people makes investments and hence each bears only a portion of risk that the enterprise faces. Insurance involves the mechanism of risk sharing.

7. Risk hedging Hedging is buying and selling future contracts to balance the risk of changing prices in the cash market. A hedger is someone who uses derivatives to reduce risk caused by price movements. Derivatives are instruments derived from the base securities like equity and bonds. Forward contracts, futures, swaps and options are examples of derivatives. Derivatives are based on the performance of separately traded commodities. These involve future commitments and hence are open to the possibility of benefiting from favorable price movements.

Operators in the derivative market are hedgers, speculators and arbitrageurs. Hedgers are those who transfer the risk component of their portfolio. Speculators take the risk from hedgers intentionally to make profit. Arbitrageurs operate in different markets simultaneously to make profit and eliminate mispricing. Therefore the derivatives make provision by hedging to reduce the existing risk.

Q3. What is VAR and how it is useful in risk management tool?

Answer : Regulators have identified derivatives as risk management tools for insurance organisations. Hence insurance companies use these within the quantitative and qualitative limits determined by the legislation, supervisory authority and the internal procedures of the organisations. The insurance companies need to obtain prior authorisation needs for every
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derivatives it intends to use. Additionally, the management of the organisation should develop a system of estimation, quantitative limitation and supervision of risks.

In case of investment choices, the administrators and supervisors must improve risks like credit risk, market risk, legal and operational risk. VAR (Value at Risk) models are accepted by banking and insurance organisations as a risk management tool to control risks. VAR is defined as the maximum potential change in value of financial instruments portfolio with a provided probability for certain time period. VAR approach is useful for risk management and regulatory purpose. The main aim of VAR approach in risk management and capital regulation is to bring capital requirements close to underlying risks of assets in a portfolio. This approach is really important for insurance organisations as they operate the sufficient capital to cover the liabilities and claims in future on a long-term basis. Risk exposure is also covered through investment rules by restricting asset categories. Because of VAR tools, the quantitative objection in risk management tools is decreasing.

VAR is a financial engineering tool used by insurance companies. Some other tools include credit assessments of individuals, pricing of risks and valuations of combined risks of companies that engage in multiple markets. Asset liability management and revenue management are optimised tools for financial management and risk management.

Q4. Explain the role of an insurance broker.

Answer : Brokers are people who legally represent the insured. The customer is the principal of the broker who provides the broker with limited authority. The brokers have to find a suitable insurer according to the principals needs. They cannot act on the insured behalf but are given commission for their work.

Brokers can also be insurance agents so that they can connect the insurers and insureds. A broker may seem similar to an agent but there is a significant difference. When a principal gives details regarding the risks to the agent, all the facts and documents related to it is passed on to the agent. But if the principal of a broker gives information about the risks no such facts or documents are given to the broker. This is where the limitation in the brokers authority appears.

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There are clearly defined laws which list the responsibilities of a broker and a principal. The insured gives the commission to a broker according to the premium charged to the insured by the insurer. The broker in turn should give priority to the principals risks and requirements. They have to design the insurance programs in such a way that the principal gets a maximum benefit from it.

The role of the broker in property and liability insurances is more in life and health insurances. Nowadays, there are well established brokerage firms which have a specialised broker for different types of insurances.

Q5. List and explain the social insurances available in India.

Answer: Various social insurances The various social insurances provided in India are: Employee state Insurance The Employee State Insurance Act which was introduced in 1948, is a piece of social welfare legislation introduced primarily with the object of providing quite a few benefits to employees in case of sickness, injury and maternity and also to create provision for certain others matters incidental to that. The Act in fact tries to achieve the goal of socio-economic justice enclosed in the directive principles of state policy which enjoin the state to make efficient condition for securing, the right to work, good health, education and public assistance in cases of unemployment, sickness, old age and so on. The act endeavors to materialise these objects through only to a restricted extent. This act provides a broader spectrum then any other insurance or factory act. While the Factory Act deals with the health, welfare and safety of the workers employed in the factory premises only, the benefits of this act expand to employees whether working inside the factory or establishment or elsewhere or they are directly employed by the principal employee or by an intermediary agency, if the employment is incidental or in connection with the factory or establishment. Disability insurance The most significant form of disability insurance is the one offered by the government. This program makes sure that all the citizens who are uninsured or underinsured are covered. This program does not offer huge benefits but it pays enough to prohibit poverty. Many well-known companies cover their employees against the probable hazards of disability. Employees face a high chance of meeting with an accident at the work place. So, it is crucial for companies to offer disability insurance. Workers compensation policy comes under disability insurance. It pays workers who get disabled by job-related injuries. This program also pays benefits to the family members of workers who died while
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performing job-related tasks and also cover all the medical expenses. Individual disability insurance policy is also a part of disability insurance. This policy is meant for the temporary employees or those who are not covered under employer disability insurance or the selfemployed. Any individual can buy such an insurance policy from any insurance company but premiums tend to stay high for policies that offer great benefits or that defines disability in a broader context. Health insurance schemes for the poor Over the last several years there have been efforts to extend health insurance by various small NGOs. Self-Employed Womens Association (SEWA) which is a membership based women workers trade union, has developed a scheme to protect the poor women from financial burdens which arise out of high medical costs and several other risks. Each member of the association has an option to join the programme by paying Rs. 60 per annum and it provides limited cover for risks arising out of sickness, maternity needs, floods, accidents, widowhood and so on. The scheme is also linked with the saving scheme. Members have the option to either deposit Rs. 500 in SEWA Bank or pay annual premium of Rs. 60. SEWA started this programme with the support of one of the public sector insurance companies. According to SEWA the patients belonging to lower income groups who opt for the schemes would need systems which are straightforward, flexible, simple, prompt, and have less paper work and consists of fewer tiers. SEWA experience illustrates that other aspects of risk which need coverage include natural and accidental death of women and her husband, disablement, loss because of riots or flood or fire or theft. Other NGOS offering similar schemes are ACCORD in Karnataka, Aga Khan Health Services, India (AKHSI) and Nav-sarjan in Gujarat, and Sewagram medical college Maharashtra. The scheme developed by government insurance companies to focus on poor is called Jan Arogya Bima Policy. Medicare Medicare covers most of the medical expenses of elderly, disabled workers and veterans. Medicare has a number of different programs, which influence the types of benefits received by the beneficiaries. Some plan levels cover different procedures and provide assistance with bills incurred through hospital stays, prescription coverage, and doctor appointments. Medicare receives the funding through taxes deducted from current workers. Unemployment insurance Unemployment Insurance provides temporary financial protection for workers who experience unforeseen layoffs due to lack of work and other reasons that are no fault of the employee. Unemployment programs also protect workers who suffer unemployment due to natural disasters like floods and cyclones. Funding for
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unemployment insurance is done through the employers unemployment tax. ICICI Lombard has introduced this insurance in India.

Q6. Mention the steps of underwriting.

Answer : The underwriting of life-insurance falls under a category that is different from all other forms of insurances. When the underwriter measures risk at beginning, the company assures a cover for 30 years or throughout life. Life assurance underwriting must consider factors, like, medical history, family details, occupational hazards, and persons lifestyle.

The underwriting process for life insurance involves the following steps: 1) Execution of field underwriting. 2) Renewing the application in the office. 3) Gathering additional information, if required. 4) Taking and underwriting decisions. Additional information is always essential for the underwriter in order to take a decision. This additional information may be in the form of questionnaires, a detail medical report from proposals own doctor (Medical Attendants Report), and an examination by an independent doctor (Medical Examiners report).

The general steps followed by Underwriters are: 1) Getting applications -The application for insurance is the main source of insurability information that the underwriter of the life insurance company evaluates first. Applications are generally collected by the field officers, the agents. A typical life insurance consists of: General information The general information consists of general aspects like name, age, address, date of birth, sex, income, marital status and occupation of the applicant. It also includes the details of requested insurance cover like type of policy, amount of insurance, name and relationship of the nominee, other insurance policies that the customer owns and the pending insurance applications as on date. Medical information The medical information consists of consumers health condition and several queries about health history and family history. The medical section of the application is comprehensive and it is mandatory to fill it completely with relevant information. Information is also collected through a medical examination, depending on age and face value of the policy. 2) The medical report An average medical test is compulsory (which is free of cost to the applicant except in case of revivals). Depending on the information filed in the application, an
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insurance company may ask the physician of the consumer for further information. Gathering information is a standard method used in all domestic insurance companies. Basically, life insurance companies have several sources of medical and financial information to assist them in the underwriting process. These include personal medical records and physicians, the medical information department, inspection reports and credit records. 3) Underwriting review After collecting all the relevant information about the applicant, an underwriter from the insurance company evaluates the information. During this evaluation, the underwriter will organise the risk offered to the company and also determines the premium for the policy depending upon the primary and secondary factors influencing the premium. The premium rates are set by the companys registrars depending upon the applicants risk profile. During each step of the underwriting process, the life insurance agent usually provides details, and is well-informed about the insured status in the process. If the applicant offers more risk than the insurance company standards, then the underwriter rejects the application. 4) Policy writing A special department writes the policy, whose main function is to issue written contracts according to the instructions from the underwriting departments. A register must be maintained as most policies are long-term. Insurance companies generally use computerised systems to maintain the records of the customers, premium payments, and they to verify that all the requirements of underwriting have been met.

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ASSIGNMENT- Set 2

Q1. Write a note on the following: a. Travel policy b. Causality insurance

Answer : a. A travel insurance policy is type of insurance coverage, which covers hospitalisation and medical costs during a persons travel in a foreign country. Travel insurance policy is referred to as holiday insurance. The most important thing about this coverage is that it encompasses all the kinds of vacations and business travels. A travel insurance policy is extremely beneficial, and its coverage is cost-efficient.

In general, companies sell travel insurance policies with many benefits to the travellers. This policy offers single-trip coverage, if a person is planning one trip overseas. And, the policy offers a multiple-trip policy, if a person is planning for many trips overseas, in a year.

Travel insurance covers all individuals (traveling abroad) against risks like baggage loss, travel accidents like injuries, illnesses and medical contingencies with hospitalisation. In India, this insurance is popular now among international travelers.

b. Casualty insurance protects against losses or damage to the business. Casualty insurance is combined with property insurance and known as property and casualty insurance. For instance, if a particular business is on seventh floor of a building and suddenly a natural disaster like flood occurs that washes out the first floor, but there is no damage caused to the seventh floor, then the loss that has occurred will not be covered by property insurance because there is no direct loss to the business location. But casualty insurance covers indirect losses to the business also.

Casualty insurance, often equated to liability insurance, is used to describe an area of insurance not directly concerned with life insurance, health insurance, or property insurance. It is mainly used to describe the liability coverage of an individual or organization's for negligent acts or omissions.However, the "elastic" term has also been used to describe property insurance for aviation insurance, boiler and machinery insurance, and glass and
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crime insurance. It may include marine insurance for shipwrecks or losses at sea or fidelity and surety insurance. It may also include earthquake, political risk insurance, terrorism insurance, fidelity and surety bonds. One of the most common kinds of casualty insurance today is automobile insurance. In its most basic form, automobile insurance provides liability coverage in the event that a driver is found "at fault" in an accident. This can cover medical expenses of individuals involved in the accident as well as restitution or repair of damaged property, all of which would fall into the realm of casualty insurance coverage.

If coverage were extended to cover damage to one's own vehicle, or against theft, the policy would no longer be exclusively a casualty insurance policy.

The state of Illinois includes vehicle, liability, worker's compensation, glass, livestock, legal expenses, and miscellaneous insurance under its class of casualty insurance.

In 1956, in the preface to the fourth edition of Casualty Insurance Clarence A. Kulp wrote: It has never been possible really to define casualty insurance. Broadly speaking, it may be defined as a list of individual insurances, usually written in a separate policy, in three broad categories: third party or liability, disability or accident and health, material damage. One of the results of comprehensive policy-writing .... is to raise the question of the usefulness of the traditional concept of casualty insurance ... some insurance men predict that the casualty insurance of the future will include liability and disability lines only.

Q2. What are the basic objectives of claims management?

Answer: Claims management is a system which sets up the rules and regulations for the assessment of damages, using the data got from medical reports, surveyor report, loss assessors report and warranties contained in the policy document. It also regulates the payment of damages and the payment of loss of future earnings.

An insurance company is usually accepted as good or bad, on the basis of the time it takes to finalise, and pay back the claim. To settle a claim promptly is the important function of an insurance organisation. The goodwill of the insurance company depends on the claim satisfaction level of its customers. Effective claim management is necessary for an organisation as it deals with the cash outflows of the company.

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Claims management by the insurer involves analysing the data, processing applications and making decisions, funding and controlling the business management. The claims management makes the principles and guidelines for profitable settlement of claims.

Claims management comprises of the process of claims handling and claims payment. The review of claims performance, monitoring of claims expenses, legal and settlement costs, planning of future payments and avoiding delay and disputes in payment of claims is included in claims management. Risk management, loss assessment, business forecasting and planning of insurance claims are also done in claims management.

Claims reserving is an important part of the overall claim management process. Insurance companies need to ensure adequacy of claims reserves in order to meet their claim obligations.

Q3. Describe the stages in claims management.

Answer : Managing insurance claims is one of the most significant management tasks. Claim management tasks involve filing, verifying insurance coverage, determining copayment levels and checking the status of submitted claims. Claims handling and claims management are the stages in the claim system. Externally both appear to be the same, but they are different by nature. Claims handing is a vital part of claims management as it executes the decisions by the claims management of the insurance company.

Claims management Claims management by the insurer involves analysing the data, processing applications and making decisions, funding and controlling the business management. The claims management makes the principles and guidelines for profitable settlement of claims.

Claims management comprises of the process of claims handling and claims payment. The review of claims performance, monitoring of claims expenses, legal and settlement costs, planning of future payments and avoiding delay and disputes in payment of claims is included in claims management. Risk management, loss assessment, business forecasting and planning of insurance claims are also done in claims management.

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Claims reserving is an important part of the overall claim management process. Insurance companies need to ensure adequacy of claims reserves in order to meet their claim obligations. Claims handling Claims handling is a way to process claims application and manage the claims settlement. It is a method, where the laid down principles and measuring methods are utilised to settle the claims. It handles the various stages of the insurance claims. Its functions include reviewing, investigating and understanding the negotiation process. This does not involve policy making and decision making or any managerial activity.

It involves only procedural methods and interpretations of the claims philosophy. Claims handling depends on each case or situation and changes accordingly. It is flexible, as well as, rigid keeping in mind the interest of the insurer. It involves receiving the claims and other procedures for efficient payment of claims. The insurers commitment to the customer is part of the claims management.

While handling claims insurers need to ensure that: Claims are handled fairly. Claims are settled promptly. Information is provided to the customers about the claim handling process. Reasons are provided when claims are rejected or not fully paid.

Q4. If you working as an actuary in an insurance company, list the factors which affect your pricing of a policy.

Answer: Basically, the pricing method gives us an idea on how to set the product price. The price value that is set for the product in the insurance company will change over time for many reasons. The company can decide to change the pricing method only when it finds out the customers needs and competition in the market.

The pricing methods allow companies to think about their business, industry and customer. The vendors must understand the variety of options available along with the merits and demerits of the pricing methods, before selecting any one of them. They may also merge a number of pricing methods to suit their business and the type of products they sell.

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MBA Semester IV There are three basic pricing methods, which are:

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Cost-based pricing In this method, the price includes the cost of ingredients and cost of operating the business. This method is based on product cost subtotal, which includes the costs of operating the business such as costs of reserves, transportation, advertisement, rent and other costs involved in manufacturing the products. The cost-based pricing comprise of three methods, which are: - Mark-up pricing Mark-up pricing includes a profit percentage with product cost. All businesses with many products use this type of pricing because it is simple to calculate. The profit level must be specified in terms of percentage. This is added to the production cost to set product price. This type of pricing is common in retail business as they have many types of products and purchases from many vendors. - Cost-plus pricing In a cost-plus pricing, a percentage is added to an unknown product cost. This type of pricing works properly when production costs are not known. The only difference between mark-up and cost-plus pricing is that, in cost-plus pricing both consumer and vendor settle on the profit percentage and believe that product cost is unknown whereas in mark-up pricing product cost is known. The cost-plus pricing reduces your risk if you produce custom order products for other firms or individuals. - Planned-profit pricing Planned profit pricing method enables you to earn a total profit for the business. It is different from the first two types of cost-based pricing. The first two pricing methods focus on per unit price. In planned-profit pricing, the product price is calculated by combining per unit costs with output projections. Planned-profit pricing uses break-even analysis to calculate product price. This method is suitable for manufacturing businesses since the manufacturer has the ability to increase or decrease the production depending upon the available demand or profit.

Q5. Describe the roles and functions of the institution of insurance ombudsman.

Answer : In 1998, Government of India formed the Institute of Insurance Ombudsman, to address the complaints of insured persons against the insurance companies. This institution became a way for the insured persons to express their problems against the companies, and to solve it as soon as possible. This institution helps the policyholders to build up confidence in the insurance companies.

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Institution of Insurance Ombudsman resolves complaints, which the insurance company denied to solve. The insured persons can approach the insurance ombudsman in their own states to solve their problems. Roles and functions The roles and functions of the Institution of Insurance Ombudsman ranges from appointment of the ombudsman, to the rewarding of insured persons. The various functions of the institution are: Appointment of insurance ombudsman - The appointment of insurance ombudsman is the main function of the institution. A committee consisting of the chairman of IRDA, chairman of LIC, chairman of GIC, and a representative of the Central Government mandates the governing body of insurance council to choose the insurance ombudsman. The Insurance council includes the members of life insurance council, and the general insurance council is formed under section 40C of the Insurance Act,1938. Some representatives of insurance companies form the governing body of insurance council. Eligibility and term of service - Officials from insurance industry, civil services and judicial services are chosen as the insurance ombudsmen. The ombudsman changes every three years and retires from the post at sixty-five years of age. Insurance ombudsmen cannot be re-appointed. Territorial jurisdiction of ombudsman - Presently, in different states of India, there are around 12 insurance ombudsmen appointed by the governing body. These ombudsmen may hold meetings with the insured persons in their corresponding areas of jurisdiction, in order to speed up and resolve their grievances. Currently, the offices of the insurance ombudsmen in India are located at Bhopal, Bhubaneswar, Cochin, Guwahati, Chandigarh, New Delhi, Chennai, Kolkata, Ahmedabad, Lucknow, Mumbai and Hyderabad. Office Management - The insurance council provides the office of the insurance ombudsman, and it consists of the secretarial staff, which supports the ombudsman in carrying out duties. The total expenses of this office are decided by the governing body, and are provided by the insurance companies of the insurance council. Removal from office - An insurance ombudsman can be removed from office on committing a gross misconduct during the three years of service. The governing body selects a person fit to do a detailed enquiry and investigation about the misconduct and all these details are given to the Insurance Regulatory and Development Authority (IRDA). IRDA then takes a decision regarding the action to be taken against the guilty ombudsman.

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Power of ombudsman The two main functions of the insurance ombudsman are: Addressing and solving the issues of the insured persons and insurance companies - The insurance ombudsman helps any person who has a complaint against the insurance company. The complaints can be of various types: - Issues regarding any partial or total denial of claims by the insurance companies. - Issues with regard to payment of premium in terms of the policy. - Disputes on the legal structuring of the policy statements which resulted in disputes related to claims. - Delay in resolution of claims. - Delay in issuance of any insurance papers to customers after acceptance of premium. Awarding a payment to the insured persons - The insurance ombudsman can issue up to Rs. 20 lakhs as awards to the insured persons. The corresponding insurance companies are obliged to credit these awards within three months.

Q6. What are the different types of reinsurance? Explain.

Answer : The two different types of reinsurances are: Facultative reinsurance. Treaty reinsurance.

1. Facultative reinsurance It is a type of reinsurance that is optional; it is a case-by-case method that is used when the ceding company receives an application for insurance that exceeds its retention limit. It is based on the individual agreements that help to cover specific losses. When any primary insurer wants reinsurance for a specific coverage, it enters the market, and bargains with different reinsurance companies for the amount of coverage and premium, looking out for a better value. According to most of the contracts, the reinsurer pays a ceding commission to the insurer to pay for purchase expenses.

Before issuing the insurance policy the insurer looks for reinsurance and speaks to many reinsurers. The insurance company does not have any commitments to cede insurance and also the reinsurer has no commitments to accept the insurance. However if the insurance

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company find a reinsurer who is willing to take the insurance policy then they can enter into a contract.

Facultative reinsurance is used when a huge amount of insurance is preferred and while considering a specific risk involved in an individual contract. Facultative reinsurance is the reinsurance of a part of a single policy or the entire policy after negotiating the terms and conditions. It reduces the risk exposure of the ceding company against a particular policy. Facultative reinsurance is not mandatory.

One advantage of facultative reinsurance is it is flexible as a reinsurance contract is arranged to fit any kind of cases. It helps the insurance companies in writing large amount of insurance policies. Reinsurance moves the huge losses of the insurers to the reinsurer and thus helps the insurer.

One main disadvantage of facultative reinsurance is that it is not reliable. The ceding insurer will not know in advance whether a reinsurer will agree to pay any part of the insurance. The other disadvantage of this kind of reinsurance is the delay in issuing the policy as it cannot be issued until the reinsurance is got for that policy. 2. Treaty reinsurance Treaty reinsurance is one in which the primary insurer agrees to cede the insurance policy to the reinsurer and the reinsurer has to accept it. It includes a standing agreement with a specific reinsurer. The amount of insurance that the primary insurer sells and those policies where both the parties provide the service is specified in the contract. All the business that comes under the contract is automatically reinsured according to the conditions of the treaty. Treaty reinsurance needs the reinsurer to assume the entire responsibility of the ceding company or a part of it for some particular sections of the business with respect to the terms of the policy. The contract is a compulsory contract because according to the treaty the ceding company has to cede the business and the reinsurer is compelled to assume the business. It is a type of reinsurance that is preferred while considering the groups of homogenous risks.

The treaty reinsurance provides many advantages to the primary insurance company. It is automatic, more reliable, and there is no delay in issuing the policy. It is also more cost effective as there is no need to shop around for reinsurers before writing the policy. The treaty reinsurance is not advantageous to the reinsurer. Usually the reinsure does not know about the individual applicant of the policy and has to depend on the underwriting
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judgment that the primary insurer gives. It may be so that the primary insurer can show bad business like more losses and get reinsured for it as the reinsurer does not know the real fact. The primary insurer may pay insufficient premium to the reinsurer. Therefore the reinsurer undergoes a loss if the risk selection of the primary insurer is not good and they charge insufficient rates.

There are different types of treaty reinsurance arrangements which may differ according to the liability of the reinsurer. They are: Quotashare treaty. Surplusshare treaty. Excessofloss treaty. Reinsurance pool.

Quotashare treaty According to this treaty the reinsurer and the ceding insurer agree to share a fixed percentage of premium and also losses depending on some proportion. Therefore because of this the quota share treaty is also called proportional reinsurance. For instance, the primary insurer can take a decision of retaining around 70% of the new business with it and transferring the rest 30% to the reinsurer. Accordingly, it also divides the expenses, incomes and losses in the same proportion. The ceding insurers retention limit is stated as a percentage. Premiums are also shared in the same proportion as agreed in the treaty. A ceding commission is paid to the primary insurer by the reinsurer that helps in balancing the expenses that it encountered while writing the business.

The major advantage of the quote-share treaty is that it permits the primary insurer in reducing its unearned premium reserve considerably by transferring a lot of profitable business to the reinsurer. Surplusshare treaty This is an agreement that shares some of the qualities of the quoteshare and excess-of-loss treaties. According to this treaty the reinsurer accepts the insurance in excess to the ceding insurers retention limit. If the amount of any insurance policy is more than the retention limits, then the reinsurer pays the excess amount up to a specified maximum limit. The loss and premium are shared among the primary insurer and the reinsurer in the same proportion.

The major advantage of the surplus-share treaty is that it increases the underwriting capacity of the primary insure.

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The major disadvantage of this treaty is that the coverage that a reinsurer provides for each policy has more record keeping and thus creates more administrative expenses. Excessofloss treaty This treaty is largely designed for providing protection against the catastrophic losses. It is an agreement where the reinsurer covers only the losses that are more than the retention limit of the primary insurer. This coverage is obtained mainly for covering the catastrophic losses. This treaty can be written to cover: 1) A single occurrence. 2) A single exposure. 3) Excess losses when the primary insurers total losses exceed some amount during some started time period. Reinsurance pool The reinsurance pool also provides reinsurance. It is an organisation of insurers that underwrites insurance on a joint basis. These are formed as a single insurer possibly will not be financially able to write huge amount of insurance policies, however a group of insurers can combine their financial resources and get the financial ability to write the huge insurance policies.

These pools are created to provide coverage for nuclear accidents, aviation disasters and exposure in foreign countries where losses can be catastrophic and that could easily exceed the financial capability of any single insurer.

The method of sharing premiums and losses are different for different types of reinsurance pools. The pool works in the following two different ways::

First all the members of the pool decide to pay some percentage of amounts for every loss that occurs. Second the agreement is same as that of the excessofloss reinsurance treaty.

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