F-2,Block, Amity Campus

Sec-125, Nodia (UP)

India 201303

ASSIGNMENTS
PROGRAM:
SEMESTER-I
Subject Name
: Financial System
Study COUNTRY
: Sudan LC
Permanent Enrollment Number (PEN) : MFC001652014-2016014
Roll Number
: AMF107 (T)
Student Name
: SOMAIA TAMBAL YOUSIF ELMALIK
INSTRUCTIONS
a) Students are required to submit all three assignment sets.
ASSIGNMENT
Assignment A
Assignment B
Assignment C

DETAILS
Five Subjective Questions
Three Subjective Questions + Case Study
45 Objective Questions

MARKS
10
10
10

b)
c)
d)
e)

Total weightage given to these assignments is 30%. OR 30 Marks

All assignments are to be completed as typed in word/pdf.
All questions are required to be attempted.
All the three assignments are to be completed by due dates (specified
from time to time) and need to be submitted for evaluation by Amity
University.
f) The evaluated assignment marks will be made available within six
weeks. Thereafter, these will be destroyed at the end of each semester.
g) The students have to attach a scan signature in the form.
Signature
:
Date
:
_________30 January 2015_______________________
( ) Tick mark in front of the assignments submitted
Assignment A
Assignment B
Assignment C

Financial System
ASSIGNMENT- A (Attempt these five analytical questions)
Q1. What do you understand by financial system of a
country? Explain its definition, significance and
structure?
Introduction to Financial System: A financial system plays a vital role in
the economic growth of a country. It intermediates with the flow of funds
between those who save a part of their income to those who invest in
productive assets. It mobilizes and usefully allocates scarce resources of a
country. A financial system is a complex well integrated set of sub systems
of financial institutions, markets, instruments and services which facilitates
the transfer and allocation of funds, efficiently and effectively. The financial
system is possibly the most important institutional and functional vehicle for
economic transformation. Finance is a bridge between the present and the
future and whether it is the mobilization of savings or their efficient,
effective and equitable allocation for investment, it is the success with which
the financial system performs its functions that sets the pace for the
achievement of broader national objectives.
Significance and Definition: The term financial system is a set of interrelated activities/services working together to achieve some predetermined
purpose or goal. It includes different markets, the institutions, instruments,
services and mechanisms which influence the generation of savings,
investment capital formation and growth.
Van Horne defined the financial system as the purpose of financial markets
to allocate savings efficiently in an economy to ultimate users either for
investment in real assets or for consumption. Christy has opined that the
objective of the financial system is to "supply funds to various sectors and
activities of the economy in ways that promote the fullest possible utilization
of resources without the destabilizing consequence of price level changes or
unnecessary interference with individual desires." According to Robinson,
the primary function of the system is "to provide a link between savings and
investment for the creation of new wealth and to permit portfolio adjustment
in the composition of the existing wealth." From the above definitions, it
may be said that the primary function of the financial system is the
mobilization of savings, their distribution for industrial investment and
stimulating capital formation to accelerate the process of economic growth.

The process of savings, finance and investment involves financial

institutions, markets, instruments and services. Above all, supervision
control and regulation are equally significant. Thus, financial management is
an integral part of the financial system. On the basis of the empirical
evidence, Goldsmith said that "... a case for the hypothesis that the
separation of the functions of savings and investment which is made
possible by the introduction of financial instruments as well as enlargement
of the range of financial assets which follows from the creation of financial
institutions increase the efficiency of investments and raise the ratio of
capital formation to national production and financial activities and through
these two channels increase the rate of growth"
The inter-relationship between varied segments of the economy is illustrated
below:

A financial system provides services that are essential in a modern economy.

The use of a stable, widely accepted medium of exchange reduces the costs
of transactions. It facilitates trade and, therefore, specialization in

production. Financial assets with attractive yield, liquidity and risk

characteristics encourage saving in financial form. By evaluating alternative
investments and monitoring the activities of borrowers, financial
intermediaries increase the efficiency of resource use. Access to a variety of
financial instruments enables an economic agent to pool, price and exchange
risks in the markets. Trade, the efficient use of resources, saving and risk
taking are the cornerstones of a growing economy. In fact, the country could
make this feasible with the active support of the financial system. The
financial system has been identified as the most catalyzing agent for growth
of the economy, making it one of the key inputs of development.
The Financial Structure of the Financial System in India:
The Organization of the Financial System in India:
The Indian financial system is broadly classified into two broad groups:
(i)
Organized sector and
(ii) Unorganized sector.
"The financial system is also divided into users of financial services and
providers. Financial institutions sell their services to households, businesses
and government. They are the users of the financial services. The boundaries
between these sectors are not always clear cut.
In the case of providers of financial services, although financial systems
differ from country to country, there are many similarities. Major
constituents of a financial system are as follows:
(i) Central bank
(ii) Banks
(iii) Financial institutions
(iv) Money and capital markets and
(v) Informal financial enterprises.
(i) Organized Indian Financial System:
The organized financial system comprises of an impressive network of
banks, other financial and investment institutions and a range of financial
instruments, which together function in fairly developed capital and money
markets. Short term funds are mainly provided by the commercial and
cooperative banking structure. Nine-tenth of such banking business is
managed by twenty-eight leading banks which are in the public sector. In
addition to commercial banks, there is the network of cooperative banks and
land development banks at state, district and block levels. With around twothird share in the total assets in the financial system, banks play an important
role. Of late, Indian banks have also diversified into areas such as merchant
banking, mutual funds, leasing and factoring.
The organized financial system comprises the following sub-systems:

1. Banking system
2. Cooperative system
3. Development Banking system
(i) Public sector
(ii) Private sector
4. Money markets and
5. Financial companies/institutions.
Over the years, the structure of financial institutions in India has developed
and become broad based. The system has developed in three areas - state,
cooperative and private. Rural and urban areas are well served by the
cooperative sector as well as by corporate bodies with national status. There
are more than 4, 58,782 institutions channelizing credit into the various areas
of the economy.
(ii) Unorganized Financial System
On the other hand, the unorganized financial system comprises of relatively
less 5controlled moneylenders, indigenous bankers, lending pawn brokers,
landlords, traders etc. This part of the financial system is not directly
amenable to control by the Reserve Bank of India (RBI). There are a host of
financial companies, investment companies and chit funds etc., which are
also not regulated by the RBI or the government in a systematic manner.
However, they are also governed by rules and regulations and are, therefore
within the orbit of the monetary authorities.
Formal and Informal Financial Systems:
The financial systems of most developing countries are characterized by coexistence and cooperation between formal and informal financial sectors.
This co-existence of two sectors is commonly referred to as financial
dualism The formal financial sector is characterized by the presence of an
organized, institutional and regulated system which caters to the financial
needs of the modern spheres of economy; the informal sector is an
unorganized, non-institutional and non-regulated system dealing with the
traditional and rural spheres of the economy.
Components of formal financial system:
The formal financial system consists of four segments or components. These
are: Financial Institutions, Financial markets, financial instruments and
financial services.
Financial Institutions: Financial Institutions are intermediaries that
mobilize savings and facilitate the allocation of funds in an efficient manner.
Financial institutions can be classified as banking and non-banking financial
institutions. Banking institutions are creators of credit while non-banking

financial institutions are purveyors of credit. While the liabilities of banks

are part of the money supply, this may not be true of non-banking financial
institutions. Financial institutions can also be classified as the term finance
institutions such as IDBI (Industrial development bank of India) ICICI
(Industrial credit and investment corporation of India) etc.
Financial Markets:
Financial markets are the mechanism enabling participants to deal in
financial claims. The markets also provide a facility in which their demands
and requirements interact to set a price for such claims. The main organized
financial markets in a country are normally money market and capital
market. The first is market for short term securities while the second is a
market for long term securities, i.e. securities having maturity period of one
year or more.
Financial markets are also classified as primary, market and secondary
market. While the primary market deals in new issues, the secondary market
deals for trading in outstanding or existing securities. There are two
components of the secondary market, OTC (over the counter) market and
Exchange traded market. The government securities market is an OTC
market, spot trades are negotiated or traded for immediate delivery and
payment while in the exchange traded market, trading takes place over a
trading cycle in stock exchanges. Derivatives markets are OTC in some
countries and exchange traded in some other countries.
Financial Instrument: A financial instrument is a claim against a person or
an institution for the payment at a future date a sum of money and/or a
periodic payment in the form of interest or dividend. The term and/or
implies that either of the payments will be sufficient but both of them may
be promised.
Financial securities may be primary or secondary securities. Primary
securities are also termed as direct securities as they are directly issued by
the ultimate borrowers of the funds to the ultimate savers. Examples of
primary or direct securities include equity shares and debentures. Secondary
securities are also referred to as indirect securities, as they are issued by
financial intermediaries to the ultimate savers. Bank deposits, mutual fund
units, and insurance policies are secondary securities.
Financial instruments differ in terms of marketability, liquidity, reversibility,
type of options, return, risk and transaction costs. Financial instruments help
the financial markets and the financial intermediaries to perform the
important role of channelizing funds from lenders to borrowers.

Financial Services: Financial intermediaries provide key financial services

such as merchant banking, leasing, hire purchase, credit-rating, and so on.
Financial services rendered by the financial intermediaries bridge the gap
between lack of knowledge on the part of investors and increasing
sophistication of financial instruments and markets. These financial services
are vital for creation of firms, industrial expansion, and economic growth.
Before investors lend money, they need to be reassured that it is safe to
exchange securities for funds. This reassurance is provided by the financial
regulator who regulates the conduct of the market, and intermediaries to
protect the investors interests. The Reserve Bank of India regulates the
money market and Securities and Exchange Board of India (SEBI) regulates
capital market.
Interaction among the Components:
These four sub-systems do not function in isolation. They are interdependent
and interact continuously with each other. Their interaction leads to the
development of a smoothly functioning financial system.
Financial institutions or intermediaries mobilize savings by issuing different
types of financial instruments which are traded in financial markets. To
facilitate the credit allocation process, they acquire specialization and render
specialized financial services.
Financial intermediaries have close links with the financial markets in the
economy. Financial institutions acquire, hold, and trade financial securities
which not only help in the credit-allocation process but also make the
financial markets larger, more liquid, and stable and diversified. Financial
intermediaries rely on financial markets to raise funds whenever they are in
need of some. This increases the competition between financial markets and
financial intermediaries for attracting investors and borrowers. The
development of new sophisticated markets has led to the development of
complex securities and complex portfolios. The evaluation of these complex
securities, portfolios, and strategies requires financial expertise which
financial intermediaries provide through financial services.
Functions of the Financial System:
A good financial system serves in the following ways:
One of the important functions of a financial system is to link the savers and
investors and thereby help in mobilizing and allocating the savings
efficiently and effectively. By acting as an efficient conduit for allocation of

resources, it permits continuous up gradation of technologies for promoting

growth on a sustained basis.
A financial system not only helps in selecting projects to be funded but also
inspires the operators to monitor the performance of the investment. It
provides a payment mechanism for the exchange of goods and services and
transfers economic resources through time and across geographic regions
and industries.
One of the most important functions of a financial system is to achieve
optimum allocation of risk bearing. It limits, pools, and trades the risks
involved in mobilizing savings and allocating credit. An efficient financial
system aims at containing risk within acceptable limits and reducing the cost
of gathering and analyzing information to assist operators in taking decisions
carefully.
It makes available price-related information which is a valuable assistance to
those who need to take economic and financial decisions.
A financial system minimizes situations where the information is
asymmetric and likely to affect motivations among operators or when one
party has the information and the other party does not. It provides financial
services such as insurance and pension and offers portfolio adjustment
facilities.
A financial system helps in the creation of a financial structure that lowers
the cost of transactions. This has a beneficial influence on the rate of return
to savers. It also reduces the cost of borrowing. Thus, the system generates
an impulse among the people to save more.
A well-functioning financial system helps in promoting the process of
financial deepening and broadening. Financial deepening refers to an
increase of financial assets as a percentage of Gross Domestic Product
(GDP). Financial broadening refers to building an increasing number and a
variety of participants and instruments.
Financial System Designs:
A financial system is a vertical arrangement of a well-integrated chain of
financial markets and financial institutions for providing financial
intermediation. Different designs of financial systems are found in different
countries. The structure of the economy, its pattern of evolution, and

political, technical and cultural differences affect the design (type) of

financial system.
Two prominent polar designs can be identified among the varieties that exist.
At one extreme is the bank-dominated system, such as in Germany, where a
few large banks play a dominant role and the stock market is not important.
At the other extreme is the market-dominated financial system, as in the US,
where financial markets play an important role while the banking industry is
much less concentrated.
In bank-based financial systems, banks play a pivotal role in mobilizing
savings, allocating capital, overseeing the investment decisions of corporate
managers, and providing risk-management facilities. In market based
financial systems, the securities markets share centrestage with banks in
mobilizing the societys savings to firms, exerting corporate control, and
easing risk management.
The other major industrial countries fall in between these two extremes. In
India, banks have traditionally been the dominant entities of financial
intermediation. The nationalization of banks, an administered interest rate
regime, and the government policy of favouring banks led to the
predominance of a bank-based financial system in India.
Financial Markets
Financial markets are an important component of the financial system. A
financial market is a mechanism for the exchange trading of financial
products under a policy framework. The participants in the financial markets
are the borrowers (issuers of securities), lender (buyers of securities), and
financial intermediaries.
Financial markets comprise two distinct types of markets:
(a) Money market
(b) Capital market
Money market: A money market is a market for short-term debt instruments
(maturity below one year). It is a highly liquid market wherein securities are
bought and sold in large denominations to reduce transaction costs. Call
money market, certificates of deposit, commercial paper, and treasury bills
are the major instruments/segments of the money market.
The function of a money market is
i. To serve as an equilibrating force that redistributes cash balances
in accordance with the liquidity needs of the participants;
ii. To form a basis for the management of liquidity and money in the
economy by monetary authorities; and
iii. To provide a reasonable access to the users of short-term money
for meeting their requirements at realistic prices.

As it facilitates the conduct of monetary policy, a money market

constitutes a very important segment of the financial system.
Capital market: A capital market is a market for long-term securities
(equity and debt). The purpose of capital market is to
i. Mobilize long-term savings to finance long-term investments;
ii. Provide risk-capital in the form of equity or quasi-equity to
entrepreneurs;
iii. Encourage broader ownership to productive assets;
iv. Provide liquidity with a mechanism enabling the investor to sell
financial assets;
v. Lower the costs of transactions and information; and
vi. Improve the efficiency of capital allocation through a competitive
pricing mechanism.
A capital market can be further classified into primary and secondary
markets. The primary market is meant for new issues and the secondary
market is a market where outstanding issues are traded. In other words,
the primary market creates long-term instruments for borrowings,
whereas the secondary market provides liquidity through the
marketability of these instruments. The secondary market is also known
as the stock market.
Money Market and Capital Market
There is strong link between the money market and the capital market:
i. Often, financial institutions actively involved in the capital market are
also involved in the money market.
ii. Funds raised in the money market are used to provide liquidity for
longer-term investment and redemption of funds raised in the capital
market.
iii. In the development process of financial markets, the development of
money market typically precedes the development of the capital
market.
Characteristics of Financial Markets:
1. Financial markets are characterized by a large volume of transactions
and a speed with which financial resources move from one market to
another.
2. There are various segments of financial markets such as stock
markets, bond markets primary and secondary segments, where
savers themselves decide when and where they should invest money.

3. There is scope of instant arbitrage among various markets and types

of instruments.
4. Financial markets are highly volatile and susceptible to panic and
distress selling as the behavior of a limited group of operators can get
generalized.
5. Markets are dominated by financial intermediaries who take
investment decisions as well as risks on behalf of their depositors.
6. Negative externalities are associated with financial markets. A failure
in any one segment of these markets may affect many other segments
of the market, including the non-financial markets.
7. Domestic financial markets are getting integrated with worldwide
financial markets. The failure and vulnerability in a particular
domestic market can have international ramifications. Similarly,
problems in external markets can affect the functioning of domestic
markets.
In view of the above characteristics, financial markets need to be closely
monitored and supervised.
Functions of Financial Markets
The cost of acquiring information and making transactions creates incentives
for the emergence of financial markets and institutions. Different types and
combinations of information and transaction costs motivate distinct financial
contracts, instruments, and institutions.
Financial markets perform various functions such as
a) Enabling economic units to exercise their time preference;
b) Separation, distribution, diversification, and reduction of risk;
c) Efficient payment mechanism;
d) Providing information about companies. This spurs investors to make
inquiries themselves and keep track of the companies activities with a
view to trading in their stock efficiently;
e) Transmutation or transformation of financial claims to suit the
preferences of both savers and borrowers;
f) Enhancing liquidity of financial claims through trading in securities;
g) Portfolio management.
A variety of services is provided by financial markets as they can alter
the rate of economic growth by altering the quality of these services.
Financial System and Economic Development:
The role of financial system in economic development has been a much
discussed topic among economists. Is it possible to influence the level of
national income, employment, standard of living, and social welfare through
variations in the supply of finance?

In what way financial development is affected by economic development?

There is no unanimity of views on such questions. A recent literature survey
concluded that the existing theory on this subject has not given any generally
accepted model to describe the relationship between finance and economic
development.
The importance of finance in development depends upon the desired nature
of development. In the environment-friendly, appropriate-technology-based,
decentralized Alternative Development Model, finance is not a factor of
crucial importance. But even in a conventional model of modem
industrialism, the perceptions in this regard vary a great deal.
One view holds that finance is not important at all. The opposite view
regards it to be very important. The third school takes a cautionary view. It
may be pointed out that there is a considerable weight of thinking and
evidence in favor of the third view also. Let us briefly explain these
viewpoints one by one.
In his model of economic growth, Solow has argued that growth results
predominantly from technical progress, which is exogenous, and not from
the increase in labor and capital. Therefore, money and finance and the
policies about them cannot contribute to the growth process.
Effects of Financial System on Saving and Investment:
It has been argued that men, materials, and money are crucial inputs in
production activities. The human capital and physical capital can be bought
and developed with money. In a sense, therefore, money, credit, and finance
are the lifeblood of the economic system. Given the real resources and
suitable attitudes, a well-developed financial system can contribute
significantly to the acceleration of economic development through three
routes. First, technical progress is endogenous; human and physical capital is
its important sources and any increase in them requires higher saving and
investment, which the financial system helps to achieve. Second, the
financial system contributes to growth not only via technical progress but
also in its own right. Economic development greatly depends on the rate of
capital formation. The relationship between capital and output is strong,
direct, and monotonic (the position which is sometimes referred to as
capital fundamentalism). Now, the capital formation depends on whether
finance is made available in time, in adequate quantity, and on favorable
terms-all of which a good financial system achieves. Third, it also enlarges
markets over space and time; it enhances the efficiency of the function of
medium of exchange and thereby helps in economic development.
We can conclude from the above that in order to understand the importance
of the financial system in economic development, we need to know its

impact on the saving and investment processes. The following theories have
analyzed this impact:
(a) The Classical Prior Saving Theory,
(b) Credit Creation or Forced Saving or Inflationary Financing Theory,
(c) Financial Repression Theory,
(d) Financial Liberalization Theory.
The Prior Saving Theory regards saving as a prerequisite of investment, and
stresses the need for policies to mobilize saving voluntarily for investment
and growth. The financial system has both the scale and structure effect on
saving and investment. It increases the rate of growth (volume) of saving
and investment, and makes their composition, allocation, and utilization
more optimal and efficient. It activates saving or reduces idle saving; it also
reduces unfructified investment and the cost of transferring saving to
investment. How is this achieved? In any economy, in a given period of
time, there are some people whose current expenditures is less than their
current incomes, while there are others whose current expenditures exceed
their current incomes. In well-known terminology, the former are called the
ultimate savers or surplus--spending-units, and the latter are called the
ultimate investors or the deficit-spending-units.
Modern economies are characterized:
(a) By the ever-expanding nature of business organizations such as jointstock companies or corporations,
(b) By the ever-increasing scale of production,
(c) By the separation of savers and investors, and
(d) By the differences in the attitudes of savers (cautious, conservative, and
usually averse to taking risks) and investors (dynamic and risk takers).
In these conditions, which Samuelson calls the dichotomy of saving and
investment, it is necessary to connect the savers with the investors.
Otherwise, savings would be wasted or hoarded for want of investment
opportunities, and investment plans will have to be abandoned for want of
savings. The function of a financial system is to establish a bridge between
the savers and investors and thereby help the mobilization of savings to
enable the fructification of investment ideas into realities. Figure below
reflects this role of the financial system in economic development.
Relationship between Financial System and Economic Development

A financial system helps to increase output by moving the economic system

towards the existing production frontier. This is done by transforming a
given total amount of wealth into more productive forms. It induces people
to hold fewer saving in the form of precious metals, real estate land,
consumer durables, and currency, and to replace these assets by bonds,
shares, units, etc. It also directly helps to increase the volume and rate of
saving by supplying diversified portfolio of such financial instruments, and
by offering an array of inducements and choices to woo the prospective
saver. The growth of banking habit helps to activate saving and undertake
fresh saving. The saving is said to be institution-elastic i.e., easy access,
nearness, better return, and other favorable features offered by a welldeveloped financial system lead to increased saving.
A financial system helps to increase the volume of investment also. It
becomes possible for the deficit spending units to undertake more
investment because it would enable them to command more capital. As
Schumpeter has said, without the transfer of purchasing power to an
entrepreneur, he cannot become the entrepreneur. Further, it encourages

investment activity by reducing the cost of finance and risk. This is done by
providing insurance services and hedging opportunities, and by making
financial services such as remittance, discounting, acceptance and
guarantees available. Finally, it not only encourages greater investment but
also raises the level of resource allocational efficiency among different
investment channels. It helps to sort out and rank investment projects by
sponsoring, encouraging, and selectively supporting business units or
borrowers through more systematic and expert project appraisal, feasibility
studies, monitoring, and by generally keeping a watch over the execution
and management of projects.
The contribution of a financial system to growth goes beyond increasing
prior-saving-based investment. There are two strands of thought in this
regard. According to the first one, as emphasized by Kalecki and
Schumpeter, financial system plays a positive and catalytic role by creating
and providing finance or credit in anticipation of savings. This, to a certain
extent, ensures the independence of investment from saving in a given
period of time. The investment financed through created credit generates the
appropriate level of income. This in turn leads to an amount of savings,
which is equal to the investment already undertaken. The First Five Year
Plan in India echoed this view when it stated that judicious credit creation in
production and availability of genuine savings has also a part to play in the
process of economic development. It is assumed here that the investment out
of created credit results in prompt income generation. Otherwise, there will
be sustained inflation rather than sustained growth.
The second strand of thought propounded by Keynes and Tobin argues that
investment, and not saving, is the constraint on growth, and that investment
determines saving and not the other way round. The monetary expansion and
the repressive policies result in a number of saving and growth promoting
forces:
(a) If resources are unemployed, they increase aggregate demand,
output, and saving;
(b) If resources are fully employed, they generate inflation which
lowers the real rate of return on financial investments. This in
turn, induces portfolio shifts in such a manner that wealth
holders now invest more in real, physical capital, thereby
increasing output and saving;
(c) Inflation changes income distribution in favour of profit earners
(who have a high propensity to save) rather than wage earners
(who have a low propensity to save), and thereby increases
saving; and

(d) Inflation imposes tax on real money balances and thereby

transfers resources to the government for financing investment.
The extent of contribution of the financial sector to saving, investment, and
growth is said to depend upon its being free or repressed (regulated). One
school of thought argues that financial repression and the low/ negative real
interest rates which go along with it encourage people
(i)
To hold their saving in unproductive real assets,
(ii)
To be rent -seekers because of non-market allocation of
investible funds
(iii) To be indulgent which lowers the rate of saving,
(iv) To misallocate resources and attain inefficient investment profile,
and
(v)
To promote capital intensive industrial structure inconsistent
with the factor-endowment of developing countries. Financial
liberalisation or deregulation corrects these ill effects and leads to
financial as well as economic development. However, as indicated
earlier, some economists believe that financial repression is
beneficial.

Q2. Financial Markets are an important component of

the financial system, what are different types of
financial markets? Explain
Financial Markets: A Financial Market can be defined as the market in
which financial assets are created or transferred. As against a real transaction
that involves exchange of money for real goods or services, a financial
transaction involves creation or transfer of a financial asset. Financial Assets
or Financial Instruments represents a claim to the payment of a sum of
money sometime in the future and /or periodic payment in the form of
interest or dividend.
Money Market- The money market is a wholesale debt market for low-risk,
highly-liquid, short-term instrument. Funds are available in this market for
periods ranging from a single day up to a year. This market is dominated
mostly by government, banks and financial institutions.
Capital Market - The capital market is designed to finance the long-term
investments. The transactions taking place in this market will be for periods
over a year.
Forex Market - The Forex market deals with the multicurrency
requirements, which are met by the exchange of currencies. Depending on
the exchange rate that is applicable, the transfer of funds takes place in this
market. This is one of the most developed and integrated market across the
globe.
Credit Market- Credit market is a place where banks, Financial Institutions
and Non-Banking Financial Corporations lend short, medium and long-term
loans to corporate and individuals.

Constituents of a Financial System:

Financial Intermediation: Having designed the instrument, the issuer

should then ensure that these financial assets reach the ultimate investor in
order to garner the requisite amount. When he borrower of funds
approaches the financial market to raise funds, mere issue of securities will
not suffice. Adequate information of the issue, issuer and the security
should be passed on to take place. There should be a proper channel within
the financial system to ensure such transfer. To serve this purpose, financial
intermediaries came into existence. Financial intermediation in the
organized sector is conducted by a wide range of institutions functioning
under the overall surveillance of the Reserve Bank of India. In the initial
stages, the role of the intermediary was mostly related to ensure transfer of
funds from the lender to the borrower. This service was offered by banks,
FIs, brokers, and dealers. However, as the financial system widened along
with the developments taking place in the financial markets, the scope of its
operations also widened. Some of the important intermediaries operating ink
the financial markets include; investment bankers, underwriters, stock
exchanges, registrars, depositories, custodians, portfolio managers, mutual
funds, financial advertisers financial consultants, primary dealers, satellite
dealers, self-regulatory organizations, etc. Though the markets are different,
there may be a few intermediaries offering their services in more than one
market e.g. underwriter. However, the services offered by them vary from
one market to another.
Intermediary
Stock Exchange
Investment Bankers

Market
Capital Market
Capital Market,
Market

Role
Secondary Market to securities
Credit Corporate advisory services,
Issue of securities

Capital Market, MoneySubscribe to unsubscribed

Market
portion of securities
Issue securities to the investors
Registrars, Depositories,
Capital Market
on behalf of the company and
Custodians
handle share transfer activity
Primary Dealers Satellite
Market making in government
Money Market
Dealers
securities
Forex Dealers
Forex Market
Ensure exchange in currencies
Financial Instruments
Underwriters

(a) Money Market Instruments: Money market is a very important

segment of the financial system of a country. It is the market dealing in
monetary assets of short term nature. Short term funds up to one year and
financial assets that are close substitutes for money are dealt in the money
market.
Features: The money Market is a whole sale market. The volumes are very
large and generally transactions are settled on daily basis. Trading in the
money market is conducted over the telephone followed by written
confirmation from both the borrowers and lenders. There are large numbers
of participants in the money market: commercial banks, mutual funds,
investment institutions, financial institutions, and finally the central bank of
a country. The banks operations ensure that the liquidity and short term
interest rates are maintained at the levels consistent with the objective of
maintaining price and exchange rate stability. The central bank occupies a
strategic position in the money market. The money market can obtain funds
from central bank either by borrowing or through sale of securities. The
bank influences liquidity and interest rates by open market operations,
REPO transactions, changes in Bank Rate , cash Reserve Requirements and
by regulating access to its accommodation. A well-developed money market
contributes to an effective implementation of the monetary policy.
Some of the important money market instruments are briefly discussed
below;
1.
Call/Notice Money
2.

Treasury Bills

3.

Term Money

4.

Certificate of Deposit

5.

Commercial Papers

1. Call /Notice-Money Market: Call/Notice money is the money borrowed

or lent on demand for a very short period. When money is borrowed or lent
for a day, it is known as Call (Overnight) Money. Intervening holidays
and/or Sunday are excluded for this purpose. Thus money, borrowed on a
day and repaid on the next working day, (irrespective of the number of
intervening holidays) is "Call Money". When money is borrowed or lent for
more than a day and up to 14 days, it is "Notice Money". No collateral
security is required to cover these transactions.
2. Inter-Bank Term Money: Inter-bank market for deposits of maturity
beyond 14 days is referred to as the term money market. The entry
restrictions are the same as those for Call/Notice Money except that, as per
existing regulations, the specified entities are not allowed to lend beyond 14
days.
3. Treasury Bills: Treasury Bills are short term (up to one year) borrowing
instruments of the union government. It is an IOU of the Government. It is a
promise by the Government to pay a stated sum after expiry of the stated
period from the date of issue (14/91/182/364 days i.e. less than one year).
They are issued at a discount to the face value, and on maturity the face
value is paid to the holder. The rate of discount and the corresponding issue
price are determined at each auction.
4. Certificate of Deposits: Certificates of Deposit (CDs) is a negotiable
money market instrument and issued in dematerialized form or as a usance
Promissory Note, for funds deposited at a bank or other eligible financial
institution for a specified time period. CDs are similar to traditional term
deposits but are negotiable and can be traded in the secondary market. It is
often a bearer security and there is a single payment principal and an interest
rate at the end of the maturity period. The bulk of the deposits have a very
short duration of 1,3 or 6 months. For long term CDs there is a fixed
coupon or a floating rate coupon. For CDs with floating rate coupons, the
life of CD is subdivided into sub periods of usually six months. Interest is
fixed at the beginning of each period and is based on LIBOR or US Treasury
bill rate or primary rate
5. Commercial Paper: CP is a note in evidence of the debt obligation of the
issuer. On issuing commercial paper the debt obligation is transformed into
an instrument. CP is thus an unsecured promissory note privately placed
with investors at a discount rate to face value determined by market forces.

CP is freely negotiable by endorsement and delivery. In India a company

shall be eligible to issue CP provided - (a) the tangible net worth of the
company, as per the latest audited balance sheet, is not less than Rs. 5 crores;
(b) the working capital (fund-based) limit of the company from the banking
system is not less than Rs.4 crores and (c) the borrowed account of the
company is classified as a Standard Asset by the financing banks (d) shares
are listed on stock exchange (e) current ratio is 1:33:1. The minimum
maturity period of CP is 7 days. The minimum credit rating shall be P-2 of
CRISIL or such equivalent rating by other agencies.
Usance: Commercial paper should be issued for a minimum period of 30
days and a maximum of one year. No grace period is allowed for payment
and if the maturity period falls on a holiday it should be paid on the previous
working day. Every issue of commercial paper is treated as a fresh issue.
Denomination: Commercial paper is issued in denomination of Rs 5 lakhs.
But the minimum lot or investment is Rs 25 lakhs (face value) per investor.
The secondary market transactions can be Rs 5 lakhs of multiples thereof.
Total amount to be proposed to be issued should be raised within two weeks
from the date on which the proposal is taken on record by the bank.
Investor: Commercial paper can be issued to any person, banks, companies
and other registered corporate bodies and unincorporated bodies. Issue to
NRI does can only be on a non-repairable basis and is non-transferable. The
paper issued to the NRI should state that it is non-repairable and nonendorsable
Procedure of Issue: Commercial paper is issued only through the bankers
who have sanctioned working capital limits to the company. It is counted as
a part of working capital. Unlike public deposits, commercial paper really
cannot augment working capital resources. There is no increase in the
overall short term borrowing facilities.
(b) Capital Market Instruments: The capital market generally consists of
the following long term period i.e., more than one year period, financial
instruments; in the equity segment Equity shares, preference shares,
convertible preference shares, non-convertible preference shares etc and in
the debt segment debentures, zero coupon bonds, deep discount bonds etc.
Hybrid Instruments: Hybrid instruments have both the features of equity
and debenture. This kind of instruments is called as hybrid instruments.
Examples are convertible debentures, warrants etc.

CAPITAL MARKET INSTRUMENTS:

SHARES: Capital refers to the amount invested in the company so that it
can carry on its activities. In a company capital refers to "share capital". The
capital clause in Memorandum of Association must state the amount of
capital with which company is registered giving details of number of shares
and the type of shares of the company. A company cannot issue share capital
in excess of the limit specified in the Capital clause without altering the
capital clause of the MA. The following different terms are used to denote
different aspects of share capital:1. Nominal, authorized or registered capital means the sum mentioned in
the capital clause of Memorandum of Association. It is the maximum
amount which the company raises by issuing the shares and on which the
registration fee is paid. This limit is cannot be exceeded unless the
Memorandum of Association is altered.
2. Issued capital means that part of the authorized capital which has been
offered for subscription to members and includes shares allotted to members
for consideration in kind also.
3. Subscribed capital means that part of the issued capital at nominal or
face value which has been subscribed or taken up by purchaser of shares in
the company and which has been allotted.
4. Called-up capital means the total amount of called up capital on the
shares issued and subscribed by the shareholders on capital account. I.e. if
the face value of a share is Rs. 10/- but the company requires only Rs. 2/- at
present, it may call only Rs. 2/- now and the balance Rs.8/- at a later date.
Rs. 2/- is the called up share capital and Rs. 8/- is the uncalled share capital.
5. Paid-up capital means the total amount of called up share capital which
is actually paid to the company by the members. In India, there is the
concept of par value of shares. Par value of shares means the face value of
the shares. A share under the Companies act, can either of Rs10 or Rs100 or
any other value which may be the fixed by the Memorandum of Association
of the company. When the shares are issued at the price which is higher than
the par value say, for example Par value is Rs10 and it is issued at Rs15 then
Rs5 is the premium amount i.e., Rs10 is the par value of the shares and Rs5
is the premium. Similarly when a share is issued at an amount lower than the
par value, say Rs8, in that case Rs2 is discount on shares and Rs10 will be
par value.

Types of shares: Shares in the company may be similar i.e. they may carry
the same rights and liabilities and confer on their holders the same rights,
liabilities and duties. There are two types of shares under Indian Company
Law:1. Equity shares means that part of the share capital of the company which
are not preference shares.
2. Preference Shares means shares which fulfill the following 2 conditions.
Therefore, a share which is does not fulfill both these conditions is an equity
share.
a. It carries Preferential rights in respect of Dividend at fixed amount or
at fixed rate i.e. dividend payable is payable on fixed figure or percent
and this dividend must paid before the holders of the equity shares can
be paid dividend.
b. It also carries preferential right in regard to payment of capital on
winding up or otherwise. It means the amount paid on preference
share must be paid back to preference shareholders before anything in
paid to the equity shareholders. In other words, preference share
capital has priority both in repayment of dividend as well as capital.
Types of Preference Shares
1. Cumulative or Non-cumulative: A non-cumulative or simple preference
shares gives right to fixed percentage dividend of profit of each year. In case
no dividend thereon is declared in any year because of absence of profit, the
holders of preference shares get nothing nor can they claim unpaid dividend
in the subsequent year or years in respect of that year. Cumulative preference
shares however give the right to the preference shareholders to demand the
unpaid dividend in any year during the subsequent year or years when the
profits are available for distribution. In this case dividends which are not
paid in any year are accumulated and are paid out when the profits are
available.
2. Redeemable and Non- Redeemable: Redeemable Preference shares are
preference shares which have to be repaid by the company after the term of
which for which the preference shares have been issued.
Irredeemable Preference shares means preference shares need not repaid by
the company except on winding up of the company. However, under the
Indian Companies Act, a company cannot issue irredeemable preference

shares. In fact, a company limited by shares cannot issue preference shares

which are redeemable after more than 10 years from the date of issue. In
other words the maximum tenure of preference shares is 10 years. If a
company is unable to redeem any preference shares within the specified
period, it may, with consent of the Company Law Board, issue further
redeemable preference shares equal to redeem the old preference shares
including dividend thereon. A company can issue the preference shares
which from the very beginning are redeemable on a fixed date or after
certain period of time not exceeding 10 years provided it comprises of
following conditions :1. It must be authorized by the articles of association to make such an
issue.
2. The shares will be only redeemable if they are fully paid up.
3. The shares may be redeemed out of profits of the company which
otherwise would be available for dividends or out of proceeds of new
issue of shares made for the purpose of redeem shares.
4. If there is premium payable on redemption it must have provided out
of profits or out of shares premium account before the shares are
redeemed.
5. When shares are redeemed out of profits a sum equal to nominal
amount of shares redeemed is to be transferred out of profits to the
capital redemption reserve account. This amount should then be
utilized for the purpose of redemption of redeemable preference
shares. This reserve can be used to issue of fully paid bonus shares to
the members of the company.
3. Participating Preference Share or non-participating preference
shares: Participating Preference shares are entitled to a preferential dividend
at a fixed rate with the right to participate further in the profits either along
with or after payment of certain rate of dividend on equity shares. A nonparticipating share is one which does not such right to participate in the
profits of the company after the dividend and capitals have been paid to the
preference shareholders.
Sweat Equity and Employee Stock Options: Sweat Equity Shares mean
equity shares issued by the company to its directors and / or employees at a
discount or for consideration other than cash for providing know how or
making available the rights in the nature of intellectual property rights or

value additions. A company may issue sweat equity shares of a class of

shares already issued if the following conditions are fulfilled:i.
ii.

A special resolution to the effect is passed at a general meeting of the

company
The resolution specifies the number of shares, the current market
price, consideration, if any, and the class of employees to whom the
shares are to be issued

iii.

At least 1 year has passed since the date on which the company
became eligible to commence business.

iv.

In case of issue of such shares by a listed company, the Sweat Equity

Shares are listed on a recognized stock exchange in accordance with
SEBI regulations and where the company is not listed on any stock
exchange, the prescribed rules are complied with.

DEBENTURES: A type of debt instrument that is not secured by physical

asset or collateral. Debentures are backed only by the general
creditworthiness and reputation of the issuer. Both corporations and
governments frequently issue this type of bond in order to secure capital.
Like other types of bonds, debentures are documented in an indenture.
Debentures have no collateral. Bond buyers generally purchase debentures
based on the belief that the bond issuer is unlikely to default on the
repayment.
An example of a government debenture would be any government-issued
Treasury bond (T-bond) or Treasury bill (T-bill). T-bonds and T-bills are
generally considered risk free because governments, at worst, can print off
more money or raise taxes to pay these types of debts.
A debenture is a long-term debt instrument used by governments and large
companies to obtain funds. It is defined as "any form of borrowing that
commits a firm to pay interest and repay capital. In practice, these are
applied to long term loans that are secured on a firm's assets. Where
securities are offered, loan stocks or bonds are termed 'debentures' in the UK
or 'mortgage bonds' in the US.
The advantage of debentures to the issuer is they leave specific assets burden
free, and thereby leave them open for subsequent financing. Debentures are
generally freely transferable by the debenture holder. Debenture holders
have no voting rights and the interest given to them is a charge against profit

There are two types of debentures:

1. Convertible Debentures, which can be converted into equity shares of
the issuing company after a predetermined period of time.
2. Non-Convertible Debentures, which cannot be converted into equity
shares of the liable company. They usually carry higher interest rates than
the convertible ones
A convertible note (or, if it has a maturity of greater than 10 years, a
"convertible debenture") is a type of bond that can be converted into shares
of stock in the issuing company or cash of equal value, at some preannounced ratio. It is a hybrid security with debt- and equity-like features.
Although it typically has a low coupon rate, the holder is compensated with
the ability to convert the bond to common stock at an agreed upon price and
thereby participate in further growth in the company's equity value.
From the issuer's perspective, the key benefit of raising money by selling
convertible bonds is a reduced cash interest payment. However, in exchange
for the benefit of reduced interest payments, the value of shareholder's
equity is reduced due to the stock dilution expected when bondholders
convert their bonds into new shares. The convertible bond markets in the
United States and Japan are of primary global importance. These two
domestic markets are the largest in terms of market capitalization. Other
domestic convertible bond markets are often illiquid, and pricing is
frequently non-standardized.

USA: It is a highly liquid market compared to other domestic markets.

Domestic investors have tended to be most active within US
convertibles
Japan: In Japan, the convertible bond market is relatively more
regulated than other markets. It consists of a large number of small
issuers.
Europe: Convertible bonds have become an increasingly important
source of finance for firms in Europe. Compared to other global
markets, European convertible bonds tend to be of high credit quality.
Asia (ex Japan): The Asia region provides a wide range of choice for
an investor. The maturity of Asian convertible bond markets varies
widely.
Canada: Canadian convertible bonds are exchange traded. Most of the
Canadian convertible bond market consists of unsecured sub-

investment grade bonds with high yields that are reflective of the
issuer's risk of default.
Non-Convertible Debentures are those that cannot be converted into equity
shares of the issuing company, as opposed to Convertible debentures, which
can be. Non-convertible debentures normally earn a higher interest rate than
convertible debentures do.
Bonds: In finance, a bond is a debt security, in which the authorized issuer
owes the holders a debt and is obliged to repay the principal and interest (the
coupon) at a later date, termed maturity. A bond is simply a loan in the form
of a security with different terminology: The issuer is equivalent to the
borrower, the bond holder to the lender, and the coupon to the interest.
Bonds enable the issuer to finance long-term investments with external
funds. Note that certificates of deposit (CDs) or commercial paper are
considered to be money market instruments and not bonds. Bonds and stocks
are both securities, but the major difference between the two is that stockholders are the owners of the company (i.e., they have an equity stake),
whereas bond-holders are lenders to the issuing company. Another difference
is that bonds usually have a defined term, or maturity, after which the bond
is redeemed, whereas stocks may be outstanding indefinitely.
Issuing bonds: Bonds are issued by public authorities, credit institutions,
companies and supranational institutions in the primary markets. The most
common process of issuing bonds is through underwriting. In underwriting,
one or more securities firms or banks, forming a syndicate, buy an entire
issue of bonds from an issuer and re-sell them to investors. Government
bonds are typically auctioned.
Features of bonds: The most important features of a bond are:

Nominal, principal or face amountthe amount on which the issuer

pays interest, and which has to be repaid at the end.

Issue pricethe price at which investors buy the bonds when they
are first issued, typically $1,000.00. The net proceeds that the issuer
receives are calculated as the issue price, less issuance fees, times the
nominal amount.

Maturity datethe date on which the issuer has to repay the nominal
amount. As long as all payments have been made, the issuer has no
more obligations to the bond holders after the maturity date. The

length of time until the maturity date is often referred to as the term or
tenure or maturity of a bond.
The maturity can be any length of time, although debt securities with a
term of less than one year are generally designated money market
instruments rather than bonds. Most bonds have a term of up to thirty
years. Some bonds have been issued with maturities of up to one hundred
years, and some even do not mature at all. In early 2005, a market
developed in Euros for bonds with a maturity of fifty years. In the market
for U.S. Treasury securities, there are three groups of bond maturities:
o
o
o

short term (bills): maturities up to one year;

medium term (notes): maturities between one and ten years;
Long term (bonds): maturities greater than ten years.

Couponthe interest rate that the issuer pays to the bond holders.
Usually this rate is fixed throughout the life of the bond. It can also
vary with a money market index, such as LIBOR, or it can be even
more exotic. The name coupon originates from the fact that in the
past, physical bonds were issued which had coupons attached to them.
On coupon dates the bond holder would give the coupon to a bank in
exchange for the interest payment.

Coupon datesthe dates on which the issuer pays the coupon to the
bond holders. In the U.S., most bonds are semi-annual, which means
that they pay a coupon every six months. In Europe, most bonds are
annual and pay only one coupon a year.

Indentures and Covenantsan indenture is a formal debt agreement

that establishes the terms of a bond issue, while covenants are the
clauses of such an agreement. Covenants specify the rights of
bondholders and the duties of issuers, such as actions that the issuer is
obligated to perform or is prohibited from performing.

In the U.S., federal and state securities and commercial laws apply to the
enforcement of these agreements, which are construed by courts as
contracts between issuers and bondholders.
The terms may be changed only with great difficulty while the bonds are
outstanding, with amendments to the governing document generally
requiring approval by a majority (or super-majority) vote of the
bondholders.

Q3. What are characteristics and functions of financial

markets?
Characteristics of Financial Markets:
Financial markets are characterized by a large volume of transactions
and a speed with which financial resources move from one market to
another.
There are various segments of financial markets such as stock
markets, bond markets primary and secondary segments, where
savers themselves decide when and where they should invest money.
There is scope of instant arbitrage among various markets and types
of instruments.
Financial markets are highly volatile and susceptible to panic and
distress selling as the behavior of a limited group of operators can get
generalized.
Markets are dominated by financial intermediaries who take
investment decisions as well as risks on behalf of their depositors.
Negative externalities are associated with financial markets. A failure
in any one segment of these markets may affect many other segments
of the market, including the non-financial markets.
Domestic financial markets are getting integrated with worldwide
financial markets. The failure and vulnerability in a particular
domestic market can have international ramifications. Similarly,
problems in external markets can affect the functioning of domestic
markets.
In view of the above characteristics, financial markets need to be closely
monitored and supervised.
Functions of Financial Markets:
The cost of acquiring information and making transactions creates incentives
for the emergence of financial markets and institutions. Different types and
combinations of information and transaction costs motivate distinct financial
contracts, instruments, and institutions.
Financial markets perform various functions such as:
(i) -Enabling economic units to exercise their time preference;

(ii) -Separation, distribution, diversification, and reduction of risk;

(iii) -Efficient payment mechanism;
(iv) -Providing information about companies. This spurs investors to
make inquiries themselves and keep track of the companies
activities with a view to trading in their stock efficiently;
(v) -Transmutation or transformation of financial claims to suit the
preferences of both savers and borrowers;
(vi) -Enhancing liquidity of financial claims through trading in
securities; and
(vii) -Portfolio management.
A variety of services is provided by financial markets as they can alter
the rate of economic growth by altering the quality of these services.
Functions of the Financial System:
A good financial system serves in the following ways:
One of the important functions of a financial system is to link the savers and
investors and thereby help in mobilizing and allocating the savings
efficiently and effectively. By acting as an efficient conduit for allocation of
resources, it permits continuous up gradation of technologies for promoting
growth on a sustained basis.
A financial system not only helps in selecting projects to be funded but also
inspires the operators to monitor the performance of the investment. It
provides a payment mechanism for the exchange of goods and services and
transfers economic resources through time and across geographic regions
and industries.
One of the most important functions of a financial system is to achieve
optimum allocation of risk bearing. It limits, pools, and trades the risks
involved in mobilizing savings and allocating credit. An efficient financial
system aims at containing risk within acceptable limits and reducing the cost
of gathering and analyzing information to assist operators in taking decisions
carefully.
It makes available price-related information which is a valuable assistance to
those who need to take economic and financial decisions.
A financial system minimizes situations where the information is
asymmetric and likely to affect motivations among operators or when one
party has the information and the other party does not. It provides financial
services such as insurance and pension and offers portfolio adjustment
facilities.

A financial system helps in the creation of a financial structure that lowers

the cost of transactions. This has a beneficial influence on the rate of return
to savers. It also reduces the cost of borrowing. Thus, the system generates
an impulse among the people to save more.
A well-functioning financial system helps in promoting the process of
financial deepening and broadening. Financial deepening refers to an
increase of financial assets as a percentage of Gross Domestic Product
(GDP). Financial broadening refers to building an increasing number and a
variety of participants and instruments.
Functions of Stock Exchange:
Stock Exchanges are established for the purpose of assisting, regulating and
controlling business of buying, selling and dealing in securities. Stock
Exchange provides a market for the trading of securities to individuals and
organizations seeking to invest their saving or excess funds through the
purchase of securities. It provides a physical location for buying and selling
securities that have been listed for trading on that exchange. It establishes
rules for fair trading practices and regulates the trading activities of its
members according to those rules
The exchange itself does not buy or sell the securities, nor does it set prices
for them. It Provides:
Fair dealing: The exchange assures that no investor will have an
undue advantage over other market participants
Efficient Market: This means that orders are executed and transactions
are settled in the fastest possible way
Transparency: Investor make informed and intelligent decision about
the particular stock based on information. Listed companies must
disclose information in timely, complete and accurate manner to the
Exchange and the public on a regular basis Required information
include stock price, corporate conditions and developments dividend,
mergers and joint ventures, and management changes etc
Doing Business: People who buy or sell stock on an exchange do so
through a broker The broker takes your order to the floor of the
exchange and looks for a broker representing someone wanting to
buy or sell. If a mutually agreeable price is found the trade is made

 Maintains active Trading: A continuous trading on exchange increases

the liquidity or marketability of the shares traded on the stock
exchange.
Fixation of prices: Price is determined by the transactions that flow
from investors demand and suppliers preferences. Usually the traded
process is made known to the public. This helps investors to make
better decisions.
Ensure safe and fair dealing: The rules regulations and by laws of the
stock exchanges provide a measure of safety to the investors.
Aids in financing the industry: A continuous market for shares
provides a favorable climate for raising capital. The negotiability of
the securities helps the companies to raise long term funds. This
simulates capital formation.
Dissemination of information: Stock exchanges provide information
through various publications. They publish the shares prices on daily
basis along with the volume traded
Performance inducer: The prices of stocks reflect the performance of
the traded companies. This makes the corporate more concerned with
its public image and tries to maintain good performance.
Self-regulating Organization: The stock exchanges are self-regulating
organizations .The stock exchanges monitor the integrity of their
members, brokers and listed companies and clients. Continuous
internal audit safeguards the investors against unfair trade practices.
Regulatory Framework:
A three tier regulatory structure consists of Ministry of Finance, the
Financial Market regulator and the Central bank of the country.

MOF

Primary market and

Primary dealers

Central
Bank

Monetary Policy
Settlement systems

Public Finance
Debt Management
Legislation

Financial
Market
Regulator

Market intermediaries
Collective investment
Secondary market

Ministry of Finance: The ministry of finance has the power to approve the
appointments of executive chiefs and nomination of public representatives in
the governing Boards of the stock exchanges. It has the responsibility of
preventing undesirable speculation.
Central bank of a country: Central bank of a country through its operations
keeps a check on the operations of the stock market. It regulates the business
of stock exchange, other security market and even the mutual funds.
Registration and regulation of other market intermediaries are also carried
out by Central bank.
Financial Market Regulators: Other financial market regulators are market
intermediaries (Securities and Exchange Commission).They function
particularly when market is poorly organized.
They set minimum entry standards;
Requires to comply with standards for internal organization and
control;
Sets limits for initial and ongoing capital;
It ensures proper management of risk;
It sets high standards of conducts;
Provides procedures for dealing with the failure of an intermediary.
Global Depositary Receipt (GDR):
Global Depository Receipt means any instrument in the form of a depository
receipt or certificate created by the overseas depository bank outside India
and issued to non-resident investors against the issue of ordinary shares or
Foreign Currency Convertible Bonds of issuing company.
Among the Indian Companies, Reliance Industries Ltd. was the first
company to raise funds through a GDR issue.
Characteristics:

Global Depository Receipt (GDR) - certificate issued by international

bank, which can be subject of worldwide circulation on capital
markets.
A financial instrument used by private markets to raise capital
denominated in either U.S. dollars or euros.
GDR's are emitted by banks, which purchase shares of foreign
companies and deposit it on the accounts.

Global Depository Receipt facilitates trade of shares, especially those

from emerging markets. Prices of GDR's are often close to values of
related shares.
Indian companies are allowed to raise equity capital in the
international market through the issue of GDR/ADRs/FCCBs.
These are not subject to any ceilings on investment.
An applicant company seeking Government's approval in this regard
should have a consistent track record for good performance (financial
or otherwise) for a minimum period of 3 years. This condition can be
relaxed for infrastructure projects such as power generation,
telecommunication, petroleum exploration and refining, ports, airports
and roads.
There is no restriction on the number of GDRs/ADRs/FCCBs to be
floated by a company or a group of companies in a financial year.
There are no end-use restrictions on GDRs/ADRs issue proceeds,
except for an express ban on investment in real estate and stock
markets.
External Commercial Borrowings (ECB) includes:

1.
2.
3.

Commercial Bank Loans,

Buyers Credit,
Suppliers Credit,
4.
Securitized Instruments Such As Floating Rate Notes, Fixed Rate
Bonds etc.
5.
Credit From Official Export Credit Agencies,
6.
Commercial Borrowings From The Private Sector Window Of
Multilateral Financial Institutions e.g. IFC
7.
Investment by Foreign Institutional Investors (FIIs) In Dedicated Debt
Funds.
Characteristics of ECBs

ECB can be raised from any internationally recognized source like

banks, export credit agencies, suppliers of equipment, foreign
collaborations, foreign equity - holders, international capital
markets etc.
ECBs can be used for any purpose (rupee-related expenditure as well
as imports) except for investment in stock market and speculation in
real estate.

They are a source of finance for Indian corporates for expansion of

existing capacity as well as for fresh investment.
ECBs provided an additional source of funds to the Indian companies,
allowing them to supplement domestically available resources and to
take advantage of lower international interest rates.
The focus of the ECB policy is to provide flexibility in borrowings by
Indian corporates, and at the same time maintain prudent limits for
total external borrowings.
The guiding principles of the policy are to keep borrowing maturities
long, costs low, and encourage infrastructure and export sector
financing, which are crucial for the overall growth of the economy.

ECB entitlement for new projects

All infrastructure and Greenfield
50% of the total project cost
projects
Telecom Projects

Up to 50% of the project cost (including

license fees)

Rights Issue: A rights issue involves selling securities in the primary market
by issuing rights to the existing shareholders. In this method the company
gives the privilege to its existing shareholders for the subscription of the new
shares on prorate basis. A company making a rights issue sends a letter of
offer along with a composite application form consisting of four parts A, B,
C, and D. Part A is meant for acceptance of the offer. Part B is used if the
shareholder wants to renounce his rights in favor of someone else. Part C is
filled by the person in whose favor the renunciation has been made. Part D is
used to request the split of the shares. The composite application form must
be mailed to the company within a stipulated period, which is usually 30
days. The shares that remain unsubscribed will be offered to the public for
subscription. Sometimes an existing company can come out with a
simultaneous 'Right cum Public Issue'.
The important characteristics of rights issue are:
1) The number of shares offered on rights basis to each existing shareholder
is determined by the issuing company. The entitlement of the existing
shareholder is determined on the basis of existing shareholding. For

example one Rights share may be offered for every 2 or 3 shares held by
the shareholder.
2) The issue price per Rights share is left to the discretion of the company.
3) Rights are negotiable. The holder of rights can transfer these rights shares
to any other person, i.e. he can renounce his right to subscribe to these
shares in favor of any other person, who can apply to the company for the
allotment of these shares in his name.
4) Rights can be exercised during a fixed period, which is usually 30 days. If
it is not exercised within this period, it automatically lapses.
Financial System and Economic Development:
The role of financial system in economic development has been a much
discussed topic among economists. Is it possible to influence the level of
national income, employment, standard of living, and social welfare through
variations in the supply of finance?
In what way financial development is affected by economic development?
There is no unanimity of views on such questions. A recent literature survey
concluded that the existing theory on this subject has not given any generally
accepted model to describe the relationship between finance and economic
development.
The importance of finance in development depends upon the desired nature
of development. In the environment-friendly, appropriate-technology-based,
decentralized Alternative Development Model, finance is not a factor of
crucial importance. But even in a conventional model of modem
industrialism, the perceptions in this regard vary a great deal.
One view holds that finance is not important at all. The opposite view
regards it to be very important. The third school takes a cautionary view. It
may be pointed out that there is a considerable weight of thinking and
evidence in favor of the third view also. Let us briefly explain these
viewpoints one by one.
In his model of economic growth, Solow has argued that growth results
predominantly from technical progress, which is exogenous, and not from
the increase in labor and capital. Therefore, money and finance and the
policies about them cannot contribute to the growth process.
Effects of Financial System on Saving and Investment:
It has been argued that men, materials, and money are crucial inputs in
production activities. The human capital and physical capital can be bought
and developed with money. In a sense, therefore, money, credit, and finance

are the lifeblood of the economic system. Given the real resources and
suitable attitudes, a well-developed financial system can contribute
significantly to the acceleration of economic development through three
routes. First, technical progress is endogenous; human and physical capital is
its important sources and any increase in them requires higher saving and
investment, which the financial system helps to achieve. Second, the
financial system contributes to growth not only via technical progress but
also in its own right. Economic development greatly depends on the rate of
capital formation. The relationship between capital and output is strong,
direct, and monotonic (the position which is sometimes referred to as
capital fundamentalism). Now, the capital formation depends on whether
finance is made available in time, in adequate quantity, and on favorable
terms-all of which a good financial system achieves. Third, it also enlarges
markets over space and time; it enhances the efficiency of the function of
medium of exchange and thereby helps in economic development.
We can conclude from the above that in order to understand the importance
of the financial system in economic development, we need to know its
impact on the saving and investment processes. The following theories have
analyzed this impact:
(a) The Classical Prior Saving Theory,
(b) Credit Creation or Forced Saving or Inflationary Financing Theory,
(c) Financial Repression Theory,
(d) Financial Liberalisation Theory.
The Prior Saving Theory regards saving as a prerequisite of investment, and
stresses the need for policies to mobilize saving voluntarily for investment
and growth. The financial system has both the scale and structure effect on
saving and investment. It increases the rate of growth (volume) of saving
and investment, and makes their composition, allocation, and utilization
more optimal and efficient. It activates saving or reduces idle saving; it also
reduces fructified investment and the cost of transferring saving to
investment. How is this achieved? In any economy, in a given period of
time, there are some people whose current expenditures is less than their
current incomes, while there are others whose current expenditures exceed
their current incomes. In well-known terminology, the former are called the
ultimate savers or surplus--spending-units, and the latter are called the
ultimate investors or the deficit-spending-units.
Modern economies are characterized:

(a) By the ever-expanding nature of business organizations such as jointstock companies or corporations,
(b) By the ever-increasing scale of production,
(c) By the separation of savers and investors, and
(d) By the differences in the attitudes of savers (cautious, conservative, and
usually averse to taking risks) and investors (dynamic and risk takers).
In these conditions, which Samuelson calls the dichotomy of saving and
investment, it is necessary to connect the savers with the investors.
Otherwise, savings would be wasted or hoarded for want of investment
opportunities, and investment plans will have to be abandoned for want of
savings. The function of a financial system is to establish a bridge between
the savers and investors and thereby help the mobilization of savings to
enable the fructification of investment ideas into realities. Figure below
reflects this role of the financial system in economic development.
Relationship between Financial System and Economic Development

A financial system helps to increase output by moving the economic system

towards the existing production frontier. This is done by transforming a

given total amount of wealth into more productive forms. It induces people
to hold fewer saving in the form of precious metals, real estate land,
consumer durables, and currency, and to replace these assets by bonds,
shares, units, etc. It also directly helps to increase the volume and rate of
saving by supplying diversified portfolio of such financial instruments, and
by offering an array of inducements and choices to woo the prospective
saver. The growth of banking habit helps to activate saving and undertake
fresh saving. The saving is said to be institution-elastic i.e., easy access,
nearness, better return, and other favorable features offered by a welldeveloped financial system lead to increased saving.
A financial system helps to increase the volume of investment also. It
becomes possible for the deficit spending units to undertake more
investment because it would enable them to command more capital. As
Schumpeter has said, without the transfer of purchasing power to an
entrepreneur, he cannot become the entrepreneur. Further, it encourages
investment activity by reducing the cost of finance and risk. This is done by
providing insurance services and hedging opportunities, and by making
financial services such as remittance, discounting, acceptance and
guarantees available. Finally, it not only encourages greater investment but
also raises the level of resource allocation efficiency among different
investment channels. It helps to sort out and rank investment projects by
sponsoring, encouraging, and selectively supporting business units or
borrowers through more systematic and expert project appraisal, feasibility
studies, monitoring, and by generally keeping a watch over the execution
and management of projects.
The contribution of a financial system to growth goes beyond increasing
prior-saving-based investment. There are two strands of thought in this
regard. According to the first one, as emphasized by Kalecki and
Schumpeter, financial system plays a positive and catalytic role by creating
and providing finance or credit in anticipation of savings. This, to a certain
extent, ensures the independence of investment from saving in a given
period of time. The investment financed through created credit generates the
appropriate level of income. This in turn leads to an amount of savings,
which is equal to the investment already undertaken. The First Five Year
Plan in India echoed this view when it stated that judicious credit creation in
production and availability of genuine savings has also a part to play in the
process of economic development. It is assumed here that the investment out
of created credit results in prompt income generation. Otherwise, there will
be sustained inflation rather than sustained growth.

The second strand of thought propounded by Keynes and Tobin argues that
investment, and not saving, is the constraint on growth, and that investment
determines saving and not the other way round. The monetary expansion and
the repressive policies result in a number of saving and growth promoting
forces:
(a) If resources are unemployed, they increase aggregate
demand, output, and saving;
(b) If resources are fully employed, they generate inflation
which lowers the real rate of return on financial
investments. This in turn, induces portfolio shifts in such
a manner that wealth holders now invest more in real,
physical capital, thereby increasing output and saving;
(c) Inflation changes income distribution in favor of profit
earners (who have a high propensity to save) rather than
wage earners (who have a low propensity to save), and
thereby increases saving; and
(d) Inflation imposes tax on real money balances and thereby
transfers resources to the government for financing
investment.
The extent of contribution of the financial sector to saving, investment, and
growth is said to depend upon its being free or repressed (regulated). One
school of thought argues that financial repression and the low/ negative real
interest rates which go along with it encourage people
(i)
To hold their saving in unproductive real assets,
(ii) To be rent -seekers because of non-market
allocation of investible funds
(iii) To be indulgent which lowers the rate of
saving,
(iv) To misallocate resources and attain inefficient
investment profile, and
(v) To promote capital intensive industrial structure
inconsistent with the factor-endowment of
developing countries. Financial liberalisation or
deregulation corrects these ill effects and leads
to financial as well as economic development.
However, as indicated earlier, some economists
believe that financial repression is beneficial.

Q4. What are money market instruments? Explain

Money market instruments are:
Commercial bills
Treasury Bills
Certificate of deposit
Commercial paper
Other instruments: FCCB, ADR, GDR
Financial Instruments:
(a) Money Market Instruments
Money market is a very important segment of the financial system of a
country. It is the market dealing in monetary assets of short term nature.
Short term funds up to one year and financial assets that are close substitutes
for money are dealt in the money market.
Features:
The money Market is a whole sale market. The volumes are very large and
generally transactions are settled on daily basis. Trading in the money
market is conducted over the telephone followed by written confirmation
from both the borrowers and lenders. There are large numbers of participants
in the money market: commercial banks, mutual funds, investment
institutions, financial institutions, and finally the central bank of a country.
The banks operations ensure that the liquidity and short term interest rates
are maintained at the levels consistent with the objective of maintaining
price and exchange rate stability. The central bank occupies a strategic
position in the money market. The money market can obtain funds from
central bank either by borrowing or through sale of securities. The bank
influences liquidity and interest rates by open market operations, REPO
transactions, changes in Bank Rate , cash Reserve Requirements and by
regulating access to its accommodation. A well-developed money market
contributes to an effective implementation of the monetary policy.
Some of the important money market instruments are briefly discussed
below;

1.

Call/Notice Money

2.

Treasury Bills

3.

Term Money

4.

Certificate of Deposit

5.

Commercial Papers

1. Call /Notice-Money Market

Call/Notice money is the money borrowed or lent on demand for a very
short period. When money is borrowed or lent for a day, it is known as Call
(Overnight) Money. Intervening holidays and/or Sunday are excluded for
this purpose. Thus money, borrowed on a day and repaid on the next
working day, (irrespective of the number of intervening holidays) is "Call
Money". When money is borrowed or lent for more than a day and up to 14
days, it is "Notice Money". No collateral security is required to cover these
transactions.
2. Inter-Bank Term Money
Inter-bank market for deposits of maturity beyond 14 days is referred to as
the term money market. The entry restrictions are the same as those for
Call/Notice Money except that, as per existing regulations, the specified
entities are not allowed to lend beyond 14 days.
3. Treasury Bills
Treasury Bills are short term (up to one year) borrowing instruments of the
union government. It is an IOU of the Government. It is a promise by the
Government to pay a stated sum after expiry of the stated period from the
date of issue (14/91/182/364 days i.e. less than one year). They are issued at
a discount to the face value, and on maturity the face value is paid to the
holder. The rate of discount and the corresponding issue price are
determined at each auction.
4. Certificate of Deposits

Certificates of Deposit (CDs) is a negotiable money market instrument and

issued in dematerialized form or as a usance Promissory Note, for funds
deposited at a bank or other eligible financial institution for a specified time
period. CDs are similar to traditional term deposits but are negotiable and
can be traded in the secondary market. It is often a bearer security and there
is a single payment principal and a interest rate at the end of the maturity
period. The bulk of the deposits have a very short duration of 1,3 or 6
months. For long term CDs there is a fixed coupon or a floating rate
coupon. For CDs with floating rate coupons, the life of CD is subdivided
into sub periods of usually six months. Interest is fixed at the beginning of
each period and is based on LIBOR or US Treasury bill rate or primary rate
5. Commercial Paper: CP is a note in evidence of the debt obligation of the
issuer. On issuing commercial paper the debt obligation is transformed into
an instrument. CP is thus an unsecured promissory note privately placed
with investors at a discount rate to face value determined by market forces.
CP is freely negotiable by endorsement and delivery. In India a company
shall be eligible to issue CP provided - (a) the tangible net worth of the
company, as per the latest audited balance sheet, is not less than Rs. 5 crores;
(b) the working capital (fund-based) limit of the company from the banking
system is not less than Rs.4 crores and (c) the borrowed account of the
company is classified as a Standard Asset by the financing banks (d) shares
are listed on stock exchange (e) current ratio is 1:33:1. The minimum
maturity period of CP is 7 days. The minimum credit rating shall be P-2 of
CRISIL or such equivalent rating by other agencies.
Usance: Commercial paper should be issued for a minimum period of 30
days and a maximum of one year. No grace period is allowed for payment
and if the maturity period falls on a holiday it should be paid on the previous
working day. Every issue of commercial paper is treated as a fresh issue.
Denomination: Commercial paper is issued in denomination of Rs 5 lakhs.
But the minimum lot or investment is Rs 25 lakhs (face value) per investor.
The secondary market transactions can be Rs 5 lakhs of multiples thereof.
Total amount to be proposed to be issued should be raised within two weeks
from the date on which the proposal is taken on record by the bank.
Investor: Commercial paper can be issued to any person, banks, companies
and other registered corporate bodies and unincorporated bodies. Issue to
NRIs can only be on a non-repairable basis and is non-transferable. The

paper issued to the NRI should state that it is non-repairable and nonendorsable
Procedure of Issue: Commercial paper is issued only through the bankers
who have sanctioned working capital limits to the company. It is counted as
a part of working capital. Unlike public deposits, commercial paper really
cannot augment working capital resources. There is no increase in the
overall short term borrowing facilities.
Note that: certificates of deposit (CDs) or commercial paper are considered
to be money market instruments and not bonds.
Maturity datethe date on which the issuer has to repay the nominal
amount. As long as all payments have been made, the issuer has no more
obligations to the bond holders after the maturity date. The length of time
until the maturity date is often referred to as the term or tenure or maturity of
a bond. The maturity can be any length of time, although debt securities with
a term of less than one year are generally designated money market
instruments rather than bonds. Most bonds have a term of up to thirty years.
Some bonds have been issued with maturities of up to one hundred years,
and some even do not mature at all. In early 2005, a market developed in
Euros for bonds with a maturity of fifty years. In the market for U.S.
Treasury securities, there are three groups of bond maturities:
o
o
o

Short term (bills): maturities up to one year.

Medium term (notes): maturities between one and ten years.
Long term (bonds): maturities greater than ten years.

Investment of Clients money:

The portfolio manager should not accept money or securities from his clients
for less than one year. Any renewal of portfolio fund on the maturity of the
initial period is deemed as a fresh placement for a minimum period of one
year. The portfolio funds and is withdrawn or taken back by the portfolio
clients at his risk before the maturity date of the contract under the following
circumstances:

Voluntary or compulsory termination of portfolio management

services by the portfolio manager.

Suspension or termination of registration of portfolio manager by the

SEBI.
Bankruptcy or liquidation in case the portfolio manager is a body
corporate.

Permanent disability, lunacy or insolvency in case the portfolio

manager is an individual.
The portfolio manager can invest funds of his clients in money market
instruments or as specified in the contract, but not in bill discounting, badly
financing or for the purpose of lending
Mutual Funds:
Mutual funds are financial intermediaries which collect the savings of
investors and invest them in a large and well diversified portfolio of
securities such as money market instruments, corporate and Government
bonds and equity shares of joint stock companies.
A mutual fund is a pool of commingle funds invested by different investors,
who have not contract with each other. Mutual funds are conceived as
institutions for providing small investors with avenues of investments in the
capital market. Since small investors generally do not have adequate time,
knowledge, experience and resources for directly accessing the capital
market, they have to rely on an intermediary which undertakes informed
investment decisions and provides the consequential benefits of professional
expertise. The raison deter of mutual funds is their ability to bring down
transaction costs.
The advantages for the investors are reduction in risk, export professional
management, diversified portfolios, and liquidity of investment and tax
benefits. By pooling their assets through mutual funds, investors achieve
economies of scale. The interests of the investors are protected by the SEBI
which acts as a watch dog. Mutual funds are governed by the SEBI (Mutual
Funds) Regulations, 1993.
Debt/Income Funds:
These funds invest predominantly in high-rated fixed-income-bearing
instruments like bonds, debentures, government securities, commercial
paper and other money market instruments. They are best suited for the
medium to long-term investors who are averse to risk and seek capital
preservation. They provide a regular income to the investor.

Liquid Funds/Money Market Funds:

These funds invest in highly liquid money market instruments. The period of
investment could be as short as a day. They provide easy liquidity. They
have emerged as an alternative for savings and short-term fixed deposit
accounts with comparatively higher returns. These funds are ideal for
corporate, institutional investors and business houses that invest their funds
for very short periods.

Q5. What are bonds? Explain their features. How are

they different from debentures?
Bonds in Finance are:
A bond is a debt security, in which the authorized issuer owes the holders a
debt and is obliged to repay the principal and interest (the coupon) at a later
date, termed maturity.
A bond is simply a loan in the form of a security with different terminology:
The issuer is equivalent to the borrower, the bond holder to the lender, and
the coupon to the interest. Bonds enable the issuer to finance long-term
investments with external funds. Note that certificates of deposit (CDs) or
commercial paper are considered to be money market instruments and not
bonds.
Bonds and stocks are both securities, but the major difference between the
two is that stock-holders are the owners of the company (i.e., they have an
equity stake), whereas bond-holders are lenders to the issuing company.
Another difference is that bonds usually have a defined term, or maturity,
after which the bond is redeemed, whereas stocks may be outstanding
indefinitely.
The convertible bond markets in the United States and Japan are of
primary global importance. These two domestic markets are the largest in
terms of market capitalization. Other domestic convertible bond markets are
often illiquid, and pricing is frequently non-standardized.

USA: It is a highly liquid market compared to other domestic markets.

Domestic investors have tended to be most active within US
convertibles
Japan: In Japan, the convertible bond market is relatively more
regulated than other markets. It consists of a large number of small
issuers.

Europe: Convertible bonds have become an increasingly important

source of finance for firms in Europe. Compared to other global
markets, European convertible bonds tend to be of high credit quality.
Asia (ex Japan): The Asia region provides a wide range of choice for
an investor. The maturity of Asian convertible bond markets varies
widely.
Canada: Canadian convertible bonds are exchange traded. Most of the
Canadian convertible bond market consists of unsecured subinvestment grade bonds with high yields that are reflective of the
issuer's risk of default.

Issuing bonds:
Bonds are issued by public authorities, credit institutions, companies and
supranational institutions in the primary markets. The most common process
of issuing bonds is through underwriting. In underwriting, one or more
securities firms or banks, forming a syndicate, buy an entire issue of bonds
from an issuer and re-sell them to investors. Government bonds are typically
auctioned.
Features of bonds:
The most important features of a bond are:

Nominal, principal or face amountthe amount on which the issuer

pays interest, and which has to be repaid at the end.

Issue pricethe price at which investors buy the bonds when they
are first issued, typically $1,000.00. The net proceeds that the issuer
receives are calculated as the issue price, less issuance fees, times the
nominal amount.

Maturity datethe date on which the issuer has to repay the nominal
amount. As long as all payments have been made, the issuer has no
more obligations to the bond holders after the maturity date. The
length of time until the maturity date is often referred to as the term or
tenure or maturity of a bond. The maturity can be any length of time,
although debt securities with a term of less than one year are generally
designated money market instruments rather than bonds. Most bonds
have a term of up to thirty years. Some bonds have been issued with
maturities of up to one hundred years, and some even do not mature at
all. In early 2005, a market developed in Euros for bonds with a

maturity of fifty years. In the market for U.S. Treasury securities,

there are three groups of bond maturities:
o short term (bills): maturities up to one year;
o medium term (notes): maturities between one and ten years;
o long term (bonds): maturities greater than ten years;

Couponthe interest rate that the issuer pays to the bond holders.
Usually this rate is fixed throughout the life of the bond. It can also
vary with a money market index, such as LIBOR, or it can be even
more exotic. The name coupon originates from the fact that in the
past, physical bonds were issued which coupons had attached to them.
On coupon dates the bond holder would give the coupon to a bank in
exchange for the interest payment.

Coupon datesthe dates on which the issuer pays the coupon to the
bond holders. In the U.S., most bonds are semi-annual, which means
that they pay a coupon every six months. In Europe, most bonds are
annual and pay only one coupon a year.

Indentures and Covenantsan indenture is a formal debt agreement

that establishes the terms of a bond issue, while covenants are the
clauses of such an agreement. Covenants specify the rights of
bondholders and the duties of issuers, such as actions that the issuer is
obligated to perform or is prohibited from performing. In the U.S.,
federal and state securities and commercial laws apply to the
enforcement of these agreements, which are construed by courts as
contracts between issuers and bondholders. The terms may be
changed only with great difficulty while the bonds are outstanding,
with amendments to the governing document generally requiring
approval by a majority (or super-majority) vote of the bondholders.

A convertible note is a type of bond that can be converted into shares:

(or, if it has a maturity of greater than 10 years, a "convertible debenture") is
a type of bond that can be converted into shares of stock in the issuing
company or cash of equal value, at some pre-announced ratio. It is a hybrid
security with debt- and equity-like features. Although it typically has a low
coupon rate, the holder is compensated with the ability to convert the bond
to common stock at an agreed upon price and thereby participate in further
growth in the company's equity value.
From the issuer's perspective, the key benefit of raising money by selling
convertible bonds is a reduced cash interest payment. However, in exchange

for the benefit of reduced interest payments, the value of shareholder's

equity is reduced due to the stock dilution expected when bondholders
convert their bonds into new shares.
Private Placement (to raise funds through private placement of bonds and
shares):
A Public Issue is a costly affair involving Press advertisements, brokers, fees
and Press conference, etc. Therefore, some of the companies find it easy and
cheaper to raise funds through private placement of bonds and shares.
In this method, the securities are issued to some selected investors like banks
or financial institutions. The private placement agreement is undertaken
when the issue size is not very big and the issuer does not want to spend
much on floating the issue. Private placement market has grown
phenomenally. During the last few years in India, the rate of growth of
private placements has been higher than public
Issues as well as right issues because of following advantages:
i) Accessibility: Whether it is a public limited company, or a private limited
company, or whether it is listed company or an unlisted one, it can easily
access the private placement market. It can accommodate issues of
smaller size, whereas public issue does not permit issue below a certain
minimum size.
ii) Flexibility: There is a greater flexibility in working out the terms of
issue. A private placement results in the sale of securities by a company
to one or few investors. In case of private placement, there is no need for
a formal prospectus as well as under-writing arrangements. Generally, the
terms of the issue are negotiated between the company (issuing
securities) and the investors. When a nun-convertible debenture issue is
privately placed, a discount may be given to institutional investor to
make the issue attractive.
(iii) Speed: The time required, for completing a public issue is generally 6
months or more because of several formalities that have to be gone
through. On the other hand, a private placement requires lesser time.
(iv) Lower Issue Cost: A public issue entails several statutory and nonstatutory expenses associated with underwriting, brokerages etc. The sum
of these costs used to work out even up to 10 percent of issue. For a
company going for a private placement it is substantially less.
SECONDARY MARKET (Bonds in the Secondary Market):

The market for long term securities like bonds, Equity, stocks and preferred
stocks is divided into primary market and secondary market. The primary
market deals with the new issues of securities. Outstanding securities are
traded in the secondary market, which is commonly known as stock market
or stock exchange. In the secondary market, the investors can sell buy
securities. Stock market predominantly deals in the equity shares. Debt
instruments like bonds and debentures are also traded in the stock market.
Well regulated and active stock market promotes capital formation. Growth
of the primary market depends on the secondary market. The health of the
economy is reflected by the growth of the stock market.
PORTFOLIO (Items that are considered a part of portfolio could
include bonds & debentures):
A Portfolio is a combination of different investment assets mixed and
matched for the purpose of achieving an investor's goal(s). Items that are
considered a part of your portfolio can include any asset you own-from
shares, debentures, bonds, mutual fund units to items such as gold, art and
even real estate etc. However, for most investors a portfolio has come to
signify an investment in financial instruments like shares, debentures, fixed
deposits, mutual fund units.
Features of debt instruments:
Each debt instrument has three features: Maturity, coupon and principal.
Maturity: Maturity of a bond refers to the date, on which the bond matures,
which is the date on which the borrower has agreed to repay the principal.
Term-to-Maturity refers to the number of years remaining for the bond to
mature. The Term-to-Maturity changes every day, from date of issue of the
bond until its maturity. The term to maturity of a bond can be calculated on
any date, as the distance between such a date and the date of maturity. It is
also called the term or the tenure of the bond.
Coupon: Coupon refers to the periodic interest payments that are made by
the borrower (who is also the issuer of the bond) to the lender (the subscriber
of the bond). Coupon rate is the rate at which interest is paid, and is usually
represented as a percentage of the par value of a bond.
Principal: Principal is the amount that has been borrowed, and is also called
the par value or face value of the bond. The coupon is the product of the
principal and the coupon rate.

The name of the bond itself conveys the key features of a bond. For
example, a GS CG2008 11.40% bond refers to a Central Government bond
maturing in the year 2008 and paying a coupon of 11.40%. Since Central
Government bonds have a face value of Rs.100 and normally pay coupon
semi-annually, this bond will pay Rs. 5.70 as six- monthly coupon, until
maturity.
Interest payable by a debenture or a bond:
Interest is the amount paid by the borrower (the company) to the lender (the
debenture-holder) for borrowing the amount for a specific period of time.
The interest may be paid annual, semi-annually, quarterly or monthly and is
paid usually on the face value (the value printed on the bond certificate) of
the bond.
Segments in the Debt Market in India:
There are three main segments in the debt markets in India, viz.
(1) Government Securities,
(2) Public Sector Units (PSU) bonds, and
(3) Corporate securities.
The market for Government Securities comprises the Centre, State and
State-sponsored securities. In the recent past, local bodies such as
municipalities have also begun to tap the debt markets for funds. Some of
the PSU bonds are tax free, while most bonds including government
securities are not tax-free. Corporate bond markets comprise of commercial
paper and bonds. These bonds typically are structured to suit the
requirements of investors and the issuing corporate, and include a variety of
tailor- made features with respect to interest payments and redemption.
Participants in the Debt Market:
Given the large size of the trades, Debt market is predominantly a wholesale
market, with dominant institutional investor participation. The investors in
the debt markets are mainly banks, financial institutions, mutual funds,
provident funds, insurance companies and corporates.
Rating of Bonds for their credit quality:
Most Bond/Debenture issues are rated by specialized credit rating agencies.
Credit rating agencies in India are CRISIL, CARE, ICRA and Fitch. The
yield on a bond varies inversely with its credit (safety) rating. The safer the
instrument, the lower is the rate of interest offered.

A credit rating agency (CRA) is a company that assigns credit ratings for
issuers of certain types of debt obligations as well as the debt instruments
themselves. In some cases, the services of the underlying debt are also given
ratings. In most cases, the issuers of securities are companies, special
purpose entities, state and local governments, non-profit organizations, or
national governments issuing debt-like securities (i.e., bonds) that can be
traded on a secondary market. A credit rating for an issuer takes into
consideration the issuer's credit worthiness (i.e., its ability to pay back a
loan), and affects the interest rate applied to the particular security being
issued. Investor can subscribe to bond issues made by the
government/corporates in the Primary market. Alternatively, one can
purchase the same from the secondary market through the stock exchanges.
DEBENTURES:
A type of debt instrument that is not secured by physical asset or collateral;
Debentures are backed only by the general creditworthiness and reputation
of the issuer. Both corporations and governments frequently issue this type
of bond in order to secure capital. Like other types of bonds, debentures are
documented in an indenture.
Debentures have no collateral. Bond buyers generally purchase debentures
based on the belief that the bond issuer is unlikely to default on the
repayment. An example of a government debenture would be any
government-issued Treasury bond (T-bond) or Treasury bill (T-bill). T-bonds
and T-bills are generally considered risk free because governments, at worst,
can print off more money or raise taxes to pay these types of debts.
A debenture:
Is a long-term debt instrument used by governments and large companies to
obtain funds? It is defined as "any form of borrowing that commits a firm to
pay interest and repay capital. In practice, these are applied to long term
loans that are secured on a firm's assets. Where securities are offered, loan
stocks or bonds are termed 'debentures' in the UK or 'mortgage bonds' in the
US.
The advantage of debentures to the issuer is they leave specific assets burden
free, and thereby leave them open for subsequent financing. Debentures are
generally freely transferable by the debenture holder. Debenture holders
have no voting rights and the interest given to them is a charge against profit

There are two types of debentures:

1. Convertible Debentures, which can be converted into equity shares of
the issuing company after a predetermined period of time.
2. Non-Convertible Debentures, which cannot be converted into equity
shares of the liable company. They usually carry higher interest rates than
the convertible ones
Non-Convertible Debentures:
Are those that cannot be converted into equity shares of the issuing
company, as opposed to Convertible debentures, which can be. Nonconvertible debentures normally earn a higher interest rate than convertible
debentures do.
Difference between bond & debenture:
Debentures and Bonds
Debentures and bonds are similar, but bonds are more secure than
debentures. In the case of both, the company pays you a guaranteed interest
that does not change in value irrespective of the fortunes of the company.
However, bonds are more secure than debentures, and carry a lower interest
rate. In the case of bonds, the company provides collateral for the loan.
Moreover, in case of liquidation, bondholders will be paid off before
debenture holders.
INSTRUMENTS ISSUED
(Example of INDIA):

OUTSIDE

DOMESTIC

COUNTRY

Foreign Currency Convertible Bond (FCCB)

A type of convertible bond (debt instrument) issued in a currency

different than the issuer's domestic currency.

In other words, the money being raised by the issuing company is in

the form of a foreign currency.

A convertible bond is a mix between a debt and equity instrument.

It acts like a bond by making regular coupon and principal payments,
but these bonds also give the bondholder the option to convert the
bond into stock. These types of bonds are attractive to both investors
and issuers.

The investors receive the safety of guaranteed payments on the bond

and are also able to take advantage of any large price appreciation in
the company's stock. (Bondholders take advantage of this appreciation
by means warrants attached to the bonds, which are activated when
the price of the stock reaches a certain point.)

Due to the equity side of the bond, which adds value, the
coupon payments
on
the
bond
are
lower
for
the
company, thereby reducing its debt-financing costs.

The pricing of FCCB options is generally at a 30% -70% premium

over the prevailing market price giving sufficient cushion to the issuer.
The FCCB holder opts to convert the FCCB, in case the market
price exceeds the option price or if there is an intention to make a
strategic investment by the lender irrespective of the stock price in
market.

In many cases, the FCCB issuer may also look forward for
conversion so that there is no fund outflow on redemption. Instead,
the issuers reserves are inflated by receipt of premium.
If however, the FCCB holders do not opt for conversion, the Issuer
has either to reissue the bonds to same holder or redeem.
The interest component or coupon on FCCBs is generally 30%40%
less than on normal debt paper or foreign currency loans or
ECBs. This translates to cost saving of approx 2-3 percent p.a. The
yield-to-maturity (YTM) in case of FCCBs normally ranges from 2 to
7%.
The FCCB issue proceeds need to confirm to external commercial
borrowing end use requirements. In addition, 25 per cent of the FCCB
proceeds can be used for general corporate restructuring.

Global Depositary Receipt (GDR)

Global Depository Receipt means any instrument in the form of a depository

receipt or certificate created by the overseas depository bank outside India
and issued to non-resident investors against the issue of ordinary shares or
Foreign Currency Convertible Bonds of issuing company.
Among the Indian Companies, Reliance Industries Ltd. was the first
company to raise funds through a GDR issue.
Benefits and Uses of a GDR:
Benefits to an Issuing Company:
Currently, there are over 1600 Depository Receipt programmes for
companies from over 60 countries. Companies have round that the
establishment of a depository receipt programme offers numerous
advantages. The primary reasons why a company would establish a
depository receipt programme can be divided into. The following are the
considerations behind issue of GDRs:
Access to capital markets outside the home market to provide a
mechanism for raising capital or as a vehicle for an acquisition.
Enhancement of company visibility by. Enhancement of image of the
companys products, services or financial instruments in a
marketplace outside its home country.
Expanded shareholder base which may increase or stabilize the share
price.
May increase local share, price as a result of global demand/ trading
through a broadened and a more diversified investor exposure.
Increase potential liquidity by enlarging the market for the companys
shares.
Adjust share price to trading market comparable through ratio.
Enhance shareholder communications and enable employees to invest
easily in the parent company.
External Commercial Borrowings (ECB) includes:

Commercial Bank Loans,

Buyers Credit,
Suppliers Credit,
Securitized Instruments Such As Floating Rate Notes, Fixed Rate
Bonds etc.
Credit From Official Export Credit Agencies,
Commercial Borrowings From The Private Sector Window Of
Multilateral Financial Institutions e.g. IFC

Investment by Foreign Institutional Investors (FIIs) In Dedicated Debt

Funds.

Assignment B
Q1. How are primary market and secondary market
different from each other? Explain
Primary market:
The capital market is the market for long term funds. Capital markets
discharge the important function of transfer of savings, especially of
household sector to companies, governments and public sector bodies.
Individuals or households with surplus money invest their savings in
exchange for shares, debentures and securities of such companies and
governments. The market for such long term sources of finance (equity and
debt) is primary market. In the primary market, new issues of equity and
debentures are arranged in the form of new floatation, either publicly or
privately in form of a rights offer, to existing shareholders. Companies raise
new cash in exchange for financial; claims. The financial claims may take
the form of shares or debentures. Public sector undertakings also issue share
securities. The transactions in primary market result in capital formation.
The primary market consists of new issue market in which new securities are
sold by public limited companies through public issue of debt or equity and
financing through venture capitalists.
The venture capital firm (a new financial intermediary which emerged in the
early eighties) provides substantial amounts of capital mostly through equity
purchases and occasionally through debt offerings to help growth oriented
firms to develop and succeed.
SECONDARY MARKET:
The market for long term securities like bonds, Equity, stocks and preferred
stocks is divided into primary market and secondary market. The primary
market deals with the new issues of securities. Outstanding securities are
traded in the secondary market, which is commonly known as stock market
or stock exchange. In the secondary market, the investors can sell buy
securities. Stock market predominantly deals in the equity shares. Debt
instruments like bonds and debentures are also traded in the stock market.
Well regulated and active stock market promotes capital formation. Growth
of the primary market depends on the secondary market. The health of the
economy is reflected by the growth of the stock market.

PRIMARY MARKET AND SECONDARY MARKET:

The Securities Market is divided into two segmentsthe Primary Market
and the Secondary Market. The main difference between these two lies in
the facts that while the former deals with the securities, which the issuer
issues for the first time, the latter deals in the existing securities.
Thus, the primary market facilitates the transfer of investible funds of the
savers to the corporates, which need them for - productive purposes. In the
Secondary Market, no new securities come into existence, rather the existing
securities change hands-one set of persons invest in them, while the other
group disinvests. The Primary Market, also called the New Issue Market, is
of vital importance in the economy of a country, as it leads to better
utilization of otherwise inactive dormant monetary resources in the
economy, These two markets are not isolated from each other, rather they are
very much inter-dependent. Activities in the new issues market and the
response of the investors to the near issues of securities depend upon the
prevailing conditions in the Secondary Market. If the secondary market is
vibrant and booming, issues of new securities in the Primary Market will be
easily able to mobilize support of a large number of investors and vice-versa.

Public issue of securities:

Public issue of shares or debentures is made in the primary market. Funds
mobilized through the primary market constitute investment. There is no

market place for issue of new securities. They are literally offered to public
through issue of prospectus and public subscribes to them directly. Wide
publicity about the offers of course, made through different media
newspapers, periodicals and television. The intermediaries who organize the
entire operation are merchant bankers. Earlier, stock brokers used to
organize the issue of shares to public. Now merchant bankers facilitate the
issue of new shares to the market.
Methods of floatation of new issue
There are three ways in which a company may raise capital in the primary
market.
i)
Public Issue
ii)
Rights Issue
iii) Private Placement

Public Issue
The most important mode of issuing securities is by issuing prospectus to the
public. If the issue has been made for the first time, by a corporate body, it is
known as Initial Public Offer (IPO).
The procedure followed in cases of public issue is as follows:
Invitation to subscribe the share is made through a document called
'prospectus'. The applications on the prescribed form, along with application
money, are invited by the company. The subscription list is open for a period
of 3 to 7 days.

No allotment can be made unless, the amount stated in the prospectus as the
minimum subscription has been subscribed, and the company has received
sum payable on application. Minimum subscription refers to the number of
shares, which should be subscribed. As per the SEBI guidelines, minimum
subscription has been fixed at 90% of entire public issue. Generally, the
amount is mobilized in two installments application money and allotment
money. If the full amount is not asked for at the time of allotment itself, the
balance is called up in one or two calls thereafter known as call money. The
letter of allotment sent by the company is exchangeable far share
certificates. If the allotted fails to pay the calls, his shares are liable to be
forfeited. In that case, allotted is not eligible for any refund. The public issue
may also be underwritten by an underwriter.
Underwriting is not mandatory now. Underwriter gives an undertaking, to
the issuing company to take the unsubscribed shares. This is called
devolvement of shares on the underwriter for which they are paid a
commission.
Rights Issue
A rights issue involves selling securities in the primary market by issuing
rights to the existing shareholders. In this method the company gives the
privilege to its existing shareholders for the subscription of the new shares
on prorate basis. A company making a rights issue sends a letter of offer
along with a composite application form consisting of four parts A, B, C,
and D. Part A is meant for acceptance of the offer. Part B is used if the
shareholder wants to renounce his rights in favor of someone else. Part C is
filled by the person in whose favor the renunciation has been made. Part D is
used to request the split of the shares.
The composite application form must be mailed to the company within a
stipulated period, which is usually 30 days. The shares that remain
unsubscribed will be offered to the public for subscription. Sometimes an
existing company can come out with a simultaneous 'Right cum Public
Issue'.
The important characteristics of rights issue are:
1) The number of shares offered on rights basis to each existing shareholder
is determined by the issuing company. The entitlement of the existing
shareholder is determined on the basis of existing shareholding. For
example one Rights share may be offered for every 2 or 3 shares held by
the shareholder.
2) The issue price per Rights share is left to the discretion of the company.
3) Rights are negotiable. The holder of rights can transfer these rights shares
to any other person, i.e. he can renounce his right to subscribe to these

shares in favor of any other person, who can apply to the company for the
allotment of these shares in his name.
4) Rights can be exercised during a fixed period, which is usually 30 days. If
it is not exercised within this period, it automatically lapses.
Private Placement
A Public Issue is a costly affair involving Press advertisements, brokers, fees
and Press conference, etc. Therefore, some of the companies find it easy and
cheaper to raise funds through private placement of bonds and shares.
In this method, the securities are issued to some selected investors like banks
or financial institutions. The private placement agreement is undertaken
when the issue size is not very big and the issuer does not want to spend
much on floating the issue. Private placement market has grown
phenomenally. During the last few years in India, the rate of growth of
private placements has been higher than public
Issues as well as right issues because of following advantages:
i) Accessibility: Whether it is a public limited company, or a private limited
company, or whether it is listed company or an unlisted one, it can easily
access the private placement market. It can accommodate issues of
smaller size, whereas public issue does not permit issue below a certain
minimum size.
ii) Flexibility: There is a greater flexibility in working out the terms of
issue. A private placement results in the sale of securities by a company
to one or few investors. In case of private placement, there is no need for
a formal prospectus as well as under-writing arrangements. Generally, the
terms of the issue are negotiated between the company (issuing
securities) and the investors. When a nun-convertible debenture issue is
privately placed, a discount may be given to institutional investor to
make the issue attractive.
iii) Speed: The time required, for completing a public issue is generally 6
months or more because of several formalities that have to be gone
through. On the other hand, a private placement requires lesser time.
iv) Lower Issue Cost: A public issue entails several statutory and nonstatutory expenses associated with underwriting, brokerages etc. The sum
of these costs used to work out even up to 10 percent of issue. For a
company going for a private placement it is substantially less.
FIXATION OF PREMIUM (Indian perspective)
Companies are allowed to issue their securities at par, at a premium or at a
discount. When the issue price is equal to the face value of the security, it is
issued at par, if the former exceeds the latter; it is issued at a premium, and

in the reverse condition at a discount. The amount charged from the

investors above the face value is called 'Premium. For example, if the share
of the face value of Rs. 10 is issued for Rs. 15, the extra amount of Rs. 5/- is
called Premium. Till May 1992, companies were required to seek the
permission of the Controller of Capital Issues, under the Control on Capital
Issues Act, to issue capital above the permitted amount. The amount of
premium was also determined by the Controller of Capital Issues, taking into
account various facts relating to the Company's functioning.
In May 1992, the above Act was repealed and instead the Securities and
Exchange Board of India (SEBI, Regulatory authority for stock market
operations in India) was empowered to exercise control over the new issues
market as well. The SEBI subsequently permitted the companies to
determine the premium themselves. However, SEBI issued guidelines in this
regard, which divided the companies into three categories, and within each
category, companies which fulfilled conditions of consistent profit for
specific number of years are permitted to charge premium. Rest of them is
permitted to issue the shares at par only. This led to great rush in the new
issues market and companies charged heavy premium for their issues.
Book Building Process
A new system to determine the amount of premium to be charged by a
company on its new issues was introduced in October 1995, when SEBI
permitted the system known as 'Book Building'. It is a pricing mechanism
wherein new issues are priced on the basis of demand feedback. Under this
system, the price of the new issue is based on real time feedback from the
investors.
The mechanism adopted under the Book Building is as follows:
a A draft prospectus containing all information, except the price and the
number of securities, is filed by the Company with SEBI.
A lead merchant banker to the issue is appointed as Book Runner.
b The Book Runner will circulate copies of the prospectus amongst the
institutional investors and underwriters inviting offer for subscription to
the security.
c The Book Runner maintains a record of the offers received from the
institutional investors and underwriters mentioning the price they are
ready to pay and the number of securities they intend to buy.
d On the basis of these offers, the Company and the book runner will
determine the price of the security. The price so determined, will be the
same for both placement position and the public issue.

Thereafter, the Underwriting Agreement is entered into and prospectus is

filed with the Registrar of Companies. One-day prior to the public issue,
institutional investors are required to submit application forms along with
money to the extent the securities are proposed to be allotted to them.
Initially, the book-building process was optional to the companies, but
gradually, an element of compulsion has been introduced. During the fiscal
year 2000-0 1, the book-building route was made compulsory for
companies, which do not have the track record of profitability and net worth
as specified in Entry norms prescribed by SEBI. Moreover, 60% of the offer
made by them is to be allotted to 'Qualified Institutional Buyers', comprising
financial institutions, banks, mutual funds, Foreign Institutional Investors
(FIIs) and venture Capital Funds registered with SEBI. Inability to meet this
condition is regarded as failure of the issue. The book-building route has
also been made compulsory for IPOs with issue size more than 5 times the
pre-issue net worth and for public issues by listed companies worth more
than 5 times the pre-issue net worth. In these cases also, 60% of the 'offer
should be allotted to QIBs.
REFORMS IN PRIMARY CAPITAL MARKET
SEBI has brought about several reforms in the new issues market during
recent years. Important reforms are as detailed below:
a) Minimum offer to public: SEBI (Disclosure and Investor Protection)
Guidelines' required a minimum offering of 25% of post-issue capital
to the public. This requirement was gradually relaxed to 10% for
companies in all sectors. For this purpose, SEBI also kept the
minimum offering size at Rs. 100 crore and retained the existing limit
of minimum public offering of 20 lakh shares. The Companies which
are unable to meet these conditions are required to make a minimum
public offering of 25%.
b) Lock-in-period: The provisions for lock-in applicable to IPOs have
been rationalized. lock-in-period of or minimum promoters
contribution of 20 per cent Continues to be 3 years, the balance of the
entire pre IPO Capital held by promoters and others shall have-lock-in
period of 1 year& from the date of allotment of the IPO. The shares
issued on preferential basis by a listed company to any person shall
have a lock-in period of one year term from the date of their
allotment.
c) Allotment of Shares: The time for finalizing the allotment of share
has been reduced from 30 days to 15 days, in case, issues are made on
book-building basis.

d) Merchant bankers have been brought under SEBI regulatory

framework and a code of conduct is issued for them.
e) Companies are required to disclose all material facts and specific risks
factors associated with their projects while making public issues
through the prospectus.
f) Prohibition been imposed on payment of any direct or indirect
discounts or commission to person receiving any firm allotment of
shares.
g) The requirement of 90% minimum subscription in case of offer for
sale is no longer applicable.
h) Underwriting of the issue made optional subject to the condition that
if an issue was not underwritten and was not able to collect at least
90% of amount offered to public as subscription, the entire amount
will be refundable to investors.
i) SEBI introduced a code of advertisement for public issues for
ensuring fair and truthful disclosures
Parties involved in the Issue
Merchant Bankers (Indian Context)
In modern times, importance of merchant banker is very much, because it
the key intermediary between the company and issue of capital. Main
activities of the merchant bankers are Determining the composition of the
capital structure, drafting of prospectus and application forms, compliance
with procedural formalities, appointment of registrars to deal with the share
application and transfer, listing of securities, arrangement of underwriting /
sub-underwriting, placing of issues, selection of brokers, bankers to the
issue, publicity and advertising agents, printers and so on. Due to
overwhelming importance of merchant banker, it is now mandatory that
merchant banker(s) functioning as lead manager(s) should manage all public
issues. In case of rights issue not exceeding Rs.50 lakh, such appointments
may not be necessary. The salient features of the SEBI framework, related to
merchant bankers are discussed as under.
Registration: Merchant bankers require compulsory registration with the
SEBI to carry out their activities. Previously there were four categories of
merchant bankers, depending upon the activities. Now, since Dec. 1997,
there is only one category of registered merchant banker and they perform
all activities.
Grant of Certificate: The SEBI grants a certificate of registration to
applicant if it fulfills all the conditions like (i) it is a body corporate and is

not a NBFC (ii) it has got necessary infrastructure to support the business
activity (iii) it has appointed at least two qualified and experienced (in
merchant banking) persons (iv) its registration is in the general interest of
investors.
Capital Adequacy Requirement: A merchant banker must have adequate
capital to support its business. Hence SEBI grants recognition to only those
merchant bankers who have paid up capital and free reserves of minimum
Rs. 1 crore.
Fee: A merchant banker has to pay a registration fee of Rs. 5 lakh and
renewal fees of Rs. 2.5 lakh every three years from the fourth year from the
date of registration.
Code of Conduct: Every merchant banker has to abide by the code of
conduct, so as to maintain highest standards of integrity and fairness, quality
of services, due diligence and professional judgment in all his dealings with
the clients and other people. A merchant banker has always to endeavor to
(a) render the best possible advice to the clients regarding clients needs and
requirements, and his own professional skill and (b) ensure that all
professional dealings are effected in a prompt, efficient and cost effective
manner.
Restriction on Business: No merchant banker, other than a bank/public
financial institution is permitted to carry on business other than that in the
securities market w.e.f. Dec.1997. However a merchant banker who is
registered with RBI(Central bank of India) as a primary dealer/satellite
dealer may carry on such business as may be permitted by RBI w.e.f.
Nov.1999.
Maximum number of lead managers: The maximum number of lead
managers is related to the size of the issue. For an issue of size less than Rs.
50 crores, two lead managers are appointed. For size groups of 50 to 100
crores and 100 to 200 crores, the maximum permissible lead managers are
three and four respectively. A company can appoint five and five or more (as
approved by SEBI) lead managers in case of issue sizes between Rs.200 to
400 crores and above Rs.400 crores respectively.
Responsibilities of Lead Managers: Every lead manager has to enter into
an agreement with the issuing companies setting out their mutual rights,
liabilities and obligation relating to such issues and in particular to
disclosure, allotment and refund. A statement specifying these is to be

furnished to the SEBI at least one month before the opening of the issue for
subscription. It is necessary for a lead manager to accept minimum
underwriting obligation of 5% of the total underwriting commitment or Rs.
25 lakh whichever is less.
Due diligence certificate: The lead manager is responsible for the
verification of the contents of a prospectus / letter of offer in respect of an
issue and the reasonableness of the views expressed in them. He has to
submit to the SEBI at least two weeks before the opening of the issue for
subscription a due diligence certificate.
Submission of documents: The lead managers to an issue have to submit at
least two weeks before the date of filing with the ROC/regional SE or both,
particulars of the issue, draft prospectus/ letter of offer, other literature to be
circulated to the investors / shareholders, and so on to the SEBI. They have
to ensure that the modifications/ suggestions made by it with respect to the
information to be given to the investors are duly incorporated.
Acquisition of Shares: A merchant banker is prohibited from acquiring
securities of any company on the basis of unpublished price sensitive
information obtained during the course of any professional assignment either
from the client or otherwise.
Disclosure to SEBI: As and when required, a merchant banker has to
disclose to SEBI (i) his responsibilities with regard to the management of the
issue, (ii) any change in the information/ particulars previously furnished
which have a bearing on the certificate of registration granted to it, (iii)
names of the companies whose issues he has managed or has been
associated with (iv) the particulars relating to the breach of capital adequacy
requirements and (v) information relating to his activities as manager,
underwriter, consultant or advisor to an issue.
Action in case of Default: A merchant banker who fails to comply with any
conditions subject to which the certificate of registration has been granted by
SEBI and / or contravenes any of the provisions of the SEBI Act, rules or
regulations, is liable to any of the two penalties (a) Suspension of
registration or (b) Cancellation of registration.
Underwriters
Another important intermediary in the new issue/ primary market is the
underwriters to issue of capital who agree to take up securities which are not
fully subscribed. They make a commitment to get the issue subscribed either

by others or by themselves. Though underwriting is not mandatory after

April 1995, its organization is an important element of primary market.
Underwriters are appointed by the issuing companies in consultation with
the lead managers / merchant bankers to the issues.
Registration: To act as underwriter, a certificate of registration must be
obtained from SEBI. On application registration is granted to eligible body
corporate with adequate infrastructure to support the business and with net
worth not less than Rs. 20 lakhs.
Fee: Underwriters had to pay Rs. 5 lakhs as registration fee and Rs. 2 lakhs
as renewal fee every three years from the fourth year from the date of initial
registration. Failure to pay renewal fee leads to cancellation of certificate of
registration.
General Obligations and responsibilities
Code of conduct: Every underwriter has at all times to abide by the code of
conduct; he has to maintain a high standard of integrity, dignity and fairness
in all his dealings. He must not make any written or oral statement to
misrepresent (a) the services that he is capable of performing for the issuer
or has rendered to other issues or (b) his underwriting commitment.
Agreement with clients: Every underwriter has to enter into an agreement
with the issuing company. The agreement, among others, provides for the
period during which the agreement is in force, the amount of underwriting
obligations, the period within which the underwriter has to subscribe to the
issue after being intimated by/on behalf of the issuer, the amount of
commission/brokerage, and details of arrangements, if any, made by the
underwriter for fulfilling the underwriting obligations.
General responsibilities: An underwriter cannot derive any direct or
indirect benefit from underwriting the issue other than by the underwriting
commission. The maximum obligation under all underwriting agreements of
an underwriter cannot exceed twenty times his net worth. Underwriters have
to subscribe for securities under the agreement within 45 days of the receipt
of intimation from the issuers.
Bankers to an Issue
The bankers to an issue are engaged in activities such as acceptance of
applications along with application money from the investor in respect of
capital and refund of application money.

Registration: To carry on activity as a banker to issue, a person must obtain

a certificate of registration from the SEBI. The applicant should be a
scheduled bank. Every banker to an issue had to pay to the SEBI an annual
free for Rs. 5 lakhs and renewal fee or Rs. 2.5 lakhs every three years from
the fourth year from the date of initial registration. Non-payment of the
prescribed fee may lead to the suspension of the registration certificate.
General Obligations and Responsibilities
Furnish Information: When required, a banker to an issue has to furnish to
the SEBI the following information: (a) the number of issues for which he
was engaged as banker to an issue (b) the number of applications / details of
the applications money received (c) the dates on which applications from
investors were forwarded to the issuing company / registrar to an issue (d)
the dates / amount of refund to the investors.
Books of account/record / documents: A banker to an issue is required
maintain books of accounts/ records/ documents for a minimum period of
three years in respect of, inter alia, the number of applications received, the
names of the investors, the time within which the applications received were
forwarded to the issuing company / registrar to the issue and dates and
amounts of refund money to investors.
Agreement with issuing companies: Every banker to an issue enters into an
agreement with the issuing company. The agreement provides for the
number of collection centers at which application/ application money
received is forwarded to the registrar for issuance and submission of daily
statement by the designated controlling branch of the baker stating the
number of applications and the amount of money received from the investor.
Code of Conduct: Every banker to an issue has to abide by a code of
conduct. He should observe high standards of integrity and fairness in all his
dealings with clients/ investors/ other members of the profession. He should
exercise due diligence. A banker to an issue should always endeavor to
render the best possible advice to his clients and ensure that all professional
dealings are affected in a prompt, efficient and cost-effective manner.
Brokers to the Issue
Brokers are persons mainly concerned with the procurement of subscription
to the issue from the prospective investors. The appointment of brokers is
not compulsory and the companies are free to appoint any number of
brokers. The managers to the issue and the official brokers organize the
preliminary distribution of securities and procure direct subscription from as

large or as wide a circle of investors as possible. A copy of the consent letter

from all the brokers to the issue, should be filed with the prospectus to the
ROC. The brokerage applicable to all types of public issue of industrial
securities is fixed at 1.5%, whether the issue is underwritten or not. The
listed companies are allowed to pay a brokerage on private placement of
capital at a maximum rate of 0.5%.
Brokerage is not allowed in respect of promoters quota including the
amounts taken up by the directors, their friends and employees, and in
respect of the rights issues taken by or renounced by the existing
shareholders. Brokerage is not payable when the applications are made by
the institutions/ bankers against their underwriting commitments or on the
amounts devolving on them as underwriters consequent to the under
subscription of the issues.
Registrars to an Issue and Share Transfer Agents
The registrars to an issue, as an intermediary in the primary market, carry on
activities such as collecting applications from the investors, keeping a proper
record of applications and money received from the investors or paid to the
sellers of securities and assisting companies in determining the basis of
allotment of securities in consultation with the stock exchanges, finalizing
the allotment of securities and processing / dispatching allotment letters,
refund orders, certificates and other related documents in respect of the issue
of capital. To carry on their business, the registrars must be registered with
the SEBI. They are divided into two categories: (a) Category I, to carry on
the activities as registrar to an issue and share transfer agent; (b) Category II,
to carry on the activity either as registrar or as a share transfer agent.
Category I registrars mush have minimum net worth of Rs. 6 lakhs and
Category II, Rs. 3. Category I is required to pay a initial registration fee of
Rs. 50,000 and renewal fee of Rs.40,000 every three years, where as
Category II is required to pay Rs.30,000 and Rs. 25,000 respectively.
Code of Conduct: The registrars to an issue and the share transfer agents
have to maintain high standards of integrity and fairness in all dealings with
their clients and other registrars to the issue and share transfer agents in the
conduct of the business. They should endeavor to ensure that
(a) Enquiries from investors are adequately dealt with, and
(b) Adequate steps are taken for proper allotment of securities and refund of
application money without delay and as per law. Also, they should not
generally and particularly in respect of any dealings in securities to be a
party to
(a) Creation of false market,

(b) Price rigging or manipulation

(c) passing of unpublished price sensitive information to brokers, members
of stock exchanges and other intermediaries in the securities market or take
any other action which is not in the interest of the investors and
(d) no registrar to an issue, share transfer agent or any of its directors,
partners or managers managing all the affairs of the business is either on
their respective accounts, or though their respective accounts, or through
their associates or family members, relatives or friends indulges in any
insider trading.
Debenture Trustees A debenture trustee is a trustee for a trust deed needed
for securing any issue of debentures by a company. To act as a debenture
trustee a certificate from the SEBI is necessary. Only scheduled commercial
banks, PFIs, Insurance companies and companies are entitled to act as a
debenture trustees. The certificate of registration is granted to suitable
applicants with adequate infrastructure, qualified manpower and requisite
funds. Registration fee is Rs. 5 lakhs and renewal fee is Rs. 2.5 lakhs every
three years.
Responsibilities and obligations: Before the issue of debentures for
subscription, the consent in writing to the issuing company to act as a
debenture trustee is obligatory. He has to accept the trust deed which
contains matters pertaining to the different aspects of the debenture issue.
Duties: The main duties of a debenture trustee include the following :
i. Call for periodical report from the company.
ii. Inspection of books of accounts, records, registration of the company and
the trust property to the extent necessary for discharging claims.
iii. Take possession of trust property, in accordance with the provisions of
the trust deed.
iv. Enforce security in the interest of the debenture holders.
v. Carry out all the necessary acts for the protection of the debenture holders
and to the needful to resolve their grievances.
vi. Ensure refund of money in accordance with the Companies Act and the
stock exchange listing agreement.
vii. Exercise due diligence to ascertain the availability of the assets of the
company by way of security as well as their adequacy / sufficiency to
discharge claims when they become due.
viii. Take appropriate measure to protect the interest of the debenture holders
as soon as any breach of trust deed/ law comes to notice.

ix. Ascertain the conversion / redemption of debentures in accordance with

the provisions / conditions under which they were offered to the holders.
x. Inform the SEBI immediately of any breach of trust deed / provisions of
law. In addition, it is also the duty of trustees to call or ask the company
to call a meeting of the debenture holders on a requisition in writing
signed by debenture holders, holding at least one-tenth of the outstanding
amount, or on the happening of an event which amounts to a default or
which, in his opinion, affects their interest.
Portfolio Managers
Portfolio manager are defined as persons who in pursuance of a contract
with clients, advice, direct, undertake on their behalf the management/
administration of portfolio of securities/ funds of clients. The term portfolio
means the total holdings of securities belonging to any person. The portfolio
management can be
(i)
Discretionary or (ii) Non-discretionary.
The first type of portfolio management permits the exercise of discretion in
regard to investment / management of the portfolio of the securities / funds.
In order to carry on portfolio services, a certificate of registration from SEBI
is mandatory. The certificate of registration for portfolio management
services is granted to eligible applicants on payment of Rs.5 lakhs as
registration fee. Renewal may be granted by SEBI on payment of Rs. 2.5
lakhs as renewal fee (every three years).
Contract with clients: Every portfolio manager is required, before taking
up an assignment of management of portfolio on behalf of the a client, is
enter into an agreement with such clients clearly defining the inter se
relationship, and setting out their mutual rights, liabilities and obligations
relating to the management of the portfolio of the client. The contract
should, inter alia, contain:
i. The investment objectives and the services to be provided.
ii. Areas of investment and restrictions, if any, imposed by the client with
regards to investment in a particular company or industry.
iii. Attendant risks involved in the management of portfolio.
iv. Period of the contract and provisions of early termination, if any.
v. Amount to be invested.
vi. Procedure of setting the clients account including the form of repayment
on maturity or early termination of contract.
vii. Fee payable to the portfolio managers

viii. Custody of securities. The funds of all clients must be placed by the
portfolio manager in a separate account to be maintained by him in a
scheduled commercial bank. He can charge an agreed fee from the clients
for rendering portfolio management services without guaranteeing or
assuring, either directly or indirectly, any return and such fee should be
independent of the returns to the client and should not be on a return
sharing basis.
Investment of Clients money: The portfolio manager should not accept
money or securities from his clients for less than one year. Any renewal of
portfolio fund on the maturity of the initial period is deemed as a fresh
placement for a minimum period of one year. The portfolio funds and is
withdrawn or taken back by the portfolio clients at his risk before the
maturity date of the contract under the following circumstances:
a. Voluntary or compulsory termination of portfolio management services by
the portfolio manager.
b. Suspension or termination of registration of portfolio manager by the
SEBI.
c. Bankruptcy or liquidation in case the portfolio manager is a body
corporate.
d. Permanent disability, lunacy or insolvency in case the portfolio manager is
an individual.
The portfolio manager can invest funds of his clients in money market
instruments or as specified in the contract, but not in bill discounting, badla
financing or for the purpose of lending

Q2. What are mutual funds? Explain the benefit and

risks involved in investing in Mutual Funds.
Mutual Funds:
Mutual funds are financial intermediaries which collect the savings of
investors and invest them in a large and well diversified portfolio of
securities such as money market instruments, corporate and Government
bonds and equity shares of joint stock companies. A mutual fund is a pool of
commingle funds invested by different investors, who have not contract with
each other. Mutual funds are conceived as institutions for providing small
investors with avenues of investments in the capital market.. Since small

investors generally do not have adequate time, knowledge, experience and

resources for directly accessing the capital market, they have to rely on an
intermediary which undertakes informed investment decisions and provides
the consequential benefits of professional expertise. The raison deter of
mutual funds is their ability to bring down transaction costs. The advantages
for the investors are reduction in risk, export professional management,
diversified portfolios, and liquidity of investment and tax benefits. By
pooling their assets through mutual funds, investors achieve economies of
scale. The interests of the investors are protected by the SEBI which acts as
a watch dog. Mutual funds are governed by the SEBI (Mutual Funds)
Regulations, 1993
Benefits of investing in Mutual Funds
There are several benefits from investing in a Mutual Fund:
Small investments: Mutual funds help you to reap the benefit of returns by
a portfolio spread across a wide spectrum of companies with small
investments.
Professional Fund Management: Professionals having considerable
expertise, experience and resources manage the pool of money collected by
a mutual fund. They thoroughly analyses the markets and economy to pick
good investment opportunities.
Spreading Risk: An investor with limited funds might be able to invest in
only one or two stocks/bonds, thus increasing his or her risk. However, a
mutual fund will spread its risk by investing a number of sound stocks or
bonds. A fund normally invests in companies across a wide range of
industries, so the risk is diversified.
Transparency: Mutual Funds regularly provide investors with information
on the value of their investments. Mutual Funds also provide complete
portfolio disclosure of the investments made by various schemes and also
the proportion invested in each asset type.
Choice: The large amount of Mutual Funds offer the investor a wide variety
to choose from. An investor can pick up a scheme depending upon his risk/
return profile.
Regulations: All the mutual funds are registered with SEBI and they
function within the provisions of strict regulation designed to protect the
interests of the investor.

Valuation of Mutual funds:

Mutual Funds are valued with the help of their NAVs.
NAV or Net Asset Value of the fund is the cumulative market value of the
assets of the fund net of its liabilities. NAV per unit is simply the net value
of assets divided by the number of units outstanding. Buying and selling into
funds is done on the basis of NAV-related prices. The NAV of a mutual fund
are required to be published in newspapers. The NAV of an open end scheme
should be disclosed on a daily basis and the NAV of a close end scheme
should be disclosed at least on a weekly basis
Entry/Exit Load
A Load is a charge, which the mutual fund may collect on entry and/or exit
from a fund. A load is levied to cover the up-front cost incurred by the
mutual fund for selling the fund. It also covers one time processing costs.
Some funds do not charge any entry or exit load. These funds are referred to
as No Load Fund. Funds usually charge an entry load ranging between
1.00% and 2.00%. Exit loads vary between 0.25% and 2.00%.
For e.g. Let us assume an investor invests Rs. 10,000/- and the current NAV
is Rs.13/-. If the entry load levied is 1.00%, the price at which the investor
invests is Rs.13.13 per unit. The investor receives 10000/13.13 = 761.6146
units. (Note that units are allotted to an investor based on the amount
invested and not on the basis of no. of units purchased).
Let us now assume that the same investor decides to redeem his 761.6146
units. Let us also assume that the NAV is Rs 15/- and the exit load is 0.50%.
Therefore the redemption price per unit works out to Rs. 14.925. The
investor therefore receives 761.6146 x 14.925 = Rs.11367.10.
Risks involved in investing in Mutual Funds
Mutual Funds do not provide assured returns. Their returns are linked to
their performance. They invest in shares, debentures, bonds etc. All these
investments involve an element of risk. The unit value may vary depending
upon the performance of the company and if a company defaults in payment
of interest/principal on their debentures/bonds the performance of the fund
may get affected. Besides incase there is a sudden downturn in an industry
or the government comes up with new a regulation which affects a particular
industry or company the fund can again be adversely affected. All these
factors influence the performance of Mutual Funds.
Some of the Risk to which h Mutual Funds are exposed to be given
below:

Market risk
If the overall stock or bond markets fall on account of overall economic
factors, the value of stock or bond holdings in the fund's portfolio can drop,
thereby impacting the fund performance.
Non-market risk
Bad news about an individual company can pull down its stock price, which
can negatively affect fund holdings. This risk can be reduced by having a
diversified portfolio that consists of a wide variety of stocks drawn from
different industries.
Interest rate risk
Bond prices and interest rates move in opposite directions. When interest
rates rise, bond prices fall and this decline in underlying securities affects the
fund negatively.
Credit risk
Bonds are debt obligations. So when the funds invest in corporate bonds,
they run the risk of the corporate defaulting on their interest and principal
payment obligations and when that risk crystallizes, it leads to a fall in the
value of the bond causing the NAV of the fund to take a beating.
Different types of Mutual funds
Mutual funds are classified in the following manner:
(a) On the basis of Objective
Equity Funds/ Growth Funds
Funds that invest in equity shares are called equity funds. They carry the
principal objective of capital appreciation of the investment over the
medium to long-term. They are best suited for investors who are seeking
capital appreciation. There are different types of equity funds such as
Diversified funds, Sector specific funds and Index based funds.
Diversified funds
These funds invest in companies spread across sectors. These funds are
generally meant for risk-averse investors who want a diversified portfolio
across sectors.
Sector funds

These funds invest primarily in equity shares of companies in a particular

business sector or industry. These funds are targeted at investors who are
bullish or fancy the prospects of a particular sector.
Index funds
These funds invest in the same pattern as popular market indices like S&P
CNX Nifty or CNX Midcap 200. The money collected from the investors is
invested only in the stocks, which represent the index. For e.g. a Nifty index
fund will invest only in the Nifty 50 stocks. The objective of such funds is
not to beat the market but to give a return equivalent to the market returns.
Tax Saving Funds
These funds offer tax benefits to investors under the Income Tax Act.
Opportunities provided under this scheme are in the form of tax rebates
under the Income Tax act.
Debt/Income Funds
These funds invest predominantly in high-rated fixed-income-bearing
instruments like bonds, debentures, government securities, commercial
paper and other money market instruments. They are best suited for the
medium to long-term investors who are averse to risk and seek capital
preservation. They provide a regular income to the investor.
Liquid Funds/Money Market Funds
These funds invest in highly liquid money market instruments. The period of
investment could be as short as a day. They provide easy liquidity. They
have emerged as an alternative for savings and short-term fixed deposit
accounts with comparatively higher returns. These funds are ideal for
corporate, institutional investors and business houses that invest their funds
for very short periods.
Gilt Funds
These funds invest in Central and State Government securities. Since they
are Government backed bonds they give a secured return and also ensure
safety of the principal amount. They are best suited for the medium to longterm investors who are averse to risk.
Balanced Funds
These funds invest both in equity shares and fixed-income-bearing
instruments (debt) in some proportion. They provide a steady return and
reduce the volatility of the fund while providing some upside for capital

appreciation. They are ideal for medium to long-term investors who are
willing to take moderate risks.
b) On the basis of Flexibility
Open-ended Funds
These funds do not have a fixed date of redemption. Generally they are open
for subscription and redemption throughout the year. Their prices are linked
to the daily net asset value (NAV). From the investors' perspective, they are
much more liquid than closed-ended funds.
Close-ended Funds
These funds are open initially for entry during the Initial Public Offering
(IPO) and thereafter closed for entry as well as exit. These funds have a
fixed date of redemption. One of the characteristics of the close-ended
schemes is that they are generally traded at a discount to NAV; but the
discount narrows as maturity nears. These funds are open for subscription
only once and can be redeemed only on the fixed date of redemption. The
units of these funds are listed on stock exchanges (with certain exceptions),
are tradable and the subscribers to the fund would be able to exit from the
fund at any time through the secondary market.
Different investment plans that Mutual Funds offer
The term investment plans generally refers to the services that the funds
provide to investors offering different ways to invest or reinvest. The
different investment plans are an important consideration in the investment
decision, because they determine the flexibility available to the investor.
Some of the investment plans offered by mutual funds in India are:
Growth Plan and Dividend Plan
A growth plan is a plan under a scheme wherein the returns from
investments are reinvested and very few income distributions, if any, are
made. The investor thus only realizes capital appreciation on the investment.
Under the dividend plan, income is distributed from time to time. This plan
is ideal to those investors requiring regular income.
Dividend Reinvestment Plan
Dividend plans of schemes carry an additional option for reinvestment of
income distribution. This is referred to as the dividend reinvestment plan.
Under this plan, dividends declared by a fund are reinvested in the scheme

on behalf of the investor, thus increasing the number of units held by the
investors.
Return form mutual funds: Investors on mutual funds can obtain the
following returns. They are:
1. Dividends.
2. Capital gains.
3. Increase or decrease in NAV
2.

Dividends: The dividend income of a mutual fund company

forms its investments in share, both equity and preference, are phased on
to the unit holders. All income received by investors form mutual funds is
exempt from tax.
3.
Capital Gains: Mutual fund unit holders or owners also got
benefits of capital gains which are realized and described to them in cash
or kind.
4.

Increase or Decrease in NAV: The increase or decrease in the

NAV is the result of unrealized gains or losses on the portfolio holdings
of the mutual fund.

Although mutual funds do not earn high rates of return, they are able to
reduce risk to the systematic level of market fluctuations. Most mutual funds
earn in long run, an average rate of return that exceeds the return on bank
tern deposits.
Structure of Mutual Funds
Following is the structure of a typical mutual fund:

The Sponsor of a fund is the entity that sets up the mutual fund. The fund is
governed either by a Board of Trustees, or The Directors Of A Trustees
Company. The sponsor selects them. The Board of Trustee is responsible
for protecting the investors interests. The sponsor or the trustee if so
authorized by the Trust Deed appoints the Asset Management Company
(AMC) for the investment and administrative functions. The AMC does the
research, and manages the corpus of the fund. It launches the various
schemes of the fund, manages them, and then liquidates them at the end of
their term. It also takes care of the other administrative work of the fund. It
receives annual management fees from the fund from its services. The
Custodians are appointed by the sponsor for looking after the transfer and
storage of the securities and co-ordinate with the brokers.
Sponsor with Track Record:
A mutual fund in a private sector has to be sponsored by a limited company
having a track record. The mutual fund has to be established as a trust under
the Indian Trust Act, 1882. The sponsoring company should have at least a
40 percent stake in the paid-up capital of the asset management company.
Mutual funds are required to avail off the services of a custodian who has
secured the necessary authorization form the SEBI.
Asset Management Company: (AMC)
A mutual fund is managed by an Asset Management Company that is
appointed by the sponsor company or by the trustee. The asset management
company has to be registered under the Companies Act,1956, and has to be
approved by the SEBI. The AMC manages the affairs of the mutual funds

and its schemes. AMC are registered by the Registrar of Companies only
after a draft memorandum and articles of association are cleared by the
SEBI.
The Trustee
A mutual fund in India is constituted in the form of a Public Trust created
under the Indian Trusts Act 1882. The Fund Sponsor acts as the Settler of the
Trust, contributing to its initial capital and appoints a trustee to hold the
assets for the benefit of the unit-holders, who are the beneficiaries of the
trust. The fund then invites investors to contribute their money in the
common pool, by subscribing to units issued by various schemes established
by the trust, units being the evidence of their beneficial interest in the fund.
The trust the mutual fund- may be managed by a Board of Trustees- a
body of individuals, or a trust company- a corporate body. The Board of
Trustees manages most of the funds in India. While the Provisions of the
Indian Trusts Act, govern the Board of Trustees where the Trustee is a
corporate body, it would also be required to comply with the provisions of
the companies Act, 1956. The Board or the trustee company, as an
independent body, acts as protector of the unit-holders interest the trustees
do not directly manage the portfolio of securities.
For this specialist function, they appoint an Asset Management Company.
They ensure that the fund is managed by the AMC as per the defined
objectives and in accordance with the Trust Deed and SEBI Regulations.
The trustees being the primary guardians of the unit holders funds and
assets, a trustee has to be a person of high repute and integrity. He acts as a
watchdog over the AMC so that the investors money is safe and secure.
Fund Management
Active Fund Management
When investment decisions of the fund are at the discretion of a fund
manager(s) and he or she decides which company, instrument or class of
assets the fund should invest in based on research, analysis, and market news
etc. such a fund is called as an actively managed fund. The fund buys and
sells securities actively based on changed perceptions of investment from
time to time. Based on the classifications of shares with different
characteristics, active investment managers construct different portfolio.
Two basic investment styles prevalent among the mutual funds are Growth
Investing and Value Investing:

 Growth Investment Style

The primary objective of equity investment is to obtain capital appreciation.
A growth manager looks for companies that are expected to give above
average earnings growth, where the manager feels that the earning prospects
and therefore the stock prices in future will be even higher. Identifying such
growth sectors is the challenge before the growth investment manager.
Value investment Style
A Value Manager looks to buy companies that they believe are currently
undervalued in the market, but whose worth they estimate will be recognized
in the market valuations eventually.
Passive Fund Management
When an investor invests in an actively managed mutual fund, he or she
leaves the decision of investing to the fund manager. The fund manager is
the decision- maker as to which company or instrument to invest in.
Sometimes such decisions may be right, rewarding the investor handsomely.
However, chances are that the decisions might go wrong or may not be right
all the time which can lead to substantial losses for the investor. There are
mutual funds that offer Index funds whose objective is to equal the return
given by a select market index. Such funds follow a passive investment
style. They do not analyse companies, markets, economic factors and then
narrow down on stocks to invest in. Instead they prefer to invest in a
portfolio of stocks that reflect a market index, such as the Nifty index. The
returns generated by the index are the returns given by the fund. No attempt
is made to try and beat the index. Research has shown that most fund
managers are unable to constantly beat the market index year after year. Also
it is not possible to identify which fund will beat the market index.
Therefore, there is an element of going wrong in selecting a fund to invest
in. This has led to a huge interest in passively managed funds such as Index
Funds where the choice of investments is not left to the discretion of the
fund manager. Index Funds hold a diversified basket of securities which
represents the index while at the same time since there is not much active
turnover of the portfolio the cost of managing the fund also remains low.
This gives a dual advantage to the investor of having a diversified portfolio
while at the same time having low expenses in fund.

Q3. Write Short notes on:

a) FDI
b) NBFC
Foreign Direct Investment (FDI): is viewed as a major stimulus to
economic growth in developing countries. Its perceived ability to deal with
major obstacles such shortages of financial resources, technology, and skills.
This has made it the center of attention for policy makers in developing
countries such as Africa. FDI refers to investment made to acquire a lasting
management interest (usually at least 10 % of voting stock) and acquiring at
least 10% of equity share in an enterprise operating in a country other than
the home country of the investor. FDI can take the form of either
greenfield investment (also called "mortar and brick" investment) or
merger and acquisition (M&A), depending on whether the investment
involves mainly newly created assets or just a transfer from local to foreign
firms.

Foreign direct investment (FDI) in its classic form is defined as a company

from one country making a physical investment into building a factory in
another country. It is the establishment of an enterprise by a foreigner. Its
definition can be extended to include investments made to acquire lasting
interest in enterprises operating outside of the economy of the investor . The
FDI relationship consists of a parent enterprise and a foreign affiliate which
together form a multinational corporation (MNC). In order to qualify as FDI
the investment must afford the parent enterprise control over its foreign
affiliate. The IMF (International Monetary Fund) defines control in this case
as owning 10% or more of the ordinary shares or voting power of an
incorporated firm or its equivalent for an unincorporated firm; lower
ownership shares are known as portfolio investment. Foreign direct
investment (FDI) is also defined as "investment made to acquire lasting
interest in enterprises operating outside of the economy of the investor." The
FDI relationship consists of a parent enterprise and a foreign affiliate which
together form a transnational corporation (TNC). In order to qualify as FDI
the investment must afford the parent enterprise control over its foreign
affiliate.
Types of FDI:
I. By Direction
1. Inward
Inward foreign direct investment is when foreign capital is invested in local
resources.
Inward FDI is encouraged by: Tax breaks, subsidies, low interest loans,
grants, lifting of certain restrictions. The thought is that the long term gain is
worth short term loss of income.
Inward FDI is restricted by: Ownership restraints or limits Differential
performance requirements
2. Outward: Outward foreign direct investment, sometimes called "direct
investment abroad", is when local capital is invested in foreign resources.
Outward FDI is encouraged by: Government-backed insurance to cover
risk.
Outward FDI is restricted by:

(ii)
(iii)

Tax incentives or disincentives on firms that invest outside

of the home country or on repatriated profits
Subsidies for local businesses

II. by Target:
1. Greenfield investment: It is direct investment in new facilities or the
expansion of existing facilities. Greenfield investments are the primary
target of a host nations promotional efforts because they create new
production capacity and jobs, transfer technology and know-how, and can
lead to linkages to the global marketplace. Greenfield investments include
research and development; and additional capital investments. Greenfield
investments results in the loss of market share for competing domestic firms.
The Profits are perceived to bypass local economies, and instead flow back
entirely to the multinational's home economy.
2. Mergers and Acquisitions: Transfers of existing assets from local firms to
foreign firms takes place; the primary type of FDI. Cross-border mergers
occur when the assets and operation of firms from different countries are
combined to establish a new legal entity. Cross-border acquisitions occur
when the control of assets and operations is transferred from a local to a
foreign company, with the local company becoming an affiliate of the
foreign company. Unlike Greenfield investment, acquisitions provide no
long term benefits to the local economy-- even in most deals the owners of
the local firm are paid in stock from the acquiring firm, meaning that the
money from the sale could never reach the local economy. Mergers and
acquisitions are a significant form of FDI
3. Horizontal FDI: Investment in the same industry abroad as a firm operates
in at home.
a) Vertical FDI: Backward Vertical FDI: Where an industry abroad provides
inputs for a firm's domestic production process.
Forward Vertical FDI: Where an industry abroad sells the outputs of a
firm's domestic production.
III. by Motive: FDI can also be categorized based on the motive behind the
investment from the perspective of the investing firm:
1. Resource-Seeking: Investments which seek to acquire factors of
production that is more efficient than those obtainable in the home economy

of the firm. In some cases, these resources may not be available in the home
economy at all (e.g. cheap labor and natural resources).
2. Market-Seeking: Investments which aim at either penetrating new markets
or maintaining existing ones. FDI of this kind may also be employed as
defensive strategy. The businesses are more likely to be pushed towards this
type of investment out of fear of losing a market rather than discovering a
new one.
3. Efficiency-Seeking: Investments which firms hope will increase their
efficiency by exploiting the benefits of economies of scale and scope, and
also those of common ownership. It is suggested that this type of FDI comes
after either resource or market seeking investments have been realized, with
the expectation that it further increases the profitability of the firm. This type
of FDI is mostly widely practiced between developed economies; especially
those within closely integrated markets (e.g. the EU).
4. Strategic-Asset-Seeking: A tactical investment to prevent the loss of
resource to a competitor. For E.g., the oil producers, whom may not need the
oil at present, but look to prevent their competitors from having it.
Foreign Direct Investment (FDI) in India is permitted as under the following
forms of investments.
1. Through financial collaborations.
2. Through joint ventures and technical collaborations.
3. Through capital markets via Euro issues.
4. Through private placements or preferential allotments.
Forbidden Territories: FDI is not permitted in the following industrial
sectors:
1. Arms and ammunition.
2. Atomic Energy.
3. Railway Transport.
4. Coal and lignite.
5. Mining of iron, manganese, chrome, gypsum, sculpture, gold,
diamonds, copper, zinc.

FDI up to 100% is allowed under the automatic route in all

activities/sectors except the following which will require approval of
the Government :
Activities/items that require an Industrial License;

Proposals in which the foreign collaborator has a previous/existing

venture/tie up in India in the same or allied field
All proposals relating to acquisition of shares in an existing Indian
company by a foreign/NRI investor.
All proposals falling outside notified sectorial policy/caps or under
sectors in which FDI is not permitted.

FOREIGN INSTITUTIONAL INVESTOR: An investor or investment

fund that is from or registered in a country outside of the one in which it is
currently investing. Institutional investors include hedge funds, insurance
companies, pension funds and mutual funds. The term is used
most commonly in India to refer to outside companies investing in the
financial markets of India. International institutional investors must register
with the Securities and Exchange Board of India to participate in the market.
One of the major market regulations pertaining to FIIs involves placing
limits on FII ownership in Indian companies. One who propose to invest
their proprietary funds or on behalf of "broad based" funds or of foreign
corporates and individuals and belong to any of the following categories can
be registered for FII.

Pension Funds
Mutual Funds
Investment Trust
Insurance or reinsurance companies
Endowment Funds
University Funds
Foundations or Charitable Trusts or Charitable Societies who propose
to invest on their own behalf, and
Asset Management Companies
Nominee Companies
Institutional Portfolio Managers
Trustees
Power of Attorney Holders
Bank

Foreign Direct Investment (FDI) are usually preferred over other forms of
external finance because they are non-debt creative, non-volatile and their
returns depend on the performance of projects financed by the investors. FDI
benefits domestic industry as well as Indian consumer by providing
opportunities for technological up gradation, access to global managerial
skills and practices, optimal utilization of natural and human resources,

making Indian industry internationally competitive, opening up export

markets, providing backward and forward linkages and access to
international quality goods and services. In a world of increased of
competition and rapid technological change, their complimentary and their
catalytic role can be very valuable.
THE COSTS AND BENEFITS OF FDI
Foreign Direct Investment as a development tool has its benefits and risks, and
will only lead to economic growth in the host country under certain conditions. It
is the responsibility of governments to make sure that certain conditions are in
place so that FDI can contribute to development goals rather than just generating
profits for the foreign investor. These conditions cover broad features of the
political and macroeconomic environment. The impact of FDI in a country would
depend on a number of factors such as:
The mode of entry (Greenfield or merger and acquisition),
The activities undertaken, and whether these are already undertaken in the host
country,
Sources of finance for FDI (reinvested earnings, intra-company loans or the
equity capital from parent companies), and
The impact on the activities of domestic companies (CUTS, 2001
The potential problems associated with FDI include:
Impact on domestic competition. FDI and in particular M&As are likely to have
a negative impact on the level of competition in the domestic market. This may
lead to restrictive business practices and abuse of dominance. TNCs may damage
host economies by suppressing domestic entrepreneurship and using their superior
knowledge, worldwide contacts, advertising skills, and a range of essential support
services to drive out local competitors and hinder the emergence of small scale
local enterprises.
Impact on the balance of payments. The trade deficit can be a real constraint for
developing countries. If investors import more that they export, FDI can end up
worsening the trade situation of the country.
Instability. Volatility is associated more with portfolio capital flows. Although
investment in physical assets is fixed, profits from investment are as mobile as
portfolio flows and can be reinvested outside the country at short notice. Profits
may surpass the initial investment value and FDI may thus contribute to capital
export.
Transfer pricing. This refers to the pricing of intra-firm transactions which does
not reflect the true value of products entering and leaving the country. This could
lead to a drain of national resources. Countries may lose out on tax revenue from
corporations, as they are able to juggle their accounts in such a manner as to avoid
their tax liabilities.
The impact of development, when FDI occur through TNCs is uneven. In many
situations TNC activities reinforce dualistic economic structures and acerbate
income inequalities. They tend to promote the interests of a small number of local

factory managers and relatively well paid modern-sector workers against the
interests of the rest of the population by widening wage differentials. They tend to
worsen the imbalance between rural and urban economic opportunities by locating
primarily in urban export enclaves and contributing to the flow of rural-urban
migration.
TNCs use their economic power to influence government policies in directions
that usually do not favor development. They are able to extract sizable economic
and political concessions from competing governments in the form of excessive
protection, tax rebates, investment allowances and the cheap provisions of factory
sites and services. As a result, the profits of TNCs may exceed social benefits.

Q3. Write Short notes on:

(b)NBFC
NON BANKING FINANCIAL COMPANIES (Indian Perspective)
Non-banking financial companies (NBFCs) in the Indian financial sector are
a force to reckon with rough estimates indicates that there are about 40,700
non-banking finance companies in the country. Of course, the number
includes many small companies operating in the unorganized sector such as
in this, chit funds, etc. The NBFCs registered with the Reserve Bank of India
(Central Bank in India) number only about 745 of which about 121 have
credit ratings with them. Till the others are also brought under the ambit of
the regulatory framework, the guidelines and rules issued by the Re-serve
Bank of India will continue to be largely imposed on the registered NBFCs
alone. We have to appreciate the fact that it is a Herculean task to supervise
effectively all the 40,000 odd finance companies scattered all over the
country. This task becomes all the more difficult since these companies do
not have a transparent, uniform or laid down accounting standards, strict
vigilance or audit systems or an effective supervisory system as compared to
those in the organized financial sector.

Definitions: A miscellaneous non-banking company is a company carrying

on all or any of the following types of business:
(a) Managing, conducting or supervising as a promoter, foreman or agent of
any transaction or arrangement by which the company enters into an
agreement with a specified number of subscribers that every one of them
shall subscribe a certain sum in installments over a definite period and that
every one of such subscribers shall in his turn, as determined by lot or by
auction or by tender or in such manner as may be provided for in the
agreement be entitled to the prize amount.
(b) Conducting any other form of chit, which is different from the type of
business referred to in (a).
(c) Undertaking or carrying on or engaging in or executing any other busyness similar to the business referred to in (a) and (b). A residuary nonbanking company is a company which receives any deposit under any
scheme or arrangement, by whatever name called, in one lump sum or in
installments by way of contributions or subscriptions or by sale of units or
certificates or other instruments, or in any other manner and which,
according to the definitions contained in the Non Banking Financial
Companies (Reserve Bank) Directions, 1977 or the Miscellaneous NonBanking Companies (Reserve Bank) Directions, 1977, as the case may be, is
not (i) an equipment leasing company, (ii) a hire purchase finance company,
(iii) a housing finance company, (iv) an insurance company, (v) an
investment company, (vi) a loan company, (vii) a mutual benefit financial
company, and (viii) a miscellaneous non-banking company.
A non-banking non-financial company is an industrial concern as defined
in Industrial Development Bank of India Act or a company whose principal
activities are agricultural operations or trading in goods and services or real
estate and which is not classified as financial or miscellaneous or residuary
non-banking
company.
Regulated Deposit is a deposit, which is subject to certain ceilings, and
other restrictions as imposed by the regulatory measures. It includes
unsecured debentures, debentures secured by movable assets, deposits
received by public limited companies from its shareholders, deposits
guaranteed by directors in their personal capacity and fixed deposits, etc.
received from public. Effective April 12, 1993 intercompany borrowings and
money received from directors/shareholders of private companies constitute
regulated deposits. Exempted Deposit signifies those types of
deposits/borrowings, which are outside the scope of the regulatory pleasures.

It includes borrowings from banks and specified financial institutions,

money received from Central/State/foreign Governments, security deposits,
advances received against orders, etc. Taking into consideration the fact that
the operations of the NBFCs affect adversely the efficacy of fiscal and
monetary policy, a series of measures have been initiated during the last few
years to regulate their operations. The present chapter deals with these
measures in a chronological order.
NBFCs can be classified into different segments depending on the type
of activities they undertake:
Hire purchase finance company Investment Company including primary
dealers
Loan Company
Mutual benefit financial company
Equipment leasing company
Chit Fund Company
Miscellaneous non-banking companies
The above mentioned entities are either partially or wholly regulated by the
RBI. Before we proceed forward lets understand few terms as these are
important for further learning.
Deposits: Definition of the deposit is in its broadest sense to include any
receipt of money by way of deposit or loan or in any other form. The term
excludes following receipts:
i. Amount received from bank.
ii Amount received from development/ State financial corporation or any
other financial institution,
iii. Amount received in the ordinary course of business by way of security
deposit, dealership deposit, earnest money, advance against order for
goods/properties and services.
iv. Amount received by way of subscription in respect of a chit and
v. Loan from Mutual Funds.
Financial Institutions: These mean any non-banking Institution / financial
companies engaged in any of the following activities:
vi. Financing by way of loans, advances and so on any activity except of its
own.
vii. Acquisition of shares/ stocks/ bonds/ debentures/securities.
viii. Hire purchase.
ix. Any class of insurance, stock-broking etc.
x. Chit-funds and

xi. Collection of money by way of subscription/ sale or units or other

instruments/any other manner and their disbursement.
Now let us discuss various types of NBFCs.
Equipment Leasing Company: This means the company which is a
financial institution carrying on the activity of leasing (or lease financing) of
equipments as its principal (main) business.
Hire Purchase Finance Company: It is a company which is a financial
institution carrying on as its principal activity hire purchase transactions or
the financing of such transactions.
Investment Company: It means a company which is a financial institution
carrying on as its principal business the acquisition of securities.
Loan Company: It means any company which is a financial institution
carrying on the as its principal business the providing of finance whether by
making loans or advances or otherwise for any activity other than its own.
Mutual Benefit Finance Company (MBFC): MBFC (also called Nidhis)
are NBFCs notified under section 620A of the Companies Act, 1956, and
primarily regulated by Department of Company Affairs (DCA) under the
directions/ guidelines issued by them under section 637A of the Companies
Act, 1956. These companies are exempt from the core provision of the RBI
Act and NBFC directions relating to acceptance of public deposits.
However, RBI is empowered to issue direction in matters relating to deposit
acceptance activities and directions relating to ceiling on interest rate. They
are also required maintain register of deposits, furnish receipt to depositors
and submit returns to the RBI.
Regulatory Non-Banking Companies (RNBC) : RNBCs are a class of
NBFCs that cannot be classified as equipment leasing company, hire
purchase, loan, investment, nidhi or chit fund companies, but which tap
public savings by operating various deposit schemes, akin to recurring
deposit schemes of Banks.
The deposit acceptance activities of these companies are governed by the
provisions of Residuary Non-Banking Companies (Reserve Bank)
Directions, 1987. To safeguard the interest of depositors, the RBI has
directed RNBCs to invest not less than 80% of aggregate deposit liabilities
as per the investment pattern prescribed by it. They can invest only 20% of
aggregate liabilities or 10 times of its net worth, whichever is lower, in a
manner decided by its BOD. The RNBCs are the only class of NBFCs for
which, floor rate of interest is specified by the RBI, while there is no upper
limit prescribed for them. RBI has also prescribed prudential norms for
RNBCs, compliance with which is mandatory and prerequisite for
acceptance of deposits.

Miscellaneous Non-Banking Companies: MNBCs are companies engaged

in the chit fund business. The term deposit as defined under section 45I(bb)
of the RBI Act, 1934, does not include subscription to chit funds. The chit
fund companies are exempted from all the core provisions of the Chapter
IIIB of the RBI Act. RBI only controls the deposits accepted by these
companies, whereas, administration is regulated by the respective state
governments.
Regulatory Measures
The first serious attempt to regulate NBFCs (including nonbanking nonfinancial companies) was taken in October 1966, by issuing two new
directives, viz., (i) Non-Banking Financial Companies (Reserve Bank)
Directives, 1966 and (ii) Non-Banking Non-Financial Companies (Reserve
Bank) Directives,1966. These directives extended the control of the Reserve
Bankto all: (i) non-banking financial companies and (ii) non-banking, nonfinancial companies accepting deposits and they were brought into force
with effect from 1 January 1967. The
directives pro-vided for restricting acceptance of deposits to 25 per cent of
paid-up capital and free reserves in the case of both non-banking financial
and non-banking non-financial companies (other than housing finance and
hire-purchase finance companies).
To obviate hardships, particularly to industrial undertakings, in com-plying
with the provisions of the directives within the specified time limit, the
Reserve Bank made certain modifications in the directives on 23 August
1967, as follows:
(i) In the case of all non-banking companies, financial or non-financial; the
Bank decided that any amount held in the statutory development rebate
reserve, created under section 4(3) of the Income Tax Act, 1961, may
(notwithstanding the fact that the period of 8 years specified in that section
might not have been completed in respect of all the assets) be counted as a
free reserve and
(ii)In the case of industrial concerns as defined in the directives which (a)
have paid dividends on their equity shares at, six per cent or more per annum
in the five years or in five out of six years immediately preceding 1 January
1967, or (b) have
unencumbered fixed assets of a book value in excess of twice the amount of
deposits and the unsecured loans, the time limit of two years, for the
adjustment of the deposits already received in excess of 25 per cent of the

paid-up capital and free reserves including the development rebate reserve,
will increase to five years, i. e., up to the end of December 1971.
The directives issued to non-banking companies were amended in December
1971 so as to bring within their purview, unsecured loans from shareholders
as also loans guaranteed by directors, ex-managing agents or secretaries and
treasurers. Such loans, hitherto exempted from the restrictions relating to
deposits, were subjected to a separate ceiling of 25 per cent of the net owned
funds of companies with effect from 1 January 1972. A period of 3 years and
3 months was provided for the adjustment of excess, if any, over the ceiling
prescribed, of the unsecured loans mentioned above. To provide for the
genuine business requirements of companies, however, certain categories of
loans, particularly loans obtained on guarantees furnished by Government
and any loan obtained from foreign source were specifically exempted from
the purview of the directives.
During 1973, the Reserve Bank issued a new set of directions known as the
Miscellaneous Non-Banking Companies (Reserve Bank) Direc-tions, 1973
which sought to regulate the acceptance of deposits by com-panies
conducting prize chits, lucky draws, savings schemes, etc. These directions
which came into effect from 1 September, 1973, had clarified that the
amounts received by such companies by way of contributions or
subscriptions or by sale of units, certificates, etc., or other instruments or any
other manner or as membership fees or service charges to or in respect of
any savings, or mutual benefit, thrift or any other scheme or arrangement
also constitute deposits. It was further clarified that the usual ceiling on
deposits (25 per cent of paid-up capital plus free reserves less accumulated
balance of loss), would also apply to such deposits. Any amount in excess of
the ceiling existing on 1 September 1973 would have to be adjusted before
October 1976. All other requirements applicable to other non-banking
companies such as these relating to the issue of advertisements, acceptance
of deposits on the basis of application forms, maintenance of registers of
deposits and furnishing of receipts to depositors, would also apply to these
companies. However, companys coming within the purview of these
directions would be required to submit their returns to the Reserve Bank
twice a year.
The two principal notifications containing the directions issued in October
1966, respectively to non-banking companies were further amended during
1973. The principal features of the amendments were: (i) any loan secured
by the creation of a mortgage or pledge of the assets of the company or any

part thereof would be exempt from the ceiling restrictions relating to

deposits only if there is a margin of only at least 25 per cent of the market
value of the assets charged as security for the loan, the mortgage or pledge,
as the case may be, is created in favor, of a trustee which should either be a
scheduled commercial bank or an executor and trustee company which is a
subsidiary of such scheduled commercial bank and the company has to
execute a trust deed in favor of the scheduled commercial bank or its
subsidiary. If the Reserve Bank is satisfied that the mortgage or pledge
created by a company is not in the public interest, it may declare that the
deposits sought to be secured by such mortgage of pledge shall not be
entitled to the benefit of the aforesaid provision. Companies accepting such
secured deposits will, however, have to comply with all other provisions
contained in the directions as applicable to ordinary deposits or unsecured
loans. (ii) Loans obtained from a registered moneylender would henceforth
be treated as deposits for the purposes of the directions. After an
examination of the recommendations of the Banking
Com-mission in regard to non-banking financial intermediaries and the
Reserve Banks view thereon, the Government of India, decided that
statutory powers shall be taken to prohibit acceptance of deposits by all
unincorporated non-banking institutions and that the existing legal
provisions and the directions issued by the Reserve Bank must be tightened
to plug the loop-holes. In June 1974, the Reserve Bank constituted a Study
Group headed by Shri James S. Raj to examine in depth all aspects of the
matter and make suitable recommendations for implementing Governments
decision. In 1974, more powers were vested with the Reserve Bank to
exercise control over non-banking institutions receiving deposits from the
public and financial institutions under the Reserve Bank of India
(Amendment) Act, 1974. The amendments:
(a) Empower the Reserve Bank to inspect non-banking financial institutions
whenever such inspection is considered necessary or expedient by the Bank;
(b) Cast a statuary obligation on the auditor of a non-banking institution to
report to the Reserve Bank the aggregate amount of deposits held by it
where the institution had failed to furnish to return etc., required to be
submitted by it.
(c) Insert the definition of the term deposit in statute itself so as to place
beyond any doubt that any money received by non-banking institutions
otherwise than by way of share capital constitutes deposits.
(d) Make the definition of the term financial institution precise and
comprehensive so as to plug the loop-holes;

(e) Make it compulsory not only for non-banking institutions but also for
brokers to disclose full particulars and information before soliciting
deposits; and
(f) Provide for enhanced penalties for contravention of the provisions of the
Act and the directions issued by the Bank.
The ceiling of 25 per cent of the paid-up capital and free reserves less the
balance of accumulated loss, if any, imposed by the Reserve Bank with
effect from January 1972, in respect of deposits accepted by non-banking
companies in the form of unsecured loans guaranteed by the directors,
deposits raised from shareholders (excluding those received by private
companies from their shareholders subject to certain stipulations) etc., was
lowered by the Bank to 15 per cent with effect from the 27th January 1975,
by issue of three notifications amending the directions in force. Non-banking
financial and non-financial companies having deposits in excess of the
reduced ceiling were given time till 31st December 1975, to wipe out the
excess. Miscellaneous non-banking companies viz., those conducting prize
chits/lucky draws/savings schemes etc., which had been allowed time up to
the end of September 1976, to wipe out the excess over the ceiling of 25 per
cent fixed earlier were allowed further time up to the 31st December 1976,
to bring down their outstanding in respect of the unsecured loans, etc.,
within the reduced ceiling of 15 per cent.
The Companies (Amendment Act), 1974 which came into force from the 1st
February 1975, has inserted anew Section 58 A in the Companies Act, 1955
regulating acceptance of deposits by non-banking companies. Under the
powers vested by the aforesaid Section, the Central Government has in
consultation with the Reserve Bank, framed rules governing acceptance of
deposits by non-financial companies. The rules came into force with effect
from the 3rd February 1975. Consequently, the directions issued by the
Reserve Bank to non-financial companies have since been withdrawn.
The Study Group headed by Shri James S. Raj referred to above submit its
Report to the Reserve Bank on 14th July 1975.
The main recommendations of the Study Group cover nonfinancial
companies, financial companies and companies conducting prize chits
and/or conventional chits. These recommendations had been accepted in
principle by the Reserve Bank and the Government of India.
With regard to non-financial companies, the Study Group observed that the
acceptance of deposits by such companies may not be prohibited altogether
but the measures should be so designed as to ensure the efficacy of monetary
policy and to avoid disruption of the productive process consistent with need
to safeguard the depositors interests. At the same time the ultimate objective

should be to discourage further growth of these deposits and to roll them

back gradually so that they would cease to be a significant source of finance
for industry and trade.
In the case of non-banking financial companies, the Study Group
recommended effective regulation of their activities considering the large
number of depositors involved as well as the incidence of malpractices in
these companies. The Study Group suggested that such companies should be
subjected, by and large, to the same type of controls as banks under the
Banking Regulation Act, 1949. As the operations of loan companies are
analogous to those of banks, the Study Group recommended a ceiling of ten
times the net owned funds. In the opinion of Study Group, avail-ability of
funds to that extent would give them a reasonable chance of profitable
working and enable them to become, viable units. While in regard to hirepurchase finance companies, which are at present exempt from ceiling
restriction, a ceiling (not exceeding ten times their net owned funds) as in
the case loan companies has been proposed, housing finance companies,
however, will continue to be exempted from the ceiling restrictions. Since
such special considerations will not be relevant in respect of investment
companies, the existing composite ceiling of 40 per cent of the net owned
funds is proposed to be reduced to 25 per cent in two stages. Apart from the
restrictions on the quantum of deposits that may be accepted by the
companies, the Group has recommended minimum capital requirements for
starting new financial companies and also in respect of existing companies
other than nidhis. Some of the other recommendations made by it relate to
the creation of reserve funds, maintenance of liquid assets, prohibition of
grant of loans and advances to the directors and firms and companies in
which they are interested and enactment of the Provisions on the lines of
certain sections of the Banking Regulation Act, 1949. In view of the
substantive nature of the recommendations made by it for the purpose of
tightening the control over the deposit acceptance activities of the financial
companies as also the operational aspects relating to their working, it has
been decided to enact a separate comprehensive legislation in place of
Chapter III B of the Reserve Bank of India Act, 1934. The drafting of the
legislation is in progress and in the meantime, steps are also being taken to
implement such of the recommendations as could be given effect to by
invoking the power vested in the Reserve Bank under the existing provisions
of Chapter III B of the said Act by suitable amendments to the directions
now force. The amendments to the directions have been finalized.
As regards companies conducting prize chits benefit savings schemes, etc.,
the Group had come to the conclusion that such schemes benefited primarily

the promoters and did not serve any social purpose. Such schemes were
prejudicial to public interest and also adversely affected the efficacy of fiscal
and monetary policy, It had, therefore, suggested that the conduct of such
schemes should be totally banned in the larger interests of the public and
suitable legislative measures should be taken for the purpose, the provisions
of the existing enactment were considered inadequate.

CASE STUDY
The US-64 Controversy
They have cheated us. I am telling everyone to sell. If they are stupid and
offering Rs 14.25 for paper worth Rs 9, why should I let go of the
opportunity?
- An unhappy US-64 investor in 1998.
CAN OF WORMS
In 1998, investors of Unit Trust of India's (UTI) Unit Scheme-1964 (US-64)
were shaken by media reports claiming that things were seriously wrong
with the mutual fund major. For the first time in its 32 years of existence,
US-64 faced depleting funds and redemptions exceeding the sales. Between
July 1995 and March 1996, funds declined by Rs 3,104 crore. Analysts
remarked that the depleting corpus coupled with the redemptions could soon
result in a liquidity crisis.
Soon, reports regarding the lack of proper fund management and internal
control systems at UTI added to the growing investor frenzy. By October
1998, US-64's equity component's market value had come down to Rs
4200 crore from its acquisition price of Rs 8200 crore. The net asset value
(NAV) of US-64 also declined significantly during 1993-1996 due to
turbulent stock market conditions. A Business Today survey cited US-64's
NAV at Rs 9.68. The US-64 units, which were sold at Rs 14.55 and
repurchased at Rs 14.25 in October 1998, thus were around 50% and 47%,
above their estimated NAV.
Amidst growing concerns over the fate of US-64 investors, it became
necessary for UTI to take immediate steps to put rest to the controversy.

CREATING TRUST
UTI was established through a Parliament Act in 1964, to channelise the
nation's savings via mutual fund schemes. This was done as in the earlier
days, raising the capital from markets was very difficult for the companies
due to the public being very conservative and risk averse. By February 2001,
UTI was managing funds worth Rs 64,250 crore through over 92 saving
schemes such as US-64, Unit Linked Insurance Plan, Monthly Income Plan
etc. UTI's distribution network was well spread out with 54 branch offices,
295 district representatives and about 75,000 agents across the country.
The first scheme introduced by UTI was the Unit Scheme-1964, popularly
known as US-64. The fund's initial capital of Rs 5 crore was contributed by
Reserve Bank of India (RBI), Financial Institutions, Life Insurance
Corporation (LIC), State Bank of India (SBI) and other scheduled banks
including few foreign banks. It was an open-ended scheme , promising an
attractive income, ready liquidity and tax benefits. In the first year of its
launch, US-64 mobilized Rs 19 crore and offered a 6.1% dividend as
compared to the prevailing bank deposit interest rates of 3.75 - 6%. This
impressed the average Indian investor who until then considered bank
deposits to be the safest and best investment opportunity. By October 2000,
US-64 increased its capital base to Rs 15993 crore, spread over 2 crore unit
holders all over the world.
However by the late 1990s, US-64 had emerged as an example for portfolio
mismanagement. In 1998, UTI chairman P.S.Subramanyam revealed that the
reserves of US-64 had turned negative by Rs 1098 crore. Immediately after
the announcement, the Sensex fell by 224 points. A few days later, the
Sensex went down further by 40 points, reaching a 22-month low under
selling pressure by Foreign Institutional Investors (FIIs). This was widely
believed to have reflected the adverse market sentiments about US-64.
Nervous investors soon redeemed US-64 units worth Rs 580 crore. There
was widespread panic across the country with intensive media coverage
adding fuel to the controversy.
DISTRUST IN TRUST
Unlike the usual practice for mutual funds, UTI never declared the NAV of
US-64 - only the purchase and sale prices for the units were announced.
Analysts remarked that the practise of not declaring US-64's NAV in the
initial years was justified as the scheme was formulated to attract the small
investors into capital markets. The declaration of NAV at that time would

not have been advisable, as heavy stock market fluctuations resulting in low
NAV figures would have discouraged the investors. This seemed to have led
to a mistaken feeling that the UTI and US-64 were somehow immune to the
volatility of the Sensex.
Following the heavy redemption wave, it soon became public knowledge
that the erosion of US-64's reserves was gradual. Internal audit reports of
SEBI regarding US-64 established that there were serious flaws in the
management of funds.
Till the 1980s, the equity component of US-64 never went beyond 30%.
UTI acquired public sector unit (PSU) stocks under the 1992-97
disinvestment program of the union government. Around Rs 6000-7000
crore was invested in scripts such as MTNL, ONGC, IOC, HPCL & SAIL.
A former UTI executive said, Every chairman of the UTI wanted to prove
himself by collecting increasingly larger amounts of money to US-64, and
declaring high dividends. This seemed to have resulted in US-64 forgetting
its identity as an income scheme, supposed to provide fixed, regular returns
by primarily investing in debt instruments.
Even a typical balanced fund (equal debt and equity) usually did not put
more than 30% of its corpus into equity. A Business Today report claimed
that eager to capitalise on the 1994 stock market boom, US-64 had
recklessly increased its equity holdings. By the late 1990s the fund's
portfolio comprised around 70% equity.
While the equity investments increased by 40%, UTI seemed to have
ignored the risk factor involved with it. Most of the above investments fared
very badly on the bourses, causing huge losses to US-64. The management
failed to offload the equities when the market started declining. While the
book value of US-64's equity portfolio went up from Rs 7,943 crore (June
1994) to Rs 13,627 (June 1998), the market value had actually declined in
the same period from Rs 18,334 crore to Rs 10,029 crore. Analysts remarked
that UTI had been pumping money into scrips whose market value kept
falling. Raising further questions about the fund management practices was
the fact that there were hardly any growth scrips'from the IT and pharma
sectors in the equity portfolio.
In spite of all this, UTI was able to declare dividends as it was paying them
out of its yearly income, its reserves and by selling the stocks that had
appreciated. This kept the problem under wraps till the reserves turned

negative and UTI could no longer afford to keep the sale and purchase prices
artificially inflated.
Following the public outrage against the whole issue, UTI in collaboration
with the government of India began the task of controlling the damage to
US-64's image.
RESTORING THE TRUST
UTI realised that it had become compulsory to restructure US-64's portfolio
and review its asset allocation policy. In October 1998, UTI constituted a
committee under the chairmanship of Deepak Parekh, chairman, HDFC
bank, to review the working of scheme and to recommend measures for
bringing in more transparency and accountability in working of the scheme.
US-64's portfolio restructuring however was not as easy as market watchers
deemed it to be. UTI could not freely offload the poor performing PSU
stocks bought under the GoI disinvestment program, due to the fear of
massive price erosions after such offloading. After much deliberation, a new
scheme called SUS-99 was launched.
The scheme was formulated to help US-64 improve its NAV by an amount,
which was the difference between the book value and the market value of
those PSU holdings. The government bought the units of SUS-99 at a face
value of Rs 4810 crore. For the other PSU stocks held prior to the
disinvestment acquisitions, UTI decided to sell them through negotiations to
the highest bidder. UTI also began working on the committee's
recommendation to strengthen the capital base of the scheme by infusing
fresh funds of Rs 500 crore. This was to be on a proportionate basis linked to
the promoter's holding pattern in the fund.
The inclusion of the growth stocks in the portfolio was another step towards
restoring US-64's image. Sen, Executive Director, UTI said, The US-64
equity portfolio has been revamped since June. During the last nine months
the new ones that have come to occupy a place among the Top 20 stocks
from the (Satyam Computers, NIIT and Infosys) and FMCG (HLL,
SmithKline Beecham and Reckitt & Colman) sectors. US-64 has reduced its
weightage in the commodity stocks (Indian Rayon, GSFC, Tisco, ACC and
Hindalco.)

To control the redemptions and to attract further investments, the income

distributed under US-64 was made tax-free for three years from 1999. To
strengthen the focus on small investors and to reduce the tilt towards
corporate investors, UTI decided that retail investors should be concentrated
upon and their number should be increased in the scheme.
UTI also decided to have five additional trustees on its board. To enable
trustees to assume higher degree of responsibility and exercise greater
authority UTI decided to give emphasis on a proper system of performance
evaluation of all schemes, marked-to-market valuation [5] of assets and
evaluation of performance benchmarked to a market index. The management
of US-64 was entrusted to an independent fund management group headed
by an Executive Director. UTI made plans to ensure that full responsibility
and accountability was achieved with support of a strong research team. Two
independent sub-groups were formed to manage the equity and debt portion
of US-64. An independent equity research cell was formed to provide market
analysis and research reports.
TABLE
HOW THINGS WERE SET RIGHT
PSU shares were transferred to a special unit scheme (SUS'99)
subscribed by the government in 1998-99.
Core promoters such as the Industrial Development Bank of
India added around Rs 450 crore to the unit capital, thus helping
to bridge the reserves deficit of Rs 2,800 crore in 1998-99.
Portfolios were recast in the current quarter to capitalise on the
stock surge as the BSE Sensex rose by 15%. Greater weightage
was given to stocks such as HLL, Infosys, Ranbaxy, M&M and
NIIT.
In US-64's case exposure to IT, FMCG and Pharma stocks rose
from 20.45% to 22.09%. This was replicated across funds.
Between June 1999 - September 1999, 21 out of UTI's 28
schemes have outperformed the Sensex.
UTI has become more proactive in fund management. For
instance, it bought into Crest at between
Rs 200 and Rs 210 in October 1999. The stock was trading at
Rs 340 in November 1999.
Stocks like Visual Software, Mastek and Gujarat Ambuja have
entered the top 50 equity holding list. Scrips like Thermax,
Thomas Cook and Carrier Aircon are out.

 Complete exit from illiquid stocks such as Esab Industries. The

divesture of around 83 stocks released estimated Rs 300-500
crore of extra investible cash.
Source: Business World, November 29, 1999.
UTI constituted an ad-hoc Asset Management Committee with 7 members
comprising 5 outside professionals and 2 senior UTI officials. The
committee's role was clearly defined and its scope covered the following
areas:
To ensure that US-64 complied with the regulations and guidelines and the
prudential investment norms laid down by the UTI board of trustees from
time
to
time.
To review the scheme's performance regularly and guide fund managers on
the future course of action to be adopted.
To oversee the key issues such as product designing, marketing and
investor servicing along with the recommendations to Board of Trustees.
One of the most important steps taken was the initiative to make US-64
scheme NAV driven by February 2002 and to increase gradually the spread
between sale and repurchase price. The gap between sale and repurchase
price of US-64 was to be maintained within a SEBI specified range. UTI
announced that dividend policy of US-64 would be made more realistic and
it would reflect the performance of the fund in the market. US-64 was to be
fully SEBI regulated scheme with appropriate amendment to the UTI Act.
The real estate investments made by UTI for the US-64 portfolio were also a
part of the controversy as they were against the SEBI guidelines for mutual
funds. UTI had Rs 386 crore worth investments in real estate. UTI claimed
that since its investments were made in real estate, it was safe and it could
sell the assets whenever required. However, the value of the real estate in
US-64's portfolio had gone down considerably over the years. The real estate
investments were hence revalued and later transferred to the Development
Reserve Fund of the trust according to the recommendations of the Deepak
Parekh committee.

By December 1999, the investible funds of US-64 had increased by 60% to

Rs 19,923 crore from Rs 12,433 crore in December 1998. The NAV had
recovered from Rs 9.57 to Rs 16 by February 2000 after the committee
recommendations were implemented
DEAD END SCHEME?
Though UTI started announcing the dividends according to the market
conditions, this was not received well by the investors. They felt that though
the dividend was tax-free, it was not appealing as most of the investors were
senior citizens and they did not come under the tax bracket.
The statement in media by UTI chairman that trust would try to attract the
corporate investors into the scheme was against the recommendation by the
committee, which had adviced the trust to attract the retail investors into the
scheme. This led to doubts about UTI's commitment towards the revival of
the scheme.
However, led by improving NAV figures and image-building exercises on
UTI's part, by 2000, US-64 was again termed as one of the best investment
avenues by analysts and market researchers. UTI had become more
proactive in fund management with its scrips rising in value, restoring the
confidence of the small investor in the scheme. The National Council of
Applied Economic Research (NCAER) and SEBI surveys mentioned that
US-64 was once again perceived as a safe investment by the middle class
income groups.
However, the euphoria seemed to be short lived as in 2001, US-64 was
involved in yet another scam due to its investments in the K-10 stocks .
Talks of a drastically low NAV, inflated prices, increasing redemption and
GoI bailouts appeared once again in the media. An Economic Times report
claimed that there was a difference of over Rs 6000 crore between the NAV
and the sale prices. Doubts were raised as to US-64 being an inherently
weak scheme, which coupled with its mismanagement, had led to its
downfall once again.
This however, was yet another story.
Source:www.icmrindia.org

QUESTIONS FOR DISCUSSION:

1.

Explain in detail the reasons behind the problems faced

by US-64 in the mid 1990s. Were these problems the sole
responsibility of UTI? Give reasons to support your
answer.

2.

Analyse the steps taken by UTI to restore investor

confidence in US-64. Comment briefly on the efficacy of
these steps.

3.

As a market analyst, would you term US-64 a safe mode

of investment? Justify your stand with reasons.

UTI's MandateUTI was formed to increase the propensity of the middle and
lower groups to save and to invest. UTI came into existence during a period
marked by great political and economic uncertainty in India. With war on the
borders and economic turmoil that depressed the financial market,
entrepreneurs were hesitant to enter capital market. The companies found it
difficult to access the equity markets, as investors did not respond
adequately to new issues. To channelise savings of the community into
equity markets to make them available for the companies to speed up the
process of industrial growth.UTI was the idea of then Finance Minister, T.T.
Krishnamachari, which would "open to any person or institution to purchase
the units offered by the trust. However, this institution as we see it, is
intended to cater to the needs of individual investors, and even among them
as far as possible, to those Whose means are small."UTI was formed as an
intermediary that would help fulfil the twin objectives of mobilizing retail
savings and investing those savings in the capital market and passing on the
benefits so accrued to the small investors. UTI commenced its operations
from July 1964 "with a view to encouraging savings and investment and
participation in the income, profits and gains accruing to the Corporation
from the acquisition, holding, management and disposal of securities."
Different provisions of the UTI Act laid down the structure of management,

scope of business, powers and functions of the Trust as well as accounting,

disclosures and regulatory requirements for the Trust.Structure of the Trust
UTI represents an unique organisational without ownership capital and an
independent Board of Trustees. Under the provisions of the first UTI
scheme, US-64, certain institutions contributed to the Scheme's initial
capital, which was redeemable at the discretion of the Trust at such value
decided by the Government of India.The contributors to the initial capital of
Rs. 5 crore for US-64 Scheme were Reserve Bank of India (RBI), Other
Financial Institutions, Life Insurance Corporation (LIC), State Bank of India
(SBI) & its subsidiaries and other scheduled banks including a few foreign
banks. In February 1976, RBIs contribution was taken up by the Industrial
Development Bank of India (IDBI). The institutions were provided
representation on the Board of the Trustees of UTI. Under the provisions of
the Act, Chairman of the Board was appointed by Government of India. The
Board of Trustees oversees the general direction and management of the
affairs and business of UTI. The Board performs its functions based on
commercial principles, keeping in mind the interest of the unit holders under
various schemes. Since UTI does not have any share capital, it operates on
the principle of "no profit no loss" as all income and gains net of all costs
and development charges ultimately go back to investors of respective
schemes. Formative Years: 1964-1974UTI commenced its operations with
R.S. Bhatt at the helm. The first product, Unit Scheme 1964 (US '64),
continues to be the most popular investment avenue to date. In the first year
itself the scheme mobilised Rs.19 crore compared to the incremental
commercial bank deposits of Rs.367 crore in that year. The first year's
dividend was 6.1% compared to the bank deposit rates of 3.75 - 6%. With
the increasing popularity of US-64 as a long-term investment avenue, the

Trust introduced a Reinvestment Plan in 1966-67 (automatic reinvestment of

income distributions to US-64 unit holders). After two successful terms,
when R S Bhatt relinquished charge, he had laid a solid foundation for the
Trust. During his tenure, unit capital had grown to Rs.92 crore, covering an
investor base of 3.64 lakh accounts.

1. Of all the recent encounters of the Indian public with the muchcelebrated forces of the market, the Unit Trusts US-64 debacle is the
worst. Its gravity far exceeds the stock market downswing of the mid1990s, which wiped out Rs. 20,000 crores in savings. The debacle is
part of the economic slowdown which has eliminated one million jobs
and also burst the information technology (IT) bubble. This has
tragically led to suicides by investors. And then suspension of trading
in US-64made the hapless investors more dejected at the sinking of
this super-safe public sector instrument that had delivered a regular
return since 1964. There is a larger lesson in the US-64 debacle for
policies towards public savings and public sector undertakings
(PSUs). The US-64 crisis is rooted in plain mismanagement. US-64
was launched as a steady income fund. Logically, it should have
invested in debt, especially low-risk fixed-income government bonds.
Instead, its managers increasingly invested in equities, with high-risk
speculative returns. In the late 1980s UTI was politicised with
other financial institutions (FIs) such as LIC and GIC, and made to
invest in certain favoured scrips. By the mid-1990s, equities exceeded
debt in its portfolio. The FIs were also used to boost the market
artificially as an endorsement of controversial economic policies.
In the past couple of years, UTI made downright imprudent but heavy
investments in stocks from Ketan Parekhs favourite K-10 portfolio,
such as Himachal Futuristic, Global Tele and DSQ. These
technology investments took place despite indications that the
technology boom had ended. US-64 lost half its Rs. 30,000 crore
portfolio value within a year. UTI sank Rs. 3,400 crores in just six out
of a portfolio of 44 scrips. This eroded by 60 percent. Early that year,
US-64s net asset value plunged below par (Rs.10). But it was repurchasing US-64 above Rs. 14! Today, its NAV stands at Rs. 8.30 a
massive loss for 13 million unit-holders.It is inconceivable that UTI
made these fateful investment decisions on its own. According to
insiders, the Finance Ministry substantially influenced them: all major

decisions need high-level political approval. Indeed, collusion

between the FIs, and shady operators like Harshad Mehta, was central
to the Securities Scam of 1992. The Joint Parliamentary Committees
report documents this. In recent months, the Finance Ministry became
desperate to reverse the post-Budget market downturn. UTIs
misinvestment now coincided with the global technology
meltdown. US-64 crashed. UTI chairman resigned. Although
culpable, he was probably a scapegoat too. The Ministry has kept a
close watch on UTI, especially since 1999.The US-64 debacle, then, is
not just a UTI scam. It is a governance scam involving
mismanagement by a government frustrated at the failure of its
macroeconomic calculations. This should have ensured the Finance
Ministers exit in any democracy which respects parliamentary norms.
There are larger lessons in the UTI debacle. If a well-established, and
until recently wellmanaged, institution like UTI cannot safeguard
public savings, then we should not allow the most precious of such
savings pensions to be put at risk. Such risky investment is banned
in many selfavowedly capitalist European economies. In India, the
argument acquires greater force given the poorly regulated, extremely
volatile, stock market where a dozen brokers control 90 percent of
trade. Yet, there is a proposal by the Finance Ministry to privatize
pensions and provident funds. Basically, the government, deplorably,
wants to get rid of its annual pension obligation of Rs. 22,000 crores.
UTI Scam : Robbery Through other Means Suman The line
between legitimate business and the mafia is getting increasingly
diffused. The greater the liberalisation/globalisation of the economy,
the more rampant is the loot. Phoolan Devi as a dacoit in the ravines
of Madhya Pradesh could not even dream of the type of wealth made
as a Member of Parliament. Her wealth at the time of her death was
estimated at a
2. minimum of Rs. 10 crores. But this is small fry compared to the
Harshad Mehtas, Bharat Shahs, Ketan Parekhs, Subramanyams etc
and the top politicians/bureaucrats/corporate houses with whom they
are linked. Phoolan Devi appears as a petty thief compared to these
gangsters. The amount robbed through the UTI scam intails thousands
of crores the bulk of which belongs to small investors who have
put their life-savings into this scheme. What is the UTI ? The Unit
Trust of India is the largest mutual fund in the country created in 1964
through an act of parliament. Mutual Funds are financal institutions
that invest peoples money in various schemes, giving a gauranteed
return to the investor. The UTI (of which the US-64 scheme is the

largest) was set-up specifically to channel small savings of citizens

into investments giving relatively large returns/interest. The US-64
scheme has 2 crore investors, the bulk of whom are small savers,
retired people, widows and pensioners. Besides the US-64 the UTI
runs 87other schemes giving inverstors various options. But the US64 has been most popular, giving returns as high as 18% in 1993 and
94. Genisis of the Scam Liberalisation of the economy immediately
led to the liberalisation of the UTI, throwing it to the mercy of the
stock market. In 1992, itself the US-64 scheme was changed from a
debtbased fund to one linked to equity. In 1992 only 28% of its funds
was in equity; today it is over 70%. Further liberalisation was pushed
by Chidambram, as the finance minister of the U F government, who,
in 1997, removed all government nominees from the board of the
UTI. Besides, the US-64 does not come under SEBI regulations, its
investment delails are kept secret (ever depositors cannot know where
their funds are being parked) and the chairman has arbitrary powers to
personally decide an investment upto a huge Rs 40 crores. Such
liberalisation is tailor-made for frauds. Not surprisingly, within one
year of Chidambrams liberalisation, in 1998, the UTI crashed, and
the new BJP-led government organised a large Rs. 3,500 crore bailout to prevent default. It was during this crisis that the new chairman,
P.S. Subramanyam, was appointed. Subramanyam was a direct
appointee of thug Jayalalitha, who had made his selection a condition
for her continuing the support of the then NDA government. Later,
though Jayalalitha withdrew from the government, Subramanyam
developed close links with the Prime Ministers Office, and
corporative big-wigs. Small investors funds were used to promote big
business houses, shower favours to politicians, and invest huge
amounts in junk bonds....all for a fat commission. Subramanyam
functioned like a fascist, arbitrarily transferring hundreds of senior
staff, in order to cover his tracks. He was a key player in the Ketan
Parekh scam. Huge amount of UTI funds were channelled into the
infamous K-10 list of Keten Parekh stock, such as Himachal
Futuristic, Zee Telefilims, Global Tele, DSQ, etc. The UTI continued
to buy these shares even when their market value began to crash in
mid-2000, in order to prop up the share values of these stocks. The
Trust saw its Rs. 30,000 portfolio (value of stocks)
3. lose half its value within a year since Feb. 2000. To take just one
example on how the UTI operated : In August 2000, much after the
software stocks had begun to crash, the UTI bought Rs. 34 crores
worth of shares in Cyberspace Infosys Ltd at the huge price of Rs 930

per share. Today the shares have no value and its Lacknow based
promoters, the Johari Group, are in jail. But, what is astounding is that
it was none other than Indias prime minister, Vajpayee, who, as late
as Jan. 31, 2001, laid the foundation stone for the Software
Tectnology Park (STP) in Luknow, promoted by this group.
(Incidentally the UP government had a 26% share in this STP).
Coincidentally, in the four days when the UTI reversed its earlier
decision and subscribed to 3.45 lakh shares of Cyberspace,
Subramanyam had rung up N.K. Singh (then secretary in the PMO) at
least 4 times. It does not take much imagination to link UTI purchases
in Cyberspace with Vajpayee. Similar were the investments in DSQ
Software, HFCL, Sriram Multitech. and others. Besides, the UTI also
invested in junk bonds like Pritish Nandy communications (Rs. 1.5
crores), Jain Studios(Rs.5 crores), Sanjay Khans Numero Uno
International (Rs. 7.5 crores), Malavika Spindles(Rs. 188 crores) etc.
This amounted to nothing but handing over peoples money
(investments) to the rich and powerful. Thereby thousands of crores
were siphoned off to big business and prominent individuals, with the
UTI chairman, bureaucrats and politicians taking their cuts. But this
was not all. The fraud continues even further. With knowledge that the
UTI was in a state of collapse, the Chairman organised a high profile
propaganda campaign promoting UTI (spending crores of rupees on
the top advertising company, Rediffusion), while at the same time
leaking information to the big corporates to withdraw their funds. The
Chairman thereby duped the lakhs of small investors through false
propaganda, while allowing windfall profits to the handfull of big
corporates who had invesed in UTI. So, in the two month prior to the
freezing of dealings in UTI shares, a gigantic sum of Rs. 4,141 crores
was redeemed. Of this Rs.4,000 crores (97%) were corporate
investments. What is more,they were re-purched at the price of Rs.
14.20 per share (face value Rs.10) when in fact its actual value (NAV
net asset value) was not more than Rs. 8. As a result UTIs small
investors lost a further Rs. 1,300 crores to the big corporates. In fact
these huge withdrawals further precipated the crisis. On July 4, 2001
the board of UTI took the unprecedented step of freezing the purchase
and sale of all US-64 UTI shares for six months. Simultaneously it
declared a pathetic dividend of 7% (10% on face-value), which is
even lower than the interests of the banks and post office saving
schemes. Such freezing of legally held shares is unheard of and is
like overnight declaring Rs. 100 notes as invalid for some time. In
other words the 2 crore shareholders could not re-invest their money

elsewhere and would have to passively see their share price erode
from Rs. 14 (at which they would have purchased it) to Rs 8 and
get interest at a mere 7% on their initial investments. Fearing a backlash, the government/UTI later announced the ability to repurchase
UTI shares at Rs. 10 i.e. at 30 % below the purchase price. Imagine
the plight of a retired person who would have put a large part of
his/her PF,
4. gratuity etc. in the US-64 scheme, considering it the safest possible
investment. Not only has the persons income (interest/dividend)
halved overnight, he/she also stands to lose a large part of the
investment. So, a person who invested Rs. 1 lakh would now only get
back Rs 70,000. Today, the entire middle class is being robbed of their
savings first it was by the private mutual funds (NBFCs), now by
the govt. sponsored mutual fund. Those who gain are the robber
barons who run the countrys economics, finance, politics. The
middle-classes, affected by these scame, will soon realise the facts and
come out of the euphoria of consumerism that has numbed their
senses. They will see through the hoax of globalisation/liberalisation,
and will turn their wrath on these so-called pillars of society. It is
important that this impending explosion be channeled in a
revolutionary direction, or else it will be diverted by the ruling elite
into fatricidal clashes. The middle-classes are most prone to fall prey
to ruling-class propaganda. But life itself is the best educator. Faced
with unemployment, loot of their savings, price rise of all essentials,
etc. they will no doubt, join the working class and their peasant
brethrens in revolt. . The UTI Scam Former UTI chairman P S
Subramanyam and two executive directors - M M Kapur and S K
Basu - and a stockbroker Rakesh G Mehta, were arrested in
connection with the 'UTI scam'. UTI had purchased 40,000 shares of
Cyberspace between September 25, 2000, and September 25, 2000 for
about Rs 3.33 crore (Rs 33.3 million) from Rakesh Mehta when there
were no buyers for the scrip. The market price was around Rs 830.
The CBI said it was the conspiracy of these four people which
resulted in the loss of Rs 32 crore (Rs 320 million). Subramanyam,
Kapur and Basu had changed their stance on an investment advice of
the equities research cell of UTI. The promoter of Cyberspace Infosys,
Arvind Johari was arrested in connection with the case. The officals
were paid Rs 50 lakh (Rs 5 million) by Cyberspace to promote its
shares. He also received Rs 1.18 crore (Rs 11.8 million) from the
company through a circuitous route for possible rigging the
Cyberspace counter. Unhappy investors Quote in 1998 "They were

invested blindly in stocks, they have cheated us. I am telling everyone

to sell. If they are stupid and offering Rs 14.25 for paper worth Rs 9,
why should I let go of the opportunity? In 1998, investors of Unit
Trust of Indias (UTI) Unit Scheme-1964 (US-64) were shaken by
media reports claiming that things were seriously wrong with the
mutual fund major. For the first time in its 32 years of existence, US64 faced depleting funds and redemptions exceeding the sales.
Between July 1995 and March 1996, funds declined by Rs 3,104
crore. Analysts remarked that the depleting corpus coupled with the
redemptions could soon result in a liquidity crisis. Soon, reports
regarding the lack of proper fund
5. management and internal control systems at UTI added to the
growing investor frenzy. By October 1998, US-64s equity
components market value had come down to Rs 4200 crore from its
acquisition price of Rs 8200 crore. The net asset value (NAV) of US64 also declined significantly during 1993-1996 due to turbulent stock
market conditions. A Business Today survey cited US-64s NAV at Rs
9.68. The US-64 units, which were sold at Rs 14.55 and repurchased
at Rs 14.25 in October 1998, thus were around 50% and 47%, above
their estimated NAV. Amidst growing concerns over the fate of US-64
investors, it became necessary for UTI to take immediate steps to put
rest to the controversy. CREATING TRUST UTI was established
through a Parliament Act in 1964, to channelise the nations savings
via mutual fund schemes. This was done as in the earlier days, raising
the capital from markets was very difficult for the companies due to
the public being very conservative and risk averse. By February 2001,
UTI was managing funds worth Rs 64,250 crore through over 92
saving schemes such as US-64, Unit Linked Insurance Plan, Monthly
Income Plan etc. UTIs distribution network was well spread out with
54 branch offices, 295 district representatives and about 75,000 agents
across the country.The first scheme introduced by UTI was the Unit
Scheme-1964, popularly known as US-64. The funds initial capital of
Rs 5 crore was contributed by Reserve Bank of India (RBI), Financial
Institutions, Life Insurance Corporation (LIC), State Bank of India
(SBI) and other scheduled banks including few foreign banks. It was
an openended scheme, promising an attractive income, ready liquidity
and tax benefits. In the first year of its launch, US-64 mobilized Rs 19
crore and offered a 6.1% dividend as compared to the prevailing bank
deposit interest rates of 3.75 - 6%. This impressed the average Indian
investor who until then considered bank deposits to be the safest and
best investment opportunity. By October 2000, US-64 increased its

capital base to Rs 15993 crore, spread over 2 crore unit holders all
over the world.However by the late 1990s, US-64 had emerged as an
example for portfolio mismanagement. In 1998, UTI chairman
P.S.Subramanyam revealed that the reserves of US-64 had turned
negative by Rs 1098 crore. Immediately after the announcement, the
Sensex fell by 224 points. A few days later, the Sensex went down
further by 40 points, reaching a 22-month low under selling pressure
by Foreign Institutional Investors (FIIs). This was widely believed to
have reflected the adverse market sentiments about US-64. Nervous
investors soon redeemed US-64 units worth Rs 580 crore. There was
widespread panic across the country with intensive media coverage
adding fuel to the controversy. DISTRUST IN TRUST Unlike the
usual practice for mutual funds, UTI never declared the NAV of US64 - only the purchase and sale prices for the units were announced.
Analysts remarked that the practise of not declaring US-64s NAV in
the initial years was justified as the scheme was formulated to attract
the small investors into capital markets. The declaration of NAV at
that time would not have been advisable, as heavy stock market
fluctuations resulting in low NAV figures would have discouraged the
investors. This seemed to have led to a mistaken feeling that the UTI
and US-64 were somehow immune to the volatility of the
Sensex.Following the heavy redemption wave, it soon became public
knowledge that the erosion of US64s reserves was gradual. Internal
audit reports of SEBI regarding US-64 established that there were
serious flaws in the management of funds. Till the 1980s, the equity
component of US-64 never went beyond 30%. UTI acquired public
sector unit (PSU) stocks under the 1992-97 disinvestment program of
the union government. Around Rs 6000-7000 crore was invested in
scrips such as MTNL, ONGC, IOC, HPCL & SAIL.A former UTI
executive said, Every chairman of the UTI wanted to prove himself
by collecting increasingly larger amounts of money to US-64, and
declaring high dividends. This seemed to have resulted in US-64
forgetting its identity as an income scheme, supposed to provide fixed,
regular returns by primarily investing in debt instruments. Even a
typical balanced fund (equal debt and equity) usually did not put more
than 30% of its corpus into
6. equity. A Business Today report claimed that eager to capitalise on
the 1994 stock market boom, US-64 had recklessly increased its
equity holdings. By the late 1990s the funds portfolio comprised
around 70% equity. While the equity investments increased by 40%,
UTI seemed to have ignored the risk factor involved with it. Most of

the above investments fared very badly on the bourses, causing huge
losses to US-64. The management failed to offload the equities when
the market started declining. While the book value of US-64s equity
portfolio went up from Rs 7,943 crore (June 1994) to Rs 13,627 (June
1998), the market value had actually declined in the same period from
Rs 18,334 crore to Rs 10,029 crore. Analysts remarked that UTI had
been pumping money into scrips whose market value kept falling.
Raising further questions about the fund management practices was
the fact that there were hardly any growth scrips from the IT and
pharma sectors in the equity portfolio.In spite of all this, UTI was able
to declare dividends as it was paying them out of its yearly income, its
reserves and by selling the stocks that had appreciated. This kept the
problem under wraps till the reserves turned negative and UTI could
no longer afford to keep the sale and purchase prices artificially
inflated.Following the public outrage against the whole issue, UTI in
collaboration with the government of India began the task of
controlling the damage to US-64s image. RESTORING THE
TRUST UTI realised that it had become compulsory to restructure
US-64s portfolio and review its asset allocation policy. In October
1998, UTI constituted a committee under the chairmanship of Deepak
Parekh, chairman, HDFC bank, to review the working of scheme and
to recommend measures for bringing in more transparency and
accountability in working of the scheme. US-64s portfolio
restructuring however was not as easy as market watchers deemed it
to be. UTI could not freely offload the poor performing PSU stocks
bought under the GoI disinvestment program, due to the fear of
massive price erosions after such offloading. After much deliberation,
a new scheme called SUS-99 was launched. The scheme was
formulated to help US-64 improve its NAV by an amount, which was
the difference between the book value and the market value of those
PSU holdings. The government bought the units of SUS-99 at a face
value of Rs 4810 crore. For the other PSU stocks held prior to the
disinvestment acquisitions, UTI decided to sell them through
negotiations to the highest bidder. UTI also began working on the
committees recommendation to strengthen the capital base of the
scheme by infusing fresh funds of Rs 500 crore. This was to be on a
proportionate basis linked to the promoters holding pattern in the
fund. The inclusion of the growth stocks in the portfolio was another
step towards restoring US-64s image. Sen, Executive Director, UTI
said, The US-64 equity portfolio has been revamped since June.
During the last nine months the new ones that have come to occupy a

place among the Top 20 stocks from the (Satyam Computers, NIIT
and Infosys) and FMCG (HLL, SmithKline Beecham and Reckitt &
Colman) sectors. US-64 has reduced its weightage in the commodity
stocks (Indian Rayon, GSFC, Tisco, ACC and Hindalco.) To control
the redemptions and to attract further investments, the income
distributed under US-64 was made tax-free for three years from 1999.
To strengthen the focus on small investors and to reduce the tilt
towards corporate investors, UTI decided that retail investors should
be concentrated upon and their number should be increased in the
scheme. UTI also decided to have five additional trustees on its board.
To enable trustees to assume higher degree of responsibility and
exercise greater authority UTI decided to give emphasis on a proper
system of performance evaluation of all schemes, marked-to-market
valuation of assets and evaluation of performance benchmarked to a
market index. The management of US-64 was entrusted to an
independent fund management group headed by an Executive
Director. UTI made plans to ensure that full responsibility and
accountability was achieved with support of a strong research team.
Two independent sub-groups were formed to manage the equity and
debt portion of US64. An independent equity research cell was formed
to provide market analysis and research reports.
7. The US-64 Controversy RESTORING THE TRUST HOW
THINGS WERE SET RIGHT PSU shares were transferred to a
special unit scheme (SUS99) subscribed by the government in
199899. Core promoters such as the Industrial Development Bank of
India added around Rs 450 crore to the unit capital, thus helping to
bridge the reserves deficit of Rs 2,800 crore in 1998-99. Portfolios
were recast in the current quarter to capitalise on the stock surge as the
BSE Sensex rose by 15%. Greater weightage was given to stocks such
as HLL, Infosys, Ranbaxy, M&M and NIIT. In US-64s case exposure
to IT, FMCG and Pharma stocks rose from 20.45% to 22.09%. This
was replicated across funds. Between June 1999 - September 1999, 21
out of UTIs 28 schemes have outperformed the Sensex. UTI has
become more proactive in fund management. For instance, it bought
into Crest at between Rs 200 and Rs 210 in October 1999. The stock
was trading at Rs 340 in November 1999. Stocks like Visual Software,
Mastek and Gujarat Ambuja have entered the top 50 equity holding
list. Scrips like Thermax, Thomas Cook and Carrier Aircon are out.
Complete exit from illiquid stocks such as Esab Industries. The
divesture of around 83 stocks released an estimated Rs 300-500 crore
of extra investible cash. Source: Business World, November 29, 1999.

UTI constituted an ad-hoc Asset Management Committee with 7

members comprising 5 outside professionals and 2 senior UTI
officials. The committees role was clearly defined and its scope
covered the following areas: To ensure that US-64 complied with the
regulations and guidelines and the prudential investment norms laid
down by the UTI board of trustees from time to time. To review the
schemes performance regularly and guide fund managers on the
future course of action to be adopted. To oversee the key issues such
as product designing, marketing and investor servicing along with the
recommendations to Board of Trustees.One of the most important
steps taken was the initiative to make US-64 scheme NAV driven by
February 2002 and to increase gradually the spread between sale and
repurchase price. The gap between sale and repurchase price of US-64
was to be maintained within a SEBI specified range. UTI announced
that dividend policy of US-64 would be made more realistic and it
would reflect the performance of the fund in the market. US-64 was to
be fully SEBI regulated scheme with appropriate amendment to the
UTI Act. The real estate investments made by UTI for the US-64
portfolio were also a part of the controversy as they were against the
SEBI guidelines for mutual funds. UTI had Rs 386 crore worth
investments in real estate. UTI claimed that since its investments were
made in real estate, it was safe and it could sell the assets whenever
required. However, the value of the real estate in US-64s portfolio
had gone down considerably over the years. The real estate
investments were hence revalued and later transferred to the
Development Reserve Fund of the trust according to the
recommendations of the Deepak Parekh committee. By December
1999, the investible funds of US-64 had increased by 60% to Rs
19,923 crore from Rs 12,433 crore in December 1998. The NAV had
recovered from Rs 9.57 to Rs 16 by February 2000 after the
committee recommendations were implemented. DEAD END
SCHEME? Though UTI started announcing the dividends according
to the market conditions, this was not received well by the investors.
They felt that though the dividend was tax-free, it was not appealing
as most of the investors were senior citizens and they did not come
under the tax bracket. The statement in media by UTI chairman that
trust would try to attract the corporate investors into the scheme was
against the recommendation by the committee, which had adviced the
trust to attract the retail investors into the scheme. This led to doubts
about UTIs commitment towards the revival of the scheme.

However, led by improving NAV figures and image-building exercises

on UTIs part, by 2000, US-64 was
8. again termed as one of the best investment avenues by analysts and
market researchers. UTI had become more proactive in fund
management with its scrips rising in value, restoring the confidence of
the small investor in the scheme. The National Council of Applied
Economic Research (NCAER) and SEBI surveys mentioned that US64 was once again perceived as a safe investment by the middle class
income groups. However, the euphoria seemed to be short lived as in
2001, US-64 was involved in yet another scam due to its investments
in the K-10 stocks . Talks of a drastically low NAV, inflated prices,
increasing redemption and GoI bailouts appeared once again in the
media. An Economic Times report claimed that there was a difference
of over Rs 6000 crore between the NAV and the sale prices. Doubts
were raised as to US-64 being an inherently weak scheme, which
coupled with its mismanagement, had led to its downfall once again.
This however, was yet another story. QUESTIONS FOR
DISCUSSION: 1. Explain in detail the reasons behind the problems
faced by US-64 in the mid 1990s. Were these problems the sole
responsibility of UTI? Give reasons to support your answer.2. Analyse
the steps taken by UTI to restore investor confidence in US-64.
Comment briefly on the efficacy of these steps.3. As a market analyst,
would you term US-64 a safe mode of investment? Justify your stand
with reasons. 4. US-64 should have been NAV driven from the very
beginning like other mutual funds. Comment. EXHIBIT IUTI
OBJECTIVES & STRUCTURE UTI's MandateUTI was formed to
increase the propensity of the middle and lower groups to save and to
invest. UTI came into existence during a period marked by great
political and economic uncertainty in India. With war on the borders
and economic turmoil that depressed the financial market,
entrepreneurs were hesitant to enter capital market. The companies
found it difficult to access the equity markets, as investors did not
respond adequately to new issues. To channelise savings of the
community into equity markets to make them available for the
companies to speed up the process of industrial growth.UTI was the
idea of then Finance Minister, T.T. Krishnamachari, which would
"open to any person or institution to purchase the units offered by the
trust. However, this institution as we see it, is intended to cater to the
needs of individual investors, and even among them as far as possible,
to those Whose means are small."UTI was formed as an intermediary
that would help fulfil the twin objectives of mobilizing retail savings

and investing those savings in the capital market and passing on the
benefits so accrued to the small investors. UTI commenced its
operations from July 1964 "with a view to encouraging savings and
investment and participation in the income, profits and gains accruing
to the Corporation from the acquisition, holding, management and
disposal of securities." Different provisions of the UTI Act laid down
the structure of management, scope of business, powers and functions
of the Trust as well as accounting, disclosures and regulatory
requirements for the Trust.Structure of the Trust UTI represents an
unique organisational without ownership capital and an independent
Board of Trustees. Under the provisions of the first UTI scheme, US64, certain institutions contributed to the Scheme's initial capital,
which was redeemable at the discretion of the Trust at such value
decided by the Government of India.The contributors to the initial
capital of Rs. 5 crore for US-64 Scheme were Reserve Bank of India
(RBI), Other Financial Institutions, Life Insurance Corporation (LIC),
State Bank of India (SBI) & its subsidiaries and other scheduled banks
including a few foreign banks. In February 1976, RBIs contribution
was taken up by the Industrial Development Bank of India (IDBI).
The institutions were provided representation on the Board of the
Trustees of UTI. Under the provisions of the Act, Chairman of the
Board was appointed by Government of India. The Board of Trustees
oversees the general direction and management of the affairs and
business of UTI. The Board performs its functions based on
commercial principles, keeping in mind the interest of the unit holders
under various schemes. Since UTI does not have any share capital, it
9 operates on the principle of "no profit no loss" as all income and
gains net of all costs and development charges ultimately go back to
investors of respective schemes. Formative Years: 1964-1974UTI
commenced its operations with R.S. Bhatt at the helm. The first
product, Unit Scheme 1964 (US '64), continues to be the most popular
investment avenue to date. In the first year itself the scheme mobilised
Rs.19 crore compared to the incremental commercial bank deposits of
Rs.367 crore in that year. The first year's dividend was 6.1%
compared to the bank deposit rates of 3.75 - 6%. With the increasing
popularity of US-64 as a long-term investment avenue, the Trust
introduced a Reinvestment Plan in 1966-67 (automatic reinvestment
of income distributions to US-64 unit holders). After two successful
terms, when R S Bhatt relinquished charge, he had laid a solid
foundation for the Trust. During his tenure, unit capital had grown to
Rs.92 crore, covering an investor base of 3.64 lakh accounts. Source:

www.unittrustofindia.com EXHIBIT IIDIVIDENDS DECLARED BY

US-64 Year Dividend declared 1989-90 18% 1991-92 25% 1993-94
26% 1995-96 20% 1997-98 20% 1999-00 13.75% 1990-91 19.50%
1992-93 26% 1994-95 26% 1996-97 20% 1998-99 13.50% 2000-01
10.00%

ASSIGNMENT C
MULTIPLE CHOICE QUESTIONS
Q1.

Equity shareholders rights are listed below. One of the rights is incorrect.

(a) rights to have first claim in the case of winding

of the company
(b)
(c)
(d)
Q2.

right to vote at the general body meeting of the company

right to share profits in the form of dividends
right to receive a copy of the statutory report

In the case of non voting shares:

(a)
the rights of voting stocks and non voting stocks are similar
(b)
rights and bonus issues for non voting shares can be issued in the form of
voting shares
(c)
the non voting shares would become voting shares after a particular period
of time

(d) non voting shares carry higher dividends

instead of voting rights
Q3.

NBFCs offer higher interest rate because of

(a)
the best management funds
(b)
the competition among the NBFCs

(c) the risk involved

(d)
Q4.

the credit rating

Primary and Secondary markets

(a)
compete with each other

(b) complement each other

(c)
(d)
Q5.

function independently
control each other

The underwriter has to take up

(a)
the fixed portion of issued capital

(b) the agreed portion of the unsubscribed part

(c)
(d)
Q6.

the agreed portion or can refuse it

none of the above

Book Building is a
(a)
method of placing an issue
(b)
method of entry in foreign market

(c) price discovery mechanism in case of an IPO

(d)
Q7.

none of the above

Sell Reliance Petro Shares at Rs 60 This order is a

(a)
Best rate order

(b) Limit order

(c)
(d)

Q8.

Discretionary order
Stop Loss Order

Stock exchange helps in

(a)
fixation of stock prices
(b)
ensures safe and fair dealing
(c)
induces good performance by the company

(d) all of the above

Q9.

In a limit order

(a) Orders are limited by a fixed price

(b)
(c)
(d)

Investor gives a range of price for purchase and sale

Order is given but to a limit a loss
None of the above

Q10. Which one of these is not true for a broker?

(a)
Broker has to abide by the code of conduct laid down by security
exchange commission
(b)
Broker facilitates the secondary market operations
(c)
Broker is a bridge between stock market and investor

(d) Broker should leak the inside information of

stock exchange
Q11.

FIIs are permitted

(a)
To invest in listed companies only
(b)
To invest in listed and unlisted companies
(c)
Not to invest in debentures

(d) To invest in shares of listed unlisted companies

and debentures.
Q12. Marketability risk of Bond is
(a)
The market risk which affects all the bonds

(b) Variation in return caused by difficulty in

selling bonds
(c)

The failure to pay the agreed value of the bond by the issuer

(d)

(a) and (b) both.

Q13. The value of bond depends on

(a)
Coupon rate
(b)
Years to maturity
(c)
Expected yield to maturity

(d) All of the above

Q14. Forex market deals with

(a) multi currency

(b)
(c)

only domestic currency

none of the above

Q15. Credit market is a place here

(a)
multi currency requirements are met
(b)
Long term financing is done

(c) Banks, Financial Institutions and NBFCs lend

short medium and long term loans to corporate or
individuals
(d)

None of the above

Q16. Money Market is a

(a)
retail market

(b) wholesale market

(c)
(d)

retail and whole sale market

none of the above

Q17. What is true for call money?

(a)
Money is borrowed for a fortnight
(b)
Money is borrowed for a week

(c) Money is borrowed for a day

(d)

None of the above

Q18. When money is borrowed or lent for more than a day and up to 14 days it is
called
(a)
Call money
(b)
Quick money

(c) Notice money

(d)

Term money

Q19. Mutual funds are valued with help of their

(a) NAVs
(b)
(c)
(d)

NFO
IPO
None of the above

Q20. Which one of the following is true

(a)
Primary market gives liquidity to secondary market

(b) Secondary market gives liquidity to primary

market
Q21. Right issue is:
(a)
issue of securities by issue of prospectus to the public
(b)
Securities are issued through some selected investors.

(c) Selling securities in the primary market by

issuing rights to the existing shareholders.
(d)

None of the above

Q22. Private placement has following advantage:

(a)
Flexibility and high cost

(b) Accessibility and speed

(c)
(d)

High cost and speed

Speed and complexity

Q23. Book Building Process is completed with the help of a

(a) Book runner

(b)
(c)
(d)

Underwriter
Registrar
Lead manager

Q24. Treasury bills are issued

(a) on discount
(b)

at premium

Q25. Commercial papers are

(a)
Secured Promissory Note

(b) Unsecured Promissory note

(c)
(d)

Issued by individuals
None of the above

Q26. Total amount of called up share capital which is actually paid to the company
by the members is called
(a)
Subscribed capital
(b)
Called up capital

(c) Paid up share capital

(d)

None of the above

Q27. A shares par value is Rs 10 but it is issued at Rs 20 , then extra amount over
par value is called
(a)
Coupon
(b)
Interest

(c) Premium
(d)

None of the above

Q28. Bad news about a company can pull down its stock prices. This is called
(a)
Market risk

(b) Non market risk

(c)
(d)

Interest risk
Callable risk

Q29. Debt/Income funds invest in

(a)
Tax saving schemes
(b)
Money Market Instruments

(c) High Rate fixed income bearing instruments

(d)

Both debt and equity

Q30. Mutual Funds investor can not earn following return

(a)
Dividend
(b)
Capital Gain
(c)
Increase in NAV

(d) Fixed interest earning

Q31. Trustees in India are registered under
(a)
Companys Act 1956

(b) Indian Trust act 1882

(c)
(d)

SEBI
Central bank

Q32. Sweat Equity are the Equity Shares issued by company to its directors or
employees.
(a)
As salary

(b) As consideration
(c)
(d)

Both of the above

None of the above

Q33. Bond prices and interest rates move in opposite direction

a)

above statement is true

b)
c)
d)

Above statement is false

Partially true
Partially false

Q34. Balanced funds provide:

(a) Steady return

(b)
(c)
(d)

High return
Increase volatility
None of the above

Q35. Stock exchanges should ensure:

(a)
Active trading and insider information
(b)
Active trading and transparency
Which of the following is true?

(a) Both a and b

(b)
(c)
(d)

Only b
Only a
Neither a nor b

Q36. Merchant bankers do not indulge in following activities

(a)
Drafting of prospectus
(b)
Appointment of Registrar

(c) Selection of Promoter

(d)

Arrangement of underwriter

Q37. Private placement reduces ________________________ of public issue:

(a) Cost
(b)
(c)
(d)

Subscription
Issue size
None of the above

Q38. NBFC can accept deposits form NRIs

a)
Above statement is true

b)

Above statement is false

c)
d)

Partly true
None of the above

Q39. FDI is seen as a important source of capital formation when:

a)

Capital base is low

b)
c)
d)

Capital base is high

Economy is self sufficient
All of the above

Q40. Preference shares means which fulfill the following two conditions

a)
It carries preferential rights in respect of dividend at fixed amount and
fixed rate
b)
It does not carry preferential rights in regard to payment of capital on
winding up .
WHICH ONE OF THESE IS TRUE:
(a)
Both a and b

(b) Only a
(c)
(d)

Only b
Neither a nor b