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MBA Semester IV MB0052

MB0052- Strategic Management and Business Policy

Assignment – Set1

Q1. What is meant by ‘Strategy’? What are the levels of strategy? Differentiate between goals and objectives.

Answer: The word strategy is derived from the Geek word “strategia”, and conventionally

used as a military term. It means a plan of action that is designed to achieve a particular

goal. Earlier, the managers adopted the day-to-day planning method without concentrating

on the future work. Later the managers tried to predict the future events using control system

and budgets. These techniques could not calculate the future happenings accurately. Thus,

an effective technique called strategy was introduced in business to deal with long term

developments and new methods of production.

The different concepts of strategy are:

It is defined as a plan to direct or guide a course of action

It is a pattern to improve the performance over time

It is a fundamental way to view an organisation’s performance

It is a scheme to out-maneuver competitor

Levels of strategy Strategy exists at different business levels. The different levels of strategies are as follows:

Corporate Strategy – This is regarding the general function and scope of the business

to meet the stakeholder’s expectations. As it is significantly influenced by the investors

in the business, it is also called the critical level strategy.

Business Strategy – This is regarding how a business competes effectively in a

particular market. It includes strategic decisions about the selection of products and

meeting customer requirements.

Operational Strategy – This is regarding how each part of the business is organised

and delivered to the corporate and business level. Operational strategy focuses on

issues of resources and practices of an organisation.

Difference between Goals and Objectives of Business


Goals are statements that provide an overview about what the project should achieve. It

should align with the business goals. Goals are long-term targets that should be achieved in

a business. Goals are indefinable, and abstract. Goals are hard to measure and do not have

definite timeline. Writing clear goals is an essential section of planning the strategy.

Example - One of the goals of a company helpdesk is to increase the customer satisfaction

for customers calling for support.

Objectives are the targets that an organisation wants to achieve over a period of time.

Example - The objective of a marketing company is to raise the sales by 20% by the end of

the financial year.

Example - An automobile company has a Goal to become the leading manufacturer of a

particular type of car with certain advanced technological features and the Objective is to

manufacture 30,000 cars in 2011.

Both goals and objectives are the tools for achieving the target. The two concepts are

different but related. Goals are high level statements that provide overall framework about

the purpose of the project. Objectives are lower level statements that describe the tangible

products and deliverables that the project will deliver.

Goals are indefinable and the achievement cannot be measured whereas the success of an

objective can be easily measured. Goals cannot be put in a timeframe, but objectives are set

with specific timelines. The difference between organisational goals and objectives is

depicted in table.

Table: Differences between Organisational Goals and Objectives

Goals Objectives

Are long term Are usually meant for short term

Are general intentions with broad

outcome

Are precise statements with

specific outcome

Cannot be validated Can be validated

Are intangible – can be qualitative

as well as quantitative

Are tangible – are usually

quantitative and measurable

Are abstract Are concrete

Q2. Define the term “Strategic Management”. Explain the importance of strategic


management?

Answer: Strategic ManagementDefinition: Strategic management is a systematic approach of analysing, planning and

implementing the strategy in an organisation to ensure a continued success. Strategic

management is a long term procedure which helps the organisation in achieving a long term

goal and its overall responsibility lies with the general management team. It focuses on

building a solid foundation that will be subsequently achieved by the combined efforts of

each and every employee of the organisation.

Importance of strategic management A rapidly changing environment in organisations requires a greater awareness of

changes and their impact on the organisation. Hence strategic management plays an

important role in an organisation.

Strategic management helps in building a stable organisation.

Strategic management controls the crises that are aroused due to rapid change in an

organisation.

Strategic management considers the opportunities and threats as the strengths and

weaknesses of the organisation in the crucial environment for survival in a

competitive market.

Strategic management helps the top level management to examine the relevant

factors before deciding their course of action that needs to be implemented in

changing environment and thus aids them to better cope with uncertain situations.

Changes rapidly happen in large organisations. Hence strategic management

becomes necessary to develop appropriate responses to anticipate changes.

The implementation of clear strategy enhances corporate harmony in the

organisation. The employees will be able to analyse the organisation’s ethics and

rules and can tailor their contribution accordingly.

Systematically formulated business activities helps in providing consistent financial

performance in the organisation.

A well designed global strategy helps the organisation to gain competitive

advantages. It increases the economies of scale in the global market, exploits other

countries resources, broadens learning opportunities, and provides reputation and

brand identification.

Q3. Describe Porter’s five forces Model.


Answer: Porter’s Five Force modelMichael E. Porter developed the Five Force Model in his book, ‘Competitive Strategy’. Porter

has identified five competitive forces that influence every industry and market. The level of

these forces determines the intensity of competition in an industry. The objective of

corporate strategy should be to revise these competitive forces in a way that improves the

position of the organisation.

Figure below describes forces driving industry competitions.

Figure: Forces Driving Industry Competitions

Forces driving industry competitions are:

Threat of new entrants – New entrants to an industry generally bring new capacity; desire to

gain market share and substantial resources. Therefore, they are threats to an established

organisation. The threat of an entry depends on the presence of entry barriers and the

reactions can be expected from existing competitors. An entry barrier is a hindrance that

makes it difficult for a company to enter an industry.

Suppliers – Suppliers affect the industry by raising prices or reducing the quality of

purchased goods and services.

Rivalry among existing firms – In most industries, organisations are mutually dependent. A

competitive move by one organisation may result in a noticeable effect on its competitors

and thus cause retaliation or counter efforts.


Buyers – Buyers affect an industry through their ability to reduce prices, bargain for higher

quality or more services.

Threat of substitute products and services – Substitute products appear different but satisfy

the same needs as the original product. Substitute products curb the potential returns of an

industry by placing a ceiling on the prices firms can profitably charge.

Other stakeholders - A sixth force should be included to Porter’s list to include a variety of

stakeholder groups. Some of these groups include governments, local communities, trade

association unions, and shareholders. The importance of stakeholders varies according to

the industry.

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

Answer: Strategy FormulationStrategy formulation is the development of long term plans. It is used for the effective

management of environmental opportunities and for the threats which weaken corporate

management. Its objective is to express strategical information to achieve a definite goal.

The following are the features of strategy formulation:

— Defining the corporate mission and goals

— Specifying achievable objectives

— Developing strategies

— Setting company policy guidelines

Process in Strategy FormulationThe main processes involved in strategy formulation are as follows:

Stimulate the identification - Identifying useful information like planning for strategic

management, objectives to achieve the goals of the employees and the stakeholders.

Utilisation and transfer of useful information as per the business strategies - A number of

questions arising during utilisation and transfer of information have to be solved The

questions that arise during utilisation and transfer of information are the following:

Who has the requested information?

What is the relationship between the partners who holds the requested information?


What is the nature of the requested information?

How can we transfer the information?

Henry Mintzberg’s contribution to strategic planningHenry Mintzberg is a well-known academician and generalist writer who has written about

strategy and organisational management. His approach is broad, involving the study of the

actions of a manager and the way the manager does it. He believes that management is

about applying human skills to systems, but not systems to people. Mintzberg states certain

factors as the reason for planning failure.

The factors are as follows:

— Processes - The elaborate processes used in the management such as creation of

bureaucracy and suppression of innovation leads to strategic planning failure.

— Data - According to Mintzberg, hard data (the raw material of all strategists) provides

information whereas soft data (the data gathered from experience) provides wisdom which

means that soft data is more relevant than the hard data.

— Detachment – Mintzberg says that effective strategists are people who do not distance

themselves from the details of a business. They are the ones who immerse themselves into

the details and are able to extract the strategic messages from it.

In 1993, Henry Mintzberg concluded that planning is a formalised procedure to produce a

coherent result in the form of an integrated system of decisions. The objectives must be

explicitly labeled by words after being carefully decomposed into strategies and sub-

strategies.


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

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

segment with a defined strategy.

The features of SBU are as follows:

SBU contains all the needs and corporate capabilities of its organisation.

There is managerial and capital resource allocation for serving the overall interest of

the organisation.

SBU segments the activities of the company in a strategic manner and allocates

resources competitively.

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

Possess different missions

Set up original plans

Have a definable group of competitors

Administer resources in key areas

Advantages Reduces problems associated with sharing resources across functional areas

Responses quickly to the environmental changes

Increases focus on products and markets

Benefits of SBU to parent company/MNCs An MNC realises parenting advantages in certain factors like global scale and scope

efficiencies, regional differences, global risk diversification etc. The SBU adds value through

parenting advantages by defining its roles and strategic priorities.

The benefits to the parent company are as follows:

Optimisation of the competitive advantages lies within the company’s global network

of business units and people.

Reforming the business model and achieving the objective

Serving a defined external market where it can conduct strategic planning in relation

to products and markets


Q6. Define the term “Business policy”. Explain its importance.

Answer: Business policies are the instructions laid by an organisation to manage its

activities. It identifies the range within which the subordinates can take decisions in an

organisation. It authorises the lower level management to resolve their issues and take

decisions without consulting the top level management repeatedly. The limits within which

the decisions are made are well defined. Business policy involves the acquirement of

resources through which the organisational goals can be achieved. Business policy analyses

roles and responsibilities of top level management and the decisions affecting the

organisation in the long-run. It also deals with the major issues that affect the success of the

organisation.

Features of business policyFollowing are the features of an effective business policy:

— Specific- Policy should be specific and identifiable. The implementation of policy is easier

if it is precise.

— Clear - Policy should be clear and instantly recognisable. Usage of jargons and

connotations should be avoided to prevent any misinterpretation in the policy.

— Uniform – Policy should be uniform and consistent. It should ensure uniformity of

operations at different levels in an organisation.

— Appropriate – Policy should be appropriate and suitable to the organisational goal. It

should be aimed at achieving the organisational objectives.

— Comprehensive – Policy has a wide scope in an organisation. Hence, it should be

comprehensive.

— Flexible – Policy should be flexible to ensure that it is followed in the routine scenario.

— Written form – To ensure uniformity of application at all times, the policy should be in

writing.

— Stable – Policy serves as a guidance to manage day to day activities. Thus, it should be

stable.


Importance of Business PoliciesA company operates consistently, both internally and externally when the policies are

established. Business policies should be set up before hiring the first employee in the

organisation. It deals with the constraints of real-life business.

It is important to formulate policies to achieve the organisational objectives. The policies are

articulated by the management. Policies serve as a guidance to administer activities that are

repetitive in nature. It channels the thinking and action in decision making. It is a mechanism

adopted by the top management to ensure that the activities are performed in the desired

way.

The complete process of management is organised by business policies.

Business policies are important due to the following reasons:

— Coordination – Reliable policies coordinate the purpose by focusing on organisational

activities. This helps in ensuring uniformity of action throughout the organisation. Policies

encourage cooperation and promote initiative.

— Quick decisions – Policies help subordinates to take prompt action and quick decisions.

They demarcate the section within which decisions are to be taken. They help subordinates

to take decisions with confidence without consulting their superiors every time. Every policy

is a guide to activities that should be followed in a particular situation. It saves time by

predicting frequent problems and providing ways to solve them.

— Effective control – Policies provide logical basis for assessing performance. They ensure

that the activities are synchronised with the objectives of the organisation. It prevents

divergence from the planned course of action. The management tends to deviate from the

objective if policies are not defined precisely. This affects the overall efficiency of the

organisation. Policies are derived objectives and provide the outline for procedures.

— Decentralisation – Well defined policies help in decentralisation as the executive roles

and responsibility are clearly identified. Authority is delegated to the executives who refer the

policies to work efficiently. The required managerial procedures can be derived from the

given policies. Policies provide guidelines to the executives to help them in determining the

suitable actions which are within the limits of the stated policies. Policies contribute in

building coordination in larger organisations.


MB0052 – Strategic Management and Business Policy

Assignment Set- 2

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

Answer: Core competencies are those skills that are critical for a business to achieve

competitive advantage. These skills enable a business to deliver essential customer benefit

like the selection of a product or service by a customer. Core competency is the key strength

of business because it comprises the essential skills. These are the central areas of

expertise of the company where maximum value is added to its services or products.

Example - Infosys has a core competency in information technology.

It is a unique skill or technology that establishes a distinct customer value. As the

organisation progresses and adapts to the new environment, the core competencies also

adjust to the change. They are not rigid but flexible to advancing time. The organisation

makes the maximum utilisation of the competencies and correlates them to new

opportunities in the market. Resources and capabilities are the building blocks on which an

organisation builds and executes a value-added strategy. The strategy is devised in a

manner that an organisation can receive reasonable profit and attain strategic

competitiveness.

Core Competencies are not fixed. They change in response to the transformation in the

environment of the company. They are adaptable and advance over time. As an organisation

progresses and adapts to new circumstances, the core competencies also adapt to the

transformation.

The characteristics of core competencies are:

To provide potential access to a wide range of market

Should be difficult to imitate by competitors

Should make considerable contribution to the customers

Example - Microsoft has expertise in IT-based innovations and technologies. Customers

receive many benefits by purchasing and using Microsoft products. For many reasons

including unique skills, it is difficult for competitors to imitate Microsoft's core competences.


Resources are the key inputs of the organisation’s production process. These can be

manpower, financial, technological, or services. For the organisation to have core

competency the resources should be unique, beneficial and specialised in the particular

field. Resources should be built on the strengths of the organisation and not on its

weaknesses.

Organisational capabilities are the ability of the organisation to identify and integrate its

resources so that it can be used in the most efficient manner. If an organisation lacks the

capability to utilise these resources productively then the organisation cannot create its core

competency. The organisation can devise strategies to either develop new resources and

capabilities or improve the existing resources and capabilities to build core competencies of

the organisation.

A company can continue to reinvest in its core competencies. When the core competencies

are advanced to those of the competitors they are called distinctive competencies. The

distinctive competencies should be unique and advanced to the competitor capacity. It

should be used to develop new product or service. Core competencies of an organisation

distinguish it from its competitors. They can help in deciding the future of the organisation.

For the strategy to have the best probability of success, it should be built on core

competencies. The competencies are enhanced continuously. They are developed through a

continuous process of improvement and enhancement.

Critical Success Factors (CSFs) Critical success factors (CSFs) are used extensively to identify the key features that an

organisation should focus on to be successful. The CSFs are important sections of activities

that are performed perfectly to achieve the mission and objective of the business. It refers to

the main areas which ensure successful competitive performance for an organisation.

Identifying the CSFs is important as the organisation can focus on its efforts to develop its

resources to meet the CSFs and measure the success of the business. It is important for the

organisation to decide in building the essential requirements to meet the CSFs.

Critical Success Factors are associated with the strategic goals of an organisation. They

also focus on the essential areas that affect the business. The chief areas that affect the

business are:

Industry - These factors result from specific industry characteristics. The organisation

should consider these factors to remain competitive.


Environmental– These are the factors that are the result of environmental influences

on an organisation like the economy, competitors, and technological advancements.

Strategic - These factors are the result of particular competitive strategy selected by

the organisation.

Temporal - These factors are the result of the organisation's internal influence like

challenges and directions.

The CSFs are essential for the success of an organisation. Identifying CSFs helps to ensure

that the business is focused and thus avoids wasting effort on insignificant areas. To keep

the project on track towards common aims and goals, CSFs should be specific and should

be communicated to everyone involved.

Q2. Describe the concept of SWOT analysis.

Answer: SWOT Analysis SWOT is an acronym for strength, weakness, opportunities and threats which are strategic

factors of an organisation. SWOT analysis not only results in the identification of

organisation’s distinctive competencies, but also identifies the opportunities that the

organisations are unable to take advantage of, due to the lack of appropriate resources.

Strengths The strengths of an organisation are its resources and capabilities that can be used as a

basis for developing a competitive advantage. Examples of such strengths are as follows:

Patents

Strong brand names

Good reputation among customers

Cost advantages from proprietary know-how

Exclusive access to high grade natural resources

Favourable access to distribution networks

Weaknesses The absence of certain strengths may be considered as weaknesses. Example - Lack of a

patent can be considered as a weakness. Each of the following factors may be considered

as a weakness:

Lack of patent protection


Weak brand name

Poor reputation among customers

High cost structure

Lack of access to the best natural resources

Opportunities The external environment analysis may disclose certain new opportunities for profit and

growth. Few examples of such opportunities are as follows:

Unfulfilled customer needs

Arrival of new technologies

Relaxing of regulations

Removal of international trade barriers

Threats Alteration in the external environment may also present threats to the organisation. Some

examples of such threats include the following:

Shift in consumer choice, it takes them away from the organisation’s product

Emergence of substitute products

New regulations

Increased trade barriers

Example - An opportunity to provide products like refrigerator or services like online ticket

booking, that can improve consumers’ lifestyle increases the demand for the company’s

product. The Threat could be a new competitor in the market with advanced technology as it

makes the existing product out-of-date.

The SWOT matrix - Organisations should concentrate to develop a strategic plan that fits in

the organisation’s strength and upcoming opportunities. In rare cases, the organisation

overcomes a weakness by planning itself for a compelling situation. The SWOT matrix is

shown in the figure below.

Strength Weakness

Opportunities S-O Strategies W-O Strategies

Threats S-T Strategies W-T Strategies

The SWOT matrix can be explained as follows:

S-O strategies follow the opportunities that suits the company’s strength


W-O strategies overcomes weakness to follow opportunities

S-T strategies find ways to use the organisation’s strength to reduce external threats

W-T strategies determines a defensive plan to prevent the organisation’s weakness from

becoming liable to external forces .

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

Answer: Strategic leadership refers to the potential to express a strategic vision and to

motivate others to acquire that vision. It is the ability to influence organisational members

and to execute organisational change.

Features of strategic leadership A strategic leader possesses the following qualities:

Loyalty and compassion – Effective leadership should be loyal and compassionate to

vision of the team.

Judicious use of power – Strategic leaders utilise power wisely. They must push their

ideas gradually along with the other members in the team.

Wider perspective or outlook – Strategic leader have a wider perspective of vision

and they act accordingly.

Motivation and reliability – Strategic leader have motivating qualities and are also

reliable.

Skillful communication – A leader shares views with the team members. Effective

communication brings effective understanding among the team members.

Quality of understanding the moods and emotions - A strategic leader must

understand the moods and emotions of his team members. He must communicate

his sentiments with the employees.

The following figure depicts the three types of leadership


Types of Leadership

Direct Leadership – This is typically in organisations where subordinates are in direct

contact with their leaders. Direct leaders are linked with their subordinates and influences

organisation through the development of subordinates. An example of direct leadership is

given in the following figure.

Figure: Direct Leadership

Organisational Leadership – In organisational leadership, the leaders reach out to far more

people and can even influence several thousands of people. Unlike direct leaders,

organisational leaders are not able to interact directly with their subordinates and need other

staff to help them lead people. The hierarchy of organisational leadership is illustrated in

below figure.


Figure: Organisational Leadership

Strategic Leadership – These leaders usually lead large organisations and influence

thousands of people. The role of a strategic leader is to establish organisational structure,

allocate resources and communicate the strategic vision of the organisation.

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

Answer: Strategic alliance is the process of mutual agreement between the organisations to

achieve objectives of common interest. They are obtained by the co-operation between the

companies. Strategic alliance involves the individual organisations to modify its basic

business activities and join in agreement with similar organisations to reduce duplication of

manufacturing products and improve performance. It is stronger when the organisations

involved have balancing strengths. Strategic alliances contribute in successful

implementation of strategic plan because it is strategic in nature. It provides relationship

between organisations to plan various strategies in achieving a common goal.

The various characteristics of strategic alliances are:

— The two independent organisations involving in agreement have a similar idea of

achieving objectives with respect to alliances.

— The organisations share the advantages and organise the management of alliance until

the agreement lasts.

— To develop more areas in alliances, the organisations contribute their own resources like

technology, production, R&D, marketing etc to increase the performance.


According to Faulkner (1995) – Strategic alliance is the inter-organisational relationship in

which the partners make substantial investment in developing a long-term collaborative

effort, and obtain common orientation.

Joint VentureJoint venture is the most powerful business concept that has the ability to pool two or more

organisations in one project to achieve a common goal. In a joint venture, both the

organisations invest on the resources like money, time and skills to achieve the objectives.

Joint venture has been the hallmark for most successful organisations in the world. An

individual partner in joint venture may offer time and services whereas the other focuses on

investments. This pools the resources among the organisations and helps each other in

achieving the objectives. An agreement is formed between the two parties and the nature of

agreement is truly beneficial with huge rewards such that the profits are shared by both the

organisations.

The advantages of joint venture are:

— A long term relationship is built among the participating organisations

— It Increases integrity by teaming with other reputable and branded organisations

— Helps in gaining new customers

— It helps in investing little money or no money

— It provides the capability to compete in the market with other organisations

— Reduces production time as the organisations are into join venture

— More new products and services can be offered to the customers

The disadvantages of joint venture are:

— Sometimes the organisations deal with wrong people, thereby losing investments

— The organisations do not have the opportunity to take up decisions individually

— There are risks of disputes among the organisations that lead to poor performance

— If the organisation enters into joint venture agreement with unprofessional selfish

organisation, then it increases the risk of hurting business reputation and devastating

customer’s trust.

Example – The China Wireless Technologies, a mobile handset maker is getting into an

agreement with the Reliance Communications Ltd (RCom) to launch its new mobile. The

joint venture between the two companies is to gain profits and provide affordable mobile

phones to the market that consists of advanced features and aims to earn eight billion


dollars in the next five years. The new mobile consists of dual SIM smart phone with 3G

technology at a cheaper rate.

Mergers Merger is the process of combining two or more organisations to form a single organisation

and achieve greater efficiencies of scale and productivity. The main reason to involve into

mergers is to join with other company and reap the rewards obtained by the combined

strengths of two organisations. A smart organisation’s merger helps to enter into new

markets, acquire more customers, and excel among the competitors in the market. The

participating organisation can help the active partner in acquiring products, distribution

channel, technical knowledge, infrastructure to drive into new levels of success.

With the perception of the organisation structure, here are a few types of mergers. The

different types of mergers are:

— Horizontal merger – The horizontal merger takes place when two organisations

competing in the same market join together. This type of merger either has a maximum or

minimum effect on the market. The minimum effect could also be zero. They share the same

product line and markets. The results of the mergers are less noticeable if the small

organisations horizontally merge. Consider a small local drug store that horizontally merges

with another small local drug store, then the effect of this merger on drug market would be

minimal.

But when the large organisations set up horizontal merger, then higher profits are obtained

in the market share providing advantages over its competitors. Consider two large

organisations that merge with twenty percent share in the market. They achieve forty percent

increase in the market share. This is an added advantage of the organisations over its

competitors in the market.

— Vertical merger – This involves the union of a customer with the vendor. It is the process

of combining assets to capture a sector of the market that it fails to acquire as an individual

organisation. The participating organisations determine the intentions of joining forces that

will strengthen the current positions of both the organisations and lay basis for expanding

into other areas. The purpose of a vertical merger is to build the strengths of the two

organisations for an effective future growth. In order to explore new methods of using

existing products to create a new product line for wider markets, it is also important to

consider the assets like property, buildings, inventories and cash assets. The vertical merger

involves careful planning.


— Market-extension merger – It is the process of merging two organisations that sell same

products in different geographical areas. The main purpose of this merger is to make the

merging organisations to achieve higher positions in bigger markets and ensure a bigger

base for client.

— Product-extension merger – Most of the organisations execute product extension merger

to sell different products of a related category. They serve the common market. This merger

enables the new organisations to pool their products to serve a common market.

— Conglomerate merger – This merger involves organisations alliance with unrelated type of

business activities. The organisations under conglomerate merger are not related either

horizontally or vertically. There are no important common factors among the organisations in

terms of production, marketing, research, development and technology. It is the union of

different kinds of businesses under one management organisation. The main purpose of this

merger is to utilise financial resources; enlarge debt capacity and obtaining synergy of

managerial functions. The organisations do not share the resources; instead it focuses on

the process of acquiring stability and using resources in a better way to generate additional

revenue.

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

Answer: There is no universally accepted definition of "product innovation" or "new product."

Everett M Rogers (Diffusion of Innovation, 4th ed. Free Press, 1995) observes that some

researchers have favoured a consumer-oriented approach in defining an innovation.

According to Hubert Gatignon and Thomas S Robertson, an innovation is a product, service,

attribute, or idea that consumers within a market segment perceive as new and that has an

effect on existing consumption patterns.

Types of InnovationA continuous innovation is, one that has a limited influence on consumption behaviour of

consumers. Consumers would use a product representing continuous innovation in much the

same way they used products that came before it. Product alteration is on a continuous

basis. Adoption of such products requires minor changes in behaviour that are unimportant

to consumers. Most of the new products that are introduced in the market represent

continuous innovations such as newer models of computers and autos etc.


A dynamically continuous innovation is, one that affects consumers’ consumption behaviour

in a pronounced way. Adoption requires a moderate change in an important behaviour or a

major change in an area of behaviour that is of low or moderate importance to the individual.

The examples include Internet shopping, digital camera, notebook computers, electric cars

and cordless phones. Real Jukebox is a dynamically continuous innovation because it

requires changes in the way we acquire, use and dispose of music and may utilise other

technologies such as CD and DVD writers.

A discontinuous innovation represents a product so new that consumers have never known

anything like it before. According to Peter Waldman ("Great Idea … If It Flies," Wall Street

Journal, June 24, 1999), a former aeronautics professor has introduced a product called

"skycar," which is a machine that flies through the air in the same manner as cars do in

cartoon shows on TV. The "skycar" uses the principle of VTL (vertical take off and landing)

and is capable of flying at speeds of up to 300 miles per hour. Products such as electric

bulbs, aeroplanes, computers, television, photocopying machines, inkjet and laser printers,

heart transplant and MRI scanning, etc. were all, at one time, discontinuous innovations.

Such innovations herald radical changes in an area of consumer behaviour which has

significant importance to the individual consumer.

Innovations can also be categorised by the benefits that products or services offer. Some

services, attributes or ideas are functional innovationbecause they provide functional

performance benefits to consumers over existing alternatives. For example, computer

notebooks offer portability over stationary computers. Functional innovations often take

advantage of new technology. For example, technological advances have offered

consumers the advantage of downloading images from the Internet and conducting

videoconferencing via their cellular phones.

Figure : depicts the innovation continuum.


Q6. Describe Corporate Social Responsibility.

Answer: Corporate Social Responsibilities (CSR)Corporate Social Responsibility (CSR) is the continuing obligation of a business to behave

ethically and contribute to the economic development of the organisation. It improves the

quality of life of the organisation. The meaning of CSR has two folds. On one hand, it

exhibits the ethical behaviour that an organisation exhibit towards its internal and external

stakeholders. And on the other hand, it denotes the responsibility of an organisation towards

the environment and society in which it operates. Thus CSR makes a significant contribution

towards sustainability and competitiveness of the organisation.

CSR is effective in number of areas such as human rights, safety at work, consumer

protection, climate protection, caring for the environment, sustainable management of

natural resources, and such other issues. CSR also provides health and safety measures,

preserves employee rights and discourages discrimination at workplace. CSR activities

include commitment to product quality, fair pricing policies, providing correct information to

the consumers, resorting to legal assistance in case of unresolved business problems, so

on.

Example – TATA implemented social welfare provisions for its employees since 1945.

Features of CSRCSR improves the customer satisfaction through its products and services. It also assists in

environmental protection and contributes towards social activities. The following are the

features of CSR:

— Improves the quality of an organisation in terms of economic, legal and ethical factors –

CSR improves the economic features of an organisation by earning profits for the owners. It

also improves the legal and ethical features by fulfilling the law and implementing ethical

standards.

— Builds an improved management system – CSR improves the management system by

providing products which meets the essential customer needs. It develops relevant

regulations through the utilisation of innovative technologies in the organization

— Contributes to countries by improving the quality of management – CSR contributes high

quality product, environment conservation and occupational health safety to various regions

and countries.


— Enhances information security systems and implementing effective security measures –

CSR enhances the information security measures by establishing improved information

security system and distributing them to overseas business sites. The information system

has improved by enhancing better responses to complex security accidents.

— Creates a new value in transportation – CSR creates a new value in transportation for the

greater safety of pedestrians and automobiles. This is done by utilising information and

technology for automobiles. The information and technology helps in establishing a safety

driving assistance system.

— Creates awareness towards environmental issues – CSR serves in preventing global

warming by reducing the harmful gases emitted into the atmosphere during the process of

business activities.


MB0053 – International Business Management

Assignment Set- 1

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

Answer: International business can be defined as any business that crosses the national

borders of the country for its establishment. It includes importing and exporting; international

movement of goods, services, employees, technology, licensing, and franchising of

intellectual property (trademarks, patents, copyright and so on). International business

includes the investment in financial and immovable assets in foreign countries. Contract

manufacturing or assembly of products for local sale or for export to other countries,

establishment of foreign warehousing and distribution systems, and import of goods from

one foreign country to a second foreign country for subsequent local sale is part of

international business.

There are various factors that affect international business. These factors include economic

environment, culture, political environment, financial and banking systems, regulatory

bodies, human capital, trade policies and so on, of the target country. Figure represents the

various factors affecting international business.

Figure: Factors Effecting International Business


International trade is growing at a rapid rate. Table, which is compiled by World Trade

Organisation, gives us an understanding on the region-wise quantum of international trade. It

illustrates the incremental value and volume of global trade in specified countries over a

period of four years. This table gives us an insight into the dynamics and importance of

international business.

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

Answer: Absolute advantageAdam Smith (a social philosopher and a pioneer of politicl economics) argued that nations

differ in their ability to manufacture goods efficiently and he saw that a country gains by

trading. If the two countries exchanged two goods at a ratio of 1:1, country I gets one unit of

goods B by sacrificing only 10 units of labour, whereas it has to give up 20 units of labour if it

produced the goods itself. In the same manner, country II gives up only 10 units of labour to

get one unit of goods A, whereas it has to give up 20 units of labour if it was made by itself.

Hence, it was understood that both countries had large amount of both goods by trading.

Comparative advantageRicardo (english political economist) questioned Smith’s theory stating that if one country is

more productive than the other in all lines of production and if country I can produce all

goods with less labour costs, will there be a need for the countries to trade. The reply was

affirmative.

He used England and Portugal as examples in his demonstration, the two goods they

produced being wine and cloth. This case is explained using table below.

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


To demonstrate that trade between both countries will lead to gains, the concept of

opportunity cost (OC) is introduced. The OC for good X is the amount of other goods that

have to be given up in order to produce one additional unit of X.

A country has a comparative advantage in producing goods if the OC is lower at home than

in the other country. The table shows that Portugal has the lower OC of the 2 countries in

wine-making while England has the lower OC in making cloth. Thus Portugal has the

comparative advantage in the production of wine whereas England has one one in the

production of cloth.

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

Answer: Cultural differences affect the success or failure of multinational firms in many

ways. The company must modify the product to meet the demand of the customers in a

specific location and use different marketing strategy to advertise their product to the

customers. Adaptations must be made to the product where there is demand or the

message must be advertised by the company. The following are the factors which a

company must consider while dealing with international business:

The consumers across the world do not use same products. This is due to varied

preferences and tastes. Before manufacturing any product, the organisation has to

be aware of the customer choice or preferences.

The organisation must manage and motivate people with broad different cultural

values and attitudes. Hence the management style, practices, and systems must be

modified.

The organisation must identify candidates and train them to work in other countries

as the cultural and corporate environment differs. The training may include language


training, corporate training, training them on the technology and so on, which help the

candidate to work in a foreign environment.

The organisation must consider the concept of international business and construct

guidelines that help them to take business decisions, and perform activities as they

are different in different nations. The following are the two main tasks that a company

must perform:

Product differentiation and marketing - As there are differences in consumer tastes

and preferences across nations; product differentiation has become business

strategy all over the world. The kinds of products and services that consumers can

afford are determined by the level of per capita income. For example, in

underdeveloped countries, the demand for luxury products is limited.

Manage employees - It is said that employees in Japan were normally not satisfied

with their work as compared with employees of North America and European

countries; however the production levels stayed high. To motivate employees in

North America, they have come up with models. These models show that there is a

relation between job satisfaction and production. This study showed the fact that it is

tough for Japanese workers to change jobs. While this trend is changing, the fact that

job turnover among Japanese workers is still lower than the American workers is

true. Also, even if a worker can go to another Japanese entity, they know that the

management style and practices will be quite alike to those found in their present

firm. Thus, even if Japanese workers were not satisfied with the specific aspects of

their work, they know that the conditions may not change considerably at another

place. As such, discontent might not impact their level of production.

The following are the three mega trends in world cultures:

The reverse culture influence on modern Western cultures from growing economies,

particularly those with an ancient cultural heritage.

The trend is Asia centric and not European or American centric, because of the

growing economic and political power of China, India, South Korea, and Japan and

also the ASEAN.

The increased diversity within cultures and geographies.

The following are the necessary implications in international business:

Avoid self reference criterion such as, one’s own upbringing, values and viewpoints.


Follow a philosophical viewpoint that considers that many perspectives of a single

observation or phenomenon can be true.

Discover and identify global segments and global niche markets, as national markets

are diverse with growing mobility of products, people, capital, and culture.

Grow the total share market by innovating affordable products and services, and

making them accessible so that, they are affordable for even subsistence level

consumers rather than fighting for market share.

Organise global enterprises around global centres of excellence.

Cultural elements that relate businessThe most important cultural components of a country which relate business transactions are:

Language.

Religion.

Conflicting attitudes.

LanguageLanguage is something more than just spoken and written words. Gestures, non-verbal

communication, facial expressions, and body language all communicate a message. An

interpreter is used when two people do not speak common language. Failure in

understanding the cultural context when non-verbal communication takes place or failure in

reading the person across the table results in sending a wrong signal.

ReligionThe dominant religious beliefs within a culture have a great impact on a person’s approach

to business than most people expect, even if that person is not a follower of a specific

culture.

Conflicting attitudesCultural values have a massive effect on the way business is carried out. The cultural values

that are evident in everyday life are not only shown in business but they are exaggerated. If

the cultural basics are not understood, then there is possibility that a deal ends even before

the negotiations start. Some of the additional cultural elements which must be known are the

customs and manners, arts, education, humour, and social organisation of a society.

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


Answer: Country Risk AnalysisCountry risk analysis is the evaluation of possible risks and rewards from business

experiences in a country. It is used to survey countries where the firm is engaged in

international business, and avoids countries with excessive risk. With globalisation, country

risk analysis has become essential for the international creditors and investors.

Country Risk Analysis (CRA) identifies imbalances that increase the risks in a cross-border

investment. CRA represents the potentially adverse impact of a country’s environment on

the multinational corporation’s cash flows and is the probability of loss due to exposure to

the political, economic, and social upheavals in a foreign country. All business dealings

involve risks. An increasing number of companies involving in external trade indicate huge

business opportunities and promising markets. Since the 1980s, the financial markets are

being refined with the introduction of new products.

When business transactions occur across international borders, they bring additional risks

compared to those in domestic transactions. These additional risks are called country risks

which include risks arising from national differences in socio-political institutions, economic

structures, policies, currencies, and geography. The CRA monitors the potential for these

risks to decrease the expected return of a cross-border investment. For example, a

multinational enterprise (MNE) that sets up a plant in a foreign country faces different risks

compared to bank lending to a foreign government. The MNE must consider the risks from a

broader spectrum of country characteristics. Some categories relevant to a plant investment

contain a much higher degree of risk because the MNE remains exposed to risk for a longer

period of time.

Analysts have categorised country risk into following groups:

Economic risk – This type of risk is the important change in the economic structure

that produces a change in the expected return of an investment. Risk arises from the

negative changes in fundamental economic policy goals (fiscal, monetary,

international, or wealth distribution or creation).

Transfer risk – Transfer risk arises from a decision by a foreign government to

restrict capital movements. It is analysed as a function of a country’s ability to earn

foreign currency. Therefore, it implies that effort in earning foreign currency increases

the possibility of capital controls.


Exchange risk – This risk occurs due to an unfavourable movement in the exchange

rate. Exchange risk can be defined as a form of risk that arises from the change in

price of one currency against another. Whenever investors or companies have

assets or business operations across national borders, they face currency risk if their

positions are not hedged.

Location risk – This type of risk is also referred to as neighborhood risk. It includes

effects caused by problems in a region or in countries with similar characteristics.

Location risk includes effects caused by troubles in a region, in trading partner of a

country, or in countries with similar perceived characteristics.

Sovereign risk – This risk is based on a government’s inability to meet its loan

obligations. Sovereign risk is closely linked to transfer risk in which a government

may run out of foreign exchange due to adverse developments in its balance of

payments. It also relates to political risk in which a government may decide not to

honor its commitments for political reasons.

Political risk – This is the risk of loss that is caused due to change in the political

structure or in the politics of country where the investment is made. For example, tax

laws, expropriation of assets, tariffs, or restriction in repatriation of profits, war,

corruption and bureaucracy also contribute to the element of political risk.

Risk assessment requires analysis of many factors, including the decision-making process in

the government, relationships of various groups in a country and the history of the country.

Country risk is due to unpredicted events in a foreign country affecting the value of

international assets, investment projects and their cash flows. The analysis of country risks

distinguishes between the ability to pay and the willingness to pay. It is essential to analyse

the sustainable amount of funds a country can borrow. Country risk is determined by the

costs and benefits of a country’s repayment and default strategies. The ways of evaluating

country risks by different firms and financial institutions differ from each other. The

international trade growth and the financial programs development demand periodical

improvement of risk methodology and analysis of country risks.

Country detailed risk refers to the unpredictability of returns on international business

transactions in view of information associated with a particular country. The techniques used

by the banks and other agencies for country risk analysis can be classified as qualitative or

quantitative. Many agencies merge both qualitative and quantitative information into a single


rating. A survey conducted by the US EXIM bank classified the various methods of country

risk assessment used by the banks into four types. They are:

Fully qualitative method - The fully qualitative method involves a detailed analysis

of a country. It includes general discussion of a country’s economic, political, and

social conditions and prediction. Fully qualitative method can be adapted to the

unique strengths and problems of the country undergoing evaluation.

Structured qualitative method – The structured method uses a uniform format with

predetermined scope. In structured qualitative method, it is easier to make

comparisons between countries as it follows a specific format across countries. This

technique was the most popular among the banks during the late seventies.

Checklist method - The checklist method involves scoring the country based on

specific variables that can be either quantitative, in which the scoring does not need

personal judgment of the country being scored or qualitative, in which the scoring

needs subjective determinations. All items are scaled from the lowest to the highest

score. The sum of scores is then used to determine the country risk.

Delphi technique – The technique involves a set of independent opinions without

group discussion. As applied to country risk analysis, the MNC can assess definite

employees who have the capability to evaluate the risk characteristics of a particular

country. The MNC gets responses from its evaluation and then may determine some

opinions about the risk of the country.

Inspection visits – Involves travelling to a country and conducting meeting with

government officials, business executives, and consumers.

These meetings clarify any vague opinions the firm has about the country.

Other quantitative methods – The quantitative models used in statistical studies of

country risk analysis can be classified as discriminant analysis, principal component

analysis, logit analysis and classification and regression tree method.

Q5. Write short notes on Foreign exchange market.

Answer: Foreign exchange market The Foreign exchange or the forex markets facilitates the participants to obtain, trade,

exchange and speculate foreign currency. The foreign exchange market consists of banks,


central banks, commercial companies, hedge funds, investment management firms and

retail foreign exchange brokers and investors. It is considered to be the leading financial

market in the world. It is vital to realise that the foreign exchange is not a single exchange,

but is created from a global network of computers that connects the participants from all over

the world.

The foreign exchange market is immense in size and survives to serve a number of

functions ranging from the funding of cross-border investment, loans, trade in goods, trade in

services and currency speculation. The participant in a foreign exchange market will

normally ask for a price.

The trading in the foreign exchange market may take place in the following forms:

Outright cash or ready – foreign exchange currency deals that take place on the

date of the deal.

Next day - foreign exchange currency deals that take place on the next working day.

Swap – Simultaneous sale and purchase of identical amounts of currency for

different maturities.

“Spot” and “Forward” contracts - A Spot contract is a binding obligation to buy or

sell a definite amount of foreign currency at the existing or spot market rate. A

forward contract is a binding obligation to buy or sell a definite amount of foreign

currency at the pre-agreed rate of exchange, on or before a certain date.

The advantage of spot dealing has resulted in a simplest way to deal with all foreign

currency requirements. It carries the greatest risk of exchange rate fluctuations due to lack of

certainty of the rate until the deal is carried out. The spot rate that is intended to receive will

be set by current market conditions, the demand and supply of currency being traded and

the amount to be dealt. In general, a better spot rate can be received if the amount of

dealing is high. The spot deal will come to an end in two working days after the deal is

struck.

A forward market needs a more complex calculation. A forward rate is based on the existing

spot rate plus a premium or discounts which are determined by the interest rate connecting

the two currencies that are involved. For example, the interest rates of UK are higher than

that of US and therefore a modification is made to the spot rate to reflect the financial effect

of this differential over the period of the forward contract. The duration will be up to two years

for a forward contract. A variation in foreign exchange markets can be affected to any


company whether or not they are directly involved in the international trade or not. This is

often referred to as ‘Economic’ foreign exchange and most difficult to protect a business.

The three ways of managing risks are as follows:

Choosing to manage risk by dealing with the spot market whenever the need of cash

flow rises. This will result in a high risk and speculative strategy since one will not

know the rate at which a transaction is dealt until the day and time it occurs.

Managing the business becomes difficult if it depends on the selling or buying the

currency in the spot market.

The decision must be made to book a foreign exchange contract with the bank

whenever the foreign exchange risk is likely to occur. This will help to fix the

exchange rate immediately and will give a clear idea of knowing the exact cost of

foreign currency and the amount to be received at the time of settlement whenever

this due occurs.

A currency option will prevent unfavourable exchange rate movements in the similar

way as a forward contract does. It will permit gains if the markets move as per the

expectations. For this base, a currency option is often demonstrated as a forward

contract that can be left if it is not followed. Often banks provide currency options

which will ensure protection and flexibility, but the likely problem to arise is the

involvement of premium of particular kind. The premium involved might be a cash

amount or it could also influence into the charge of the transaction.

Q6. Discuss the importance of transfer pricing for MNCs.

Answer: Transfer pricing is the process of setting a price that will be charged by a

subsidiary (unit) of a multi-unit firm to another unit for goods and services, which are sold

between such related units.

Transfer pricing is a critical issue for a firm operating internationally. Transfer pricing is

determined in three ways: market based pricing, transfer at cost and cost-plus pricing. The

Arm’s Length pricing rule is used to establish the price to be charged to the subsidiary.

Transfer pricing can also be defined as the rates or prices that are utilised when selling

goods or services between a parent company and a subsidiary or company divisions and

departments that may be across many countries. The price that is set for the exchange in

the process of transfer pricing may be a rate that is reduced due to internal depreciation or


the original purchase price of the goods in question. When properly used, transfer pricing

helps to efficiently manage the ratio of profit and loss within the company.

Transfer pricing is a relatively simple method of moving goods and services among the

overall corporate family.

Many managers consider transfer pricing as non-market based. The reason for transfer

pricing may be internal or external. Internal transfer pricing include motivating managers and

monitoring performance. External factors include taxes, tariffs, and other charges.

Transfer Pricing Manipulation (TPM) is used to overcome these reasons. Governments

usually discourage TPM since it is against transfer pricing, where transfer pricing is the act of

pricing commodities or services. However, in common terminology, transfer pricing generally

refers TPM.

TPM assists in saving the organisation’s tax by shifting accounting profits from high tax to

low tax jurisdictions. It also enables to fix transfer price on a non-market basis and thus

enables to save tax. This method facilitates in moving the tax revenues of one country to

another. A similar trend can be observed in domestic markets where different states try to

attract investment by reducing the Sales tax rates, and this leads in an outflow from one

state to another. Therefore, the Government is trying to implement a taxing system in order

to curb tax evasion.


MB0053 – International Business Management

Assignment Set- 2

Q1. What is globalisation and what are its benefits?

Answer: GlobalisationGlobalisation is a process where businesses are dealt in markets around the world, apart

from the local and national markets. According to business terminologies, globalisation is

defined as ‘the worldwide trend of businesses expanding beyond their domestic boundaries’.

It is advantageous for the economy of countries because it promotes prosperity in the

countries that embrace globalisation.

Benefits of globalizationThe merits and demerits of globalisation are highly debatable. While globalisation creates

employment opportunities in the host countries, it also exploits labour at a very low cost

compared to the home country. Let us consider the benefits and ill-effects of globalisation.

Some of the benefits of globalisation are as follows:

Promotes foreign trade and liberalisation of economies.

Increases the living standards of people in several developing countries through

capital investments in developing countries by developed countries.

Benefits customers as companies outsource to low wage countries. Outsourcing

helps the companies to be competitive by keeping the cost low, with increased

productivity.

Promotes better education and jobs.

Leads to free flow of information and wide acceptance of foreign products, ideas,

ethics, best practices, and culture.

Provides better quality of products, customer services, and standardised delivery

models across countries.

Gives better access to finance for corporate and sovereign borrowers.


Increases business travel, which in turn leads to a flourishing travel and

hospitality industry across the world.

Increases sales as the availability of cutting edge technologies and production

techniques decrease the cost of production.

Provides several platforms for international dispute resolutions in business, which

facilitates international trade.

Q2. Describe the theories of international business.

Answer: The importance of cross border commerce and the globalisation of production are

well recognized and since MNCs conduct business in many new forms other than traditional

importing and exporting, international trade theory has become too limited for explaining the

current challenges to IB.

Basis for trade Though the price difference remains the basic cause of trade, this explanation is not

adequate. The two-way flow of goods must be traced to systematic international differences

in the cost and pricing structure. Goods that are cheaper to produce at home will be

exported and goods that are cheaper to produce abroad will be imported.

The following trade theories explain the basics behind international trade:

1. Mercantilism This was the economic theory that prevailed in the 17th and 18th centuries. This theory was

highly nationalistic, viewed national well-being to be of prime importance and favoured the

regulation and planning of economic activity as a means of national advancement.

According to this theory, the most important way for a nation to grow rich was by the

acquisition of precious metals, especially gold. Exports were viewed as favourable as long

as they brought in gold, but imports were viewed unfavourably as depriving the country of its

true source of wealth and hence trade had to be regulated.

2. Absolute advantage


Adam Smith (a social philosopher and a pioneer of politicl economics) argued that nations

differ in their ability to manufacture goods efficiently and he saw that a country gains by

trading. If the two countries exchanged two goods at a ratio of 1:1, country I gets one unit of

goods B by sacrificing only 10 units of labour, whereas it has to give up 20 units of labour if it

produced the goods itself. In the same manner, country II gives up only 10 units of labour to

get one unit of goods A, whereas it has to give up 20 units of labour if it was made by itself.

Hence, it was understood that both countries had large amount of both goods by trading.

3. Comparative advantage Ricardo (english political economist) questioned Smith’s theory stating that if one country is

more productive than the other in all lines of production and if country I can produce all

goods with less labour costs, will there be a need for the countries to trade. The reply was

affirmative.

4. Product lifecycle theory This theory was proposed by Raymond Vernon in the mid-1960’s and was based on the

observation that from most of the 20th century, a very large proportion of the world’s new

products were developed by American firms and sold there first. He argued that the wealth

and size of the market gave American firms a strong incentive to develop new consumer

products and in addition, the high cost of labor was an incentive to develop cost-saving

innovations.

He did not agree with earlier theories and he placed emphasis on information, risk, and

economies of scale, rather than on cost. He focused on the lifecycle of the product and came

up with his theory which identified three distinct stages:

New product stage - The need for a new product, in the domestic market, is identified and it

is developed, manufactured and marketed in limited numbers. It is not exported, not in

sizeable quantities, at any rate, since it is primarily for the national market.

Maturing product stage - Once the product has become popular in the domestic market,

foreign demand increases and manufacturing facilites abroad may be set up to meet

demand there. After success in the foreign markets and towards the end of the product

maturity stage, the manufacturers try and produce it in the developing countries.

Standardised product stage - In the last stage of the life-cycle theory, the product

becomes a commodity, the price becomes optimised and the makers look for countries

where it can be made with the least production costs. One of the results of this is the product


being imported into the firm’s home country. Dell manufactures hardware in Asia, which is

then transported to the US, its country of origin.

5. Porter’s diamond model In 1990, Michael Porter analysed the reason behind some nations’ success and others’

failurein international competition. His thesis outlined four broad attributes that shape the

environment in which local firms compete and these attributes promote the creation of

competitive advantage. They are explained as follows:

Factor endowments - Characteristics of production were analysed in detail.

Heirarchies are recognised, as is distinguishing between basic factors like natural

resources, climate, location and so on and advanced factors like communications

infrastructure, research facilities.

Demand conditions - The role of home demand in improving competitive advantage

is emphasised since firms are most sensitive about the needs of their closest

customers. Example, the Japanese camera industry which caters to a sophisticated

and knowledgeable local market.

Relating and supporting industries - The presence of suppliers or related industries

is advantageous since the benefits of investment in

advanced factors of production spill over to these supporting industries. Successful

industries within a country tend to be grouped into clusters of related

industries.Example, Silicon Valley.

Firm strategy, structure and rivalry Domestic rivalry creates pressure to innovate, improve quality, reduce costs which in turn

helps create world-class competitors.

He said that these four attributes constituted the diamond and he argued that firms are most

likely to succeed in industries where the diamond is most favourable. He also stated that the

diamond is a mutually reinforcing system and the effect of one attribute depends on the state

of others. For example, favourable demand conditions will not result in a competitive

advantage unless the state of rivalry is enough to elicit a response from the firms.

Figure gives you an illustration of Porter’s diamond model.


Porter’s Diamond Model

Q3. Explain the importance of ethics in international business.

Answer: Most countries have similar ethical values, but are practiced differently. This

section deals with the way individuals in different countries approach ethical issues, and their

ethically acceptable behaviour. With the rise in global firms, issues related to ethical values

and traditions become more common. These ethical issues create complications to Multi-

National Companies (MNCs) while dealing with other countries for business. Hence, many

companies have formulated well-designed codes of conduct to help their employees.

Two of the most prominent issues that managers in MNCs operating in foreign countries

face are bribery and corruption and worker compensation.


Bribery and corruption – Bribery can be defined as the act of offering, accepting, or

soliciting something of value for the purpose of influencing the action of officials in the

discharge of their duties. Corruption is the abuse of public office for personal gain. The issue

arises when there are differences in perception in different countries. For example, in the

Middle East, it is perfectly acceptable to offer an official a gift. In Britain it is considered as an

attempt to bribe the official, and hence, considered unlawful.

Worker compensation – Businesses invest in production facilities abroad because of the

availability of low-cost labour, which enables them to offer goods and services at a lower

price than their competitors. The issue arises when workers are exploited and are underpaid

compared to the workers in the parent country who are paid more for the same job. The

disparity arises due to the differences in the regulatory standards in the two countries.

Managing ethics Earlier, we believed that ethics is a prerogative of individuals, but now this perception has

immensely changed. Many companies use management techniques to encourage ethical

behaviour at an organisational level. Various techniques of managing ethics like practicing

ethics at the top level management, special training on ethics, forming committees to

oversee ethical issues, and defining and implementing code of ethics are illustrated in the

following figure.

Figure: Techniques of Managing Ethics


Let us discuss each technique in detail.

Top management – The senior management of a company must be committed to ensure

that ethical standards are met. The chief executive of the company must not engage in

business practices harmful to employees, or the society. The top management must focus

on ethical practices while informing employees of their intention.

Code of ethics – One of the best practices for ethics is creating a ‘corporate ethical

statement’ and communicating it within the company. Such practices enhance the

company’s public image. Almost all Fortune 500 companies have such codes.

Ethics committee – There are ethics committees in many firms to help them deal with and

advise on work related ethical issues. The Chief Executive Officer can head the committee

that includes the Board of Directors. Such a committee answers employee queries, helps the

company to establish policies in uncertain areas, advises the Board on ethical issues, and

oversees the enforcement of the code of ethics.

Ethics hotline – A company’s ethical hotline helps its employees report any ethical issues

they face at work. The ethics committee then investigates these issues. Such hotline calls

are treated confidential, where the caller’s identity is protected to encourage employees to

report on ethical issues.

The act of reporting illegal, immoral, or illegitimate practices by former or current employees

involving its employees is known as Whistle-blowing. Whistle-blowing is favourable to a

company because employees can alert the management on possibly deviant behaviour

rather than reporting it to the media, which adversely affects the company. A case of whistle-

blowing in Xerox corporation (a pioneer in copier machines), led its Chief Financial Officer to

be fined $ 5.5 million and banned from practicing accountancy after reports of falsified

financial statements emerged.

Ethics training programs – Most firms take ethics seriously and provide training for its

managers and employees. Such training programs help the employees become familiar with

the official policy on ethical issues. These programs demonstrate the use of these ethic

policies in everyday decision-making. Ethics training is most effective when conducted by

managers and when focused on work environment.


Ethics and law – Both law and ethics focus on defining the perfect human behaviour, but

they are not the same. Law is the government’s attempt to formalise rightful behaviour, but it

is rarely possible to enforce written laws. It depends on individual or business ethics to

reduce unlawful incidents. Ethical concepts are more complex than written rules since it

deals with human dilemmas that go beyond the formal language of law.

Legal rules seek to promote ethical behaviour in companies. The following are some of the

Acts which seek to ensure fair business practices in India:

Foreign Exchange Management Act (FEMA) of 1999 - FEMA regulates the cross

border movement of foreign and local currencies.

Companies Act of 1956 - Companies Act provides the complete legal framework for

the formation, running, and winding up of a company.

Consumer Protection Act of 1986 (CPA) - CPA provides and regulates the framework

for the protection of consumer rights.

Essential Commodities Act of 1955 - This act defines the goods and services that are

essential for the people at all times and provides a legal framework for the

uninterrupted supply of the same.

Free market ethics In this section, we will discuss the ethical aspects of competition used to explain free market

ethics. Competition is an important element that differentiates free market from command

market. Competition is a mechanism for free market production and distribution of goods and

services that are in demand. Competition in business is seen as an essential cultural trait of

a free market society. Most activities of the free market can be viewed as a competitive

contest in which businesses engage to provide products and services for a profit.

In addition to the economic nature of the free market system, there are ethic- related issues

as well. The three widely accepted factors of ethics in the free market are market ethics, the

Protestant ethics, and the liberty ethics. These three ethics set the stage for the industrial

revolution and the accompanying growth in business. During this period, industrial capitalists

were allowed to freely operate businesses, build large organisations, exploit workers, and

engage in fiercely competitive practices for profit and economic expansion.

Market ethics – Market ethics is the basic system of ethics followed by a business in a free

market scenario. It covers the entire spectrum of business including sales, pricing, and

competitor issues.


The Protestant ethics – The Protestant ethics considered ideology as an important factor

along with the moral aspects in a capitalist scenario. As an ideology, this ethic served to

legitimise the capitalistic system by providing a moral justification for the pursuit of profit and

distribution of income.

Liberty ethics – Liberty ethics encourages a person to play a participatory role on

government, encourages private property, and introduces more freedom and individualism in

all spheres of life.

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

Answer: Regional integration can be defined as the unification of countries into a larger

whole. Regional integration also reflects a country’s willingness to share or unify into a larger

whole. The level of integration of a country with other countries is determined by what it

shares and how it shares. Regional integration requires some compromise on the part of

countries. It should aim to improve the general quality of life for the citizens of those

countries.

In recent years, we have seen more and more countries moving towards regional integration

to strengthen their ties and relationship with other countries. This tendency towards

integration was activated by the European Union (EU) market integration. This trend has

influenced both developed and developing countries to form customs unions and Free Trade

Areas (FTA). The World Trade Organisation (WTO) terms these agreements of integration

as Regional Trade Agreements (RTA).

Different types of regional integration are:1. Preferential trading agreementPreferential trading agreement is a trade pact between countries. It is the weakest type of

economic integration and aims to reduce the taxes on few products to the countries who sign

the pact. The tariffs are not abolished completely but are lower than the tariffs charged to

countries not party to the agreement. India is in PTA with countries like Afghanistan, Chile

and South Common Market (MERCOSUR). The introduction of PTA has generated an

increase in the market size, and resulted in the availability and variety of new products.


2. Free trade areaFree Trade Area (FTA) is a type of trade bloc and can be considered as a second stage of

economic integration. It is made up of all the countries that are willing to or agree to reduce

preferences, tariffs and quotas on most of the services and goods traded between them.

Countries choose this kind of economic integration if their economical structures are similar.

If the countries compete among themselves, they are likely to choose customs union.

The importers must obtain product information from all the suppliers within the supply chain,

in order to determine the eligibility for a Free Trade Agreement (FTA). After receiving the

supplier documentation, the importer must evaluate the eligibility of the product depending

on the rules surrounding the products. The importers product is qualified individually by the

FTA. The basis on which the product will be qualified is that the finished product should have

a minimum percentage of local content.

3. Common marketCommon market is a group formed by countries within a geographical area to promote duty

free trade and free movement of labour and capital among its members. European

community is an example of common market. Common markets levy common external tariff

on imports from non-member countries. A single market is a type of trade bloc, comprising a

free trade area with common policies on product regulation, and freedom of movement of

goods, capital, labour and services, which are known as the four factors of production. This

agreement aims at making the movement of four factors of production between the member

countries easier. The technical, fiscal and physical barriers among the member countries are

eliminated considerably as these barriers hinder the freedom of movement of the four factors

of production. The member countries must come forward to eliminate the barriers, have a

political will and formulate common economic policies.

A common market is a first step towards a single market. It may be initially limited to a FTA

with moderate free movement of capital and services, but it is not capable of removing rest

of the trade barriers.

Benefits and costs


A single market has many advantages. The freedom of movement of goods, capital, labour

and services between the member countries, results in the efficient allocation of these

production factors and increases productivity.

A single market presents a challenging environment for businesses as well as for customers,

making the existence of monopolies difficult. This affects the inefficient companies and

hence, results in a loss of market share and the companies may have to close down.

However, efficient companies can gain from the increased competitiveness, economies of

scale and lower costs. Single market also benefits the consumers in a way that the

competitive environment provides them with inexpensive products, more efficient providers

of products and increased variety of products.

A country changing over to a single market may experience some short term negative

effects on the national economy due to increased international competition. The national

companies that earlier benefited from market protection and subsidies, may find it difficult to

cope with their efficient peers. If the companies fail to improve their methods, they may have

to close down leading to migration and unemployment.

4. Economic unionEconomic union is a type of trade bloc and is instituted through a trade pact. It comprises of

a common market with a customs union. The countries that are part of an economic union

have common policies on the freedom of movement of four factors of production, common

product regulations and a common external trade policy. The purpose of an economic union

is to promote closer cultural and political ties, while increasing the economic efficiency

between the member countries.

Economic unions are established by means of a formal intergovernmental legal agreement,

among independent countries with the intention of fostering greater economic integration.

The members of an economic union share some elements associated with their national

economic jurisdictions.

These include the free movements of:

Goods and services within the union along with a common taxing method for imports

from non-member countries.

Capital within the economic union.

Persons within the economic union. Some form of cooperation usually exists when

framing fiscal and monetary policies.


5. Political union

A political union is a type of country, which consists of smaller countries/nations. Here, the

individual nations share a common government and the union is acknowledged

internationally as a single political entity. A political union can also be termed as a legislative

union or state union.

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

Answer: The Challenges of E-Business:As the ebusiness is growing, there are many technical and business trends that are

associated with it. Some important trends in e-business are explained below.

E-business is crucial to business success. Many companies come out with changes that are

necessary for e-business to become profitable. The process of e-business is long lasting

than that of the re-engineering. There are some important trends in the e-business that are

described as follows:

Technology focus is on e-business - The hardware, software, and network

vendors, focus on providing the tools for e-business. The ebusiness is mainly the

extension of the products and services.

E-business produces cumulative effects - E-business is long lasting.

The relationship with customers, suppliers, and employees changes as we

implement e-business.

E-business implementation effects success and failure of a business - There

will be both the success and the failures that are associated with any kind of

business. The failures become dramatic with e-business as it is more visible

externally.

There are some major success factors for e-business. These factors include the strategic

factors, structural factors and the management oriented factors. These factors are explained

as follows:

Strategic factors.

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

technologies.


The basis of competition that is not shifted from traditional competitive advantages such as

cost, profit, quality, service and features.

The new competitors and market shares are tracked.

The web centric marketing strategy.

The strategic position of the company in the market has strengthened.

The frequent review of the distribution and supply chain model is done in order to

maximise the company's gain.

The buyer’s behaviour and the customer personalisation.

The first-mover advantage and quick time to start.

The e-business offered good products and services.

The innovation was allowed when risks are low.

The customer’s and partner's expectations from the well managed.

Structural factors Correct digital infrastructure.

Good e-business education and training to employees, management and customers.

Current systems expanded to cover entire supply chain.

Good cost control.

Management-oriented factors The organisation wide commitment to e-business leadership.

The necessary support for e-business from the top management.

The awareness and understanding of capabilities of technology by executives.

The top management has to communicate about the value of ebusiness throughout

the organisation.

The e-business is facing challenges mainly in the areas of technology, logistics, and legal

issues.

1. TechnologyThe technology plays a major role in the concept of new economy. The technology has two

dimensions; one is the shift from manufacturing to services and second is the shift from

physical resources to the knowledge resources. There are so many mechanisms for

technology innovation and diffusion, both within and outside the countries. Many of the

organisations will include different technologies both for quantitative and qualitative terms.

Small scale enterprises play a vital role in the implementation of new technologies. They

have added more value in terms of population, employment, and services that they are


offering. Internet also plays a vital role as it helps the small and medium enterprises in

providing the cost effective possibilities to advertise their products. Internet also provides the

contacts to buyers and suppliers on a global basis. E-business is helps the radical

transformation in the way that the business is done. The introduction of technologies like the

common database, electronic networks and value added services are helpful for speeding

up the transactions and these are fundamental at the industrial level. The e-business has to

undergo lot of challenges in implementing the technologies that are helpful for the

organisation since many of the people in the organisation will not be interested to shift to the

new technology and learn the new skills.

2. LogisticsThe logistics is defined as the planning framework for maintaining the material, information,

and capital flow. The logistics includes the complex information, communication and control

systems required in the business environment. The logistics presents e-business with

challenges that exceeds the expectations of the customers with a reasonable cost. Now–

aday, attempt has been made to reduce the inventory costs. In order to meet the high

expectations of the customers, an e-business needs the special infrastructure for tuning and

managing the interactions. The interactions can be in between the shippers, logistic

providers, shipping companies, and also the customers.

3. Legal concernsAs there is tremendous usage of internet, it is better to consider the legal concerns behind

the internet. This is because whatever is printed on the net will be accessed by public

throughout the world. We also have an option of going back and seeing the basics of that

information. Now-–a-day with the help of wireless phones, Personal Digital Assistants

(PDAs), internet can be accessed from anywhere in the world. As a result the customers

must be provided proper security and privacy to access internet. It becomes very difficult to

trust the actual with the unethical, illegal, internet marketing and advertising frauds and e-

business email scams and hence one must be careful while performing e-business.

It is necessary to concern the privacy and legal matters while writing a copy and maintaining

a client's e-business.

There are uncertainties in e-business when compared with direct business. The

uncertainties are related to the security, privacy, credit and debit card handling. The security

is the primary concern in e-business. The PCI Data Security standard (PCI DSS) needs to

be followed by one who handles the credit card information. E-business is all about the trust


between buyer and the seller so one must be careful while dealing with the transactions

which involve the handling of credit and debit cards.

There will also be copyright issues that is copying something from other sites and presenting

the same content as their own. It is important to check for plagiarism when the company is

publishing their own articles. When some concepts are copyright then it is necessary to

credit the original authors. Disclaimer notice is required at the start of any business website.

If the webmasters include some unethical information about the client then that can cause

everlasting negative consequences for the client. The legal action is taken against the false

advertisements also.

The risks associated with conducting e-business over the internet are explained as follows:

Jurisdiction - Contracting over the cyberspace is a challenge for the website owners

and the internet is the form of communication that rises above the spatial boundaries.

There is a jurisdiction problem in the disputes between the buyer and seller regarding

where the contract was formed and which state law applies for the contract.

Contact validity - The emerging issue is the legal validity of web wrap or click on

contracts. This type of contract is mainly found on the web site that offers goods and

services for the sale. This e-business creates the legal relationship between the

seller and buyer.

Contract information - The advent of the e-business over the net is responsible for

various legal issues regarding the formation of the electronic contracts.

There is a need for matching both the e-customers and e-merchants with the legally

responsible parties in the real world. There is a need for on cryptographic methods for

reducing the risks associated with the identification and authentication. The cryptographic

methods for eliminating the risks those are associated with the non repudiation and security.

Q6. Write short notes on WTO.

Answer: WTO was established on 1st January 1995. In April 1994, the Final Act was signed

at a meeting in Marrakesh, Morocco. The Marrakesh Declaration of 15th April 1994 was

formed to strengthen the world economy that would lead to better investment, trade, income

growth and employment throughout the world. The WTO is the successor to the General

Agreement of Tariffs and Trade (GATT). India is one of the founder members of WTO. WTO

represents the latest attempts to create an organisational focal point for liberal trade

management and to consolidate a global organisational structure to govern world affairs.


WTO has attempted to create various organisational attentions for regulation of international

trade. WTO created a qualitative change in international trade. It is the only international

body that deals with the rules of trades between nations.

Objectives and functions of WTOThe key objective of WTO is to promote and ensure international trade in developing

countries. The other major functions include:

Helping trade flows by encouraging nations to adopt discriminatory trade policies.

Promoting employment, expanding productions and trade and raising standard of

living and income and utilising the world’s resources.

Ensuring that developing countries secure a better share of growth in world trade.

Providing forum for trade negotiations.

Resolving trade disputes.

The important functions of the WTO as stated in the WTO agreement are the following:

Developing transitional economies – Majority of the WTO members belong to developing

countries. The developing countries such as India, China, Mexico, Brazil and others have an

important role in the organisation. The WTO helps in solving the problems of developing

economies. The developing states are provided with trade and tariff data. This depends on

the country’s individual export interest and their participation in WTO-bodies. The new

members benefit hugely from these services.

Providing help for export promotion – The WTO provides specialised help for export

promotion to its members. The export promotion is done through the International Trade

Center established by the GATT in 1964. It is operated by the WTO and the United Nations.

The center accepts requests from member countries, usually developing countries for

support in formulating and implementing export promotion programmes. The center provides

information on export market and marketing techniques. The center also provides assistance

in establishing export promotion and marketing services. Through this WTO proves its

commitment in the upliftment of the world economy.

Cooperating in global economic policy-making – The main function of the WTO is to

cooperate in global economic policy-making. In the Marrakesh Ministerial Meeting in April

1994, a separate declaration was adopted to achieve this objective. The declaration

specifies the responsibility of WTO as, to improve and maintain the cooperation with

international organisations such as the World Bank, International Monetary Fund (IMF) that


are involved in monetary and financial matters. WTO analyses the impact of liberalisation on

the growth and development of national economies which is the important factor in the

success of the economy.

Monitoring implementation of the agreement – The WTO administers sixty different

agreements that have the statue of international legal documents. The member-

governments sign and confirm all WTO agreements on attainment.

Providing forum for negotiations – The WTO provides a permanent forum for negotiations

among members. The negotiations can be on matters already in the WTO agreements or

matters not addressed in the WTO law.

Administrating dispute settlement – The important function of WTO is the administration

of the WTO dispute settlement system. It helps in settling multilateral trading dispute. A

dispute arises when a member country adopts a trade policy and other fellow members

consider it as a violation of WTO agreements. The Dispute Settlement Body (DSB) is

responsible for the settlement of disputes. The dispute settlement system is prohibited from

adding or deleting the rights and obligations provided in the WTO agreements. The WTO

dispute settlement system helps to:

Preserve the rights and responsibilities of the members.

Clarify the current provisions of the agreements.

Structure The structure of the WTO consists of the Ministerial Conference, which is the highest

authority. This body consists of the representatives from all WTO members. The WTO

members meet in every two years and take decisions on all matters under the multilateral

trade agreements. The daily activities of the WTO are conducted by subsidiary bodies and

principally by the General Council which is composed of WTO members. The members

report to the Ministerial Conference. The General Council on behalf of the Ministerial

Conference administers as the Dispute Settlement Body to manage the dispute settlement

procedures. It also acts as the Trade Policy Review Body that conducts regular reviews of

the trade policies of the individual WTO members.

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

Council for Trade in Goods manages the implementation and functioning of all

agreements covering trade in goods.


Trade in Services and Trade of Intellectual Property Rights are the two councils that

have responsibility for their respective WTO agreements and can establish their own

subsidiary bodies if required.

The Committee on Trade and Development manages issues relating to the

developing countries.

The Committee on Balance of Payments conducts consultations between WTO

members and countries that take trade-restrictive measures to handle balance-of-

payments difficulties.

Committee on Budget and Administration manages issues relating to financing and

budget of WTO.

Principles The WTO principles of the trading system are:

Trading without discrimination – One aspect of nondiscrimination is that foreigners

and people within the home country must be treated equally. This implies that

imported goods that are in the market must not face discrimination. There is also a

Most Favoured Nation (MFN) principle which requires the nations to treat all WTO

members equally. In case one nation grants a special trade deal to another nation,

the deal must be extended to all WTO members.

Trade barriers negotiated downwards – To lower trade barriers such as import

tariffs, red tape and encourage trade growth.

Predictable trading – The predictability in business helps to know the real costs.

The WTO operates with tariff bindings and agreements that restricts raising a specific

tariff over a given time. This provides the business people with realistic data. Making

trade rules clear and accessible helps the business people to anticipate stable future.

Competitive trading – The WTO works towards trade liberalisation and understands

that trade relationships between nations can be very complex. The WTO agreements

support healthy competition in services and intellectual property and discourage

subsidies and dumping of products at prices below the cost of their manufacturer.

Encourage development and economic reforms – The majority of the WTO

members are developing economies that are changing to market economies. The

developed nations must give market access to goods from the under developed

countries and provide technical assistance. Developed countries are allowing duty-

free and quota-free imports for all the products from the under developed countries.

MBA Semester IV MF0015

MF0015 – International Financial Management

Assignment Set- 1

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

Answer:Forward Points = ((Spot * (1 + (OCR rate * n/360))) / (1 + (BCR rate * n/360))) - Spot

OCR = Other Currency Rate

BCR = Base Currency Rate

Forward points = ((0.07940 * (1 + (0.018215 * 90/360))) / (1 + (0.08007 * 90/360))) –

0.07940

SWAP = -0.00120

Forward rate = 0.07940 - 0.00120 = 0.0782

Customer sells EUR 3 Mio against USD at 0.0782 at 3 month (0.07940 - 0.00120).

Customer wants to Buy EUR 3 Mio against USD 3 months forward.

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

Answer: A Eurobond is underwritten by an international syndicate of banks and other

securities firms, and is sold exclusively in countries other than the country in whose currency

the issue is denominated. For example, a bond issued by a U.S. corporation, denominated in

U.S. dollars, but sold to investors in Europe and Japan (not to investors in the United

States), would be a Eurobond. Eurobonds are issued by multinational corporations, large

domestic corporations, sovereign governments, governmental enterprises, and international

institutions. They are offered simultaneously in a number of different national capital

markets, but not in the capital market of the country, nor to residents of the country, in whose

currency the bond is denominated. Almost all Eurobonds are in bearer form with call

provisions and sinking funds.


A foreign bond is underwritten by a syndicate composed of members from a single country,

sold principally within that country, and denominated in the currency of that country. The

issuer, however, is from another country. A bond issued by a Swedish corporation,

denominated in dollars, and sold in the U.S. to U.S. investors by U.S. investment bankers,

would be a foreign bond. Foreign bonds have nicknames: foreign bonds sold in the U.S. are

"Yankee bonds"; those sold in Japan are "Samurai bonds"; and foreign bonds sold in the

United Kingdom are "Bulldogs." Figure 4 specifically reclassifies foreign bonds from a U.S.

investor`s perspective.

FOREIGN BONDS TO U.S. INVESTORSForeign currency bonds are issued by foreign governments and foreign corporations,

denominated in their own currency. As with domestic bonds, such bonds are priced inversely

to movements in the interest rate of the country in whose currency the issue is denominated.

For example, the values of German bonds fall if German interest rates rise. In addition,

values of bonds denominated in foreign currencies will fall (or rise) if the dollar appreciates

(or depreciates) relative to the denominated currency. Indeed, investing in foreign currency

bonds is really a play on the dollar. If the dollar and foreign interest rates fall, investors in

foreign currency bonds could make a nice return. It should be pointed out, however, that if

both the dollar and foreign interest rates rise, the investors will be hit with a double whammy.

Characteristics of Eurobond markets1. Currency denomination: The generic, plain vanilla Eurobond pays an annual fixed

interest and has a long-term maturity. There are a number of different currencies in which

Eurobonds are sold. The major currency denominations are the U.S. dollar, yen, and euro.

(70 to 75 percent of Eurobonds are denominated in the U.S. dollar.) The central bank of a


country can protect its currency from being used. Japan, for example, prohibited the yen

from being used for Eurobond issues of its corporations until 1984.

2. Non-registered: Eurobonds are usually issued in countries in which there is little

regulation. As a result, many Eurobonds are unregistered, issued as bearer bonds. (Bearer

form means that the bond is unregistered, there is no record to identify the owners, and

these bonds are usually kept on deposit at depository institution). While this feature provides

confidentiality, it has created some problems in countries such as the U.S., where

regulations require that security owners be registered on the books of issuer.

3. Credit risk: Compared to domestic corporate bonds, Eurobonds have fewer protective

covenants, making them an attractive financing instrument to corporations, but riskier to

bond investors. Eurobonds differ in term of their default risk and are rated in terms of quality

ratings.

4. Maturities: The maturities on Eurobonds vary. Many have intermediate terms (2 to 10

years), referred to as Euronotes, and long terms (10-30 years), and called Eurobonds. There

are also short-term Europaper and Euro Medium-term notes.

5. Other features:Like many securities issued today, Eurobonds often are sold with many innovative features.

For example:

a) Dual-currency Eurobonds pay coupon interest in one currency and principal in another.

b) Option currency Eurobond offers investors a choice of currency. For instance, a

sterling/Canadian dollar bond gives the holder the right to receive interest and principal in

either currency.

1. A number of Eurobonds have special conversion features. One type of convertible

Eurobond is a dual-currency bond that allows the holder to convert the bond into stock or

another bond that is denominated in another currency.

2. A number of Eurobonds have special warrants attached to them. Some of the warrants

sold with Eurobonds include those giving the holder the right to buy stock, additional bonds,

currency, or gold.


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

Answer: Subprime lending is the practice of extending credit to borrowers with certain

credit characteristics – e.g. a FICO score of less than 620 – that disqualify them from loans

at the prime rate (hence the term ’sub-prime’). Sub-prime lending covers different types of

credit, including mortgages, auto loans, and credit cards. Since sub-prime borrowers often

have poor or limited credit histories, they are typically perceived as riskier than prime

borrowers. To compensate for this increased risk, lenders charge sub-prime borrowers a

premium. For mortgages and other fixed-term loans, this is usually a higher interest rate; for

credit cards, higher over-the-limit or late fees are also common. Despite the higher costs

associated with sub-prime lending, it does give access to credit to people who might

otherwise be denied. For this reason, sub-prime lending is a common first step toward “credit

repair”; by maintaining a good payment record on their sub-prime loans, borrowers can

establish their creditworthiness and eventually refinance their loans at lower, prime rates.

Sub-prime lending became popular in the U.S. in the mid-1990s, with outstanding debt

increasing from $33 billion in 1993 to $332 billion in 2003. As of December 2007, there was

an estimated $1.3 trillion in sub-prime mortgages outstanding.20% of all mortgages

originated in 2006 were considered to be sub-prime, a rate unthinkable just ten years ago.

This substantial increase is attributable to industry enthusiasm: banks and other lenders

discovered that they could make hefty profits from origination fees, bundling mortgages into

securities, and selling these securities to investors.

These banks and lenders believed that the risks of sub-prime loans could be managed, a

belief that was fed by constantly rising home prices and the perceived stability of mortgage-

backed securities. However, while this logic may have held for a brief period, the gradual

decline of home prices in 2006 led to the possibility of real losses. As home values declined,

many borrowers realized that the value of their home was exceeded by the amount they

owed on their mortgage. These borrowers began to default on their loans, which drove home

prices down further and ruined the value of mortgage-backed securities (forcing companies

to take write downs and write-offs because the underlying assets behind the securities were

now worth less).

This downward cycle created a mortgage market meltdown. The practice of sub-prime

lending has widespread ramifications for many companies, with direct impact being on

lenders, financial institutions and home-building concerns. In the U.S. Housing


Market, property values have plummeted as the market is flooded with homes but bereft of

buyers. The crisis has also had a major impact on the economy at large, as lenders are

hoarding cash or investing in stable assets like Treasury securities rather than lending

money for business growth and consumer spending; this has led to an overall credit crunch

in 2007. The sub-prime crisis has also affected the commercial real estate market, but not as

significantly as the residential market as properties used for business purposes have

retained their long-term value.

The International Monetary Fund estimated that large U.S. and European banks lost more

than $1 trillion on toxic assets and from bad loans from January 2007 to September 2009.

These losses are expected to top $2.8 trillion from 2007-10. U.S. banks losses were forecast

to hit $1 trillion and European bank losses will reach $1.6 trillion. The IMF estimated that

U.S. banks were about 60 percent through their losses, but British and euro zone banks only

40 percent.

Drivers of sub-prime lendingHome price appreciationHome price appreciation seemed an unstoppable trend from the mid-1990’s through to

today. This "assumption" that real estate would maintain its value in almost all circumstances

provided a comfort level to lenders that offset the risk associated with lending in the sub-

prime market. Home prices appeared to be growing at annualized rates of 5-10% from the

mid-90s forward. In the event of default, a very large percentage of losses could be

recouped through foreclosure as the actual value of the underlying asset (the home) would

have since appreciated.

Lax lending standardsOutstanding mortgages and foreclosure starts in 1Q08, by loan type. The reduced rigor in

lending standards can be seen as the product of many of the preceding themes. The

increased acceptance of securitized products meant that lending institutions were less likely

to actually hold on to the risk, thus reducing their incentive to maintain lending standards.

Moreover, increasing appetite from investors not only fueled a boom in the lending industry,

which had historically been capital constrained and thus unable to meet demand, but also

led to increased investor demand for higher-yielding securities, which could only be created

through the additional issuance of sub-prime loans. All of this was further enabled by the

long-term home price appreciation trends and altered rating agency treatment, which

seemed to indicate risk profiles were much lower than


they actually were. As standards fell, lenders began to relax their requirements on key loan

metrics. Loan-to-value ratios, an indicator of the amount of collateral backing loans,

increased markedly, with many lenders even offering loans for 100% of the collateral value.

More dangerously, some banks began lending to customers with little effort made to

investigate their credit history or even income. Additionally, many of the largest sub-prime

lenders in the recent boom were chartered by state, rather than federal, governments. States

often have weaker regulations regarding lending practices and fewer resources with which to

police lenders. This allowed banks relatively free rein to issue sub-prime mortgages to

questionable borrowers.

Adjustable-rate mortgages and interest ratesAdjustable-rate mortgages (ARMs) became extremely popular in the U.S. mortgage market,

particularly the sub-prime sector, toward the end of the 1990s and through the mid-2000s.

Instead of having a fixed interest rate, ARMs feature a variable rate that is linked to current

prevailing interest rates. In the recent sub-prime boom, lenders began heavily promoting

ARMs as alternatives to traditional fixed-rate mortgages. Additionally, many lenders offered

low introductory, or “teaser”, rates aimed at attracting new borrowers. These teaser rates

attracted droves of sub-prime borrowers, who took out mortgages in record numbers.

While ARMs can be beneficial for borrowers if prevailing interest rates fall after the loan

origination, rising interest rates can substantially increase both loan rates and monthly

payments.

In the sub-prime bust, this is precisely what happened. The target federal funds rate (FFR)

bottomed out at 1.0% in 2003, but it began hiking steadily upward in 2004. As of mid-2007,

the FFR stood at 5.25%, where it had remained for over one year. This 4.25% increase in

interest rates over a three-year period left borrowers with steadily rising payments, which

many found to be unaffordable. The expiration of teaser rates didn’t help either; as these

artificially low rates are replaced by rates linked to prevailing interest rates, sub-prime

borrowers are seeing their monthly payments jump by as much as 50%, further driving the

increasing number of delinquencies and defaults. Between September of 2007 and January

2009, however, the U.S. Federal Reserve slashed rates from 5.25% to 0-.25% in hopes of

curbing losses. Though many sub-prime mortgages continue to reset from fixed to floating,

rates have fallen so much that in many circumstances the fully indexed reset rate is below

the pre-existing fixed rate; thus, a boon for some sub-prime borrowers.

The exchange rate is an important price in the economy and some governments like to

control it, manage it or influence it. Others prefer to leave the exchange rate to be


determined only by market forces. This decision is the choice of exchange rate regime.

Many alternative regimes exist:

Floating Exchange Rate (Flexible) Regimes: A flexible exchange rate system is one

where the value of the currency is not officially fixed but varies according to the supply and

demand for the currency in the foreign exchange market. In this system, currencies are

allowed to:

Appreciate – when the currency becomes more valuable relative to others.

Depreciate– when the currency becomes less valuable relative to others.

Fixed Exchange Rate Regimes: A Fixed exchange rate system is one where the value of

the currency is set by official government policy. The exchange rate is determined by

government actions designed to keep rates the same over time. The currencies are altered

by the government:

Revaluation – Government action to increase the value of domestic currency relative

to others.

Devaluation – Government action to decrease the value of domestic currency.

After the transition period of 1971-73, the major currencies started to float. Flexible

exchange rates were declared acceptable to the IMF members. Gold was abandoned

as an international reserve asset. Since 1973, most major exchange rates have been

“floating” against each other.

However, there are countries which have fixed exchange rate regimes.

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

Answer: Parallel loanThe forerunner of a swap; a method of raising capital in a foreign country to finance assets

there without a cross-border movement of capital. For example, a $US loan would be made

to an Australian company to finance its factory in the US; at the same time the US party

which made the loan would borrow $A in Australia from the Australian company's parent to

finance a project in Australia. Parallel loans enjoyed considerable popularity in the 1970s in

the UK when they were frequently used to circumvent strict exchange controls.

A type of foreign exchange loan agreement that was a precursor to currency swaps. A

parallel loan involves two parent companies taking loans from their respective national

financial institutions and then lending the resulting funds to the other company's subsidiary.


For example, ABC, a Canadian company, would borrow Canadian dollars from a Canadian

bank and XYZ, a French company, would borrow euros from a French bank. Then ABC

would lend the Canadian funds to XYZ's Canadian subsidiary and XYZ would lend the euros

to ABC's French subsidiary.

The first parallel loans were implemented in the 1970s in the United Kingdom in order to

bypass taxes that were imposed to make foreign investments more expensive.

Back-to-back loanA Back-to-back loan is a loan agreement between entities in two countries in which the

currencies remain separate but the maturity dates remain fixed. The gross interest rates of

the loan are separate as well and are set on the basis of the commercial rates in place when

the agreement is signed.

Most back-to-back loans come due within 10 years, due to their inherent risks. Initiated as a

way of avoiding currency regulations, the practice had, by the mid-1990s, largely been

replaced by currency swaps.

A Back-to-back loan is a loan agreement between entities in two countries in which the

currencies remain separate but the maturity dates remain fixed. The gross interest rates of

the loan are separate as well and are set on the basis of the commercial rates in place when

the agreement is signed.

Most back-to-back loans come due within 10 years, due to their inherent risks. Initiated as a

way of avoiding currency regulations, the practice had, by the mid-1990s, largely been

replaced by currency swaps.

One disadvantage of such agreements is asymmetrical liability - absent a specific

agreement, when one party defaults on the loan, the other party may still be held responsible

for repayment. Another disadvantage in comparison with currency swaps is that back-to-

back loan transactions are customarily recorded on banking institutions' records as liabilities

and thereby increase their capitalization requirements, while currency swaps were, during

the 2000s, widely exempted from this requirement.

Q5. Explain double taxation avoidance agreement in detail

Answer: Double Taxation Avoidance Agreements


Double Taxation Avoidance Agreements

Double taxation relief

Double taxation means taxation of same income of a person in more than one country. This

results due to countries following different rules for income taxation. There are two main

rules of income taxation (a) source of income rule and (b) residence rule.

As per source of income rule, the income may be subject to tax in the country where the

source of such income exists (i.e. where the business establishment is situated or where the

asset/property is located) whether the income earner is a resident in that country or not.

On the other hand, the income earner may be taxed on the basis of his residential status in

that country. For example if a person is resident of a country, he may have to pay tax on any

income earned outside that country as well.

Further some countries may follow a mixture of the above two rules.

Thus problem of double taxation arises if a person is taxed in respect of any income on the

basis of source of income rule in one country and on the basis of residence in another

country or on the basis of mixture of above two rules.

Relief against such hardship can be provided mainly in two ways

(a) Bilateral relief (b) Unilateral relief.

Bilateral ReliefThe governments of two countries can enter into agreement to provide relief against double

taxation, worked out on the basis of mutual agreement between the two concerned

sovereign states. This may be called a scheme of ‘bilateral relief’ as both concerned powers

agree as to the basis of the relief to be granted by either of them.

Unilateral ReliefThe above procedure for granting relief will not be sufficient to meet all cases. No country

will be in a position to arrive at such agreement as envisaged above with all the countries of

the world for all time. The hardship of the taxpayer, however, is a crippling one in all such

cases. Some relief can be provided even in such cases by home country irrespective of

whether the other country concerned has any agreement with India or has otherwise

provided for any relief at all in respect of such double taxation. This relief is known as

unilateral relief.

Method of Giving Relief from Double Taxation

Relief from double taxation is provided by abatement on the basis of mutual agreement

between two states concerned where by the assessee is given relief by credit/refund in a


particular manner even though he is taxed in both countries. Relief may be in the form of

credit for tax payable in another country or by charging tax at lower rate.

Various models of treatiesAlthough treaties entered into by various countries cannot be exactly identical, a certain

amount of uniformity is desirable in its framework; with this in view, tax treaties have been

based on models such as:

1. OECD model (Organisation of Economic Co-operation and Development)

2. UN Models Double Taxation Convention between developed and developing countries,

1980. Most of India’s treaties are based on OECD models.

Types of AgreementsAgreements can be divided into two main categories:

1. Limited agreements

2. Comprehensive agreements

Limited agreements are generally entered into to avoid double taxation relating to income

derived from operation of aircraft, ships, carriage of cargo and freight.

Comprehensive agreements, on the other hand, are very elaborate documents which lay

down in detail how incomes under various heads may be dealt with.

Countries with which no agreement exists [section 91] [unilateral relief]

If any person who is resident in India in any previous year proves that, in respect of his

income which accrued or arose during that previous year outside India (and which is not

deemed to accrue or arise in India), he has paid in any country with which there is no

agreement under section 90 for the relief or avoidance of double taxation, income-tax, by

deduction or otherwise, under the law in force in that country, he shall be entitled to the

deduction from the Indian income-tax payable by him of a sum calculated on such doubly

taxed income ‘at the Indian rate of tax or the rate of tax of the said country, whichever is the

lower, or at the Indian rate of tax if both the rates are equal’.

In other words, unilateral relief will be available, if the following conditions are satisfied:

1. The assessee in question must have been resident in the taxable territories.

2. That some income must have accrued or arisen to him outside the taxable territory during

the previous year and it should also be received outside India.

3. In respect of that income, the assessee must have paid by deduction or otherwise tax

under the law in force in the foreign country in question in which the income outside India

has arisen.

4. There should be no reciprocal arrangement for relief or avoidance from double taxation

with the country where income has accrued or arisen.


India has agreements for avoidance of double taxation with over 60 countries.

If all the above conditions are satisfied, such person shall be entitled to deduction from the

Indian income-tax payable by him of a sum calculated on such doubly taxed income

(a) At the average Indian rate of tax or the average rate of tax of the said country, whichever

is the lower, or

(b) At the Indian rate of tax if both the rates are equal.

Average rate of tax means the tax payable on total income divided by the total income.

Steps for calculating relief under this section:

Step I: Calculate tax on total income inclusive of the foreign income on which relief is

available. Claim relief if available under sections 88, 88B and 88C.

Step II: Calculate average rate of tax by dividing the tax computed under Step I with the total

income (inclusive of such foreign income).

Step III: Calculate average rate of tax of the foreign country by dividing income-tax actually

paid in the said country after deduction of all relief due but before deduction of any relief due

in the said country in respect of double taxation by the whole amount of the income as

assessed in the said country.

Step IV: Claim the relief from the tax payable in India at the rate calculated at Step II or Step

III whichever is less

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

Answer: The objective of capital structure management is to mix the permanent sources of

funds in a manner that will maximise the company’s common stock price. This will also

minimise the firm’s composite cost of capital. This proper mix of fund sources is referred to

as the optimal

capital structure. Thus, for each firm, there is a combination of debt, equity and other

forms(preferred stock) which maximises the value of the firm while simultaneously

minimising the cost of capital. The financial manager is continuously trying to achieve an

optimal proportion of debt and equity that will achieve this objective.

Cost of Capital across CountriesJust like technological or resource differences, there exist differences in the cost of capital

across countries. Such differences can be advantageous to MNCs in the following ways:

1. Increased competitive advantage results to the MNC as a result of using low cost capital

obtained from international financial markets compared to domestic firms in the foreign


country. This, in turn, results in lower costs that can then be translated into higher market

shares.

2. MNCs have the ability to adjust international operations to capitalise on cost of capital

differences among countries, something not possible for domestic firms.

3. Country differences in the use of debt or equity can be understood and capitalised on by

MNCs. We now examine how the costs of each individual source of finance can differ across

countries.

Country differences in Cost of DebtBefore tax cost of debt (Kd) = Rf + Risk Premium

This is the prevailing risk free interest rate in the currency borrowed and the risk premium

required by creditors. Thus the cost of debt in two countries may differ due to difference in

the risk free rate or the risk premium.

(a) Differences in risk free rate: Since the risk free rate is a function of supply and demand,

any factors affecting the supply and demand will affect the risk free rate. These factors

include:

Tax laws: Incentives to save may influence the supply of savings and thus the

interest rates. The corporate tax laws may also affect interest rates through effects

on corporate demand for funds.

Demographics: They affect the supply of savings available and the amount of

loanable funds demanded depending on the culture and values of a given country.

This may affect the interest rates in a country.

Monetary policy: It affects interest rates through the supply of loanable funds. Thus

a loose monetary policy results in lower interest rates if a low rate of inflation is

maintained in the country.

Economic conditions: A high expected rate of inflation results in the creditors

expecting a high rate of interest which increases the risk free rate.

(b) Differences in risk premium: The risk premium on the debt must be large enough to

compensate the creditors for the risk of default by the borrowers. The risk varies with the

following:

Economic conditions: Stable economic conditions result in a low risk of recession.

Thus there is a lower probability of default.

Relationships between creditors and corporations: If the relationships are close

and the creditors would support the firm in case of financial distress, the risk of

illiquidity of the firm is very low. Thus a lower risk premium.

Government intervention: If the government is willing to intervene and rescue a


firm, the risk of bankruptcy and thus, default is very low, resulting in a low risk

premium.

Degree of financial leverage: All other factors being the same, highly leveraged

firms would have to pay a higher risk premium.


MF0015 – International Financial Management

Assignment Set- 2

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

Answer: International Finance is a distinct field of study and certain features set it apart from

other fields. The important distinguishing features of international finance are discussed

below:

Foreign exchange risk: An understanding of foreign exchange risk is essential for

managers and investors in the modern day environment of unforeseen changes in

foreign exchange rates. In a domestic economy this risk is generally ignored because a

single national currency serves as the main medium of exchange within a country. When

different national currencies are exchanged for each other, there is a definite risk of

volatility in foreign exchange rates. The present International Monetary System set up is

characterized by a mix of floating and managed exchange rate policies adopted by each

nation keeping in view its interests. In fact, this variability of exchange rates is widely

regarded as the most serious international financial problem facing corporate managers

and policy makers.

Political risk: Another risk that firms may encounter in international finance is political

risk. Political risk ranges from the risk of loss (or gain) from unforeseen government

actions or other events of a political character such as acts of terrorism to outright

expropriation of assets held by foreigners. MNCs must assess the political risk not only

in countries where it is currently doing business but also where it expects to establish

subsidiaries. The extreme form of political risk is when the sovereign country changes

the “rules of the game” and the affected parties have no alternatives open to them.

Expanded opportunity sets: When firms go global, they also tend to benefit from

expanded opportunities which are available now. They can raise funds in capital markets

where cost of capital is the lowest. In addition, firms can also gain from greater

economies of scale when they operate on a global basis.

Market imperfections: The final feature of international finance that distinguishes it from

domestic finance is that world markets today are highly imperfect. There are profound

differences among nations’ laws, tax systems, business practices and general cultural

environments. Imperfections in the world financial markets tend to restrict the extent to

which investors can diversify their portfolio. Though there are risks and costs in coping


with these market imperfections, they also offer managers of international firm’s

abundant opportunities.

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

Answer: Debits and credits

Since the balance of payments statement is based on the principle of double entry

bookkeeping, every credit in the account is balanced by a matching debit and vice versa.

The following section now explains, with examples, the BOP accounting principles regarding

debits and credits. These principles are logically consistent, though they may be a little

confusing sometimes.

A country earns foreign exchange on some transactions and expends foreign exchange on

others when it deals with the rest of the world. Credit transactions are those that earn foreign

exchange and are recorded in the balance of payments with a plus (+) sign. Selling either

real or financial assets or services to nonresidents is a credit transaction. For example, the

export of Indian made goods earns foreign exchange for us and is, hence, a credit

transaction. Borrowing abroad also brings in foreign exchange and is recorded as a credit.

An increase in accounts payable due to foreigners by Indian residents has the same BOP

effect as more formal borrowing in the world’s capital market. The sale to a foreign resident

of a service, such as an airline trip on Air India or ‘hotel booking’ in an Indian hotel, also

earns foreign exchange and is a credit transaction.

Transactions that expend or use up foreign exchange are recorded as debits and are

entered with a minus (–) sign. The best example here is of import of goods and services

from foreign countries. When Indian residents buy machinery from US or perfumes from

France, foreign exchange is spent and the import is recorded as a debit. Similarly, when

Indian residents purchase foreign services, foreign exchange is used and the entry is

recorded as a debit.

The BOP’s accounting principles regarding debits and credits can be summarised as follows:

1. Credit Transactions (+) are those that involve the receipt of payment from foreigners.

The following are some of the important credit transactions:

(a) Exports of goods or services

(b) Unilateral transfers (gifts) received from foreigners

(c) Capital inflows


2. Debit Transactions (–) are those that involve the payment of foreign exchange i.e.,

transactions that expend foreign exchange. The following are some of the important debit

transactions:

(a) Import of goods and services

(b) Unilateral transfers (or gifts) made to foreigners

(c) Capital outflows

Let us now analyse the two terms – capital inflows and capital outflows – in a little more

detail.

Capital Inflows can take either of the two forms:

(a) An increase in foreign assets of the nation

(b) A reduction in the nation’s assets abroad

For example, you can better understand the debit and credit transaction from the examples

given below:

· A US resident purchases an Indian stock. When a US resident acquires a stock in an

Indian company, foreign assets in India go up. This is a capital inflow to India because it

involves the receipt of a payment from a foreigner.

· When an Indian resident sells a foreign stock, Indian assets abroad decrease. This

transaction is a capital inflow to India because it involves receipt of a payment from a

foreigner.

Capital Outflows can also take any of the following forms:

(a) An increase in the nation’s assets abroad

(b) A reduction in the foreign assets of the nation

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

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

Answer: Cross Rates: The exchange rate between any two non-dollar currencies is

referred to as a cross rate. A relatively large number of cross rates would be required to

trade every currency directly against every other currency.

For example, N currencies would require N x (N-1)/2 separate cross rates. For this reason,

most exchange rates are quoted in terms of dollars and by far the greatest volume of trading

directly involves the dollar. This reduces the number of cross-currency quotes that dealers


must keep track of and reduces the potential losses associated with mispricing currencies

relative to one another (which permit Triangular Arbitrage).

Exchange Rates Quotations

There are two methods of quotation for exchange rates between the dollar and the currency

of another country. The two methods are referred to as the direct (American) and indirect

(European) methods of quotation. The exchange rate between any two non-dollar currencies

is referred to as a cross rate:

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

currency.

For example, a direct quotation of the exchange rate between dollar and the British pound

(German mark) is $1.6000/£1 ($0.6000/DM1), indicating that the dollar cost of one British

pound (German mark) is $1.6000 ($0.6000).

Direct exchange rate quotations are most frequently used by banks in dealing with their non-

bank customers. In addition, the prices of currency futures contracts traded on the Chicago

Mercantile exchange are quoted using the direct method.

2. Indirect/European Quotation: The number of units of a foreign currency that are

required to purchase one dollar.

For example, an indirect quotation of the exchange rate between the dollar and the

Japanese yen (German mark) is ¥125.00/$1 (DM 1.6667/$1), indicating that one dollar can

be purchased for either 125.00 Japanese Yen or 1.6667 German Marks.

Q4. Explain covered and uncovered interest rate arbitrage.

Answer: Uncovered Interest Arbitrage

The transfer of funds abroad to take advantage of higher interest rates in foreign monetary

centres usually involves the conversion of the domestic currency to the foreign currency, to

make the investment. At the time of maturity, the funds (plus the interest) are reconverted

from the foreign currency to the domestic currency. During the period of investment, a

foreign exchange risk is involved due to the possible depreciation of the foreign currency. If

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

have uncovered interest arbitrage.


Suppose that the interest rate on three-month treasury bills is 11 per cent at an annual basis

in Germany and 15 per cent in London. It may then pay for a German investor to exchange

marks for pounds at the current spot rate and purchase British treasury bills to earn the extra

1 per cent interest for the three months. When the British treasury bills mature, the German

investor may want to exchange the pounds he invested plus the interest he earned back into

marks. The situation is shown in Figure.

Covered Interest Arbitrage

Interest arbitrage is usually covered as investors of short-term funds abroad generally want

to avoid the foreign exchange risk. To do this, the investor exchanges the domestic currency

for the foreign currency at the current spot rate so as to purchase the foreign treasury bills

and at the same time he sells forward the amount of the foreign currency he is investing plus

the interest he will earn so as to coincide with the maturity of his foreign investment. Thus,

covered interest arbitrage refers to the spot purchase of the foreign currency to make the

investment and offsetting the simultaneous forward sale (swap of the foreign currency) to

cover the foreign exchange risk. When the treasury bills mature, the investor can then get

the domestic currency equivalent of the foreign investment plus the interest earned without a

foreign exchange risk. Since the currency with the higher interest rate is usually at a forward

discount, the net return on the investment is roughly equal to the positive interest differential

earned abroad minus the forward discount on the foreign currency. This reduction in

earnings is the cost of insurance against the foreign exchange risk.

Continuing with the earlier example where the interest rate on three-month treasury bills is

11 per cent per year in Germany and 15 per cent in London, let us also assume that the

pound is at a three-month forward discount of 1 per cent per year. To engage in covered


interest arbitrage, the German investor must exchange marks for pounds at the current

exchange rate (to purchase the British treasury bills) and at the same time sell forward a

quantity of pounds equal to the amount invested plus the interest he will earn at the

prevailing forward rate. Since the pound is at a forward discount of 1 per cent per year,

German investor loses 1 per cent on the foreign exchange transaction to cover his foreign

exchange risk for the three month period. His net gain is thus the extra 1 per cent interest he

earns for the three months minus ¼th of the 1 per cent he loses on the foreign exchange

transaction, or 3/4 of 1 per cent.

Covered interest arbitrage and interest parity theory

Figure shows the relationship through Covered Interest Arbitrage (CIA) between the interest

rate differentials between the two nations and the forward premium or discount on the

foreign currency.

The horizontal axis in the diagram shows the forward premium (+) or forward discount on the

foreign currency expressed in percentages per year. The vertical axis measures the interest

differential in favour of the foreign country in per cent per annum. The solid line in the Figure

depicts interest parity. Positive values indicate that interest rates are higher abroad.

Negative values indicate that interest rates are higher domestically. And when the interest

differential is zero, the foreign currency is neither at a forward discount nor at a forward

premium (i.e., the forward rate on the foreign currency is equal to its spot rate).

For example, when the positive interest differential is 1.5 per cent per year in favour of the

foreign nation, the foreign currency is at a forward discount of 1.5 per cent per year.

Similarly, a negative interest differential of 2.0 per cent is associated with a forward premium

of 2.0 per cent.


The Figure shows that for all points above the interest parity line, there will be a net gain

from an arbitrage outflow due to two reasons. First, the positive interest differential exceeds

the forward discount and second, the forward premium exceeds the negative interest

differential.

Q5. Explain briefly the mechanism of futures trading

Answer: Mechanism of Futures Trading

The mechanics of futures trading consists of two parts.

(a) Components of futures trade

(b) Execution of futures trade

Components of Futures Trade1. Futures players: Futures trading, which represents a less than zero-sum game, can be

considered beneficial if it results in utility gains. This is done by the transfer of risks between

the market players. These players are:

· Hedgers

· Speculators

· Arbitrage

2. Clearing houses: Every organised futures exchange has a clearing house that

guarantees performance to all of the participants in the market. It serves this role by

adopting the position of buyer to every seller and seller to every buyer. Thus, every trading

party in the futures markets has obligations only to the clearing house. Since the clearing

house matches its long and short positions exactly, it is perfectly hedged, i.e., its net futures

position is zero.

It is an independent corporation and its stockholders are its member clearing firms. All

futures traders maintain an account with member clearing firms either directly or through a

brokerage firm.

3. Margin requirements: Each trader is required to post a margin to insure the clearing

house against credit risk. This margin varies across markets, contracts and the type of

trading strategy involved. Upon completion of the futures contract, the margin is returned.


4. Daily resettlement: For most futures contracts, the initial margins are 5% or less of the

underlying commodity’s value. These margins are marked to the market on a daily basis and

the traders are required to realise any losses in cash on the day they occur. Whenever the

margin deposit falls below minimum maintenance margin, the trader is called upon to make it

up to the initial margin amount. This resettlement is also called marked-to-the-market.

Delivery terms. This includes:

(a) Delivery date: Some contracts may be delivered on any business day of the delivery

month while others permit delivery after the last trading day.

(b) Manner of delivery: The possibilities are:

- Physical exchange of underlying asset.

- Cash settlement as in the case of stock index futures.

(c) Reversing trade: This trade effectively makes a trader’s net futures position zero thus

absolving him from further trading requirements. In futures markets, 99% of all futures

positions are closed out via a reversing trade.

5. Types of orders: Besides placing a market order, the other types are:

(a) Limit order: It stipulates to buy or sell at a specific price or better.

(b) Fill-or-kill order: It instructs the commission broker to fill an order immediately at a

specified price.

(c) All-or-none-order: It allows the commission broker to fill part of an order at a specified

price and remainder at another price.

(d) On-the-open or on-the-close order: This represents orders to trade within a few minutes

of operating or closing.

(e) Stop order: Triggers a reversing trade when prices hit a prescribed limit.

6. Transaction costs: The costs incurred are:

(a) Floor trading and clearing fees: These are small fees charged by the exchange and its

associated clearing house.

(b) Commissions: A commission broker charges a commission fees to transact a public

order.

(c) Bid: Ask spreads.

(d) Delivery costs: Those are incurred in case of actual delivery.

7. Tax rules: The regulations include:

(a) Marketing-to-the-market: The gains/losses are considered at the end of the calendar year

where futures contracts are marked-to-the-market.


(b) Gains: The realised and unrealised gains are taxed at the ordinary personal income tax

rate.

(c) Losses: The realised and unrealised losses are made deductible by offsetting them

against any other investment gains.

(d) Commissions: Brokerage commissions are tax deductible.

Execution of Futures TradeFor a client who wants to assume a long position in, say, a July British pound futures

contract, the following steps are undertaken:

1. Phone call to the agent.

2. The agent trades through an exchange member who may be a commission broker or a

local.

3. The actual trading is conducted in a past for the particular futures contract involved.

Trades are conducted through the use of sophisticated hand signals.

4. The commission broker confirms the trade with the agent who then notifies the client of

the completed transaction and price.

5. The client then deposits the initial margin with a member firm of the clearing house.

6. The commission broker can transact in the pit with another commission broker

representing another client or with a local.

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

Answer: Functional Versus Reporting Currency

Financial Accounting Standards Board Statement 52 (FASB 52) was issued in December

1981, and all US MNCs were required to adopt the statement for fiscal years beginning on or

after December 15, 1982. According to FASB 52, firms must use the current rate method to

translate foreign currency denominated assets and liabilities into dollars. All foreign currency

revenue and expense items on the income statement must be translated at either the

exchange rate in effect on the date these items were recognised or at an appropriate

weighted average exchange rate for the period. The other important part about FASB 52 is

that it requires translation gains and losses to be accumulated and shown in a separate

equity account on the parent’s balance sheet. This account is known as the ‘cumulative

translation adjustment’ account. ASB 52 differentiates between a foreign affiliate’s

“functional” and “reporting” currency.


Functional currency is defined as the currency of the primary economic environment in which

the affiliate operates and in which it generates cash flows. Generally, this is the local

currency of the country in which the entity conducts most of its business. Under certain

circumstances the functional currency may be the parent firm’s home country currency or

some third country currency.

The reporting currency is the currency in which the parent firm prepares its own financial

statements. This currency is normally the home country currency, i.e., the currency of the

country in which the parent is located and conducts most of its business.

In general, if the foreign affiliate’s operations are relatively self-contained and integrated with

a particular country, its functional currency will be the local currency of that country. Thus, for

example, the German affiliates of Ford and General Motors, which do most of their

manufacturing in Germany and sell most of their output for Deutschmarks, use the

Deutschmark as their functional currency. If the foreign affiliate’s operations were an

extension of the US parent’s operations, the functional currency could be the US dollar.

If the foreign affiliate’s functional currency is deemed to be the parent’s currency, translation

of the affiliate’s statements employs the temporal method of FAS # 8. Thus, many US

multinationals continue to use the temporal method for those foreign affiliates that use the

dollar as their functional currency, while using the current rate method for their other

affiliates. Under FAS # 52, if the temporal method is used, translation gains or losses flow

through the income statement as they did under FAS # 8; they are not charged to the CTA

account.


MF0016: Treasury Management

ASSIGNMENT- Set 1

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

Answer: Call money market is an important segment in Indian money market. It is a short-

term market where financial institutions borrow and lend money. It is also known as inter-

bank call money market as banks are major participants. The day to day surplus funds are

traded in the call money market. The maturity of the loans in this market varies between one

day and a fortnight. The loans are repaid on demand of either the borrower or the lender.

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

The characteristics of call money market are as follows:

It is a market for short-term funds, also known as money on call.

It is highly liquid as the funds are repayable on demand of the borrower or lender.

It is a sensitive segment of financial system.

It varies from country to country based on the institutional structure and the nature of

the participants.

It is used by RBI to conduct open market operations effectively.

Changes in the demand and supply for short-term fund get quickly reflected in the

financial system.

The participants of call money market in India are state, district and urban co-operative

banks, scheduled and non-scheduled commercial banks, Discount and Finance House of

India (DFHI), and Securities Trading Corporation of India (STCI). DFHI and STCI are

permitted to operate like Primary Dealers (PDs) in call money market. Since 1970’s,

institutions like UTI, Life Insurance Corporation of India (LIC), and General Insurance

Corporation (GIC) and term lending institutions such as Industrial Development Bank of India

(IDBI), Industrial Credit and Investment Corporation of India (ICICI) and International

Finance Corporation (IFC) started participating in it. Earlier, only foreign banks were allowed

to conduct operations in call money market, but now the market is expanded to include small

and non-scheduled banks.


In India, call loans are unsecured. The call money market rates are subjected to seasonal

fluctuations. The fluctuations are reflected in volume of money at call and short notice. The

demand for call money is higher in March as the financial institutions withdraw funds to meet

their year-end tax payments and statutory obligations.

Call rate is the rate of the interest paid on the call loans. The call rate in the market is highly

variable. It varies on a daily basis and sometimes on hourly basis. The call rates in India are

highly volatile and they are based on the following factors:

Mechanism of Cash Reserve Ratio (CRR) creates fluctuations in the call market. Huge

borrowings by the banks to meet CRR requirements increase the demand of liquid

resources, thereby increasing the call rate.

During the end of financial year, most of the business organisations have to pay advance

tax which causes fluctuations in the market.

Changes in forex market leads to volatility in the call market.

Mismatch between assets and liabilities of the banks.

Huge flow of funds and increase in deposits with banks decreases the call rate.

Stock market conditions cause wide fluctuations in the call market.

The opening of subscription to government loans increases the demand for call loans

thus increasing the call rates.

The business activities of Friday (end of business week) increases demand for call

loans.

RBI has tried to prevent call rate volatility through the following measures:

Regulating the liquidity and volatility in market through repo - Repo auction provides a

base for call money rates as a short-term opportunity for banks to park their surplus

funds.

Increasing the number of participants - The non-bank entities like GIC and Unit Trust of

India (UTI) are allowed to participate as lenders. Primary dealers (PDs) and DFHI have

been permitted to act as lenders and borrowers.

Relieving inter-bank liabilities from reserve requirements - This helps to generate a

smooth yield curve and thereby reduces the volatility in the call rate.

b. Money markets are a short-term market with a maturity period of up to one year. It meets

the short-term requirements of borrowers and lenders. Money market provides funds to the

trade and industry sectors. The characteristic features of Indian money market are as

follows:

It is a short-term market .The funds are borrowed or lent for short-term.


The interest rate is based on the demand and supply of funds.

The parties mutually agree on terms and conditions for exchange of funds.

Money market is subjected to RBI regulations.

The borrowers in money market are commercial banks, manufacturing firms and the

government.

Commercial banks and financial institutions act as fund suppliers in this market.

Objectives of money marketThe objectives of money market are as follows:

It maintains equilibrium between demand and supply of short-term funds.

It is a pivotal point of RBI intervention for influencing liquidity in the economy.

It provides access to the users of short-term funds to fulfill their borrowing and investing

requirements at an efficient market price.

Structure of money marketThe Indian money market is classified as:

· Organised sector

· Unorganised sector

Organised sector - It consists of the RBI, State Bank of India (SBI) with its seven associates,

20 nationalised commercial banks, schedule and non-scheduled commercial banks, foreign

banks, and regional rural banks. RBI controls the entire banking sector in India. The non-

banking financial institutions namely LIC, GIC and its subsidiaries, and UTI operate indirectly

through banks in the market. The surplus funds of quasi-governmental and large

organisations are available to the organised markets through banks.

Unorganised sector – This sector consists of unregulated non-bank financial intermediaries,

indigenous bankers and money lenders who can exist even in small towns and big cities.

The people who borrow from unorganised sectors include farmers, small traders, small scale

producers and artisans.

Q2. Analyse the significance and objectives of asset liability management.


Answer : Asset liability management refers to the strategic balance involving risk caused

due to the changes in interest rate, exchange rates and liquidity position in the organisation.

The credit risk and contingency risk are the roots of ALM. During the post liberalisation

period, India witnessed rapid industrial growth which has further inspired the growth of fund

raising activities. The changes in the sources and features of funds were remarkable due to

rise in demand for funds. Hence this reflected in the organisation’s profile and exposure

limits in interest rate structure for deposits and advances etc.

SignificanceThe changing environment in assets and liabilities has brought the following significances of ALM in recent years: Volatility – The globalisation scenario has led to increase in number of economies. This

has paved way for market driven economies due to the changing dynamics of the

financial markets. These changes are reflected in interest rate structures, money supply,

and credit position of the market, exchange rates and price levels. Hence the

organisation experiences low market value, net interest income etc.

Product innovation – The innovation in financial products has grown rapidly. Some of the

innovations are repacked with existing products with slight modifications. These have

major impact on the risk profile in the organisation enhancing the need for ALM.

Regulatory environment – The integration of domestic and international market has

enabled the regulatory bodies of financial markets to initiate number of measures. These

measures prevent major losses that occur due to market impulses.

Management recognition – The top management in the organisation realised that asset

liability is neither a franchise for credit disbursement nor it’s a place for retail deposit

base. It must be considered to relate and link the asset with liability. Hence the need for

efficient asset liability management came into existence.

ObjectivesThe objective of ALM is to achieve perfect match in assets and liabilities. The match is

related to the changes in the present value of assets and liabilities. The importance of ALM

has led to the change in the functional environment. The ALM objectives are divided into

micro and macro levels.

The macro level objectives deal with formulation of critical business policies, efficient

allocation of capital and designing of products with suitable pricing strategies. At macro level,

the ALM aims at obtaining profits through price matching while ensuring liquidity by maturity


matching. The process of price matching ensures deployment of liabilities which are greater

than costs.

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

Answer : Foreign exchange trading is very profitable but can be risky too. There are

numerous foreign exchange risk management tactics that can be used to reduce the effect

of risk and financial exposure.

Foreign Exchange Risk Management (FERM) and control proceduresEach of the banks engaged in foreign exchange activities is responsible for evolving,

applying and supervising procedures to manage and control foreign exchange risk based on

the risk management policies. In devising a firm’s FERM policy, certain factors have to be

taken into account – the firm’s exposure, general attitude towards risk management, whether

its risk-averse, risk-indifferent or risk-seeking, the firm’s ability to alter exposed positions i.e.

the maximum exchange loss it can absorb without much impact, the competitor’s stance and

most importantly regulatory requirements. Foreign exchange risk management procedures

include the following:

Systems to measure and monitor foreign exchange risk – Management of foreign exchange

risk involves a clear understanding of the amount of risk and the influence of exchange rate

changes on the foreign currency exposure. In order to make these determinations, adequate

information must be readily available to permit suitable action to be taken within the

acceptable time period. Therefore, each of the banking organisations engaged in foreign

exchange activities must have an operative accounting and management information system

in place that records and measures the following accurately:

- The risk exposures related to foreign exchange trading.

- The impact of potential exchange rate changes on the bank.

· Control of foreign exchange activities – Though the control of foreign activities vary widely

among the banks depending upon the nature and extent of their foreign exchange activities,

the main elements of any foreign exchange control plan are well-defined procedures

governing:

- Organisational controls – To guarantee that there exists a clear and effective isolation of

duties between those persons who initiate the foreign exchange transactions and are

responsible for operational functions of foreign exchange activities.


- Procedural controls – To ensure that the transactions are completely recorded in the

accounts of the banks, they are promptly and correctly settled and to identify unauthorised

dealing instantly and reported to the management.

- Other controls – To make sure that the foreign exchange activities are supervised

frequently against the bank’s foreign exchange risk, counterparty and other limits and those

excesses are reported to the management.

· Independent inspections/audits – Independent inspections/audits are an important factor

for managing and controlling a bank’s foreign exchange risk management plan. Banks must

use them to ensure compliance with, and the integrity of, the foreign exchange policies and

procedures. Independent inspections/audits should examine the bank’s foreign exchange

risk management activities in order to:

- Ensure adherence to the foreign exchange management policies and procedures.

- Ensure operative management controls over foreign exchange positions.

- Verify the capability and accurateness of the management information reports regarding

the institution’s foreign exchange risk management activities.

- Ensure that the foreign exchange hedging activities are consistent with the bank’s foreign

exchange risk management policies and procedures.

- Ensure that employees involved in foreign exchange risk management are given accurate

and complete information about the institution’s foreign exchange risk policies, risk limits and

positions.

Q4. Describe liquidity management.

Answer : Liquidity management refers to the management of assets and liabilities (both on-

and off-balance sheets); so as to make them available when there is a cash inflow/outflow

requirement. The management of an organisation should take care to ensure that sufficient

cash is available whenever necessary.

Whenever a financial trade is taken into consideration, liquidity risk is represented in the

form of an asset or a particular security, which would make it difficult for a financier to do any

transaction that involves the security or asset when desired. The risk of liquidity may

increase if principal and interest cash-flows related to assets, liabilities and off-balance sheet

items mismatch. An effective liquidity management enables the organisation to fetch

maximum gains at minimum expenses.


The main objectives of an effective liquidity management are: Keeping track of cash outflow commitments (both on- and off-balance sheets) on a

regular basis.

Avoiding raising funds at market payments or through the forced sale of assets.

Maintaining the statutory liquidity and reserve requirements.

Need for liquidity managementLiquidity management plays an important role in the financial markets. It is needed during

the following situations:

When there is a difficulty in handling and synchronising multiple accounts held in various

banks.

When there is no stability in the positions of cash flow.

When there is surplus cash in transit or float locked during the operational processes.

The organisation is unable to predict the cash position for a group of companies situated

in multiple places.

When the number of reconciliation processes exceeds the limit and keeps the staff away

from working on useful activities.

When the organisation is unable to predict the short term and long term cash

requirements.

Inability to obtain finance from banks due to poor cash flow positions or too high

leverage.

Complex interfacing and group-wise cash management due to usage of different IT

systems by entities.

No fully leveraged technology.

Inefficient procedures and policies for cash and risk management.

Difficulty in centralising and outsourcing cash management decisions.

Imbalanced cash flows – Either too high or too low cash balances in relation to the

working capital.

Liquidity risk arises when a party is interested in trading an asset but there is no buying party

and this affects their trading ability.

Sufficiency of liquidityIt is essential for banks to calculate the liquidity level they need to maintain before the

maturity period ends. Also it is required that banks and credit institutions fulfil the minimum

liquidity requirement before the liquidity disposal or maturity period.


There are instances wherein even a stable economy might face problems, if the bank is

unable to repay the funds as per their commitment. It is important that certain conditions

have to be fulfilled by banks as far as liquidity risk management is concerned. Hence, banks

must perform the liquidity check on a monthly basis to know about their liquidity

requirements. Along with this, banks must use separate reporting systems for calculating the

liquidity requirements.

Liquidity reporting systemUsually, banks and other money lending institutions, compare their current liquidity with the

required liquidity. In fact the actual liquidity is derived from the bank’s balance sheet and is

calculated through aggregate of weighted liquidity values. The weighted liquidity value is

derived from the available number of liquid assets and the cash inflow for the relevant period

of time.

Factors affecting liquidityThe factors affecting liquidity risk are as follows: Delay in credit.

Non Performing Assets (NPA) of high-level.

Assets of lower quality.

No proper management.

Embedded option risk that is not recognised.

Dependence on a few wholesale depositors.

Large undrawn loan guarantees.

Liquidity policy & contingent plans that are ineffective.

Sources of liquidityFew sources of liquidity risk management are:

Unexpected change in capital charge.

Usage of a number of assumptions.

Irregular behaviour of financial markets.

Improper judgement.

Risk stimulation by secondary sources.

Absence of financial setup.

Failure of payments system.

Macroeconomic imbalances.

Contractual forms.


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

Answer : Factors Affecting Interest RateInterest rate is a vital component in market assessments and so it is an important economic

indicator. Interest rate is important to companies as well as governments because it is an

important constituent of the capital cost.

The following are the factor that influences the level of market interest rate: Intensity of inflation – Inflation is defined as an increase in the typical price level of goods

and services in an economy over a period of time. Inflation reduces the procuring power

of a currency. So people with excess funds claim higher interest rates, as they want to

protect their investment returns against the unfavourable conditions of higher inflation.

Fluctuation of monetary policy – The central bank of a country controls the money supply

in the economy through its monetary policy. In India, the monetary policy of RBI focuses

at the price stability and economic growth. If RBI loosens its monetary policy then the

interest rate gets reduced which leads to higher inflation. Whereas, if RBI strengthens its

monetary policy then interest rate increases, this thereby limits the inflation. Repo rate is

used by RBI to inject or remove liquidity from the monetary system.

General economic conditions – If the economic growth of an economy improves then the

demand for money goes up. It ultimately compels the interest rates to move forward.

Global liquidity – If global liquidity is high then the domestic liquidity of a country will also

be high which ultimately reduces the pressure on interest rates.

Foreign exchange market activity – Foreign investor demand for debt securities

influences the interest rate. Higher inflows of foreign capital lead to increase in domestic

money supply which in turn leads to higher liquidity and lower interest rates.

Credit and payment history – Making timely mortgage or rent payment is very important.

Late payments on credit cards, car payments and other bills affect the interest rate.

Debt to income ratio – The higher the debt to income ratio, the higher will be the interest

rate.

Property type – The interest rate depends upon the type of property owned by an

individual. The less risky is the property, the better the interest rate proposed.

Loan amount – The amount of money the borrower borrows makes a difference in the

interest rate.


Reduced paperwork activities – Many lenders offer reduced paperwork alternatives.

These alternatives increase the suitability of getting a loan for the consumer. It also

increases the risks for the lender.

Property state – Varying property states have different regulations and requirements that

results in fluctuating business costs. These costs are often passed to the consumer in

the form of an interest rate for the lenders.

Budgetary deficit – Budgetary deficit and increased borrowing programme of the

Government will lead to increase in interest rates as the demand for funds increases.

With increase in interest rates, costs go up and this will result in inflation.

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

Answer : Banks utilise various financial instruments and deal with a multitude of

counterparties and securities organisations to fulfill the requirements of its borrowers, handle

fluctuation exposures in market interest rates and currency exchange rates, and indulge in

temporary investments of liquidity prior to disbursement. All these transactions include

differing risk degrees that the counterparty in the trading may fail to meet its commitments to

the bank.

Treasury risk management needs precise reporting of metrics that is associated to control

the risks that would arise from trading and other treasury processes.

PracticesTreasury management practices describe the method in which the company will achieve the

policies and objectives summarised in its treasury management policy statement. These

practices advise how the company should manage and govern its treasury activities.

Treasury management practices consist of the following steps:

Managing risks

Analysing and decision making

Approving instruments, methods and techniques


Treasury management practices set out the approach in which the firm should seek to

achieve those policies and objectives, and suggest the way to manage and govern those

activities.

PoliciesThe Investment Policy guidelines approved by the board will govern the investment activities

of the Treasury. Formulating policies provides a framework to handle risks. It provides

standard levels of exposures to protect cash flows in the organisation. Policy framing

depends on organisation’s objectives and its risk tolerance levels. The objectives of

formulations policies are as follows:

o Managing the central management which raises finance and financial exposures while

assigning specific responsibilities to appropriate business units.

o Diversifying funding sources through operating both banking finance and capital markets;

and engaging limited or non-resource project finance when it is available.

o Arranging finance to balance each business features and cash flows to the possible

extent.


MF0016: “TREASURY MANAGEMENT”

ASSIGNMENT- Set 2

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

Answer: Commercial Papers (CPs) is a type of instrument in money market and it was

introduced in Jan 1990. Commercial paper is a short-term unsecured promissory note issued

by large corporations. They are issued in bearer forms on a discount to face value. It issued

by the corporations to raise funds for a short-term. The maturity period ranges from 30 days

to one year. CPs is negotiable by endorsement and delivery. They are highly liquid as they

have buy-back facility.

The CPs is issued in denominations of Rs. 5 lakh or multiples of Rs. 5 lakh. Generally CPs is

issued through banks, dealers or brokers. Sometimes they are issued directly to the

investors. It is purchased mostly by the commercial banks, Non-Banking Finance

Companies (NBFCs) and business organisations. CPs is issued in domestic as well as

international financial markets. In international financial markets, they are known as Euro-

commercial paper.

Features of commercial papersThe salient features of CPs are as follows: CPs is an unsecured promissory note.

CPs can be issued for a maturity period of 15 days to less than one year.

CPs is issued in the denomination of Rs.5 lakh. The minimum size of the issue is Rs. 25

lakh.

The ceiling amount of CPs should not exceed the working capital of the issuing

company.

The investors in CPs market are banks, individuals, business organisations and the

corporate units registered in India and incorporated units.

The interest rate of CPs depends on the prevailing interest rate on CPs market, forex

market and call money market. The attractive rate of interest in any of these markets,

affects the demand of CPs.

The eligibility criteria for the companies to issue CPs are as follows:


o The tangible worth of the issuing company should not be less than Rs. 4.5 Crores.

o The company should have a minimum credit rating of P2 and A2 obtained from Credit

Rating Information Services of India (CRISIL) and Investment Information and Credit Rating

Agency of India Limited. (ICRA) respectively

o The current ratio of the issuing company should be 1.33:1.

o The issuing company has to be listed on stock exchange.

Advantages of CPsCPs is like T-Bills and is close a competitor of T-Bills, but T-Bills have an edge over CPs

because they are less risky and more easily marketable. The advantages of CPs are as

follows:

They are negotiable by endorsement and delivery.

Highly safe and liquid instrument – They are believed to be one of the highest quality

investment instruments available in private sectors.

CPs facilitates security for the loans. This results in creation of secondary market for CPs

and there is efficient movement of funds providing surplus cash to cash deficit units.

Flexible instrument – It can be issued with varying maturities as insisted by the issuing

company.

High returns – The CPs provide high returns when compared to the banks.

b. Certificate of deposit (CDs) is a short-term instrument issued by commercial banks and

financial institutions. It is a document issued for the amount deposited in a bank for a

specified period at a specified rate of interest. The concerned bank issues a receipt which is

both marketable and transferable in the market. The receipts are in bearer or registered

form. CDs are known as negotiable instruments and they are also known as Negotiable

Certificates of Deposit. Basically they are a part of bank’s deposit; hence they are riskless in

terms of payments and principal amount. CDs are interest-bearing, maturity-dated

obligations of banks. CDs benefit both the banker and the investor. The bankers need not

encash the deposit before the maturity and the investor can sell the CDs in the secondary

market before the maturity. This contributes to the liquidity and ready marketability for the

instrument. CDs can be issued only by the schedule banks. It is issued at discount to face

value. The discount rate depends on the market conditions. CDs are issued in the multiples

of Rs. 25 lakh and the minimum size of the issue is Rs.1 crore. The maturity period ranges

from three months to one year.

The introduction of CDs in Indian market was assessed in 1980. RBI appointed the Vaghul

Working Group to study the Indian market for five years. Based on the suggestions of

Vaghul committee; RBI formulated a scheme for the issue of CDs. As per the scheme, CDs


can be issued only by the scheduled banks at a discount rate to face value. There is no

restriction on the discount rate by the RBI.

Features of CDs in Indian marketThe characteristic features of CDs in Indian money market are as follows:

Schedule banks are eligible to issue CDs

Maturity period varies from three months to one year

Banks are not permitted to buy back their CDs before the maturity

CDs are subjected to CRR and Statutory Liquidity Ratio (SLR) requirements

They are freely transferable by endorsement and delivery. They have no lock-in period.

CDs have to bear stamp duty at the prevailing rate in the markets

The NRIs can subscribe to CDs on repatriation basis

Q2. Explain the treasury organisation and risk management.

Answer: A more advanced treasury organisation has evolved in the past decade in which

the focus on management activity has followed the economic factors which drive firm value

with corporate wide cash flow. This modern treasury organisation concentrates on a different

financial statement which is the statement of cash flows. Now, it is in the process of adapting

to the complex environment and cash flow of the global business. Structure of treasury

organisation has many dimensions. However, we focus mainly on the following dimensions:

· Range of services

· Extent of centralisation of management control

· Define resultant organisation models

We evaluate the relationship between organisation models and influencing factors that helps

to choose the right model. The theme is to investigate the compatibility of the models with

the organisational situations.

Organisations must select treasury organisation models based on their operations,

irrespective of their underlying business. The most important dimensions of these choices

are the range of activities covered by the treasury and the extent of centralisation of

management control. Four main service models can be opted based on these models. They

are full service global, full service local, limited service global and limited service local.


Treasury implementation in an organisation gains profits in several aspects. The treasury

activities focus on the financial strategy and decision making of the company, cash

management, capital market funding, tax management and international financial activities of

the firm. Multinational firms always possess large number of foreign subsidiaries and ensure

that they are frequently managed on the regional level by the basic functions like cash

management, foreign exchange.

Regional treasuries are always required as an intermediary step between the barely staffed

foreign affiliate and its independence on other regional affiliates. However, there is a

frequent overlapping in responsibilities and activities between the regional treasury offices

and international treasury.

In banks, treasury is organised either as a department of the bank or as a specialised branch

which is under the direct control of the bank’s head office. If treasury acts as a department of

the bank, it has the advantage to coordinate easily with the other related departments like

accounting and credit departments at head office. However, it is preferred if treasury acts as

a specialised branch as the accounting books of treasury can be maintained independently.

While the head office department of bank can only act through a branch, the specialised

branch also has an additional advantage to act as an authorised dealer for forex business

and can directly participate in clearing and settlement systems.

As treasury is a key activity of the bank, treasury should be headed by a member of the

senior management like General Manager, Dy. General Manager, Vice-President and

others, who could directly report to the Chief Executive of the bank. However, the level of

reporting and delegating powers depends on the bank size and the importance of treasury

activity within the bank.

Treasury might be divided into three main divisions. They are the front office (Dealing room),

Middle office and Back office (Treasury administration).

· Front office (Dealing room) – It is headed by the person who is in charge of the front office,

that is Chief Dealer. Dealers working under him generally trade in the market. They are

familiar with all the markets but specialise in one of the markets like forex market, money

market or securities market.

· Middle office - It is created for providing information to the management. It monitors the

limits of exposure and stops loss of treasury and reports the key parameters of performance

to the management. It may also act as ALM Support Group in smaller banks.


· Back office (Treasury administration) – It takes the responsibility of verifying and settling

the deals concluded by the dealers. They are verified on the basis of deal slips prepared by

the dealers. They take care of the book-keeping and periodic returns submission to RBI.

Refer to unit 01 for detailed information on treasury management organisation.

Q3. What are the features of ADRs and GDRs?

Answer: ADRs and GDRsA Depository Receipt (DR) is a versatile financial security that is traded on a local stock

exchange but it represents a security that is issued by a foreign publicly listed company. Two

of the most common types of DRs are the American Depository Receipt (ADR) and Global

Depository Receipt (GDR).

ADR is a security issued by a non-U.S. company and is traded on U.S. stock exchanges.

ADRs are issued to offer investment methods that avoid the unwieldy laws applied to the

non-citizens who buy shares on local exchanges. ADRs are listed on NYSE, AMEX or

NASDAQ.

Few advantages of ADRs are:· ADRs are easy and cost efficient methods to buy shares in foreign companies.

· ADRs save money by reducing administration costs and avoiding foreign taxes on the

transaction.

GDRs were developed on the basis of ADRs and are listed on stock exchanges outside US.

GDRs are traded globally instead of the original shares on exchanges. The objective of GDR

is to enable investors to gain economic exposure to a planned company in developed

markets.

Features of GDRs are as follows:

· GDR holders do not have a voting right.

· It has less exchange risk as compared to foreign currency loan.

· GDR investors may cancel his receipt by advising the depository.

ADRs and GDRs are excellent means of investment for NRIs and foreign nationals who want

to invest in India. By buying these, they can invest directly in Indian companies without going

through the harassment of understanding the rules in Indian financial market.

Benefits of depository receipts


The increasing demand for DRs is determined by the need of investors to diversify their

portfolios, reduce risk and invest internationally. It allows the investors to achieve the

benefits of global divergence without the added expense and complexities of investing

directly in the local trading markets.

Participatory notesInternational entrance to Indian capital market is limited to Foreign Institutional Investors

(FIIs). The market has found a way to avoid the limitation by creating an instrument called

Participatory Notes (PNs). PNs are basically contract notes.

Indian traders buy securities and then issue PNs to foreign investors. Any dividends or

capital gains collected from the primary securities are returned back to the investors. Any

entity investing in PNs may not register with SEBI, whereas all FIIs have to register

compulsorily.

The benefits of PNs are as follows: Entities route their investment through PNs to extract advantage of the tax laws system.

It provides a high degree of secrecy, which enables large funds to carry out their

operations without revealing their identity.

Investors use PNs to enter Indian market and shift to fully fledged FII structure when they

are established.

Q4. Discuss the recommendations of Tarapore Committee for CAC

Answer: India’s cautious approach towards capital account and assessing it as a

liberalisation process based on certain pre conditions has held India in good state. But with

the changes that have taken place over the last two decades, India felt the need to revisit

the CAC and suggested a new map towards FCAC based on current situations. RBI, in

consultation with the Government of India (GOI) appointed a committee on FCAC. S.S

Tarapore was the chairman of committee. The committee suggested several

recommendations for the development of financial market in addition to addressing issues

related to interaction of monetary policy and exchange rate management, regulation and

supervision of banks, and the timing and sequencing of capital account liberalisation

measures. The objectives of FCAC are as follows:

Economic growth - It facilitates economic growth through higher capital investment .This

will lead to growth in employment opportunities, infrastructure development and other

areas.


Improvement in financial sector - Huge capital flow into the system will lead to the

improvement of financial sector which will enhance performance of the companies. This

will enhance the liquidity in the system.

Diversify the investment – The diversification of investment will help ordinary people, to

invest in foreign countries without restriction. This will help them to diversify their

portfolio.

Risks involved in FCACFCAC risk arises from inadequate preparedness before liberalisation in domestic and

external sector of policy consolidation, strengthening of regulation and development of

financials markets. A transparent financial consolidation is necessary to reduce risk of the

currency crisis. The risks are as follows:

Market risks - Markets risks like interest rate and foreign exchange risks become more

complicated when financial institutions have access to new markets or securities.

Participation of foreign investors in domestic market changes the working of the

domestic market. For example, banks have to quote rates and take open positions in

new and more volatile currencies. Likewise, the change in foreign interest rate, affects

the bank’s interest rate and liabilities.

Credit risk – It includes a new dimension with cross border transaction. Cross border

transactions introduces country risks to domestic market participants, the risk associated

with economic, social, and political environment of the borrower’s country.

Risk in derivatives transaction – It is very important with FCAC as derivatives transaction

are main tools used in hedging risks .It includes both market and credit risk.

Liquidity risk – It includes risk in foreign currencies denominated assets and liabilities.

Large flow of funds in different currencies will expose the banks to greater variations in

their liquidity position and complicate their asset-liability management.

Operational risk – The difference between domestic and foreign legal rights and

obligations and their enforcements is important with FCAC. Operational risk may

increase with FCAC.

Limitations of FCACThe effort of making the Indian rupee fully convertible has a number of difficulties involved in

it. The limitations are as follows:

Indian industries lack competitive strength.

Lack of emphasis on the quality of labour and management practices.

Inadequate technology for industrial economy.


Absence of prudent fiscal management.

Lack of resilient exchange rate mechanism at work.

Inadequate attention on tariff reduction and the rationalisation of tax structure in the

adjustment scheme.

Inflationary pressure on the economy.

Consequences of FCACIndia might face the following consequences if it implements full convertibility without

adequate reform measures:

It will have to face the danger of becoming vulnerable to free movement of foreign

capital, which may further worsen the macro-economic imbalances.

Though the banks and financial institutions are fully capitalized, they are not fully

prepared to handle the intricacies of the fuller convertibility. Hence it is desirable to

further strengthen their financial base.

The prevailing high interest rates in the economy will attract capital inflow. This will result

in rupee appreciation which will affect Indian exporters.

Q5. If you are the CEO of an MNC, how would you implement and maintain effective liquidity practices in your firm for the benefit of the company?

Answer : · Launching the overall policy framework – Before processing any funding, market

operations or risk management activities; policies are elected by the top management.

These policies administer the treasury functions and indicate the principles motivating the

asset liability management of the balance sheet.

· Market operation activities – Banks alter the term of their obligations to different maturities

on the asset side of the balance sheet. The actual flow of funds need not mandatorily reflect

in the contractual terms. This flow of funds differs as per the market conditions. The key

aspect of liquidity management is the structure of a bank’s funding. The bank without a

deposit base is likely to be more exposed to liquidity problems when compared to a stable,

large and diverse deposit base bank.

· Risk evaluation and compliance – Risk measurement and management concentrates on

providing a systematic approach to control risk in portfolio management. It provides an

independent evaluation of the market risks considered across several treasury businesses.


This evaluation is for the benefit of traders and management. Periodic computation of risk

measurement like measuring risks on a daily, monthly or quarterly basis is important. A good

compliance is very important to ensure that the treasury functions act appropriately and in

the best interests of the respective traders and management.

· Treasury operations – Handling treasury operational functions has become more

complicated due to the changes in the financial markets, regulatory requirement and

technological upgrades. These functions focus on the risks of market operations such as

electronic inputs and a greater concentration over the payment approval/release functions,

improving control on the transaction confirmations and the settlement of bank accounts at

nostro accounts.

Features of treasury functionsA successful treasury function has the same attributes as any other functions that are

considered successful in the organisation. The features of treasury functions are as follows:

Teamwork

Respect towards the firm

Broad and positive thinking

Global thinking

Technologically advanced

Customer oriented

Knowledge in finance

Knowledge in legal issues

Trustworthy

Q6. Evaluate various options available in foreign exchange market?

Answer: Various tools and techniques are used for measuring foreign exchange risk

management. Some of the foreign exchange management tools used are as follows:

Forward contracts

Currency futures

Currency options

Currency swaps


Forward contractsForeign exchange forward contracts are the most common resources for hedging

transactions in foreign currencies. A forward contract is an agreement to buy or sell foreign

exchange for an amount determined in advance, at a specified exchange rate at a

designated date in future. The specified rate is called the ‘forward rate’, the designated date

the ‘settlement date’ or ‘delivery date’. The difference between forward contract and other

sales contracts is that the delivery and payment of the commodity occurs at a specified

future date in case of forward contracts. Forward contracts are privately exchanged and are

not standardized. This gives rise to counterparty risk or default risk arising out of failure of

the other party to honour its commitment. For such situations currency futures are more

suitable.

Currency futuresCurrency futures are forward contracts in which two parties agree between them to

exchange something in the future. As futures contracts are traded on exchange with

appropriate controls, counter party risk as prevalent in Forward contracts is prevented. The

major currency futures market is the EUR futures market, based upon the Euro to US Dollar

exchange rate. The most popular currency futures are provided by the Chicago Mercantile

Exchange group, and include the following futures markets:

· EUR - It is the Euro to US Dollar futures market.

· GBP - It is the British Pound (Sterling) to US Dollar futures market.

· CAD - It is the Canadian Dollar to US Dollar futures market.

· CHF - It is the Swiss Franc to US Dollar futures market.

Currency optionsA currency option is an alternative tool for managing forex risk. A foreign exchange option is

an agreement for future supply of a currency interchanged with another, where the owner of

the option has the right to buy (or sell) the currency at a settled price. The right to buy is a

call; the right to sell is called as put. For such a right the holder pays a price called the option

premium. The option seller receives the premium and is indebted to make (or take) delivery

at the agreed-upon price if the buyer exercises his option.

Currency swapsCurrency swaps deal with the exchange of payments in different currencies between two

trading partners. For productivity currency swaps feature netting, in which the winning party

obtains payment at the end of the swap term.


MF0017 – Merchant Banking and Financial Services - 4 Credits

Assignment Set- 1 (60 Marks)

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

Allotment procedureThe Executive Director or Managing Director of the Regional Stock Exchange consults with

the post-issue lead merchant banker and the registrars regarding public issue of securities.

This method ensures that the basis of allotment is done fairly according to the following

guidelines:

Proportionate allotment procedureThe lead banker must ensure that the allotment is made on a proportionate basis as

explained below:

The applicants are divided into separate category based on the number of shares

they have applied for.

The total number of shares to be allotted to each category is done on a proportionate

basis. This is based on the product of the total number of shares applied for in that

category and the inverse of the oversubscription ratio.

Example 1:Total number of applicants in category of 100s = 2,000

Total number of shares applied for = 2, 00,000

Number of times oversubscribed = 5

Proportionate allotment to category = 2, 00,000 x 1/5 = 40,000

The number of the shares to be allotted to the successful allottees is done on a

proportionate basis. This is the product of the total number of shares applied by each

applicant in that category and the inverse of the oversubscription ratio. This is shown below

with an example:

Example 2:Number of shares applied for by each applicant = 300

Number of times oversubscribed = 3

Proportionate allotment to each successful applicant = 300 x 1/3 =100


In the applications where the proportionate allotment is less than 100 shares per

applicant, the allotment is carried out as follows:

- Each successful applicant is allotted a minimum of 100 securities.

- The successful applicants for that category are determined by drawl of lots in such a way

that the total number of shares allotted in that category corresponds to the number of shares

as shown in Example 2.

The proportionate allotment to an applicant is more than 100 but not a multiple of

100. In such a case, the number in excess of the multiple of 100 is rounded off to the

higher multiple of 100, only if that number is 50 or higher. But if the number is lower

than 50, it is rounded off to the lower multiple of 100.

Example 3:If the proportionate allotment works out to 350, the applicant is allotted 400 shares.

However, the proportionate allotment works out to 140, the applicant is allotted 100 shares.

If the shares allocated on a proportionate basis to any category exceed the shares

allotted to the applicants in that category, the balance available shares for allotment

are first adjusted against any other category. This condition arises when the allocated

shares are not enough for proportionate allotment to the successful applicants in that

category.

The remaining shares after such adjustment are added to the category in which the

applicants have applied for minimum number of shares.

The process of rounding off to the nearest multiple of 100 may result in a higher

allocation of shares than the shares offered. Therefore, it is necessary to permit a

10% margin. This means, the final allotment may be higher by 10 % of the net offer

to the public.

Reservation for small individual applicants

The proportionate allotment of securities in an issue, when oversubscribed, is subjected to

the reservation for small individual applicants as explained below:

A minimum 50% of the net offer of securities to the public is first made available for

allotment to individual applicants, who have applied for allotment of equal to or less than

10 marketable lots of shares or debentures or the securities offered.

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

individual applicants, who have applied for allotment of more than 10 marketable lots of

shares or debentures or the securities offered.


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

Answer: Green shoe optionGreen Shoe Option (GSO) is an option where a company can retain a part of the over-

subscribed capital by issuing additional shares. Oversubscription is a situation when a new

stock issue has more buyers than shares to meet their orders. This excess demand over

supply increases the share price. There is another situation called undersubscription. In

undersubscription, a new stock issue has fewer buyers than the shares available. An issuing

company appoints a stabilizing agent, which is usually an underwriter or a lead manager, to

purchase shares from the open market using the funds collected from the over-subscription

of shares. The stabilizing agent stabilizes the price for a period of 30 days from the date of

listing as authorised by the SEBI. Green shoe option agreement allows the underwriters to

sell 15 percent more shares to the investors than planned by the issuer in an underwriting.

Some issuers do not include green shoe options in their underwriting contracts under certain

circumstances where the issuer funds a particular project with a fixed amount of price and

does not require more funds than quoted earlier. The green shoe option is also known as

over-allotment option. The over-allotment refers to allocation of shares in excess of the size

of the public issue made by the stabilizing agent out of shares borrowed from the promoters

in pursuance of a GSO exercised by the issuing company.

The mechanism by which the greenshoe option works to provide stability and liquidity to a

public offering is described in the following example: A company intends to sell 1 million

shares of its stock in a public offering through an investment banking firm (or group of firms

which are known as the syndicate) whom the company has chosen to be the offering's

underwriter(s). When the stock offering is the first time the stock is available for public

trading, it is called an IPO (initial public offering). When there is already an established

market and the company is simply selling more of their non-publicly traded stock, it is called

a follow-on offering.

The underwriters function as the broker of these shares and find buyers among their clients.

A price for the shares is determined by agreement between the company and the buyers.

One responsibility of the lead underwriter in a successful offering is to help ensure that once

the shares begin to publicly trade, they do not trade below the offering price.


When a public offering trades below its offering price, the offering is said to have "broke

issue" or "broke syndicate bid". This creates the perception of an unstable or undesirable

offering, which can lead to further selling and hesitant buying of the shares. To manage this

possible situation, the underwriter initially oversells ("shorts") to their clients the offering by

an additional 15% of the offering size. In this example the underwriter would sell 1.15 million

shares of stock to its clients. When the offering is priced and those 1.15 million shares are

"effective" (become eligible for public trading), the underwriter is able to support and stabilize

the offering price bid (which is also known as the "syndicate bid") by buying back the extra

15% of shares (150,000 shares in this example) in the market at or below the offer price.

They can do this without the market risk of being "long" this extra 15% of shares in their own

account, as they are simply "covering" (closing out) their 15% oversell short.

If the offering is successful and in strong demand such that the price of the stock

immediately goes up and stays above the offering price, then the underwriter has oversold

the offering by 15% and is now technically short those shares. If they were to go into the

open market to buy back that 15% of shares, the underwriter would be buying back those

shares at a higher price than it sold them at, and would incur a loss on the transaction.

This is where the over-allotment (greenshoe) option comes into play: the company grants

the underwriters the option to take from the company up to 15% more shares than the

original offering size at the offering price. If the underwriters were able to buy back all of its

oversold shares at the offering price in support of the deal, they would not need to exercise

any of the greenshoe. But if they were only able to buy back some of the shares before the

stock went higher, then they would exercise a partial greenshoe for the rest of the shares. If

they were not able to buy back any of the oversold 15% of shares at the offering price

("syndicate bid") because the stock immediately went and stayed up, then they would be

able to completely cover their 15% short position by exercising the full green shoe


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

Answer: An insider is a person who is connected with a company and who is expected to

have access to unpublished sensitive information with respect to securities of the company.

A person who has access to unpublished information which deals in securities and is

involved in violations of the provisions will be guilty of insider trading. Insiders have access

to confidential information of a company due to the position occupied by them in the

company. They are in a position to manipulate the share prices to their own advantage and

make huge profits. These actions cause major fluctuations in the prices of the securities.

Considering the fact that the actions of insiders cause devastating effects on the functioning

of stock exchange, SEBI has issued regulations to control such practices. Another problem

that the stock market faces is unofficial trading in shares before listing of new companies.

The company is not guilty of insider trading if the acquisition of shares was as per SEBI

Substantial Acquisition of Shares and Takeover Regulations. If SEBI suspects that any

person has violated the regulations of prohibition of insider trading, it can initiate an inquiry.

For the prevention of insider trading, SEBI has introduced a policy on disclosure and internal

procedure. According to this policy:

All listed companies and organisations associated with the securities markets have to

frame a code of conduct for internal procedure as per the specified model.

Any person holding more than five per cent shares in any listed company has to

disclose the number of shares held by him to the company, within 54 working days.

Every listed company must disclose the information received about the initial and

continual disclosures within five days to all the respective stock exchanges.

Any person other than a company violating the disclosure provisions would be liable for

action under the SEBI Act. SEBI has prescribed a model code of conduct for prevention of

insider trading for listed companies. According to this model, the listed company appoints a

compliance officer who reports to the managing director and is responsible for setting the

policies and procedures, monitoring adherence to the rules for the preservation of ‘price

sensitive information’, pre-clearance of designated employees’ trade, monitoring of trades

and implementation of the code of conduct. Preservation of price sensitive information is

done by the employees and directors. They have to maintain confidentiality of all price

sensitive information. The information must not be passed to any person directly or

indirectly.


Regulatory provisionsMerchant bankers are administered by the SEBI (Merchant Bankers) Rules and Regulations,

1992. According to the rules and regulations, a merchant banker is a person who is engaged

in the business of issue management either by buying, subscribing to securities as manager,

consulting or rendering corporate advisory service in relation to issue management. The

regulatory framework is designed to ensure that the merchant bankers have sufficient

competence and follow diligence in their work so that the issuers comply with the statutory

requirements concerning the issue. SEBI has emphasised on ensuring that all merchant

bankers fulfil the eligibility criteria. As stated earlier, all merchant bankers must have a valid

registration certificate. Merchant bankers must follow the general obligations, responsibility,

code of conduct prescribed under the SEBI regulations. Under the regulations, the merchant

bankers must submit periodical returns and other additional information to SEBI regularly.

SEBI has the authority to conduct inspection of the accounts, records and documents of the

merchant banker at any time if necessary.

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

Answer: Advantages of leasingLeasing has many advantages for the lessee as well as for the lessor. Lease financing offers

the following benefits to the lessee:

One hundred percent finance without immediate down payment for huge

investments, except for his margin money investment.

Facilitates the availability and use of equipments without the necessary blocking of

capital funds.

Acts as a less costly financing alternative as compared to other source of finance.

Offers restriction free financing without any unduly restrictive covenants.

Enhances the working capital position.

Provides finance without diluting the ownership or control of the lessor.

Offers tax benefits which depend on the structure of the lease.

Enables lessee to pay rentals from the funds generated from operations as lease

structure can be made flexible to suit the cash flow.

When compared to term loan and institutional financing, lease finance can be

arranged fast and documentation is simple and without much formalities.

The lessor being the owner of the asset bears the risk of obsolescence and the

lessee is free on this score. This gives the option to the lessee to replace the

equipment with latest technology


The following are the benefits offered by lease financing to the lessor:

The lessor’s ownership is fully secured as he is the owner and can always take

possession in case of default by the lessee.

Tax benefits are provided on the depreciation value and there is a scope for him to

avail more depreciation benefits by tax planning.

High profit is expected as the rate of return increases

Return on equity is elevated by leveraging results in low equity base which enhance

the earnings per share.

High growth potential is maintained even during periods of depression.

Limitations of leasingThe following are some of the limitations of leasing:

Lessee is not capable of adding or altering anything to the leased asset because of

the restrictive conditions of the lease agreement.

Financial lease can bring about higher payout accountability if machinery is not found

useful, and the lessee is planning to cancel the lease agreement or opts for

premature termination of the lease contract.

Termination of the lease happens when lessee fails to continue with the terms and

conditions of the lease and the lessor can take possession of the leased asset, In

case of financial lease, the lessee may be made liable for damages and compelled to

make payment of his lease rental in an accelerated manner.

Double sales tax can be charged once at the time of purchase of the asset by the lessor and

again when it is leased out to the lessee.


Q5. Discuss Accounting standard 19 for lease based on operating lease.

Answer: Accounting Standard 19 as Applicable for Leases Accounting Standard (AS)-19, Leases, is issued by the Council of the Institute of Chartered

Accountants of India. This standard comes into force with respect of all assets leased during

accounting periods commencing on or after 1.4.2001 and is mandatory in nature from that

date. Accordingly, the ‘Guidance Note on Accounting for Leases’ issued by the Institute in

1995, is not applicable in respect of such assets. Earlier application of this Standard is,

however, encouraged.

Scope The right accounting policies and disclosures in relation to finance leases and operating

leases should be applied in accounting for all leases other than the following:

Lease agreements to explore or to use natural resources, such as oil, gas , timber,

metals and other mineral rights; and

Licensing agreements for items such as motion picture films, video recordings, plays,

manuscripts, patents and copyrights; and

Lease agreements to use property such as lands.

This applies to agreements that transfer the right to utilize assets even though significant

services by the lessor called for in connection with the operation or maintenance of such

assets. Besides, this Statement does not apply to agreements that are contracts and do not

transfer the right to use assets from one contracting party to the other.

Related definitions The following terms are used in this statement:

Lease – A lease is an agreement calling for the lessee (user) to pay the lessor

(owner) for use of an asset for an agreed period of time. A rental agreement is a

lease in which the asset is a substantial property.

Finance lease – A lease which transfers all the risks and rewards incident to

ownership of an asset.

Operating lease – A lease for which the lessee acquires the property for only a small

portion of its useful life.

Non-cancellable lease – A non-cancellable lease is a lease that can be abandoned

only:


Upon the occurrence of some remote contingency.

With the permission of the lessor.

If the lessee enters into a new lease for the same or an equivalent asset with

the same lessor.

Upon payment by the lessee of an additional amount such that, at the

beginning, continuation of the lease is reasonably certain.

Inception of lease – The inception of lease is the former date of the lease

agreement and the commitment date by the parties to the principal provisions of the

lease.

Lease term – The lease term is the non cancellable period for which the lessee has

agreed to take on lease asset together with future periods.

Minimum lease payments – It is the regular rental payments excluding executory

costs to be paid by the lessee to the lessor in a capital lease. The lessee informs that

an asset and liability at the discounted value of the future minimum lease payments.

Fair value – The expected value of all assets and liabilities of a owned company

used to combine the financial statements of both companies.

Economic life – The outstanding period of time for which real estate improvements

are expected to generate more income than operating expenses cost.

Useful life – Useful life of a leased asset is either the period over which leased asset

is expected to be useful by the lessee or the number of production units expected to

be gained from the use of the asset by the lessee.

Residual value – The value of a leased asset is the estimated fair value of the asset

at the end of the lease term.

Guaranteed residual value – It is guaranteed by the lessee or by a party on behalf

of the lessee to pay the maximum amount of the guarantee; and in the case of the

lessor, the part of the residual value which is guaranteed by the lessee or on behalf

of the lessee, or an independent third party who is financially able of discharging the

obligations under the guarantee.

Unguaranteed residual valued of a lease asset – It is the value of a leased asset

that is the total amount by which the residual value of the asset exceeds its

guaranteed residual value.

Gross investment in the lease – It is the sum of the minimum lease payments

within a finance lease from the lessors’ view and any unguaranteed residual value

accumulating to the lessor.

Unearned finance income – Any income that comes from investments and other

sources unrelated to employment services.


Net investment in the lease – Net investment in the lease is the gross investment in

the lease less unearned finance income.

Implicit interest – An interest rate that is not explicitly stated, but the implicit rate

can be determined by use of present value factors.

Contingent rent – It is the portion of the lease payments that is not permanent in

amount but is based on a factor other than just the passage of time. For example,

percentage of sales.

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

Answer:Types of Mutual Funds It is important to remember that mutual funds offer risks and rewards – the higher the

potential returns, the greater the possible loss prospects.

Therefore, it is important to understand the kinds of mutual funds available in the market.

Mutual funds are classified on the basis of structure and investment objective.

Figure illustrates the classifications of mutual funds.

On the basis of structure The following are the structures of mutual funds:

Open ended funds – This scheme of mutual funds is available for subscription

throughout the year. Such funds do not have a fixed maturity date, and therefore, can

be sold or purchased any time. The prices are based on the net asset value (NAV).

This scheme is convenient for those investors who need investments that have a

high level of liquidity.

Close ended funds – Unlike open ended funds, close ended funds have a specific

maturity period. An investor can purchase these funds at the time of initial issue.

There are two exit options in case the investor wants to buy or sell these funds after


the initial offer period closes. One option is to buy or sell the units at the stock

exchanges where they are listed. The NAV may vary based on the demand or supply

of the units. The other option is to directly sell the units to the Mutual Fund. In this

case, the company repurchases the units at NAV.

Interval funds – This scheme is a combination of open ended and close ended

mutual funds. An investor may purchase or sell these funds at the stock exchange.

These may be for sale or redemption at specific periods. The interval funds are

transacted at NAV prices.

On the basis of investment objective Mutual funds are also classified based on the objectives of the fund. The investor can invest

in mutual funds based on these objectives:

Growth funds – This scheme is also referred to as equity schemes. The objective is

to provide capital appreciation over medium to long term. A large portion of the fund

is invested in equities for long term.

Income funds – This scheme is also referred to as debt schemes. The objective is to

provide investors a regular income. Therefore, investments are made in fixed income

securities such as corporate debentures and bonds. Unlike the growth scheme, the

capital appreciation is limited.

Balanced schemes – This scheme provides appreciation and income. The company

periodically distributes a part of the capital gains earned. This scheme invests in

shares and fixed income securities. The proportion specified in the offer documents

is usually 50:50.

Money market funds – The objective of this scheme is to provide the investor

income, preserve capital and easy liquidity. In this scheme, the investor’s money is

safer since investments are made in short term financial instruments. These are also

called liquid funds.

Load funds – This scheme is also referred to as sales load. The investor pays the

sum (known as front end load) at the time of purchase which is used to compensate

an intermediary such as brokers, investment advisers, and financial planners.

Recently the SEBI has slashed the entry load and funds should not charge entry load

if you go directly to a fund. In another directive it has issued instructions that no

distinction should be made among unit holders on the amount of subscription while

charging exit loads (back end load). Some mutual funds do not charge any exit load.

No load funds – This scheme does not have a front end load or back end sales

charge. No sales charges are applied to any load funds. However, they do have

costs. The objective is to reduce the expense on the investor’s bank or brokerage


statement. This is because the fees are paid from the fund’s assets to the investment

advisers instead of the broker who sells the funds.

Gilt funds – These funds invest completely in government securities. Government

securities do not have any default risk. NAVs of these schemes also vary due to

alteration in interest rates and supplementary economic factors as is the case with

income or debt oriented schemes.

Index funds – Index funds imitate the portfolio of a selected index such as the BSE

Sensitive Index, S&P NSE, Index (Nifty) etc, These schemes invest in the securities in the

same weightage comprising of an index. NAVs of such schemes would rise or fall in

accordance with the risk or fall in the index, though not exactly by the same percentage.

There are also exchange traded index funds launched by the mutual funds which are traded

on the stock exchanges.


MF0017 – Merchant Banking and Financial Services - 4 Credits

Assignment Set- 2 (60 Marks)

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

Answer: Prohibition of Fraudulent and Unfair Trade Practices Relating to the SecuritiesThe SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to the Securities

Market) Regulations, 2003 authorises SEBI to investigate into cases of market fraudulent

and unfair trade practices. The regulations prohibit market manipulation, misleading

statements to increase sale or purchase of securities, unfair trade practices relating to

securities. The SEBI can conduct investigation by an investigating officer regarding conduct

and affairs of any person dealing, buying, and selling securities. The investigating officer

prepares a report based on this information. The SEBI can take action for cancellation or

suspension of registration of an intermediary based on this report. Fraud is any act,

expression or concealment committed by a person or his agent while dealing with securities

in order to prompt the deal in securities. The regulations prohibit the dealing in securities in

fraudulent method, it prohibits market manipulation, misleading statements that promote sale

of securities and unfair trade practice related to securities. Any dealing in securities shall be

considered to be fraudulent or an unfair trade practice if it involves fraud. The following are

considered as fraudulent or an unfair trade practice if it:

Indulges in an act which creates misleading or false impression of trading in

securities market.

Advances or agrees to advance any money to any person to induce other person to

buy any security in any issue with an intention of securing the minimum subscription

to such issue.

Pays, offers, or agrees to pay directly or indirectly to any person, any money for

inducing such person for dealing in any security with the object of depression or

causing fluctuation in the price of such security.

Acts to manipulate the price of security.

Publishes reports, dealing in securities which are not true.

Sells and deals with stolen security whether in physical or dematerialised form.

Advertises misleading or containing information in a distorted manner which can

influence the decision of the investors.


Spread false or misleading news which induces sale or purchase of securities.

For restricting unethical trading practices, SEBI propagated the SEBI (Prohibition of

Fraudulent and Unfair Trade Practices relating to the Securities Market).

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

Answer: Price discovery through book building processThe following are the steps involved in the book building process:

1. The issuer company proposing an IPO appoints a lead merchant banker as a Book

Running Lead Manager (BRLM).

2. Primarily, the issuer company consults with the BRLM in drawing up an offer document

which does not mention the price of the issues, but consists of other details about the size of

the issue, companies past history, and a price band. The securities which are available to

the public, separately identified as “net offer to the public”.

3. The draft prospectus is filed with SEBI to provide a legal standing.

4. A definite period is set as the bid period and BRLM conducts awareness campaigns like

advertisement, road shows and so on.

5. To underwrite the issues similar to the „net offer to the public‟, the BRLM selects a

syndicate member, a SEBI registered intermediary.

6. The BRLM is allowed to remuneration for conducting the book building process.

7. The BLRM may circulate the copy of the draft prospectus to the institutional investors and

to the syndicate members.

8. The syndicate members build demand and ask each investor for the number of shares

and the offer price.

9. Syndicate members send the feedback about the investor‟s bids to the BRLM.

10. During the bid period the prospective investors are allowed to revise their bids.

11. The BRLM has to build up an order book after getting the feedback from the syndicate

members about the bid price and the quantity of shares applied. The order book must show

the demand for the shares

of the company at various prices. The syndicate members must also have a record book for

the orders they have received from institutional investors for subscribing to the issue out of

the placement portion.

12. The BRLM and the issuer company decide the issue price after getting all the information

and this issue price is called the market-clearing price.


13. The BRLM then consult with the issuer company and close the book. After that they

decide the issue size of placement portion and public offer portion.

14. After deciding the final price, the BLRM must make the allocation of securities based on

the prior commitment, investor‟s quality, price aggression, earliness of bids and so on.

15. Within two days from determining the issue price and receipts of acknowledgement card

from SEBI, the final prospectus is filed with the registrar of companies.

16. Two different accounts for collection of application money within which first one for the

private placement portion and the other for the public subscription must be opened by the

issuer company.

17. The placement portion is closed one day prior the opening of the public issue through

fixed price method. The BRLM must have the application money from the institutional buyers

along with the application forms and the underwriters to the private placement portion.

18. On the second day from the closure of the issue, the allotment for the private placement

portion will be made and the private placement portion will ready to be listed.

19. The allotment and listing of issues under the fixed price portion must be as per the

existing statutory requirements.

20. Finally, the SEBI has the right to examine such records and books which are handled by

the BRLM and other intermediaries involved in the Book Building process.

A demand for the securities which is proposed to be issued by a body corporate is

determined by book building process. The bids, obtained for the quantum of securities and

offered by the issuer for subscription, are used to determine the price of the securities. Book

building method gives an opportunity to the market to find out the price for securities.

Q3. Discuss the role of a custodian of shares.

Answer:Custodial services refer to the safeguarding of securities of a client. The activities

relating to custodial services involve collecting the rights benefiting the client in respect to

securities, maintaining the securities’ account of the client, informing the clients about the

actions taken or to be taken, and maintaining records of the services.

Custodian of services is a person who proposes or carries on the business of providing

custodial services. The custodian provides the services to a client. To receive custodial

services, the client enters into an agreement with the custodian of securities. The custodian

of securities must be registered with the SEBI. The person proposing to carry on business as

custodian of securities after the commencement of the SEBI regulations has to send an

application to the Board to grant a certificate. The applicant has to provide the necessary

information to the Board to receive the certificate of registration. The application without


complete information is rejected. However, before rejecting any application, the Board gives

an opportunity to the applicant to remove the objection within a specified time.

Custodial services is a new method of services provided to Foreign Institutional Investors

(FIIs) and Mutual Funds (MFs) to protect their assets such as security certificates and

documents of ownership. Every custodian should have adequate facilities, sufficient capital

and financial strength to manage the custodial services.

Roles and responsibilities of custodiansThe SEBI regulations prescribe the roles and responsibilities of the custodians. According to

the SEBI the roles and responsibilities of the custodians are to:

Administrate and protect the assets of the clients.

Open a separate custody account and deposit account in the name of each client.

Record assets.

Conduct registration of securities.

Segregate securities and cash belonging of each client from others including

custodian himself.

Take adequate insurance of risks.

Maintain records manually or in machine readable form.

State clearly the method and system of receiving instructions from the client

regarding collection, receipt, reporting and delivery of securities.

Conduct verification of securities and to follow the stated control mechanism.

Mention specifically the fees charged in the agreement.

Conduct audit annually.

The custodian should have an adequate internal control system to prevent the manipulation

of records and documents, which includes audit for securities and entitlements arising from

securities, and held on behalf of the clients. To ensure that securities are protected from

theft and natural hazards, the custodian must have appropriate safekeeping measures. On

behalf of the client, the custodians have to maintain records and documents such as details

of securities, money received and released registration of securities, and all reports

submitted to the SEBI.

To monitor the compliance to the SEBI Act, every custodian of securities appoints a

compliance officer. The SEBI can ask for any information with respect to any matter relating

to the activities of the custodian. The SEBI is authorised to conduct inspection or

investigation of accounts, documents or records of the custodians to ensure that the


provisions of the SEBI Act and regulations are followed. In case of default, the SEBI can

suspend or cancel registration of a custodian.

Every registered custodian must follow the code of conduct prescribed by SEBI. The

following are the code of conduct prescribed by SEBI:

Integrity – The custodian of securities must maintain high standards of integrity and

professionalism while discharging duties.

Prompt distribution – The custodian of securities must be prompt in distributing

interests and dividends collected by him, on behalf of his clients on the securities held in

custody.

Infrastructure – The custodian of securities must establish and maintain suitable

infrastructure to discharge custodial services to the satisfaction of the clients. The

operating procedures and systems of the custodian of securities need to be well

documented.

Accountability – The custodian of securities is responsible for the movement of

securities. The movement of securities can be from custody account, deposit and

withdrawal of cash from the client’s account. Whenever demanded by SEBI or the client,

the custodian of securities must provide the complete audit trail.

Confidentiality – The custodian of securities has to maintain confidentiality regarding

the client.

Precautions – The custodian of securities must take necessary precautions to ensure

that continuity in custodial records is not lost or destroyed. To maintain sufficient backup

records, the custodial records are kept electronically.

Records – The custodian of securities must create and maintain records of securities

held in custody appropriately. This must be done to locate securities or obtain duplicate

documents easily if the original records are lost due to any reason.

Cooperation – The custodian of securities must cooperate with other custodial entities

and depositories which are necessary for the conduct of business, especially in the

areas of inter custodial settlements and transfer of securities and funds.

Diligence – The custodian of securities must exercise diligence in administrating and

safekeeping the client’s assets which are in his custody.


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

Answer: The lease options available to the company are as following:Finance leaseIn finance lease, the transfer of risks takes place. All the risks and secondary rewards

incidental to the ownership of the asset are transferred to the lessee by the lessor, whether

or not the title is eventually transferred. It involves payment of rentals over a compulsory,

non-cancellable lease period which must be sufficient to repay the capital outlay of the lessor

and leave some profit. Such a lease is also known as full payout lease. The lessor is

essentially interested in the transaction as a financier and has no interest in the asset which

is essentially required for the lessee for his business. Assets included under finance lease

are ships, aircraft, land, buildings, heavy machinery, and so on.

Operating leaseIn an operating lease, transfer of all the risks and the rewards associated therewith does not

take place and the cost of the asset is not fully recovered during the primary lease period.

The lessor does not depend on a single lessee for recovering the cost of the asset. Services

such as maintenance, repair and technical advice are provided by the lessor to the lessee. It

is also known as service lease.

Sale and lease back and direct leaseSale and lease backSale and lease back is an indirect form of leasing. The owner of an asset sells the asset to a

lessor and the lessor leases it back to the owner who acts like the lessee. The sale and

lease back of safe deposits vaults by banks is a good example of this type of leasing. The

lease back arrangement in sale and lease back type of leasing can either be in the form of a

finance lease or operating lease.

Direct leaseIn direct lease, the lessee and the owner are two different bodies. A direct lease is of two

types: bipartite and tripartite lease.

Bipartite lease – It consists of two parties the equipment supplier being the lessor. This

lease is typically structured as an operating lease with inbuilt facilities, like upgradation of

the equipment. The lessor maintains the asset and, if needed, replaces it with similar

equipment.


Tripartite lease – This lease involves three parties, the equipment supplier, the lessor

and the lessee.

Single investors lease and leveraged leaseSingle investor leaseIn single investors lease, there are only two parties, the lessor and the lessee. The leasing

company manages the fund of the entire investment by an appropriate mix of debt and

equity funds. The lender is not entitled to payment from the lessee when there is a default in

servicing. The debt raised by the leasing company to finance the asset is without recourse to

the lessee.

Leveraged leaseIn leveraged lease, there are three parties - the lessor, lender and the lessee. In such a

lease, the leasing company buys the asset through considerable borrowing according to the

requirement of the lessee. The lender obtains an obligation of the lease and the lessee has

to pay rentals. The deal is routed through a trustee who looks after the interest of the lender

and lessor. After receiving the receipt of the rentals from the lessee, the trustee sends the

debt service component of the rental to the loan participant and the balance to the lessor.

Domestic lease and international leaseDomestic leaseIn domestic lease, all parties mentioned in the agreement are the residents of the same

country. The party consists of the equipment supplier, lessor and the lessee. This lease is

less prone to risks.

International leaseIn international lease, the parties to the lease transaction reside in different countries. Import

lease and cross-border lease are the sub classifications of international lease. This lease is

affected by two types of risks - country and currency risk.

Import lease – The lessor and the lessee are resident of the same country but the

equipment provider is located in a different country

Cross-Border lease – The lessor and the lessee are resident of different countries and

the residence of the supplier is not at all important.


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

Answer: Indian Venture Capital ScenarioIn India, the emergence of venture capital companies is a relatively new phenomenon. Until

1985, individual investors and Development Finance Institutions (DFIs) have played the role

of venture capitalists in the absence of an organised venture capital industry. During that

time entrepreneurs have largely depended on private placements, public offerings and

lending by financial institutions. The venture capital phenomenon has arrived at a take-off

stage in India with the easy availability of risk capital in all forms. In the earlier stage, it was

easy to raise only growth capital but financing of ideas or seed capital is now available after

the introduction of venture capital phenomenon. The number of players offering growth

capital and the number of investors is rising rapidly.

In India, the concept of venture capital was initiated by the Industrial Finance Corporation of

India (IFCI) when it established the Risk Capital Foundation (RCF) to provide seed capital to

small and risky projects. However, the concept of venture capital financing first time got

statutory recognition in the fiscal budget for the year 1986 to 1987.

The venture capital companies operating at present in India can be divided into four

categories based on their mode of promotion. Let us read about each mode.

Promoted by All-India Development Financial Institution (IDFI)The ICICI provided the required impetus to venture capital activities in India. In 1986 it

started providing venture capital finance. In 1998, it promoted with the Unit Trust of India

(UTI) and Technology Development and Information Company of India (TDICI) as the first

venture capital company registered under the Companies Act, 1956.

The risk capital foundation established by the IFCI in 1975 was converted to Risk Capital

and Technology Finance Company (RCTC). The RCTC was established as a subsidiary

company of IFCI to provide assistance in form of conventional loans and to give financial

support to high technology projects.

Promoted by state level finance institutionIn India, the state level financial institutions in some states like Gujarat, Uttar Pradesh have

done an excellent job by providing venture capital finance to small scale enterprises.


Promoted by commercial banksVenture capital funds have been established by their corresponding commercial banks to

undertake venture capital financing activity. Examples of these funds are Canbank venture

capital fund, State bank venture capital fund, and Grindlays bank.

Private venture capital fundsIn India, several venture capital funds have been established to provide funding to various

small scale enterprises. Examples of these funds established in India are 20th Century

Venture Capital Corporation and Indus venture capital fund.

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

Answer: Mutual Fund Schemes or ProductsBroad range of Mutual Fund Schemes exists to cater to the needs such as financial position,

risk tolerance and return expectations and so on. The schemes are as follows:

· Open ended and close ended schemes – An open-end fund is accessible for

subscription throughout the year. These are not subjected to a fixed maturity. Investors can

easily buy and sell units at Net Asset Value (NAV) related prices. The key quality of open-

end schemes is liquidity.

· Close ended schemes have a pre-defined maturity period. At the time of the initial issue

one can invest directly in the scheme. Depending on the arrangement of the scheme there

are two exit options on hand to an investor after the preliminary offer period closes. Investors

can buy or sell the units of the scheme on the stock exchanges where they are listed.

· Investment objective schemes – Mutual funds are also classified based on the objectives

of the fund. The investor can invest in mutual funds based on these objectives. The types of

investment objective schemes are as follows:

- Pure growth schemes – Pure growth schemes are also acknowledged as equity

schemes. The intention of these schemes is to offer capital approval over medium to long

term. These schemes usually invest a main part of their fund in equities and are keen to bear

short-term turn down in value for possible future appreciation.


- Pure income schemes – Pure income schemes are also identified as debt schemes. The

target of these schemes is to supply regular and steady income to investors. These schemes

normally invest in fixed income securities such as bonds. Capital appreciation in such

schemes possibly will be limited.

- Taxes saving schemes – Tax-saving schemes recommend tax rebates to the investors

under tax laws approved from time to time. Under Sec.88 of the Income Tax Act,

contributions made to any Equity Linked Savings Scheme (ELSS) are eligible for rebate.

- Balanced schemes – Balanced schemes aim to give both growth and income by

occasionally distributing a part of the income and capital gains they earn. These schemes

put in in both shares and fixed income securities.

· Miscellaneous schemes – The miscellaneous schemes include the following:

- Sector funds – These are the funds which put in the securities of only those sectors as

specified in the offer documents. Examples of such funds are pharmaceuticals, software,

fast moving consumer goods, and petroleum stocks and so on. The returns in these funds

are reliant on the performance of the respective sectors. These funds have the potential to

give higher returns but they are more risky compared to diversified funds. Investors need to

keep a watch on the performance of those sectors and must exit at an appropriate time.

- Money market mutual funds – Money market mutual funds aim to present easy liquidity,

conservation of capital and moderate income. These schemes commonly invest in safer,

short-term instruments, such as bills of treasury, commercial paper, deposit certificates, and

inter-bank call money.

Mutual Funds are always a good investment option in the financial portfolio. The returns are

always more in these funds when compared to risk free investment options in banks. Also

the risk in these investments is much less as compared to direct investments in shares.

Mutual funds can be called as diversified methods to invest our money and they offer

numerous benefits to invest our hard earned money. But, before investing we should

analyse the entire document provided by the concern mutual fund company as various risks

are involved. Taxes and entry fees are also a part of mutual fund investments that reduces

the returns on investments. The risk of losing the principal amount invested in a mutual fund

is always there as the mutual funds are not guaranteed by the government. At the same time


mutual funds present several advantages which made people to start investing in them. The

first advantage is affordability which facilitates any kind of investor even without a huge

capital to start investing in mutual funds to gain benefits for themselves. There are quite a lot

of mutual funds schemes such as monthly payments, systematic investment plans and so on

that can be customised based on the individual needs of the investor. The liquidity that

mutual funds offer to the investors is more when compared to others. The investor can

recover possession of the mutual funds whenever they want in the form of the current NAV

per unit at that time but there will be a deduction of the charges from the net amount.


MF0018: Insurance and Risk Management

ASSIGNMENT- Set 1 (Marks 60)

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

Answer: Term products are life insurance plans that offers financial cover equivalent to the

face value of the policy in case the policy holders dies during the policy period. They do not

carry any cash value. According to the plan, policy holders pay a certain premium to protect

their dependants against their sudden death. But if the insured person lives upto the

specified period of the policy, the insured will not get any benefits from this plan.

Endowment products are plans that combine risk cover with financial savings. Endowment

plans are the most popular products in the world of life insurance. In this plan, the sum

assured is payable even if the insured survives the policy term. But when the insured dies

during the specified period, the amount is paid to the sum assured. The insured who remain

alive upto the specified period of the plan get back the sum assured with some other

investment benefits. It also offers offer various benefits such as double endowment and

marriage/ education endowment plan. The cost of this plan is slightly higher but is worth its

value.

The following are the features of term and endowment products:

· Term and endowment products provide death benefits ensuring the security of those

important persons of the insured.

· They provide disability protection ensuring the insured that their insurance will remain in

force if they are disabled and unable to work.

· They provide retirement planning and funds to the insured for the future retirement needs.

They cover other risks of the life of the insured such as accidents, hospitalisation and

business loss.

Term and endowment products have been in the market for a long time and are very

popular. Hence many insurance companies while designing products offer these. They

incorporate the basic features of these plans and try to provide product differentiation by

providing marginal benefits to attract more customers.


Features of Endowment Assurance PolicyThe previous section discussed the role of term and endowment policies in product design.

This section discusses the features of endowment assurance policy.

Endowment assurance policy is a fixed term life assurance policy in which provisions are

made for premiums to pay for life cover and to save or invest. The policy pays out a sum of

money (the sum assured) on the death of the policyholder or at the maturity date if the

policyholder is alive till the term of completion. If an endowment policy is claimed prior to its

maturity period, then the amount returnable to the policyholder will normally be below the

value of the premiums paid up to cancellation.

The important features of the endowment assurance policy are:

Moderate premiums.

High bonus.

High liquidity.

Savings oriented.

Sum assured is payable to the policyholder either on survival to the term or on death

occurring within the term.

Under this policy with Profit and a without Profit plans are available.

Bonus for the full term is payable to the policyholder on the date of maturity or in the

occasion of death, whichever is earlier.

Premiums can be limited to smaller term or can be paid as single premium.

Premiums come to an end on expiry of term or on death whichever is earlier.

This policy provides provisions for the family of policyholder, in event of his death, and

also assures an amount at a desired age. The amount can be reinvested, to provide an

annuity during rest of his life or in any other way. Premiums are payable for specified

number of years. Endowment assurance policy is affordable for people of all ages and

social groups, who wish to protect their family members from a financial risk that might

occur in future. If the policy holder becomes permanently disabled on account of an

accident, before reaching the age of 70 and the policy is in full force, then it is not

compulsory for him to pay the remaining premiums; and the policy will be unaffected.

b. Corporate finance is the traditional aspect of investment banks which also involves

helping customers raise funds in capital markets and giving advice on mergers and

acquisitions (M&A). This may involve subscribing investors to a security issuance,

coordinating with bidders, or negotiating with a merger target. Another term for the


investment banking division is corporate finance, and its advisory group is often termed

mergers and acquisitions. A pitch book of financial information is generated to market the

bank to a potential M&A client; if the pitch is successful, the bank arranges the deal for the

client. The investment banking division (IBD) is generally divided into industry coverage and

product coverage groups. Industry coverage groups focus on a specific industry, such as

healthcare, industrials, or technology, and maintain relationships with corporations within the

industry to bring in business for a bank. Product coverage groups focus on financial

products, such as mergers and acquisitions, leveraged finance, public finance, asset finance

and leasing, structured finance, restructuring, equity, and high-grade debt and generally

work and collaborate with industry groups on the more intricate and specialized needs of a

client.

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

Answer : Risk Management StrategiesTthe various risk management strategies used to handle both pure and speculative risk.

1. Risk avoidanceRisk avoidance is where a certain loss exposure is never acquired or the existing one is

totally removed. This is one of the strongest methods to deal with risks. The major

advantage of this method is that it reduces the chance of loss to zero. The two ways by

which risk can be avoided are proactive avoidance and abandonment avoidance. In the first

case, the person does not assume any risk and therefore any project which brings in risk is

not taken up.

For example a company which has chances of nuclear radiation will not set up the company,

due to the perils which it can bring up.

In the case of abandonment avoidance, the existing loss exposure is abandoned. All

activities with a certain degree of risk are abandoned. The case of abandonment avoidance

is very few. If a firm abandons risky activities, then it faces difficulties in remaining in the

market. The firm in the process of abandoning might take up new activities which exposes to

another type of risk.

2. Risk reduction


This strategy aims to decrease the number of losses by reducing the occurrence of loss,

which can be done in two ways namely loss prevention and loss control.

Loss prevention is a desirable way of dealing with risks. It eliminates the possibility of loss

and hence risk is also removed. The examples of this are safety programs like medical care,

security guards, and burglar alarms.

Loss control refers to measures that reduce the severity of a loss after it occurs. For

example segregation of exposure units by having warehouses with inventories at different

locations. Insurance companies provide guidance and incentives to the company which has

taken the policy to avoid the occurrence of loss.

3. Risk retentionRetention simply means that the firm retains part or all the losses incurred from a given loss.

Risks may be knowingly or unknowingly retained by the organisation. They are hence

classified as active and passive based on this. Active risk retention is when the firm knows of

the loss exposure and plans to retain it without making any attempt to transfer it or reduce it.

Passive retention is the failure to identify the loss exposure and retaining it unknowingly.

Retention can be used only under the following circumstances:

· When insurers are unwilling to write coverage or if the coverage is too expensive.

· If the exposure cannot be insured or transferred.

· If the worst possible loss is not serious.

· When losses are highly predictable.

Based on past experience if most losses fall within the probable range of frequency, they

can be budgeted out of the company’s income.

4. Risk combination In this strategy, risks are retained in a proportion that reduces the overall risk combination to

a minimum level. In order to minimise the overall risk, one risk is added to another existing

risk instead of transferring a risk. This strategy is mostly used in management of financial

risk. The risk is distributed over a number of issuers instead of putting it on a single issuer.

This reduces the chances of default. For example it is better to have multiple suppliers

instead of relying on a single supplier.

5. Risk transfer


If the risk is being borne by another party other than the one who is primarily exposed to risk

then it is termed as risk transfer. In this case, transfer of asset does not take place but only

the risk involved is transferred. The two parties involved in this strategy are the transferor

(party transferring the risk) and the transferee (party to whom the risk is transferred). The

contracts made in this strategy are grouped as exculpatory contracts.

In this contract the transferor is not liable if the event of risk takes place. But if the transferor

is supposed to pay for the risk incurred then it cannot be termed as risk transfer.

6. Risk sharingThis is an arrangement made by which the loss incurred is shared. For example in a

corporation, a large number of people makes investments and hence each bears only a

portion of risk that the enterprise faces. Insurance involves the mechanism of risk sharing.

7. Risk hedgingHedging is buying and selling future contracts to balance the risk of changing prices in the

cash market. A hedger is someone who uses derivatives to reduce risk caused by price

movements. Derivatives are instruments derived from the base securities like equity and

bonds. Forward contracts, futures, swaps and options are examples of derivatives.

Derivatives are based on the performance of separately traded commodities. These involve

future commitments and hence are open to the possibility of benefiting from favorable price

movements.

Operators in the derivative market are hedgers, speculators and arbitrageurs. Hedgers are

those who transfer the risk component of their portfolio. Speculators take the risk from

hedgers intentionally to make profit. Arbitrageurs operate in different markets simultaneously

to make profit and eliminate mispricing. Therefore the derivatives make provision by hedging

to reduce the existing risk.

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

Answer : Regulators have identified derivatives as risk management tools for insurance

organisations. Hence insurance companies use these within the quantitative and qualitative

limits determined by the legislation, supervisory authority and the internal procedures of the

organisations. The insurance companies need to obtain prior authorisation needs for every


derivatives it intends to use. Additionally, the management of the organisation should

develop a system of estimation, quantitative limitation and supervision of risks.

In case of investment choices, the administrators and supervisors must improve risks like

credit risk, market risk, legal and operational risk. VAR (Value at Risk) models are accepted

by banking and insurance organisations as a risk management tool to control risks. VAR is

defined as the maximum potential change in value of financial instruments portfolio with a

provided probability for certain time period. VAR approach is useful for risk management and

regulatory purpose. The main aim of VAR approach in risk management and capital

regulation is to bring capital requirements close to underlying risks of assets in a portfolio.

This approach is really important for insurance organisations as they operate the sufficient

capital to cover the liabilities and claims in future on a long-term basis. Risk exposure is also

covered through investment rules by restricting asset categories. Because of VAR tools, the

quantitative objection in risk management tools is decreasing.

VAR is a financial engineering tool used by insurance companies. Some other tools include

credit assessments of individuals, pricing of risks and valuations of combined risks of

companies that engage in multiple markets. Asset liability management and revenue

management are optimised tools for financial management and risk management.

Q4. Explain the role of an insurance broker.

Answer : Brokers are people who legally represent the insured. The customer is the

principal of the broker who provides the broker with limited authority. The brokers have to

find a suitable insurer according to the principal’s needs. They cannot act on the insured

behalf but are given commission for their work.

Brokers can also be insurance agents so that they can connect the insurers and insureds. A

broker may seem similar to an agent but there is a significant difference. When a principal

gives details regarding the risks to the agent, all the facts and documents related to it is

passed on to the agent. But if the principal of a broker gives information about the risks no

such facts or documents are given to the broker. This is where the limitation in the broker’s

authority appears.


There are clearly defined laws which list the responsibilities of a broker and a principal. The

insured gives the commission to a broker according to the premium charged to the insured

by the insurer. The broker in turn should give priority to the principal’s risks and

requirements. They have to design the insurance programs in such a way that the principal

gets a maximum benefit from it.

The role of the broker in property and liability insurances is more in life and health

insurances. Nowadays, there are well established brokerage firms which have a specialised

broker for different types of insurances.

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

Answer: Various social insurancesThe various social insurances provided in India are:

· Employee state Insurance – The Employee State Insurance Act which was introduced in

1948, is a piece of social welfare legislation introduced primarily with the object of providing

quite a few benefits to employees in case of sickness, injury and maternity and also to create

provision for certain others matters incidental to that. The Act in fact tries to achieve the goal

of socio-economic justice enclosed in the directive principles of state policy which enjoin the

state to make efficient condition for securing, the right to work, good health, education and

public assistance in cases of unemployment, sickness, old age and so on. The act

endeavors to materialise these objects through only to a restricted extent. This act provides

a broader spectrum then any other insurance or factory act. While the Factory Act deals with

the health, welfare and safety of the workers employed in the factory premises only, the

benefits of this act expand to employees whether working inside the factory or establishment

or elsewhere or they are directly employed by the principal employee or by an intermediary

agency, if the employment is incidental or in connection with the factory or establishment.

· Disability insurance – The most significant form of disability insurance is the one offered

by the government. This program makes sure that all the citizens who are uninsured or

underinsured are covered. This program does not offer huge benefits but it pays enough to

prohibit poverty. Many well-known companies cover their employees against the probable

hazards of disability. Employees face a high chance of meeting with an accident at the work

place. So, it is crucial for companies to offer disability insurance. Worker’s compensation

policy comes under disability insurance. It pays workers who get disabled by job-related

injuries. This program also pays benefits to the family members of workers who died while


performing job-related tasks and also cover all the medical expenses. Individual disability

insurance policy is also a part of disability insurance. This policy is meant for the temporary

employees or those who are not covered under employer disability insurance or the self-

employed. Any individual can buy such an insurance policy from any insurance company but

premiums tend to stay high for policies that offer great benefits or that defines disability in a

broader context.

· Health insurance schemes for the poor – Over the last several years there have been

efforts to extend health insurance by various small NGOs. Self-Employed Women’s

Association (SEWA) which is a membership based women workers’ trade union, has

developed a scheme to protect the poor women from financial burdens which arise out of

high medical costs and several other risks. Each member of the association has an option to

join the programme by paying Rs. 60 per annum and it provides limited cover for risks

arising out of sickness, maternity needs, floods, accidents, widowhood and so on. The

scheme is also linked with the saving scheme. Members have the option to either deposit

Rs. 500 in SEWA Bank or pay annual premium of Rs. 60. SEWA started this programme

with the support of one of the public sector insurance companies. According to SEWA the

patients belonging to lower income groups who opt for the schemes would need systems

which are straightforward, flexible, simple, prompt, and have less paper work and consists of

fewer tiers. SEWA experience illustrates that other aspects of risk which need coverage

include natural and accidental death of women and her husband, disablement, loss because

of riots or flood or fire or theft. Other NGOS offering similar schemes are ACCORD in

Karnataka, Aga Khan Health Services, India (AKHSI) and Nav-sarjan in Gujarat, and

Sewagram medical college Maharashtra. The scheme developed by government insurance

companies to focus on poor is called Jan Arogya Bima Policy.

· Medicare – Medicare covers most of the medical expenses of elderly, disabled workers

and veterans. Medicare has a number of different programs, which influence the types of

benefits received by the beneficiaries. Some plan levels cover different procedures and

provide assistance with bills incurred through hospital stays, prescription coverage, and

doctor appointments. Medicare receives the funding through taxes deducted from current

workers.

· Unemployment insurance – Unemployment Insurance provides temporary financial

protection for workers who experience unforeseen layoffs due to lack of work and other

reasons that are no fault of the employee. Unemployment programs also protect workers

who suffer unemployment due to natural disasters like floods and cyclones. Funding for


unemployment insurance is done through the employer’s unemployment tax. ICICI Lombard

has introduced this insurance in India.

Q6. Mention the steps of underwriting.

Answer : The underwriting of life-insurance falls under a category that is different from all

other forms of insurances. When the underwriter measures risk at beginning, the company

assures a cover for 30 years or throughout life. Life assurance underwriting must consider

factors, like, medical history, family details, occupational hazards, and person’s lifestyle.

The underwriting process for life insurance involves the following steps:

1) Execution of field underwriting.

2) Renewing the application in the office.

3) Gathering additional information, if required.

4) Taking and underwriting decisions.

Additional information is always essential for the underwriter in order to take a decision. This

additional information may be in the form of questionnaires, a detail medical report from

proposal’s own doctor (Medical Attendant’s Report), and an examination by an independent

doctor (Medical Examiner’s report).

The general steps followed by Underwriters are:

1) Getting applications -The application for insurance is the main source of insurability

information that the underwriter of the life insurance company evaluates first. Applications

are generally collected by the field officers, the agents. A typical life insurance consists of:

º General information – The general information consists of general aspects like name,

age, address, date of birth, sex, income, marital status and occupation of the applicant. It

also includes the details of requested insurance cover like type of policy, amount of

insurance, name and relationship of the nominee, other insurance policies that the customer

owns and the pending insurance applications as on date.

º Medical information – The medical information consists of consumer’s health condition

and several queries about health history and family history. The medical section of the

application is comprehensive and it is mandatory to fill it completely with relevant

information. Information is also collected through a medical examination, depending on age

and face value of the policy.

2) The medical report – An average medical test is compulsory (which is free of cost to the

applicant except in case of revivals). Depending on the information filed in the application, an


insurance company may ask the physician of the consumer for further information. Gathering

information is a standard method used in all domestic insurance companies. Basically, life

insurance companies have several sources of medical and financial information to assist

them in the underwriting process. These include personal medical records and physicians,

the medical information department, inspection reports and credit records.

3) Underwriting review – After collecting all the relevant information about the applicant, an

underwriter from the insurance company evaluates the information. During this evaluation,

the underwriter will organise the risk offered to the company and also determines the

premium for the policy depending upon the primary and secondary factors influencing the

premium. The premium rates are set by the company’s registrars depending upon the

applicants risk profile. During each step of the underwriting process, the life insurance agent

usually provides details, and is well-informed about the insured status in the process. If the

applicant offers more risk than the insurance company standards, then the underwriter

rejects the application.

4) Policy writing – A special department writes the policy, whose main function is to issue

written contracts according to the instructions from the underwriting departments. A register

must be maintained as most policies are long-term. Insurance companies generally use

computerised systems to maintain the records of the customers, premium payments, and

they to verify that all the requirements of underwriting have been met.


MF0018: “INSURANCE AND RISK MANAGEMENT”

ASSIGNMENT- Set 2

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

Answer : a. A travel insurance policy is type of insurance coverage, which covers hospitalisation and

medical costs during a person’s travel in a foreign country.

Travel insurance policy is referred to as ‘holiday insurance’. The most important thing about

this coverage is that it encompasses all the kinds of vacations and business travels. A travel

insurance policy is extremely beneficial, and its coverage is ‘cost-efficient’.

In general, companies sell travel insurance policies with many benefits to the travellers. This

policy offers single-trip coverage, if a person is planning one trip overseas. And, the policy

offers a multiple-trip policy, if a person is planning for many trips overseas, in a year.

Travel insurance covers all individuals (traveling abroad) against risks like baggage loss,

travel accidents like injuries, illnesses and medical contingencies with hospitalisation. In

India, this insurance is popular now among international travelers.

b. Casualty insurance protects against losses or damage to the business. Casualty

insurance is combined with property insurance and known as ‘property and casualty’

insurance. For instance, if a particular business is on seventh floor of a building and

suddenly a natural disaster like flood occurs that washes out the first floor, but there is no

damage caused to the seventh floor, then the loss that has occurred will not be covered by

property insurance because there is no direct loss to the business location. But casualty

insurance covers indirect losses to the business also.

Casualty insurance, often equated to liability insurance, is used to describe an area of

insurance not directly concerned with life insurance, health insurance, or property insurance.

It is mainly used to describe the liability coverage of an individual or organization's for

negligent acts or omissions.However, the "elastic" term has also been used to describe

property insurance for aviation insurance, boiler and machinery insurance, and glass and


crime insurance. It may include marine insurance for shipwrecks or losses at sea or fidelity

and surety insurance. It may also include earthquake, political risk insurance, terrorism

insurance, fidelity and surety bonds.

One of the most common kinds of casualty insurance today is automobile insurance. In its

most basic form, automobile insurance provides liability coverage in the event that a driver is

found "at fault" in an accident. This can cover medical expenses of individuals involved in the

accident as well as restitution or repair of damaged property, all of which would fall into the

realm of casualty insurance coverage.

If coverage were extended to cover damage to one's own vehicle, or against theft, the policy

would no longer be exclusively a casualty insurance policy.

The state of Illinois includes vehicle, liability, worker's compensation, glass, livestock, legal

expenses, and miscellaneous insurance under its class of casualty insurance.

In 1956, in the preface to the fourth edition of Casualty Insurance Clarence A. Kulp wrote:

It has never been possible really to define casualty insurance. Broadly speaking, it may be

defined as a list of individual insurances, usually written in a separate policy, in three broad

categories: third party or liability, disability or accident and health, material damage. One of

the results of comprehensive policy-writing .... is to raise the question of the usefulness of

the traditional concept of casualty insurance ... some insurance men predict that the casualty

insurance of the future will include liability and disability lines only.

Q2. What are the basic objectives of claims management?

Answer: Claims management is a system which sets up the rules and regulations for the

assessment of damages, using the data got from medical reports, surveyor report, loss

assessor’s report and warranties contained in the policy document. It also regulates the

payment of damages and the payment of loss of future earnings.

An insurance company is usually accepted as good or bad, on the basis of the time it takes

to finalise, and pay back the claim. To settle a claim promptly is the important function of an

insurance organisation. The goodwill of the insurance company depends on the claim

satisfaction level of its customers. Effective claim management is necessary for an

organisation as it deals with the cash outflows of the company.


Claims management by the insurer involves analysing the data, processing applications and

making decisions, funding and controlling the business management. The claims

management makes the principles and guidelines for profitable settlement of claims.

Claims management comprises of the process of claims handling and claims payment. The

review of claims performance, monitoring of claims expenses, legal and settlement costs,

planning of future payments and avoiding delay and disputes in payment of claims is

included in claims management. Risk management, loss assessment, business forecasting

and planning of insurance claims are also done in claims management.

Claims reserving is an important part of the overall claim management process. Insurance

companies need to ensure adequacy of claims reserves in order to meet their claim

obligations.

Q3. Describe the stages in claims management.

Answer : Managing insurance claims is one of the most significant management tasks.

Claim management tasks involve filing, verifying insurance coverage, determining co-

payment levels and checking the status of submitted claims. Claims handling and claims

management are the stages in the claim system. Externally both appear to be the same, but

they are different by nature. Claims handing is a vital part of claims management as it

executes the decisions by the claims management of the insurance company.

Claims managementClaims management by the insurer involves analysing the data, processing applications and

making decisions, funding and controlling the business management. The claims

management makes the principles and guidelines for profitable settlement of claims.

Claims management comprises of the process of claims handling and claims payment. The

review of claims performance, monitoring of claims expenses, legal and settlement costs,

planning of future payments and avoiding delay and disputes in payment of claims is

included in claims management. Risk management, loss assessment, business forecasting

and planning of insurance claims are also done in claims management.


Claims reserving is an important part of the overall claim management process. Insurance

companies need to ensure adequacy of claims reserves in order to meet their claim

obligations.

Claims handlingClaims handling is a way to process claims application and manage the claims settlement. It

is a method, where the laid down principles and measuring methods are utilised to settle the

claims. It handles the various stages of the insurance claims. It’s functions include reviewing,

investigating and understanding the negotiation process. This does not involve policy making

and decision making or any managerial activity.

It involves only procedural methods and interpretations of the claims philosophy. Claims

handling depends on each case or situation and changes accordingly. It is flexible, as well

as, rigid keeping in mind the interest of the insurer. It involves receiving the claims and other

procedures for efficient payment of claims. The insurer’s commitment to the customer is part

of the claims management.

While handling claims insurers need to ensure that:

Claims are handled fairly.

Claims are settled promptly.

Information is provided to the customers about the claim handling process.

Reasons are provided when claims are rejected or not fully paid.

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

Answer: Basically, the pricing method gives us an idea on how to set the product price. The

price value that is set for the product in the insurance company will change over time for

many reasons. The company can decide to change the pricing method only when it finds out

the customers’ needs and competition in the market.

The pricing methods allow companies to think about their business, industry and customer.

The vendors must understand the variety of options available along with the merits and

demerits of the pricing methods, before selecting any one of them. They may also merge a

number of pricing methods to suit their business and the type of products they sell.

There are three basic pricing methods, which are:


· Cost-based pricing – In this method, the price includes the cost of ingredients and cost of

operating the business. This method is based on product cost subtotal, which includes the

costs of operating the business such as costs of reserves, transportation, advertisement,

rent and other costs involved in manufacturing the products. The cost-based pricing

comprise of three methods, which are:

- Mark-up pricing – Mark-up pricing includes a profit percentage with product cost. All

businesses with many products use this type of pricing because it is simple to calculate. The

profit level must be specified in terms of percentage. This is added to the production cost to

set product price. This type of pricing is common in retail business as they have many types

of products and purchases from many vendors.

- Cost-plus pricing – In a cost-plus pricing, a percentage is added to an unknown product

cost. This type of pricing works properly when production costs are not known. The only

difference between mark-up and cost-plus pricing is that, in cost-plus pricing both consumer

and vendor settle on the profit percentage and believe that product cost is unknown whereas

in mark-up pricing product cost is known. The cost-plus pricing reduces your risk if you

produce custom order products for other firms or individuals.

- Planned-profit pricing – Planned profit pricing method enables you to earn a total profit

for the business. It is different from the first two types of cost-based pricing. The first two

pricing methods focus on per unit price. In planned-profit pricing, the product price is

calculated by combining per unit costs with output projections. Planned-profit pricing uses

break-even analysis to calculate product price. This method is suitable for manufacturing

businesses since the manufacturer has the ability to increase or decrease the production

depending upon the available demand or profit.

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

Answer : In 1998, Government of India formed the Institute of Insurance Ombudsman, to

address the complaints of insured persons against the insurance companies. This institution

became a way for the insured persons to express their problems against the companies, and

to solve it as soon as possible. This institution helps the policyholders to build up confidence

in the insurance companies.


Institution of Insurance Ombudsman resolves complaints, which the insurance company

denied to solve. The insured persons can approach the insurance ombudsman in their own

states to solve their problems.

Roles and functionsThe roles and functions of the Institution of Insurance Ombudsman ranges from appointment

of the ombudsman, to the rewarding of insured persons. The various functions of the

institution are:

Appointment of insurance ombudsman - The appointment of insurance ombudsman

is the main function of the institution. A committee consisting of the chairman of IRDA,

chairman of LIC, chairman of GIC, and a representative of the Central Government

mandates the governing body of insurance council to choose the insurance ombudsman.

The Insurance council includes the members of life insurance council, and the general

insurance council is formed under section 40C of the Insurance Act,1938. Some

representatives of insurance companies form the governing body of insurance council.

Eligibility and term of service - Officials from insurance industry, civil services and

judicial services are chosen as the insurance ombudsmen. The ombudsman changes

every three years and retires from the post at sixty-five years of age. Insurance

ombudsmen cannot be re-appointed.

Territorial jurisdiction of ombudsman - Presently, in different states of India, there are

around 12 insurance ombudsmen appointed by the governing body. These ombudsmen

may hold meetings with the insured persons in their corresponding areas of jurisdiction,

in order to speed up and resolve their grievances. Currently, the offices of the insurance

ombudsmen in India are located at Bhopal, Bhubaneswar, Cochin, Guwahati,

Chandigarh, New Delhi, Chennai, Kolkata, Ahmedabad, Lucknow, Mumbai and

Hyderabad.

Office Management - The insurance council provides the office of the insurance

ombudsman, and it consists of the secretarial staff, which supports the ombudsman in

carrying out duties. The total expenses of this office are decided by the governing body,

and are provided by the insurance companies of the insurance council.

Removal from office - An insurance ombudsman can be removed from office on

committing a gross misconduct during the three years of service. The governing body

selects a person fit to do a detailed enquiry and investigation about the misconduct and

all these details are given to the Insurance Regulatory and Development Authority

(IRDA). IRDA then takes a decision regarding the action to be taken against the guilty

ombudsman.


Power of ombudsmanThe two main functions of the insurance ombudsman are:

· Addressing and solving the issues of the insured persons and insurance companies - The insurance ombudsman helps any person who has a complaint against the insurance

company. The complaints can be of various types:

- Issues regarding any partial or total denial of claims by the insurance companies.

- Issues with regard to payment of premium in terms of the policy.

- Disputes on the legal structuring of the policy statements which resulted in disputes related

to claims.

- Delay in resolution of claims.

- Delay in issuance of any insurance papers to customers after acceptance of premium.

· Awarding a payment to the insured persons - The insurance ombudsman can issue up to

Rs. 20 lakhs as awards to the insured persons. The corresponding insurance companies are

obliged to credit these awards within three months.

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

Answer : The two different types of reinsurances are:

· Facultative reinsurance.

· Treaty reinsurance.

1. Facultative reinsuranceIt is a type of reinsurance that is optional; it is a case-by-case method that is used when the

ceding company receives an application for insurance that exceeds its retention limit. It is

based on the individual agreements that help to cover specific losses. When any primary

insurer wants reinsurance for a specific coverage, it enters the market, and bargains with

different reinsurance companies for the amount of coverage and premium, looking out for a

better value. According to most of the contracts, the reinsurer pays a ceding commission to

the insurer to pay for purchase expenses.

Before issuing the insurance policy the insurer looks for reinsurance and speaks to many

reinsurers. The insurance company does not have any commitments to cede insurance and

also the reinsurer has no commitments to accept the insurance. However if the insurance

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

a contract.


Facultative reinsurance is used when a huge amount of insurance is preferred and while

considering a specific risk involved in an individual contract. Facultative reinsurance is the

reinsurance of a part of a single policy or the entire policy after negotiating the terms and

conditions. It reduces the risk exposure of the ceding company against a particular policy.

Facultative reinsurance is not mandatory.

One advantage of facultative reinsurance is it is flexible as a reinsurance contract is

arranged to fit any kind of cases. It helps the insurance companies in writing large amount of

insurance policies. Reinsurance moves the huge losses of the insurers to the reinsurer and

thus helps the insurer.

One main disadvantage of facultative reinsurance is that it is not reliable. The ceding insurer

will not know in advance whether a reinsurer will agree to pay any part of the insurance. The

other disadvantage of this kind of reinsurance is the delay in issuing the policy as it cannot

be issued until the reinsurance is got for that policy.

2. Treaty reinsuranceTreaty reinsurance is one in which the primary insurer agrees to cede the insurance policy to

the reinsurer and the reinsurer has to accept it. It includes a standing agreement with a

specific reinsurer. The amount of insurance that the primary insurer sells and those policies

where both the parties provide the service is specified in the contract. All the business that

comes under the contract is automatically reinsured according to the conditions of the treaty.

Treaty reinsurance needs the reinsurer to assume the entire responsibility of the ceding

company or a part of it for some particular sections of the business with respect to the terms

of the policy. The contract is a compulsory contract because according to the treaty the

ceding company has to cede the business and the reinsurer is compelled to assume the

business. It is a type of reinsurance that is preferred while considering the groups of

homogenous risks.

The treaty reinsurance provides many advantages to the primary insurance company. It is

automatic, more reliable, and there is no delay in issuing the policy. It is also more cost

effective as there is no need to shop around for reinsurers before writing the policy.

The treaty reinsurance is not advantageous to the reinsurer. Usually the reinsure does not

know about the individual applicant of the policy and has to depend on the underwriting

judgment that the primary insurer gives. It may be so that the primary insurer can show bad

business like more losses and get reinsured for it as the reinsurer does not know the real


fact. The primary insurer may pay insufficient premium to the reinsurer. Therefore the

reinsurer undergoes a loss if the risk selection of the primary insurer is not good and they

charge insufficient rates.

There are different types of treaty reinsurance arrangements which may differ according to

the liability of the reinsurer. They are:

Quota–share treaty.

Surplus–share treaty.

Excess–of–loss treaty.

Reinsurance pool.

Quota–share treaty – According to this treaty the reinsurer and the ceding insurer agree to

share a fixed percentage of premium and also losses depending on some proportion.

Therefore because of this the quota share treaty is also called proportional reinsurance.

For instance, the primary insurer can take a decision of retaining around 70% of the new

business with it and transferring the rest 30% to the reinsurer. Accordingly, it also divides the

expenses, incomes and losses in the same proportion. The ceding insurer’s retention limit is

stated as a percentage. Premiums are also shared in the same proportion as agreed in the

treaty. A ceding commission is paid to the primary insurer by the reinsurer that helps in

balancing the expenses that it encountered while writing the business.

The major advantage of the quote-share treaty is that it permits the primary insurer in

reducing its unearned premium reserve considerably by transferring a lot of profitable

business to the reinsurer.

Surplus–share treaty – This is an agreement that shares some of the qualities of the quote-

share and excess-of-loss treaties. According to this treaty the reinsurer accepts the

insurance in excess to the ceding insurer’s retention limit. If the amount of any insurance

policy is more than the retention limits, then the reinsurer pays the excess amount up to a

specified maximum limit. The loss and premium are shared among the primary insurer and

the reinsurer in the same proportion.

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

of the primary insure.

The major disadvantage of this treaty is that the coverage that a reinsurer provides for each

policy has more record keeping and thus creates more administrative expenses.


Excess–of–loss treaty – This treaty is largely designed for providing protection against the

catastrophic losses. It is an agreement where the reinsurer covers only the losses that are

more than the retention limit of the primary insurer. This coverage is obtained mainly for

covering the catastrophic losses. This treaty can be written to cover:

1) A single occurrence.

2) A single exposure.

3) Excess losses when the primary insurer’s total losses exceed some amount during some

started time period.

Reinsurance pool – The reinsurance pool also provides reinsurance. It is an organisation of

insurers that underwrites insurance on a joint basis. These are formed as a single insurer

possibly will not be financially able to write huge amount of insurance policies, however a

group of insurers can combine their financial resources and get the financial ability to write

the huge insurance policies.

These pools are created to provide coverage for nuclear accidents, aviation disasters and

exposure in foreign countries where losses can be catastrophic and that could easily exceed

the financial capability of any single insurer.

The method of sharing premiums and losses are different for different types of reinsurance

pools. The pool works in the following two different ways::

First all the members of the pool decide to pay some percentage of amounts for every loss

that occurs.

Second the agreement is same as that of the excess–of–loss reinsurance treaty.

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