Chpt 1 Introduction to Financial Services ffvs

7/27/2019 Chpt 1 Introduction to Financial Services ffvs

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Agencies Providing Financial Services

Commercial Banks: Mainly involved in

fund based activities Term loans, working capital, cash credit andoverdraft facilities

Fee based services Project appraisal services,

loan syndication, debt restructuringMerchant Bankers: Managementactivities related to capital raising in the form ofIPO, debenture issue and loan syndication


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Shares and debentures issue management,underwriting, selling, advisory, consultancy,appraisal etc., raising funds for working capital

Leasing and Hire Purchase

Companies:Leasing and hire purchase are

financial facilities which allow a business to usean asset over a fixed period, in return for regularpayments


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Many kinds of business asset are suitable forfinancing using hire purchase or leasing,

including:- Plant and machinery- Business cars- Commercial vehicles

- Agricultural equipment- Hotel equipment- Medical and dental equipment- Computers, including software packages

-Office equipment


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With a hire purchase agreement, after all thepayments have been made, the businesscustomer becomes the owner of the equipment.

The fundamental characteristic of a lease is thatownership never passes to the business

customer.


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Venture capital financing is a type offinancing by venture capital: the type of private

equity capital is provided as seed funding toearly-stage, high-potential, growth companiesand more often after the seed funding round asgrowth funding round

A mutual fund is a type of professionally-managed collective investment scheme thatpools money from many investors to purchasesecurities.


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Rating Agencies: A credit rating agency(CRA) is a company that assigns credit ratingsfor issuers of certain types of debt obligations aswell as the debt instruments

NBFCs: Consumer finance companies, portfolio

management companies Stock Exchanges: Marketplace for funds

going public


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Stock Exchanges

Marketplace:

Maintains liquidity: Allows investors to maintainliquidity

Stocks which are not listed on stock exchangesare traded at lower price as they cant be easily

liquidated


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Stock Exchanges

Monitoring agency:

If the stock is listed on stock exchange it ensuresstability as before listing it has to fulfill therequirements of SEBI

The listing requirements vary for each stock

exchange Easy to get listed on local stockexchange than getting listed on NSE or BSE


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Services provided by Stock Exchanges

Provides liquidity to investment : Stockexchange provides liquidity (i.e easy convertibility to

cash) to investment in securities. An investor cansell his securities at any time because of the readymarket provided by the stock exchange. Stockexchange provides easy marketability to corporatesecurities.

Provides collateral value to securities : Stockexchange provides better value to securities ascollateral for a loan. This facilitates borrowing froma bank against securities on easy terms.


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Offers opportunity to participate in theindustrial growth : Stock exchange provides capital

for industrial growth. It enables an investor toparticipate in the industrial development of the country.

Estimates the worth of securities : Stock exchangeprovides the facility of knowing the worth (i.e true

market value) of investment due to quotations (i.e pricelist) and reports published regularly by the exchange.This type of information guides investors as regards theirfuture investments. They can purchase or sell securitiesas per the price trends (i.e latest price value) in the

market.


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Offers safety in corporate investment : Aninvestor can invest his surplus money (i.e extra

money) in the listed securities with reasonablesafety. The risk in such investment is reducedconsiderably due to the supervision of stockexchange authorities on listed companies. Moreover,securities are listed only when the exchangeauthorities are satisfied as regards legality andsolvency of company concerned. Such scrutiny(detailed checking) avoids listing, of securities ofunsound companies (i.e companies with badfinancial status).


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Services given by Stock Exchange toCompanies Widens market for securities : Stock exchange

widens the market for the listed securities and

enables the companies to collect capital forpromotion, expansion and modernization purpose.It indirectly provides financial support to companies/ corporations.

Creates goodwill and reputation : Stockexchange enhances the goodwill and the reputationof the companies whose securities are listed. Listingacts as a charater certificate given to a company. Itgives prestigious position to company.


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Services given by Stock Exchange toCompanies Facilitates fair pricing of listed securities : The

market price of listed securities tends to be slightly

higher in relation to earnings and property values. Provides better response from investors : Listedsecurities get better response from the investor due tosafety and security. Listing of securities is a uniqueservice which stock exchanges offer to companies. It is a

moral support given to stable companies. Facilitates quick selling of securities : Stock

exchange enables companies to sell their securities easilyand quickly. This is natural as investors always prefer toinvest money in listed securities.


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Service given by Stock Exchange toEconomy Brings economic development : Stock

exchanges brings rapid economic development

through mobilization of funds for productivepurposes. This facilitates the process ofeconomic growth.


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Financial Services and Innovation

Introduction of newer services and functions infinance is called as financial innovation

Engineering is the process by which some valueis added to the raw materials and semi finishedgoods to make it useful for its customers

Financial engineering is adding value to existingfinancial products


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Financial Engineering Financial engineering is the design and construction

of a new financial contract or the packaging of

existing financial instruments to meet very specificrisk and return requirements of the client Design, development and implementation of

innovative financial instruments and processes

Not all engineered products are innovative Engineered products should be different and shouldadd value to users

Innovative products become common after certainperiod of time


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Financial Engineering For example, the building construction contract

may include specifications regarding size,

number of rooms, adequate plumbing and heat,quality of materials to be used, and a completiondate. The financially engineered contract mayalso include specifications of size (or dollar

amount), the types ofsecurities that will beused, the cash flows that they will generate, therisk associated with those cash flows, and thedate upon which the contract will be renewed or

expired.


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Financial Engineering This very general definition of financial engineering

includes many contracts that are now considered

commonplace. For example,banks sustained largelosses in the early 1980s when their cost of funds rosesharply with interest rates. These banks had madelarge, long-term, fixed interest rate loans to families

purchasing homes. The banks found, however, that themoderate fixed interest charges they received on theseloans was not sufficient to cover the interest expensethat was incurred to attract new funds to the bank.

Hence, banks began to write adjustable-rate loans thatwould var interest char es to borrowers


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Financial Engineering Another common example of financial engineering

is the mutual fund. Individual investors realizedthat there were benefits in terms of risk reduction ifthey could invest in a broad array of securities. Mostindividuals, however, had limited resources andfound it very expensive to purchase small amountsof many securities. A basic mutual fund is a portfolioof securities that can be as diverse and numerous asthe client demands. The creation of these fundsallowed individuals to purchase shares of an alreadydiversified portfolio and establish an investmentwith lower risk, and at a more moderate cost thanthey could achieve otherwise.


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Need for Financial Engineering

Competition:

Liberalization:

Technology:

Financial Awareness:

Matured Legal Processes:


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Stages involved in FinancialEngineering Need Identification

Idea Formation of the Product

Product development and Model building

Product testing

Product improvement based on test feedback

Product Pricing Restructuring the product

Test marketing

Launching the product


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Financially engineered products Preference shares: High risk high return product Compared to equity it is lower risk lower return product

Cumulative and Non cumulative Preference shares Cumulative preference shares give the right to thepreference shareholders to receive arrears of dividendwhich were not paid in previous years due to companymaking loss. While Non- cumulative Preferenceshareholders do not have right like Cumulative

preference shareholders and therefore they cannotdemand any arrears of dividend which were not paidduring previous years by the company.


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Financially engineered products Participating and Non Participating Preference

shares Participating Preference shareholders have

the right to receive any remaining profit which is leftafter payment of dividend to the equityshareholders, while Non Participating Preferenceshareholders do not have such rights.

Convertible and Non Convertible Preference shares Convertible Preference shares can be convertedinto equity shares if preference shareholder decidesto do so while Non Convertible Preference sharesdoes not have any such right.


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Financially engineered products

Redeemable and Non Redeemable Preferenceshares Redeemable Preference shares are

those shares which have to be repaid by thecompany after a fixed period of time from thedate of issue of such shares while NonRedeemable Preference shares cannot beredeemed repaid by the company except onwinding up of the company.


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Financially engineered products An option contract gives the buyer the right, but not

the obligation to buy/sell an underlying asset at a

pre-determined price on or before a specified time. The option buyer acquires a right, while the option

seller takes on an obligation The underlying asset for option contracts may be

stocks, indices, commodity futures, currency orinterest rates

When you buy a call option, on a stock, you acquirea right to buy the stock. And when you buy a putoption, you acquire a right to sell the stock


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Warrants: a warrant is a security that entitles theholder to buy the underlying stock of the issuing

company at a fixed exercise price until the expirydate.

The word warrant simply means to "endow with

the right Warrants are frequently attached to bonds orpreferred stock as a sweetener, allowing theissuer to pay lower interest rates or dividends


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Financially engineered products Derivatives: Aderivative instrument is a contract

between two parties that specifies conditions (especiallythe dates, resulting values of the underlying variables,

and notional amounts) under which payments are to bemade between the parties

Derivatives are broadly categorized by the relationshipbetween the underlying asset and the derivative (such asforward, option, swap); the type of underlying asset

(such as equity derivatives, foreign exchange derivatives,interest rate derivatives, commodity derivatives, orcredit derivatives); the market in which they trade (suchas exchange-traded or over-the-counter); and their pay-off profile.


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Non-Voting Shares: Non-voting stock is stockthat provides the shareholder very little or no

vote on corporate matters, such as election of theboard of directors or mergers.

This type of share is usually implemented for

individuals who want to invest in the companysprofitability and success at the expense of votingrights in the direction of the company.

Preferred stock typically has nonvoting qualities


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Financially engineered products ESOP: An employee stock ownership plan (ESOP) is

a defined contribution plan that provides a

company's workers with an ownership interest inthe company. In an ESOP, companies provide their employees

with stock ownership, typically at no cost to theemployees.

Shares are given to employees and are held in theESOP trust until the employee retires or leaves thecompany, or earlier diversification opportunitiesarise.


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Financially engineered products Sweat Equity Shares: Sweat equity is a party's contribution

to a project in the form of effort -- as opposed to financial

equity, which is a contribution in the form of capital. In a partnership, some partners may contribute to the firm

only capital and others only sweat equity. Similarly, in astartup company formed as a corporation, employees mayreceive stock or stock options, becoming thus part-owners

of the firm, in return for accepting salaries that are belowtheir respective market values (this includes zero wages).

The term used to refer to a form of compensation bybusinesses to their owners or employees.


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Challenges before financial services

industry Market issues: Competitive marketplace focus

on customer retention

Customer retention can be achieved throughcustomer management and customersegmentation

Regulatory issues: Regulatory requirements

often consume time and money Operational issues: To improve the efficiency

and effectiveness of operations due toglobalization and competition


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Challenges before financial services

industry Operational issues: Cost control is the major

issue

These issues need to be addressed through businessprocess management (BPM), Business ActivityMonitoring (BAM), Corporate performancemanagement (CPM), and Employee Performancemanagement (EPM)

Technology Issues: Need to replace and upgradetechnology and infrastructure

Manpower Issues: Difficult to get and retain thenecessary manpower

Chpt 1 Introduction to Financial Services ffvs

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