Course: Corporate Finance (5585)

ASSIGNMENT No. 1Q. 1 Use the following information to complete the balance sheet and sales information in the table that follows for Hopkins industries using the following financial data:

Debt ratio 65%Quick Ratio 1.1xTotal Asset turnover 2.5xReceivable turnover

8.333Gross profit margin on sales 30%Inventory turnover ratio 5x

BALANCE SHEETCash Accounts PayableAccount Receivable

Long term debt 3,00,000

Inventories Common stockFixed Assets Retained Earnings 2,25,000Total Assets 10,00,000 Total Liabilities &

EquitySales Cost of goods sold

Answer of Q.No.1Balance Sheet

Assets Rs Liabilities RsCash (Balance Value) A/RInventory Fixed Assets

84988300012350000265000_1000000

A/p Long Term Debts C/Stock (Balance Value)Returned Earning

350000300000125000225000_1000000

Sale 2500000 Cost of Goods sold 1750000 Debts Ratio = 65% Total Liabilities = 65% Total Assets Total Liabilities = 65% (1000000) Total Liabilities = 650000 -Long term Debts = 300000 Current Debts 350000

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Inventory Turn Over = __C.G.S__ = 5 Inventory Inventory = 1750000 = 350000 5

G.P = 30% of sale G.P = 30% (2500000) Quick Ratio = C.A-Inventory C.LG.P = 750000 101 = C.A-350000 350000Sale – C.G.S = G.P C.A = 7350002500000 – C.G.S = 750000C.G.S = 1750000

Total Assets Turnover = Sale______ = 2.5 Total Assets = Sale__ = 2.5 1000000 Sale = 2500000Receivable Turnover = Sale = 8.333 A/R = 2500000 8.333 A/R = 300012Q. 2 Perform the ratio analysis of any listed company; write in-depth interpretations of each ration calculated. You are required to take past three years financial statements for the ratio analysis. (Also make line chart to show the trend of each ratio).

ANS-A financial ratio (or accounting ratio) is a relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm's creditors. Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios. Ratios can be expressed as a decimal value, such as 0.10, or given as an equivalent percent value, such as 10%. Some ratios are usually quoted as percentages, especially ratios that are usually or always less than 1, such as earnings yield, while others are usually quoted as decimal numbers, especially ratios that are usually more than 1, such as P/E ratio; these latter are also called multiples. Given any ratio, one can take its reciprocal; if the ratio was above 1, the reciprocal will be below 1, and conversely. The reciprocal expresses the same information, but may be more understandable: for instance,

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the earnings yield can be compared with bond yields, while the P/E ratio cannot be: for example, a P/E ratio of 20 corresponds to an earnings yield of 5%.

Sources of data for financial ratios

Values used in calculating financial ratios are taken from the balance sheet, income statement, statement of cash flows or (sometimes) the statement of retained earnings. These comprise the firm's "accounting statements" or financial statements. The statements' data is based on the accounting method and accounting standards used by the organization.

Purpose and types of ratios

Financial ratios quantify many aspects of a business and are an integral part of the financial statement analysis. Financial ratios are categorized according to the financial aspect of the business which the ratio measures. Liquidity ratios measure the availability of cash to pay debt. Activity ratios measure how quickly a firm converts non-cash assets to cash assets. Debt ratios measure the firm's ability to repay long-term debt. Profitability ratios measure the firm's use of its assets and control of its expenses to generate an acceptable rate of return. Market ratios measure investor response to owning a company's stock and also the cost of issuing stock. These are concerned with the return on investment for shareholders, and with the relationship between return and the value of an investment in company’s shares.

Financial ratios allow for comparisons

between companies between industries between different time periods for one company between a single company and its industry average

Ratios generally are not useful unless they are benchmarked against something else, like past performance or another company. Thus, the ratios of firms in different industries, which face different risks, capital requirements, and competition are usually hard to compare.

Accounting methods and principles

Financial ratios may not be directly comparable between companies that use different accounting methods or follow various standard accounting practices. Most public companies are required by law to use generally accepted accounting principles for their home countries, but private companies, partnerships and sole proprietorships may not use accrual basis accounting. Large multi-national corporations may use International Financial Reporting Standards to produce

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their financial statements, or they may use the generally accepted accounting principles of their home country.

Abbreviations and terminology

Various abbreviations may be used in financial statements, especially financial statements summarized on the Internet. Sales reported by a firm are usually net sales, which deduct returns, allowances, and early payment discounts from the charge on an invoice. Net income is always the amount after taxes, depreciation, amortization, and interest, unless otherwise stated. Otherwise, the amount would be EBIT, or EBITDA (see below). Companies that are primarily involved in providing services with labour do not generally report "Sales" based on hours. These companies tend to report "revenue" based on the monetary value of income that the services provide. Note that Shareholders' Equity and Owner's Equity are not the same thing, Shareholder's Equity represents the total number of shares in the company multiplied by each share's book value; Owner's Equity represents the total number of shares that an individual shareholder owns (usually the owner with controlling interest), multiplied by each share's book value. It is important to make this distinction when calculating ratios.

Other abbreviations COGS = Cost of goods sold, or cost of sales. EBIT = Earnings before interest and taxes EBITDA = Earnings before interest, taxes, depreciation, and amortization EPS = Earnings per share

Ratios Profitability ratios

Profitability ratios measure the company's use of its assets and control of its expenses to generate an acceptable rate of return

Gross margin, Gross profit margin or Gross Profit Rate

OR

Operating margin, Operating Income Margin, Operating profit margin or Return on sales (ROS)

Note: Operating income is the difference between operating revenues and operating expenses, but it is also sometimes used as a synonym for EBIT and

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operating profit. This is true if the firm has no non-operating income. (Earnings before interest and taxes / Sales

Profit margin, net margin or net profit margin

Return on equity (ROE)

Return on assets (ROA ratio or Du Pont Ratio)

Return on assets (ROA)

Return on assets Du Pont (ROA Du Pont)

Return on Equity Du Pont (ROE Du Pont)

Return on net assets (RONA)

Return on capital (ROC)

Risk adjusted return on capital (RAROC)

OR

Return on capital employed (ROCE)

Note: this is somewhat similar to (ROI), which calculates Net Income per Owner's EquityCash flow return on investment (CFROI)

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Efficiency ratio

Net gearing

Basic Earnings Power Ratio[16]

Liquidity ratios

Liquidity ratios measure the availability of cash to pay debt.

Current ratio (Working Capital Ratio)

Acid-test ratio (Quick ratio)

Cash ratio

Operation cash flow ratio

Activity ratios (Efficiency Ratios)

Activity ratios measure the effectiveness of the firms use of resources.

Average collection period

Degree of Operating Leverage (DOL)

DSO Ratio.

Average payment period

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Asset turnover

Stock turnover ratio

Receivables Turnover Ratio

Inventory conversion ratio

Inventory conversion period (essentially same thing as above)

Receivables conversion period

Payables conversion period

Cash Conversion Cycle

Debt ratios (leveraging ratios)

Debt ratios quantify the firm's ability to repay long-term debt. Debt ratios measure financial leverage.

Debt ratio

Debt to equity ratio

Long-term Debt to equity (LT Debt to Equity)

Times interest earned ratio (Interest Coverage Ratio)

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OR

Debt service coverage ratio

Market ratios

Market ratios measure investor response to owning a company's stock and also the cost of issuing stock. These are concerned with the return on investment for shareholders, and with the relationship between return and the value of an investment in company’s shares.

Earnings per share (EPS)

Payout ratio [25] [26]

Dividend cover (the inverse of Payout Ratio)

P/E ratio

Dividend yield

Cash flow ratio or Price/cash flow ratio

Price to book value ratio (P/B or PBV)

Price/sales ratio

PEG ratio

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Other Market Ratios

EV/EBITDA

EV/Sales

Cost/Income ratio

Capital budgeting ratios

In addition to assisting management and owners in diagnosing the financial health of their company, ratios can also help managers make decisions about investments or projects that the company is considering to take, such as acquisitions, or expansion. Many formal methods are used in capital budgeting, including the techniques such as

Net present value Profitability index Internal rate of return Modified internal rate of return Equivalent annuity

Q. 3 Marks Write Pen Company has an outstanding issue of convertible bonds with a $1,000 par value. These bonds are convertible into 50 shares of common stock. They have a 10 percent coupon and a 10-year maturity. The interest rate on a straight bond of similar risk is eight percent.

(a) Calculate the straight bond value of the bond.(b) Calculate the conversion value of the bond when the market price

of the stock is $30/share.(c) What is the least you would expect the bond to sell for at a market

price of common stock of $ 18/share?ANS-Q.No.3

Par Value = 1000Converted into 50 shares

Coupon interest 10% (1000 x 10%) = 100Life 10yMarket interest 8%

a)

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ßo = I ( PviFAi% ny) + Mv (PviFi%ny) = 100(PviFA8% 10y) + 1000 (PviF8% 10y) = 100( 6.710) + 1000 ( 0.463) = 671 + 463 = 1134

b) Conversion value of the Bonds 1 Bonds = 50 shares 1000 = (50x30) = 1500

c) Expect the Bonds sells (50 x 18) = Rs. 900

Q. 4 (a) Explain the role of financial institutions as financial intermediaries?

ANS-In financial economics, a financial institution is an institution that provides financial services for its clients or members. Probably the most important financial service provided by financial institutions is acting as financial intermediaries. Most financial institutions are regulated by the government.

Broadly speaking, there are three major types of financial institutions:[1][2]

1. Depositary Institutions : Deposit-taking institutions that accept and manage deposits and make loans, including banks, building societies, credit unions, trust companies, and mortgage loan companies

2. Contractual Institutions : Insurance companies and pension funds; and3. Investment Institutes : Investment Banks, underwriters, brokerage firms.

Function

Financial institutions provide service as intermediaries of financial markets. They are responsible for transferring funds from investors to companies in need of those funds. Financial institutions facilitate the flow of money through the economy.

Standing settlement instructions

Standing Settlement Instructions (SSIs) are the agreements between two financial institutions which fix the receiving agents of each counterparty in ordinary trades of some type. These agreements allow traders to make faster trades since time used to settle the receiving agents is conserved. Limiting the trader to an SSI also lowers the likelihood of a fraud.

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Regulation

Financial institutions in most countries operate in a heavily regulated environment as they are critical parts of countries' economies. Regulation structures differ in each country, but typically involve prudential regulation as well as consumer protection and market stability. Some countries have one consolidated agency that regulates all financial institutions while others have separate agencies for different types of institutions such as banks, insurance companies and brokers. Countries that have separate agencies include the United States, where the key governing bodies are the Federal Financial Institutions Examination Council (FFIEC), Office of the Comptroller of the Currency - National Banks, Federal Deposit Insurance Corporation (FDIC) State "non-member" banks, National Credit Union Administration (NCUA) - Credit Unions, Federal Reserve (Fed) - "member" Banks, Office of Thrift Supervision - National Savings & Loan Association, State governments each often regulate and charter financial institutions. Countries that have one consolidated financial regulator include United Kingdom with the Financial Services Authority, Norway with the Financial Supervisory Authority of Norway, Hong Kong with Hong Kong Monetary Authority and Russia with Central Bank of Russia. See also List of financial regulatory authorities by country.

Financial Regulator

The Financial Regulator (Irish: Rialtóir Airgeadais), officially the Irish Financial Services Regulatory Authority, was the single regulator of all financial institutions in Ireland from May 2003 until October 2010 and was a "constituent part" of the Central Bank of Ireland.It was re-unified with the Central Bank of Ireland on 1 October 2010 and its board structure was replaced by a new Central Bank of Ireland Commission. Matthew Elderfield, formerly head of the Bermuda Monetary Authority, led the organisation from January 2010 until it was disestablished in November 2010. The previous chief executive officer was Patrick Neary, who retired early over the handling of the regulator's investigation into the €87 million in secret directors' loans at Anglo Irish Bank.

Developments that led to its disestablishment

Following the failure of existing regulatory structures to prevent excessive lending to the property sector, consultants Mazars, which were brought in to review operations said that "regulatory expertise was lacking in some areas." Responding to the highlighted weakness, Brian Lenihan, the Minister for Finance, said "substantial additional staff with the skills, experience and market-based expertise will be appointed. Those recruited will also have the expertise to regulate the international financial services sector." He also announced that all consumer functions will be '"re-assigned"' to other agencies.

Controversy

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The Financial Regulator was warned by the German regulator, BaFin, as early as 2004 that Sachsen LB's troubled Irish subsidiaries were involved in highly risky and under-scrutinised transactions worth as much as €30bn or 20 times the parent bank's capitalisation. Despite the warning, in 2007 the Regulator approved another Sachsen investment vehicle and two months later the stable of off-balance sheet companies needed a €17.3bn bail-out from the German association of savings banks to keep Sachsen afloat. The Irish Brokers Association said there was "intense frustration and annoyance" about excessive red tape and the FR refusing to listen to them in 2005. The same year the Regulator was criticised for publishing a report, which it was said, read a bit like a promotional brochure for the money lending industry. It included a section devoted to arguing why moneylenders should be allowed to charge as much as they do. (188%-plus collection fees of up to 11%.) Their consumer panel stated that the regulator was slow to respond to consumer issues and '"appears to seek complexity and obstacles rather than to seek consumer-oriented solutions to current and emerging problems"'. And it warned that this approach can undermine consumer confidence in the "efficacy of the regulatory process. " The same month in 2006, a government-appointed panel that consists of banking and insurance representatives revealed widespread dissatisfaction with the regulator’s skills base. The regulator’s industry panel, which provides the regulator with feedback on its charges and policies said the levy on financial institutions for industry funding is ‘‘perceived by industry as cumbersome and bureaucratic’’ and had ‘‘major concerns with the quality and cost of the services’’ provided to the regulator by the Central Bank.

Financial market

A financial market is a market in which people and entities can trade financial securities, commodities, and other fungible items of value at low transaction costs and at prices that reflect supply and demand. Securities include stocks and bonds, and commodities include precious metals or agricultural goods. There are both general markets (where many commodities are traded) and specialized markets (where only one commodity is traded). Markets work by placing many interested buyers and sellers, including households, firms, and government agencies, in one "place", thus making it easier for them to find each other. An economy which relies primarily on interactions between buyers and sellers to allocate resources is known as a market economy in contrast either to a command economy or to a non-market economy such as a gift economy. In finance, financial markets facilitate:

The raising of capital (in the capital markets) The transfer of risk (in the derivatives markets) Price discovery Global transactions with integration of financial markets The transfer of liquidity (in the money markets) International trade (in the currency markets)

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– and are used to match those who want capital to those who have it. Typically a borrower issues a receipt to the lender promising to pay back the capital. These receipts are securities which may be freely bought or sold. In return for lending money to the borrower, the lender will expect some compensation in the form of interest or dividends. This return on investment is a necessary part of markets to ensure that funds are supplied to them. In economics, typically, the term market means the aggregate of possible buyers and sellers of a certain good or service and the transactions between them. The term "market" is sometimes used for what are more strictly exchanges, organizations that facilitate the trade in financial securities, e.g., a stock exchange or commodity exchange. This may be a physical location (like the NYSE, BSE, NSE) or an electronic system (like NASDAQ). Much trading of stocks takes place on an exchange; still, corporate actions (merger, spinoff) are outside an exchange, while any two companies or people, for whatever reason, may agree to sell stock from the one to the other without using an exchange. Trading of currencies and bonds is largely on a bilateral basis, although some bonds trade on a stock exchange, and people are building electronic systems for these as well, similar to stock exchanges. Financial markets can be domestic or they can be international.

Types of financial markets

Within the financial sector, the term "financial markets" is often used to refer just to the markets that are used to raise finance: for long term finance, the Capital markets; for short term finance, the Money markets. Another common use of the term is as a catchall for all the markets in the financial sector, as per examples in the breakdown below.

Capital markets which consist of: o Stock markets, which provide financing through the issuance of

shares or common stock, and enable the subsequent trading thereof.

o Bond markets, which provide financing through the issuance of bonds, and enable the subsequent trading thereof.

Commodity markets , which facilitate the trading of commodities. Money markets, which provide short term debt financing and investment. Derivatives markets, which provide instruments for the management of

financial risk. Futures markets, which provide standardized forward contracts for trading

products at some future date; see also forward market. Insurance markets, which facilitate the redistribution of various risks. Foreign exchange markets, which facilitate the trading of foreign

exchange.

The capital markets may also be divided into primary markets and secondary markets. Newly formed (issued) securities are bought or sold in primary markets, such as during initial public offerings. Secondary markets allow investors to buy

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and sell existing securities. The transactions in primary markets exist between issuers and investors, while in secondary market transactions exist among investors. Liquidity is a crucial aspect of securities that are traded in secondary markets. Liquidity refers to the ease with which a security can be sold without a loss of value. Securities with an active secondary market mean that there are many buyers and sellers at a given point in time. Investors benefit from liquid securities because they can sell their assets whenever they want; an illiquid security may force the seller to get rid of their asset at a large discount. The financial market is broadly divided into 2 types: 1) Capital Market and 2) Money market. The Capital market is subdivided into 1) primary market and 2) Secondary market.

Raising capital

Financial markets attract funds from investors and channel them to corporations—they thus allow corporations to finance their operations and achieve growth. Money markets allow firms to borrow funds on a short term basis, while capital markets allow corporations to gain long-term funding to support expansion. Without financial markets, borrowers would have difficulty finding lenders themselves. Intermediaries such as banks, Investment Banks, and Boutique Investment Banks can help in this process. Banks take deposits from those who have money to save. They can then lend money from this pool of deposited money to those who seek to borrow. Banks popularly lend money in the form of loans and mortgages. More complex transactions than a simple bank deposit require markets where lenders and their agents can meet borrowers and their agents, and where existing borrowing or lending commitments can be sold on to other parties. A good example of a financial market is a stock exchange. A company can raise money by selling shares to investors and its existing shares can be bought or sold.

Lenders

Who have enough money to lend or to give someone money from own pocket at the condition of getting back the principal amount or with some interest or charge, is the Lender.

Individuals & Doubles

Many individuals are not aware that they are lenders, but almost everybody does lend money in many ways. A person lends money when he or she:

puts money in a savings account at a bank; contributes to a pension plan; pays premiums to an insurance company; invests in government bonds; or invests in company shares.

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Companies

Companies tend to be borrowers of capital. When companies have surplus cash that is not needed for a short period of time, they may seek to make money from their cash surplus by lending it via short term markets called money markets. There are a few companies that have very strong cash flows. These companies tend to be lenders rather than borrowers. Such companies may decide to return cash to surplus (e.g. via a share buyback.) Alternatively, they may seek to make more money on their cash by lending it (e.g. investing in bonds and stocks).

Borrowers Individuals borrow money via bankers' loans for short term needs or

longer term mortgages to help finance a house purchase.

Companies borrow money to aid short term or long term cash flows. They also borrow to fund modernization or future business expansion.

Governments often find their spending requirements exceed their tax revenues. To make up this difference, they need to borrow. Governments also borrow on behalf of nationalized industries, municipalities, local authorities and other public sector bodies. In the UK, the total borrowing requirement is often referred to as the Public sector net cash requirement (PSNCR).

Governments borrow by issuing bonds. In the UK, the government also borrows from individuals by offering bank accounts and Premium Bonds. Government debt seems to be permanent. Indeed the debt seemingly expands rather than being paid off. One strategy used by governments to reduce the value of the debt is to influence inflation. Municipalities and local authorities may borrow in their own name as well as receiving funding from national governments. In the UK, this would cover an authority like Hampshire County Council. Public Corporations typically include nationalized industries. These may include the postal services, railway companies and utility companies. Many borrowers have difficulty raising money locally. They need to borrow internationally with the aid of Foreign exchange markets. Borrowers having similar needs can form into a group of borrowers. They can also take an organizational form like Mutual Funds. They can provide mortgage on weight basis. The main advantage is that this lowers the cost of their borrowings.

Currency markets

Seemingly, the most obvious buyers and sellers of currency are importers and exporters of goods. While this may have been true in the distant past, [when?] when international trade created the demand for currency markets, importers and exporters now represent only 1/32 of foreign exchange dealing, according to the Bank for International Settlements.[2]

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The picture of foreign currency transactions today shows:

Banks/Institutions Speculators Government spending (for example, military bases abroad) Importers/Exporters Tourists

(b) Why it is important for a financial institution to specialize in the production and analysis of economic, business and financial information?

ANS-Much effort has gone into the study of financial markets and how prices vary with time. Charles Dow, one of the founders of Dow Jones & Company and The Wall Street Journal, enunciated a set of ideas on the subject which are now called Dow Theory. This is the basis of the so-called technical analysis method of attempting to predict future changes. One of the tenets of "technical analysis" is that market trends give an indication of the future, at least in the short term. The claims of the technical analysts are disputed by many academics, who claim that the evidence points rather to the random walk hypothesis, which states that the next change is not correlated to the last change. In recent years the rise of algorithmic and high-frequency program trading has seen the adoption of momentum, ultra-short term moving average and other similar strategies which are based on technical as opposed to fundamental or theoretical concepts of market Behaviour.

Financial market slang

Poison pill, when a company issues more shares to prevent being bought out by another company, thereby increasing the number of outstanding shares to be bought by the hostile company making the bid to establish majority.

Quant, a quantitative analyst with a PhD (and above) level of training in mathematics and statistical methods.

Rocket scientist, a financial consultant at the zenith of mathematical and computer programming skill. They are able to invent derivatives of high complexity and construct sophisticated pricing models. They generally handle the most advanced computing techniques adopted by the financial markets since the early 1980s. Typically, they are physicists and engineers by training; rocket scientists do not necessarily build rockets for a living.

White Knight, a friendly party in a takeover bid. Used to describe a party that buys the shares of one organization to help prevent against a hostile takeover of that organization by another party. round-tripping

Role (Financial system and the economy)

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One of the important requisite for the accelerated development of an economy is the existence of a dynamic financial market. A financial market helps the economy in the following manner.

Saving mobilization: Obtaining funds from the savers or surplus units such as household individuals, business firms, public sector units, central government, state governments etc. is an important role played by financial markets.

Investment: Financial markets play a crucial role in arranging to invest funds thus collected in those units which are in need of the same.

National Growth: An important role played by financial market is that, they contributed to a nations growth by ensuring unfettered flow of surplus funds to deficit units. Flow of funds for productive purposes is also made possible.

Entrepreneurship growth: Financial market contribute to the development of the entrepreneurial claw by making available the necessary financial resources.

Industrial development: The different components of financial markets help an accelerated growth of industrial and economic development of a country, thus contributing to raising the standard of living and the society of well-being.

Functions of Financial Markets

Intermediary Functions: The intermediary functions of a financial markets include the following:

Transfer of Resources: Financial markets facilitate the transfer of real economic resources from lenders to ultimate borrowers.

Enhancing income: Financial markets allow lenders to earn interest or dividend on their surplus invisible funds, thus contributing to the enhancement of the individual and the national income.

Productive usage: Financial markets allow for the productive use of the funds borrowed. The enhancing the income and the gross national production.

Capital Formation: Financial markets provide a channel through which new savings flow to aid capital formation of a country.

Price determination: Financial markets allow for the determination of price of the traded financial assets through the interaction of buyers and sellers. They provide a sign for the allocation of funds in the economy based on the demand and supply through the mechanism called price discovery process.

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Sale Mechanism: Financial markets provide a mechanism for selling of a financial asset by an investor so as to offer the benefit of marketability and liquidity of such assets.

Information: The activities of the participants in the financial market result in the generation and the consequent dissemination of information to the various segments of the market. So as to reduce the cost of transaction of financial assets.

Financial Functions

o Providing the borrower with funds so as to enable them to carry out their investment plans.

o Providing the lenders with earning assets so as to enable them to earn wealth by deploying the assets in production debentures.

o Providing liquidity in the market so as to facilitate trading of funds.

Constituents of Financial Market

Based on market levels

Primary market: Primary market is a market for new issues or new financial claims. Hence it’s also called new issue market. The primary market deals with those securities which are issued to the public for the first time.

Secondary market: It’s a market for secondary sale of securities. In other words, securities which have already passed through the new issue market are traded in this market. Generally, such securities are quoted in the stock exchange and it provides a continuous and regular market for buying and selling of securities.

Based on security types

Money market: Money market is a market for dealing with financial assets and securities which have a maturity period of up to one year. In other words, it’s a market for purely short term funds.

Capital market: A capital market is a market for financial assets which have a long or indefinite maturity. Generally it deals with long term securities which have a maturity period of above one year. Capital market may be further divided in to: (a) industrial securities market (b) Govt. securities market and (c) long term loans market.

Equity markets: A market where ownership of securities are issued and subscribed is known as equity market. An example of a secondary equity market for shares is the Bombay stock exchange.

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Debt market: The market where funds are borrowed and lent is known as debt market. Arrangements are made in such a way that the borrowers agree to pay the lender the original amount of the loan plus some specified amount of interest.

Derivative markets:

Financial service market: A market that comprises participants such as commercial banks that provide various financial services like ATM. Credit cards. Credit rating, stock broking etc. is known as financial service market. Individuals and firms use financial services markets, to purchase services that enhance the working of debt and equity markets.

Depository markets: A depository market consist of depository institutions that accept deposit from individuals and firms and uses these funds to participate in the debt market, by giving loans or purchasing other debt instruments such as treasure bills.

Q. 5 As an organization expands its operations into different countries there is an increase in political risk as there are more levels of government to deal with and varying government regulations and policies. It is important that a company understand the risk that exists in all countries they operate in. Critically comment on this statement with the help of examples.

ANS-Financial risk is an umbrella term for multiple types of risk associated with financing, including financial transactions that include company loans in risk of default.[1][2] Risk is a term often used to imply downside risk, meaning the uncertainty of a return and the potential for financial loss. [3][4] A science has evolved around managing market and financial risk under the general title of modern portfolio theory initiated by Dr. Harry Markowitz in 1952 with his article, "Portfolio Selection".[5] In modern portfolio theory, the variance (or standard deviation) of a portfolio is used as the definition of risk.

Types of risk

Asset-backed risk

Risk that the changes in one or more assets that support an asset-backed security will significantly impact the value of the supported security. Risks include interest rate, term modification, and prepayment risk.

Credit risk

Credit risk, also called default risk, is the risk associated with a borrower going into default (not making payments as promised). Investor losses include lost principal and interest, decreased cash flow, and increased collection costs. An

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investor can also assume credit risk through direct or indirect use of leverage. For example, an investor may purchase an investment using margin. Or an investment may directly or indirectly use or rely on repo, forward commitment, or derivative instruments.

Foreign investment risk

Risk of rapid and extreme changes in value due to: smaller markets; differing accounting, reporting, or auditing standards; nationalization, expropriation or confiscatory taxation; economic conflict; or political or diplomatic changes. Valuation, liquidity, and regulatory issues may also add to foreign investment risk.

Liquidity risk

This is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit). There are two types of liquidity risk:

Asset liquidity - An asset cannot be sold due to lack of liquidity in the market - essentially a sub-set of market risk. This can be accounted for by:

o Widening bid-offer spreado Making explicit liquidity reserveso Lengthening holding period for VaR calculations

Funding liquidity - Risk that liabilities: o Cannot be met when they fall dueo Can only be met at an uneconomic priceo Can be name-specific or systemic

Market risk

This is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices:

Equity risk is the risk that stock prices in general (not related to a particular company or industry) or the implied volatility will change.

Interest rate risk is the risk that interest rates or the implied volatility will change.

Currency risk is the risk that foreign exchange rates or the implied volatility will change, which affects, for example, the value of an asset held in that currency.

Commodity risk is the risk that commodity prices (e.g. corn, copper, crude oil) or implied volatility will change.

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Operational risk Reputational risk Legal risk IT risk

Model risk

Diversification

Financial risk, market risk, and even inflation risk, can at least partially be moderated by forms of diversification. The returns from different assets are highly unlikely to be perfectly correlated and the correlation may sometimes be negative. For instance, an increase in the price of oil will often favour a company that produces it, but negatively impact the business of a firm such an airline whose variable costs are heavily based upon fuel. However, share prices are driven by many factors, such as the general health of the economy which will increase the correlation and reduce the benefit of diversification. If one constructs a portfolio by including a wide variety of equities, it will tend to exhibit the same risk and return characteristics as the market as a whole, which many investors see as an attractive prospect, so that Index Funds have been developed that invest in equities in proportion to the weighting they have in some well known index such as the FTSE. However, history shows that even over substantial periods of time there is a wide range of returns that an index fund may experience; so an index fund by itself is not "fully diversified". Greater diversification can be obtained by diversifying across asset classes; for instance a portfolio of many bonds and many equities can be constructed in order to further narrow the dispersion of possible portfolio outcomes.

Hedging

Hedging is a method for reducing risk where a combination of assets are selected to offset the movements of each other. For instance when investing in a stock it is possible to buy an option to sell that stock at a defined price at some point in the future. The combined portfolio of stock and option is now much less likely to move below a given value. As in diversification there is a cost, this time in buying the option for which there is a premium.

Financial / Credit risk related acronyms

ACPM Active credit portfolio management

EAD Exposure at default

EL Expected loss

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ERM Enterprise risk management

LGD Loss given default

PD Probability of default

KMV quantitative credit analysis solution developed by credit rating agency Moody's

In ideal risk management, a prioritization process is followed whereby the risks with the greatest loss (or impact) and the greatest probability of occurring are handled first, and risks with lower probability of occurrence and lower loss are handled in descending order. In practice the process of assessing overall risk can be difficult, and balancing resources used to mitigate between risks with a high probability of occurrence but lower loss versus a risk with high loss but lower probability of occurrence can often be mishandled. Intangible risk management identifies a new type of a risk that has a 100% probability of occurring but is ignored by the organization due to a lack of identification ability. For example, when deficient knowledge is applied to a situation, a knowledge risk materializes. Relationship risk appears when ineffective collaboration occurs. Process-engagement risk may be an issue when ineffective operational procedures are applied. These risks directly reduce the productivity of knowledge workers, decrease cost effectiveness, profitability, service, quality, reputation, brand value, and earnings quality. Intangible risk management allows risk management to create immediate value from the identification and reduction of risks that reduce productivity. Risk management also faces difficulties in allocating resources. This is the idea of opportunity cost. Resources spent on risk management could have been spent on more profitable activities. Again, ideal risk management minimizes spending (or manpower or other resources) and also minimizes the negative effects of risks.

Method

For the most part, these methods consist of the following elements, performed, more or less, in the following order.

1. identify, characterize threats2. assess the vulnerability of critical assets to specific threats3. determine the risk (i.e. the expected likelihood and consequences of

specific types of attacks on specific assets)4. identify ways to reduce those risks5. prioritize risk reduction measures based on a strategy

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Principles of risk management

The International Organization for Standardization (ISO) identifies the following principles of risk management:

Risk management should:

create value – resources expended to mitigate risk should be less than the consequence of inaction, or (as in value engineering), the gain should exceed the pain

be an integral part of organizational processes be part of decision making process explicitly address uncertainty and assumptions be systematic and structured

Process

According to the standard ISO 31000 "Risk management – Principles and guidelines on implementation," the process of risk management consists of several steps as follows:

Establishing the context

This involves:

1. identification of risk in a selected domain of interest2. planning the remainder of the process3. mapping out the following:

o the social scope of risk managemento the identity and objectives of stakeholderso the basis upon which risks will be evaluated, constraints.

4. defining a framework for the activity and an agenda for identification5. developing an analysis of risks involved in the process6. mitigation or solution of risks using available technological, human and

organizational resources.

Identification

After establishing the context, the next step in the process of managing risk is to identify potential risks. Risks are about events that, when triggered, cause problems. Hence, risk identification can start with the source of problems, or with the problem itself.

Source analysis[- Risk sources may be internal or external to the system that is the target of risk management.

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Examples of risk sources are: stakeholders of a project, employees of a company or the weather over an airport.

Problem analysis- Risks are related to identified threats. For example: the threat of losing money, the threat of abuse of confidential information or the threat of accidents and casualties. The threats may exist with various entities, most important with shareholders, customers and legislative bodies such as the government.

When either source or problem is known, the events that a source may trigger or the events that can lead to a problem can be investigated. For example: stakeholders withdrawing during a project may endanger funding of the project; confidential information may be stolen by employees even within a closed network; lightning striking an aircraft during takeoff may make all people on board immediate casualties. The chosen method of identifying risks may depend on culture, industry practice and compliance. The identification methods are formed by templates or the development of templates for identifying source, problem or event. Common risk identification methods are:

Objectives-based risk identification Organizations and project teams have objectives. Any event that may endanger achieving an objective partly or completely is identified as risk.

Scenario-based risk identification - In scenario analysis different scenarios are created. The scenarios may be the alternative ways to achieve an objective, or an analysis of the interaction of forces in, for example, a market or battle. Any event that triggers an undesired scenario alternative is identified as risk – see Futures Studies for methodology used by Futurists.

Taxonomy-based risk identification - The taxonomy in taxonomy-based risk identification is a breakdown of possible risk sources. Based on the taxonomy and knowledge of best practices, a questionnaire is compiled. The answers to the questions reveal risks.

Common-risk checking - In several industries, lists with known risks are available. Each risk in the list can be checked for application to a particular situation.

Risk charting - This method combines the above approaches by listing resources at risk, threats to those resources, modifying factors which may increase or decrease the risk and consequences it is wished to avoid. Creating a matrix under these headings enables a variety of approaches. One can begin with resources and consider the threats they are exposed to and the consequences of each. Alternatively one can start with the threats and examine which resources they would affect, or one can begin with the consequences and determine which combination of threats and resources would be involved to bring them about.

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Assessment

Once risks have been identified, they must then be assessed as to their potential severity of impact (generally a negative impact, such as damage or loss) and to the probability of occurrence. These quantities can be either simple to measure, in the case of the value of a lost building, or impossible to know for sure in the case of the probability of an unlikely event occurring. Therefore, in the assessment process it is critical to make the best educated decisions in order to properly prioritize the implementation of the risk management plan. Even a short-term positive improvement can have long-term negative impacts. Take the "turnpike" example. A highway is widened to allow more traffic. More traffic capacity leads to greater development in the areas surrounding the improved traffic capacity. Over time, traffic thereby increases to fill available capacity. Turnpikes thereby need to be expanded in a seemingly endless cycles. There are many other engineering examples where expanded capacity (to do any function) is soon filled by increased demand. Since expansion comes at a cost, the resulting growth could become unsustainable without forecasting and management.

Composite Risk Index

The above formula can also be re-written in terms of a Composite Risk Index, as follows:

Risk Options

Risk mitigation measures are usually formulated according to one or more of the following major risk options, which are:

1. Design a new business process with adequate built-in risk control and containment measures from the start.

2. Periodically re-assess risks that are accepted in ongoing processes as a normal feature of business operations and modify mitigation measures.

3. Transfer risks to an external agency (e.g. an insurance company)4. Avoid risks altogether (e.g. by closing down a particular high-risk business

area)

Later research has shown that the financial benefits of risk management are less dependent on the formula used but are more dependent on the frequency and how risk assessment is performed. In business it is imperative to be able to present the findings of risk assessments in financial, market, or schedule terms. Robert Courtney Jr. (IBM, 1970) proposed a formula for presenting risks in

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financial terms. The Courtney formula was accepted as the official risk analysis method for the US governmental agencies. The formula proposes calculation of ALE (annualised loss expectancy) and compares the expected loss value to the security control implementation costs (cost-benefit analysis).

Potential risk treatments

Once risks have been identified and assessed, all techniques to manage the risk fall into one or more of these four major categories:

Avoidance (eliminate, withdraw from or not become involved) Reduction (optimize – mitigate) Sharing (transfer – outsource or insure) Retention (accept and budget)

Ideal use of these strategies may not be possible. Some of them may involve trade-offs that are not acceptable to the organization or person making the risk management decisions. Another source, from the US Department of Defense (see link), Defense Acquisition University, calls these categories ACAT, for Avoid, Control, Accept, or Transfer. This use of the ACAT acronym is reminiscent of another ACAT (for Acquisition Category) used in US Defense industry procurements, in which Risk Management figures prominently in decision making and planning.

Risk avoidance

This includes not performing an activity that could carry risk. An example would be not buying a property or business in order to not take on the legal liability that comes with it. Another would be not flying in order not to take the risk that the airplane were to be hijacked. Avoidance may seem the answer to all risks, but avoiding risks also means losing out on the potential gain that accepting (retaining) the risk may have allowed. Not entering a business to avoid the risk of loss also avoids the possibility of earning profits.

Hazard prevention

Hazard prevention refers to the prevention of risks in an emergency. The first and most effective stage of hazard prevention is the elimination of hazards. If this takes too long, is too costly, or is otherwise impractical, the second stage is mitigation.

Risk reduction

Risk reduction or "optimization" involves reducing the severity of the loss or the likelihood of the loss from occurring. For example, sprinklers are designed to put out a fire to reduce the risk of loss by fire. This method may cause a greater loss

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by water damage and therefore may not be suitable. Halon fire suppression systems may mitigate that risk, but the cost may be prohibitive as a strategy. Acknowledging that risks can be positive or negative, optimizing risks means finding a balance between negative risk and the benefit of the operation or activity; and between risk reduction and effort applied. By an offshore drilling contractor effectively applying HSE Management in its organization, it can optimize risk to achieve levels of residual risk that are tolerable.

Risk sharing

Briefly defined as "sharing with another party the burden of loss or the benefit of gain, from a risk, and the measures to reduce a risk." The term of 'risk transfer' is often used in place of risk sharing in the mistaken belief that you can transfer a risk to a third party through insurance or outsourcing. In practice if the insurance company or contractor go bankrupt or end up in court, the original risk is likely to still revert to the first party. As such in the terminology of practitioners and scholars alike, the purchase of an insurance contract is often described as a "transfer of risk." However, technically speaking, the buyer of the contract generally retains legal responsibility for the losses "transferred", meaning that insurance may be described more accurately as a post-event compensatory mechanism. For example, a personal injuries insurance policy does not transfer the risk of a car accident to the insurance company. The risk still lies with the policy holder namely the person who has been in the accident. The insurance policy simply provides that if an accident (the event) occurs involving the policy holder then some compensation may be payable to the policy holder that is commensurate to the suffering/damage. Some ways of managing risk fall into multiple categories. Risk retention pools are technically retaining the risk for the group, but spreading it over the whole group involves transfer among individual members of the group. This is different from traditional insurance, in that no premium is exchanged between members of the group up front, but instead losses are assessed to all members of the group.

Risk retention

Involves accepting the loss, or benefit of gain, from a risk when it occurs. True self insurance falls in this category. Risk retention is a viable strategy for small risks where the cost of insuring against the risk would be greater over time than the total losses sustained. All risks that are not avoided or transferred are retained by default. This includes risks that are so large or catastrophic that they either cannot be insured against or the premiums would be infeasible. War is an example since most property and risks are not insured against war, so the loss attributed by war is retained by the insured. Also any amounts of potential loss (risk) over the amount insured is retained risk. This may also be acceptable if the chance of a very large loss is small or if the cost to insure for greater coverage amounts is so great it would hinder the goals of the organization too much.

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Create a risk management plan

Select appropriate controls or countermeasures to measure each risk. Risk mitigation needs to be approved by the appropriate level of management. For instance, a risk concerning the image of the organization should have top management decision behind it whereas IT management would have the authority to decide on computer virus risks. The risk management plan should propose applicable and effective security controls for managing the risks. For example, an observed high risk of computer viruses could be mitigated by acquiring and implementing antivirus software. A good risk management plan should contain a schedule for control implementation and responsible persons for those actions. According to ISO/IEC 27001, the stage immediately after completion of the risk assessment phase consists of preparing a Risk Treatment Plan, which should document the decisions about how each of the identified risks should be handled. Mitigation of risks often means selection of security controls, which should be documented in a Statement of Applicability, which identifies which particular control objectives and controls from the standard have been selected, and why.

Implementation

Implementation follows all of the planned methods for mitigating the effect of the risks. Purchase insurance policies for the risks that have been decided to be transferred to an insurer, avoid all risks that can be avoided without sacrificing the entity's goals, reduce others, and retain the rest.

Review and evaluation of the plan

Initial risk management plans will never be perfect. Practice, experience, and actual loss results will necessitate changes in the plan and contribute information to allow possible different decisions to be made in dealing with the risks being faced. Risk analysis results and management plans should be updated periodically. There are two primary reasons for this:

1. to evaluate whether the previously selected security controls are still applicable and effective

2. to evaluate the possible risk level changes in the business environment. For example, information risks are a good example of rapidly changing business environment.

Limitations

Prioritizing the risk management processes too highly could keep an organization from ever completing a project or even getting started. This is especially true if other work is suspended until the risk management process is considered complete. It is also important to keep in mind the distinction between risk and

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uncertainty. Risk can be measured by impacts x probability. If risks are improperly assessed and prioritized, time can be wasted in dealing with risk of losses that are not likely to occur. Spending too much time assessing and managing unlikely risks can divert resources that could be used more profitably. Unlikely events do occur but if the risk is unlikely enough to occur it may be better to simply retain the risk and deal with the result if the loss does in fact occur. Qualitative risk assessment is subjective and lacks consistency. The primary justification for a formal risk assessment process is legal and bureaucratic.

Areas of risk management

As applied to corporate finance, risk management is the technique for measuring, monitoring and controlling the financial or operational risk on a firm's balance sheet. See value at risk. The Basel II framework breaks risks into market risk (price risk), credit risk and operational risk and also specifies methods for calculating capital requirements for each of these components.

Enterprise risk management

In enterprise risk management, a risk is defined as a possible event or circumstance that can have negative influences on the enterprise in question. Its impact can be on the very existence, the resources (human and capital), the products and services, or the customers of the enterprise, as well as external impacts on society, markets, or the environment. In a financial institution, enterprise risk management is normally thought of as the combination of credit risk, interest rate risk or asset liability management, market risk, and operational risk. In the more general case, every probable risk can have a pre-formulated plan to deal with its possible consequences (to ensure contingency if the risk becomes a liability). From the information above and the average cost per employee over time, or cost accrual ratio, a project manager can estimate:

Risk management activities as applied to project management

In project management, risk management includes the following activities:

Planning how risk will be managed in the particular project. Plans should include risk management tasks, responsibilities, activities and budget.

Assigning a risk officer – a team member other than a project manager who is responsible for foreseeing potential project problems. Typical characteristic of risk officer is a healthy skepticism.

Maintaining live project risk database. Each risk should have the following attributes: opening date, title, short description, probability and importance. Optionally a risk may have an assigned person responsible for its resolution and a date by which the risk must be resolved.

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Creating anonymous risk reporting channel. Each team member should have the possibility to report risks that he/she foresees in the project.

Preparing mitigation plans for risks that are chosen to be mitigated. The purpose of the mitigation plan is to describe how this particular risk will be handled – what, when, by whom and how will it be done to avoid it or minimize consequences if it becomes a liability.

Risk management for megaprojects

Megaprojects (sometimes also called "major programs") are extremely large-scale investment projects, typically costing more than US$1 billion per project. Megaprojects include bridges, tunnels, highways, railways, airports, seaports, power plants, dams, wastewater projects, coastal flood protection schemes, oil and natural gas extraction projects, public buildings, information technology systems, aerospace projects, and defence systems. Megaprojects have been shown to be particularly risky in terms of finance, safety, and social and environmental impacts. Risk management is therefore particularly pertinent for megaprojects and special methods and special education have been developed for such risk management.

Risk management regarding natural disasters

It is important to assess risk in regard to natural disasters like floods, earthquakes, and so on. Outcomes of natural disaster risk assessment are valuable when considering future repair costs, business interruption losses and other downtime, effects on the environment, insurance costs, and the proposed costs of reducing the risk. There are regular conferences in Davos to deal with integral risk management.

Risk management of information technology

Information technology is increasingly pervasive in modern life in every sector. IT risk is a risk related to information technology. This is a relatively new term due to an increasing awareness that information security is simply one facet of a multitude of risks that are relevant to IT and the real world processes it supports. A number of methodologies have been developed to deal with this kind of risk.

Positive Risk Management

Positive Risk Management is an approach that recognizes the importance of the human factor and of individual differences in propensity for risk taking. It draws from the work of a number of academics and professionals who have expressed concerns about scientific rigor of the wider risk management debate, or who have made a contribution emphasizing the human dimension of risk. Firstly, it recognizes that any object or situation can be rendered hazardous by the involvement of someone with an inappropriate disposition towards risk; whether

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too risk taking or too risk averse. Secondly, it recognizes that risk is an inevitable and ever present element throughout life: from conception through to the point at the end of life when we finally lose our personal battle with life threatening risk. Thirdly, it recognizes that every individual has a particular orientation towards risk; while at one extreme people may by nature be timid, anxious and fearful, others will be adventurous, impulsive and almost oblivious to danger. These differences are evident in the way we drive our cars, in our diets, in our relationships, in our careers. Finally, Positive Risk Management recognizes that risk taking is essential to all enterprise, creativity, heroism, education, scientific advance – in fact to any activity and all the initiatives that have contributed to our evolutionary success and civilization. It is worth noting how many enjoyable activities involve fear and willingly embrace risk taking.

Risk management and business continuity

Risk management is simply a practice of systematically selecting cost effective approaches for minimising the effect of threat realization to the organization. All risks can never be fully avoided or mitigated simply because of financial and practical limitations. Therefore all organizations have to accept some level of residual risks. Whereas risk management tends to be preemptive, business continuity planning (BCP) was invented to deal with the consequences of realised residual risks. The necessity to have BCP in place arises because even very unlikely events will occur if given enough time. Risk management and BCP are often mistakenly seen as rivals or overlapping practices. In fact these processes are so tightly tied together that such separation seems artificial. For example, the risk management process creates important inputs for the BCP (assets, impact assessments, cost estimates etc.). Risk management also proposes applicable controls for the observed risks. Therefore, risk management covers several areas that are vital for the BCP process. However, the BCP process goes beyond risk management's preemptive approach and assumes that the disaster will happen at some point.

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