FINANCE MODEL QUESTIONS AND ANSWERS

Prepared by Professor Sujoy Kumar Dhar.

Faculty Member,
IBS Kolkata.

1. What is the difference between Preference share and Equity share?

Ans. Preference shareholder enjoys preference in case of distribution of dividend

and repayment of capital when company goes on liquidation. All Preference
shares are redeemable in India. Preference share holder has no voting right and it
is not market traded. Therefore preference shareholders only can enjoy dividend
gain.
Equity share is not redeemable. Equity shareholders are owner of the company.
Equity shareholder has voting right in selection of board of directors of company.
Equity shares are market traded. Equity share holders will enjoy both dividend
and capital gain.

2. What is the difference between NPV and IRR ?

Ans. Net present value of a project is defined as excess of the sum total of present
value of future inflow over and above the current outflow. If NPV of the project is
positive, project is accepted. NPV follows additive rule. Multiple NPV is not
possible for a project. NPV aims to maximize the wealth of the firm.
Internal Rate of Return is the discounting rate for which sum total of
present value of future inflows will be equal to current outflow. If IRR is greater
than cost of capital, project is accepted. IRR does not follow additive rule.
Multiple IRR is possible if direction of cash flow of the project changes more than
once, so many times direction will be changed, so much number of IRR will be
there. IRR maximizes the return from the project.

3. What is the difference between forward and future?

Ans. Both forward and futures are derivative instrument. They are basically the
agreement between buyers and sellers to deliver a particular asset at a
predetermined future price at a predetermined future date. They are different due
to following aspects-
Forward is not market traded but future is market traded.
Default risk is high in forward but in future there is no default risk.
Forward is highly illiquid but liquidity of future is high.
Forward has no standardized format but future has standardized format.
No margin money is required for forward as there is no clearing house
between buyer and seller but both the buyer and seller has to deposit margin
money in future to the clearing house.

4. What is the difference between future and option?

Ans. Future is an agreement between buyers and sellers to deliver an instrument
at a particular predetermined price at a predetermined future date.
 Option is an agreement that gives the buyers right but no obligation to buy
or sell any instrument at a particular price within or on a predetermined future
date. Option seller is obliged to sell or buy the instrument when option buyer
exercises its option. Option seller is enjoying premium from option buyer. The
option that gives right to buy is called call option. The option that gives right to
sell is called put option.
In case of future , either trader has to take or make the delivery of the underlying
asset on the delivery date or they have to square off their position before the
maturity date. In case of option, buyer has the right but no obligation to exercise
the contract.
In future possible profit or loss can not be forecasted in advance unless and until
trader squares of its position. In case of option, for the buyer maximum possible
loss is limited to premium price.

5. What is the difference between systematic and unsystematic risk ?

Ans. Systematic risk implies that risk which will affect the share of all sectors.
Example of systematic risk is political risk, inflation risk, interest risk. Systematic
risk can be reduced by hedging.
Unsystematic risk is a sector specific risk which arises due to inefficient operation
of a particular sector. Example of unsystematic risk is Government regulation,
external risk, market risk, financial risk, corporate governance risk. If investor can
invest in different stocks of diversified nature, unsystematic risk can be reduced to
minimum.

6. What is the difference between CML and SML?

Ans. Capital Market Line(CML) shows linear relationship between portfolio risk
and portfolio return. Capital market line is efficient frontier when the individual
diversifies their investment into risk free and risky asset.
Security Market Line(SML) measures the required rate of return of an
individual security. Required rate of return of a security is risk free rate of return
plus risk premium multiplied by beta value of the security. If the expected return
form the security is greater than the required rate of return, the asset is under
priced or vice versa. Whether an asset is overpriced or under priced, it is
determined by SML. If the asset is plotted above SML, it is underpriced and if the
asset is plotted below SML , it is over priced.

7. What do you mean by hedger, speculator and arbitrageur?

Ans. Hedger wants to minimize their risk by adopting appropriating investment
strategy.
Speculator wants to maximize its gain by using their speculation power.
They are ready to take higher risk to get higher return.
Arbitrageur wants to earn risk less profit by taking the advantage of price
differentials.
8. What do you mean by Sensex and Nifty ?
Ans. Sensex is the index of Bombay Stock Exchange. It is the weighted average
of the price of 30 securities.
Nifty is the index of National Stock exchange. It is the weighted average of
the price of 50 securities.

9. What do you mean by beta value of a security? How it is calculated?

Ans. Beta value is the market sensitivity of a stock. It measures the change in the
market price of the security due to change in market index. Beta is the measure of
systematic risk.
Beta value of the stock is calculated by the formula
= Covariance between the return of market index and return of the particular stock
/variance of the market index

10. What is trading on Equity?

Ans. If return on capital employed of the firm is greater than cost of debt capital,
by relying more and more on debt capital, firm can raise its earning per share. It is
called trading on equity.

11. In future trading, how many types of margin an investor is required to keep?
Ans. There are three types of margin- initial margin, variation margin,
maintenance margin, that a future trader is required to keep. Both the buyer and
seller of the contract has to deposit a certain percentage (usually 10%) of total
value of the contract in the clearing house as initial margin. If any one of the party
makes default, clearing house will compensate the other party with the help of the
margin money.
Maintenance margin is the minimum necessary margin money that each party to
has to keep in their account. Since future is being traded daily, depending on
appreciation or depreciation of the market price of future margin will increase or
decrease.
If Margin money falls below the maintenance margin, party will get a call from
the clearing house to deposit the money so that his margin balance will increase to
initial margin level. This is known as variation margin.

12. What is the difference between Technical analysis and Fundamental

analysis?
Ans. According to Technical analysis market price of the stock is determined by
the free movement of market forces such as demand and supply. These demand
and supply are influence by both fundamental and psychological factors. The
bottom line is that barring few exceptions, stock prices are moving along a
 particular trend. Therefore future stock price trend can be determined from the
past movement of stock price. Stock price movement can be explained with the
help of graph and charts.
Fundamental analysis is used to determine the intrinsic value of the share. It
includes economic analysis, industry analysis and company analysis. Economic
analysis takes into account different factors such as GDP of the nation, Saving
and investment pattern, Money supply, inflation and interest rate, Union Budget,
balance of payment position etc. Industry analysis incorporates Porter’s five
factor model, Industry life cycle and nature of industry (Growth industry, cyclical
industry, defensive industry).
Company analysis includes analysis of liquidity, solvency, profitability position
of the company which will be followed by valuation of the company by
discounted cash flow method such as Dividend Discount Model, Free cash flow
to equity Model, Free cash flow to firm model etc. If the intrinsic value of the
stock is less than the market price, it is undervalued or vice versa.

13. What do you mean by weak, semi strong and strong form of efficiency in the
market?
Ans. Market efficiency means to which extent current information are
instantaneously reflected in the market price of the stock. Weak from of
efficiency implies that all the market participants have the information of past
period stock price. Therefore current period stock price is reflecting the past
period stock price. On the basis on past period stock price information, no body
can earn extraordinary profit in weak form efficient market. Autocorrelation test
and run tests are used to judge whether the market is following weak form
efficiency or not.
Semi strong form of efficiency implies market participants have
information about the past period stock price movement as well as all published
information about the company such as quarterly financial report, dividend
declaration, bonus issue, right issue, stock split, merger acquisition news etc. Thus
current stock price reflects previous period stock price as well as all publicly
available information. On the basis of information of past period stock price and
published information , no body can earn extraordinary profit if market is semi
strong efficient.
Strong form of efficiency implies market participants have the easy access
to both internal and published information about the company. Thus stock price
will reflect publicly available information as well as internal information . Insider
trading also not possible if market is strong form efficient.

14. What is Dow theory ?

Ans. According to Dow theory of Technical Analysis, stock price is moving along
a particular cyclical trend. Market is governed by primary trend, secondary trend
and day to day fluctuation. Primary trend shows the the long range cycle which
makes the entire market up or down. Secondary trend implies market correction
that restraints the movement of primary trend. Secondary trend moves in opposite
direction of primary trend. Day to Day fluctuation of stock price depends on
 sentiments of the people. Volume will also move along the primary trend. If
primary trend is bullish, volume will increase when share prices are going up and
volume will go down when share price decreases. On the contrary, if primary
trend is bearish, volume will increase when share prices are going down and
volume will fall when share prices are going up.

15. What is repo and reverse repo ?

Ans. Often commercial banks borrow from RBI by selling their securities with an
agreement to repurchase it after a certain period of time at a higher price . The
rate the commercial bank has to pay to RBI is called repo rate. In inflationary
period, RBI raises the repo rate. During the recession time, repo rate is reduced.
Current repo rate is 6%.
When RBI is borrowing from RBI, the commercial bank will receive the
interest from the borrowers. The rate commercial banks receive from the RBI is
known as the reverse repo. Current reverse repo rate is 5%. During the
inflationary period, reverse repo rate is also increased and vice versa.

16. What is covered call and naked call ?

Ans. A covered call strategy involves writing a call option on an asset along with
buying the asset. It is called covered position because potential obligation to
deliver the stock is covered by the underlying stock in portfolio.
A naked call strategy involves writing a call option on asset without buying
the asset. It is called naked position because potential obligation to deliver the
stock is not covered by the underlying stock in the portfolio.

17. What is in the money and out of the money call option ?
Ans. If buyer of the call option has a net cash inflow as because market price is
greater than the exercise price, it is In the Money call option.
If buyer of the call option has a net cash inflow as because market price is
less than the exercise price, it is On the Money Call Option.

18. What do you mean by protective put strategy ?

Ans. When an investor purchases an under priced stock with the anticipation that
its price will go up in the near future, there is a risk that due to market risk price
of the stock may fall. To hedge risk, they will purchase put option. It is known as
protective put.

19. What is the difference between the close ended and open ended mutual fund
scheme?
Ans. The subscription to a close ended scheme is kept open only for a limited
period. A close ended scheme does not allow investors to with draw funds as and
when they like. A close ended fund has a fixed maturity period.
The open ended scheme accepts funds from investors by offering its units on
a continuous basis. Open ended scheme permits investors to withdraw funds on a
continuing basis under a repurchase agreement. An open ended scheme has no
maturity period.
20. What is Systematic Investment plan and Systematic Withdrawal plan ?
Ans. Under Systematic Investment plan , the investor can invest regular sums of
money every month to buy units of a mutual fund scheme. As the investment is
made regularly, the investor buys more units when the price is low and less units
when the price is high. It implies SIP provides the opportunity of rupee cost
averaging to the investor.
Systematic Withdrawal plan allows the investor to withdraw a fixed amount
every month. The mutual fund sends the redemption proceeds to the investor
every month automatically. The investor can opt for a fixed sum every month or
a certain percentage of the capital appreciation in the NAV of the scheme.

21. What is Book Building Process?

Ans. Usually public companies go for Initial Public Offer with the help of Book
Building process. It is a method of offering share to the people where issue price
is not fixed in advance but is determined through a bidding process. In a book
building offer, price reflects revealed demand and contemporary market
conditions.

22. What is Circuit Filter/Circuit Breaker ?

Ans. Stock market volatility is generally a cause of concern for both policy maker
as well as investors. To curb excess volatility, SEBI has prescribed a system of
price bands .Price bands or circuit breakers bring about a coordinated trading halt
in all equity and equity derivative markets nation wide. An index based market
wide circuit breaker system at three stages of index movement either way at 10%,
15% and 20%has been prescribed. The breakers are triggered by movement of
either Nifty or Sensex whichever is beached earlier. As an additional measure of
safety, individual scrip wise price bands of 20% either way have been imposed for
all scrip. Therefore there is no reason of worry for individual investors.

23. What do you mean by Transaction, Translation and Operating Exposure ?

Ans. When a firm has a receivable or payable in a foreign currency, a change in

exchange rate will alter the amount of local currency received or paid. Such risk
exposure is referred as transaction exposure.

The law in many countries require that the account of foreign subsidiaries
and branches have to be consolidated with those of the parent company. For such
considerations, assets and liabilities expressed in foreign currencies have to be
translated into domestic currencies at the exchange rate prevailing on the
consolidation date. If the value of foreign currency changes between two
successive consolidation dates, translation gain or loss will arise.

The essence of Operating Exposure is that exchange rate changes significantly

alters the cost of a firm’s input and the price of its output and thereby influences
 the competitive position substantially. It is possible when manufacturing takes
place in one nation and selling takes place in another nation.

24. What is Global Depository Receipt ?

Ans. A depository receipt is a negotiable certificate that usually presents a
company’s publicly traded equity or debt. Depository receipts are created when a
broker purchases the company’s share on the home stock market and deliver those
to the depositories local custodian bank which then instructs the depository bank
to issue a depository receipt. Depository receipts are quoted and traded in the
country in which they trade and are governed by trading and settlement procedure
of the market. All the depository receipts including GDR are essentially equity
instrument created or issued abroad, not by the companies but by the oversea
depositories bank which are authorized by the company in say India to issue them
to non resident investors against their shares. These shares are physically held
by domestic custodian banks nominated or appointed by Overseas Depositories
Banks(ODB). In the company’s book the ODBs’ name appear as the holder of
their shares.

25. What is difference between European an American option ?

Ans. A European option can be exercised only on the expiration date whereas an
American option can be exercised on or before the expiration date. Therefore
American option offers much flexibility than European option.

26. Mention some names of Credit Rating Agencies.

Ans. In India, the Credit Rating Information Services Limited CRISIL),
Investment Information and Credit Rating Agency(ICRA) and Credit Analysis
and Research Limited(CARE) provide bond and other debt rating.

27. What are the instruments in Money Market ?

Ans. Money market is a mechanism when fund can be borrowed or lent for short
term that is less than one year. The instruments in the Money Market is Call
Money, Notice Money, Treasury Bill, Bills of Exchange , Commercial bill,
Certificate of Deposits and Repo and Reverse Repo rate.

28. What is Short Selling ?

Ans. Often investors sells the shares of a company in the first half of the day
when they do not have the ownership of the share . This is known as short selling
which takes place specifically in intraday activity where traders have to buy the
shares in the second half of the day. They anticipate that price will go down in the
second half of the day. If their speculation is correct, they will earn lucrative profit.
On the contrary, if speculation goes wrong, they have to incur loss.

29. What is straddle?

Ans. When investor is feeling that there will be a big suing in the market, but he is
uncertain that it will take place in which direction, he uses the strategy known as
 straddle. Straddle is a strategy to purchase/sell a call and a put option simultaneously
with same exercise price and same expiration date. Long straddle is used when it is
expected that spot price will move to the either direction from the exercise price. Short
straddle is used when stock price is expected to be very close with exercise price.

30. Explain the concept of Bull Spread and Bear Spread strategy.
Ans. If investor perceives that there will be bullish trend in the market but he is not
very sure about it, he uses Bull spread strategy. Here investor buys one call option and
sells another call option with same expiration date but with different exercise price.
Investor purchases that call option whose exercise price is below than the spot price and
sells that call option whose exercise price is greater than the spot price. Profit will be
maximized if the spot price is above than out the money call option. Loss will be
maximum if the spot price is below the in the money call option. Bear spread strategy
is used when investor anticipates there will be bearish trend in the market but he is not
certain about the intensity of it. Here investor buys a call option whose exercise price is
higher than spot price and sells a call option whose exercise price is less than spot price.
Profit will be maximized if spot price falls below the exercise price of in the money of
the call option and loss will be maximized when spot price is above the exercise price
of out the money call option.

31. What is Butterfly strategy?

Ans. Another popular strategy is called butterfly strategy .In long butterfly, investor
purchases two extreme call options and sell 2 units of intermediate call options. For
example if there are 3 call options A, B, C whose exercise price are Rs.100,150,200
respectively, in long butterfly investor will buy A and C and sell 2 units of B. In long
butterfly, profit will be maximized if spot price comes close to the exercise price of B.
in short butterfly, investor will sell A and C and buy 2 units of B. In short butterfly,
profit will be maximized if spot price becomes either below the exercise price of A or
above the exercise price of B.

32. Define Decision Tree and its uses

Ans. Concept of decision tree is widely used in investment analysis. Decision tree is
graphical method for identifying alternative actions, estimating probabilities and
indicating the resulting payoff. A decision tree is basically used to make decisions in
complex situations when outcome of a later situation is dependent on the outcome of the
former. By incorporating the probabilities of various investment possibilities in the
decision tree, it is possible to comprehend the true probability of a decision leading to
results desired. A basic value of decision tree lies in expressing all outcomes or events in
quantitative terms which provide precision in decision making.

33. How liquidity position of a company is judged ?

Ans. To conclude regarding the firm’s liquidity position, concept of ratio analysis
is to be taken into account. a) Current ratio= Current asset/Current liability
Current assets are those assets which can be converted into cash within one
year without any diminution in value such as cash in hand, cash in bank,
 sundry debtors, bills receivables, stocks, prepaid expenses etc. Current
liability is the expenses those are to be incurred within one year such as bills
payable, sundry creditors, outstanding expenses, provision for taxation,
provision for depreciation and proposed dividend etc. The ideal current ratio
is 2 so that each rupee of current liability should be backed by 2 rupee of
current asset.
b) Quick ratio= Quick ratio is the ratio of quick asset to quick liability. It is
defined as current asset- stock/ current liability- bank overdraft.
Sometimes it happens that current ratio is high but quick ratio is low. It
shows majority of the current assets are in the form of stocks where there is
no guarantee whether company will be able to offload the stock within one
year or not. Higher quick ratio stands for sound liquidity position of the
company. Company has consolidated its position in such way, that there is
no chance of payment default to the suppliers and creditors.

34. How solvency position of a company is judged ?

Ans. Whenever an investor is willing to invest in a stock, at first the solvency
aspect of the company is to be judged.
a) Debt Equity ratio= Debt equity ratio is an indicator of long term solvency
position of the firm.
Debt Equity ratio= Long term debt/shareholder’s fund
Long term debt includes long term loan from bank or financial institution, bond
and debenture. Shareholder’s fund= equity capital+ preference share capital+
reserve and surplus-fictitious asset if any .If firm has lower debt equity ratio, it
implies that firm is depending more and more on equity capital instead of debt
capital. So investor’s fund is almost safe. On the contrary if debt equity ratio is
high, there is a risk of insolvency as the firm relying more and more on debt
capital.

b) Proprietary ratio= By definition, Proprietary ratio=

Shareholder’s/proprietor’s fund
Total asset
If proprietary ratio of the firm is high, it interprets that long term solvency
position of the firm is good. Majority of the assets are financed by
shareholder’s fund. Low proprietary ratio presents just reverse scenario
that firm has a lot of debt burden.

35. What do you mean by Efficiency or Turn Over analysis of a firm ?

Ans. This describes the degree of efficiency in utilization of various assets deployed inthe
firm.
a) Inventory turn over ratio= Inventory turn over ratio is defined cost of goods
sold/average inventory.

Average inventory holding period= 365/Inventory turn over

Inventory turnover throws light at the degree of efficiency in inventory management. A
high inventory turnover ratio is the indicator of sound inventory management. A low
inventory turnover ratio implies excessive inventory levels than warranted by volume of
operation. A high level of idle or obsolete inventory means blockage or loss of capital. A
very high inventory turn over ratio should be examined cautiously. It may be due to
maintaining an inadequate level of inventory which may cause frequent stock out.

b) Debtors turn over ratio =It is defined as Credit sales/ average receivables.
Average collection period= 365/debtors turn over ratio
Higher debtor turn over ratio means shorter average collection period. It
indicates efficiency in collection of debt. Debtors are not allowed to linger their
payment.
Lower debt turn over ratio means longer average collection period. This reflects
inefficiency in collection of debt. It may result the bad debt which may erode
profitability.
c) Creditors turnover ratio= It is explained as
Annual Credit purchase/Average payable.

Average payment period=365/creditors turn over ratio. A low credit turn over ratio is
apparently favourable as in that case firm enjoys lengthy credit period. Strain on working
capital is low. High credit turn over ratio indicates firm is to pay its suppliers
immediately after purchase.

36. How profitability position of a firm is judged ?

• Ans. Vital parameter to measure the success of the
company is its profitability. Usually profit is defined as the difference between
total revenue and total cost. There are several measurements of profitability-
a) Gross profit margin=Gross profit is nothing but
excess of sales over and above the cost of goods sold. Gross profit margin =
gross profit/sales x100.
If gross profit margin of a firm is high it indicates that firm has achieved
excellence in curtailing the production/manufacturing cost.
b) Net profit margin = Net profit is nothing but post tax
profit of the company.Net profit=operating income+ income from other sources-
depreciation-interest-tax.Net profit margin = net profit/sales x 100 .If net profit
margin of a firm is high it implies that the firm is able to cope with all
unfavorable circumstances whatever may take place in near future such as fall
in the price of the product, emergence of substitutes, difficulty of obtaining raw
materials etc. If gross profit margin is high but net profit margin is low, it
implies though firm has attained efficiency in manufacturing but due to higher
office and administrative expense, its net profit is not up to the mark.
c) Return on equity=The most important indicator of
financial performance , the Return on Equity(ROE) is defined as
ROE= PBIT/sales x sales/assets x PBT/PBIT x PAT/PBT x asset/net worth
ROE=PBIT efficiency x asset turnover x interest burden x tax burden x leverage
 In simple version Return on Equity is interpreted as
PAT/Net worth.
Net worth of a company is Equity capital +Preference capital + Reserve and
surplus- fictitious assets if any.
If return on equity is high, it shows stock performance of the company is very
good.
Earning per share=Earning per share is the ratio of firm’s total earnings, net taxes
minus preference dividend over the number of equity shares. It is desirable that a
company should have a higher EPS. Then the stock of the company will be lucrative
option for the investor

37. What do you mean by Operating Leverage and Financial Leverage?

Ans. Leverage analysis of firm is also very vital to get an idea about the firm.

a) Operating Leverage= Operating leverage measures

disproportionate change in profit due to proportionate change in sales. Degree of
Operating Leverage(DOL) is defined as contribution/ contribution-fixed cost. If
fixed cost of a firm is higher, its DOL will be higher. Break even point of output
will be higher. The firm will be in a risky position. There is a risk that due to
reduction of small amount of sale, profit will be reduced to large extent.
Higher DOL is preferable when demand for the product or service of the firm is
more or less stable.
b) Financial leverage= Financial leverage measures
disproportionate change in earning per share due to proportionate change in profit.
Degree of Financial leverage(DFL) is defined as Profit Before Interest and
Tax(PBIT)/Profit Before Tax(PBT).DFL=PBIT/PBIT-I. If interest burden of a
firm is high, DFL will be higher. When firm depends more and more on
borrowed capital, firm will be in risky position because due to higher DFL there is
a risk that earning per share will fall to a larger extent when profit falls.
Higher financial leverage is favourable if the return on capital employed is higher
than the cost of raising capital. In this case, by relying more and more on debt
capital, earning per share can be enhanced which is known as Trading on Equity.

38. What is Random Walk Theory ?

Ans. Random Walk theory implies that stock price of today has no influence on stock
price of tomorrow. Change in stock price occurs if there is a change in economy,
industry or company. That information is immediately and instantaneously reflected
in the stock price. Therefore movement of stock price is at random rather than in a
predicted pattern.

39. Mention some methods of capital budgeting where risk and uncertainty is
incorporated.
Ans. Some methods of capital budgeting with risk and uncertainty is
• Risk Adjusted Discount Rate
• Certainty Equivalent method
• Sensitivity Analysis
 • Decision Tree approach

40. What do you mean by intangible assets & fictitious asset ?

Ans. Intangible assets are those assets which are created through time and effort but
they are not physically measurable. Intangible assets are of two type’s such as official
asset and fictitious asset .The example of official assets are patent, copy right. These
are intellectual property right that the innovator of a new product, process, concept
enjoys. Paten and copy right has finite period of life. Over the life company has to
write off them.
Fictitious assets are those which have monetary value without backed by any physical
asset. For example- externally generated goodwill. When one company acquires
another company, the excess of face value acquirer company pays to the target
company for its each share multiplied by number of outstanding shares of the target
company is known as externally generated good will for the acquirer company and it
will be shown as the asset side of the balance sheet. In case of fictitious assets, they
have to be written off at a higher rate.
There are some items which are placed in the asset side of balance sheet in
accounting sense but they can not be considered as the asset of the company logically.
If a company incurs loss, it will be shown in the asset side of the balance sheet though
loss is not an asset for a company. Preliminary expense and discount on issue of
shares are also example of fictitious asset.

41. What is the difference between Free Cash Flow to Equity and Free Cash
Flow to Firm concept?
Ans. FCFE model is used as a modern equity valuation approach. It shows the free
cash flow available to equity shareholder after meeting all expenses.
FCFE= Net Income- ( Capital expenditure- Depreciation- amortization )-Change in
non cash working capital +Net cash inflow from debt issue.
Net Income= Profit After tax
Current Market price of the share= FCFE1/(r-g)
FCFE1= Free cash flow equity shareholder after 1 year.
r= cost of equity (determined by CAPM model)
r= risk free rate of return + Beta value x risk premium
g= expected growth rate
Reinvestment rate calculation is done on the basis of FCFE model. In case of equity
valuation, Growth rate = Reinvestment rate x return on Equity
Reinvestment rate= (Capital expenditure – depreciation- amortization + change in
non cash WC – debt issue+ debt redemption)/ Net Income
Return on Equity= PAT/Net worth
FCFF model shows cash flow available to the members of the firm that is both debt
and equity holder.
FCFF= PBIT(1-t) + R(1-t) + Depreciation+ Amortization- Capital expenditure –
change in non cash working capital
R = Interest payment by the company to creditor
g= ROCE x Reinvestment rate
ROCE= PBIT (1-t)/ ( book value of debt + book value of equity)
Reinvestment rate= Capital expenditure – depreciation- amortization + Change in
Non cash working capital/ [ PBIT (1-t) + R(1-t)]
Current price of the market share= FCFF1 /(k-g)
K= weighted average cost of capital
= (Book value of debt/ Book value) x cost of debt + (Book value of equity/ Book
value ) x cost of equity

42. Compare between EVA and MVA .

Ans. EVA is the Economic Value Added which is considered as a performance
evaluation for the company. EVA can be computed by two methods – Residual
Income method and Refined Earning method.
According to Residual Income Method,
EVA= {(NOPLAT/Total capital)-WACC}x total capital
NOPLAT=Net Operating Profit Less Adjusted Tax
WACC=Weighted Average Cost of Capital
WACC= (Book Value of debt/Total book value)x cost of debt x (1-t) + (Book value
of Equity/ total book value)x cost of equity
According to refined earning method, EVA is calculated as
EVA= ( sales- operating expense)- WACC x net assets

If EVA of a company is positive, it implies return earned from investment is greater

than cost of capital. Therefore if sales is increased by 1 Rs, it will able to enhance
EPS. When EVA is negative, even if sales increased by Rs1, it will deteriorate the
EPS.
EVA is better financial indicator for the financial organization because
• It takes into account only operating profit.
• For computation of EVA, WACC is taken into consideration where both cost
of equity and cost of debt are included.
MVA is market value added which is defined as
MVA= Market value of equity-( Book value of debt+ Book Value of Preference
Share+ Book Value of equity)
MVA of a company is the sum total of present value of future EVA.
MVA= EVA1/(1+WACC) + EVA2/(1+WACC)2+ EVA3/(1+WACC)3+-------EVAn/
(1+WACC)n
If MVA of a company is positive , it implies company’s performance is satisfactory.
Otherwise investors will think twice before investing in that company.

43. What is hedge fund?

Ans. Hedge fund is a new concept which is different from mutual fund where in case
mutual fund , mutual fund company has to provide quarterly statement to the
investors, to specify the area where the investor’s fund has been invested in which
proportion but in former case they don’t reveal their investment pattern. Provision of
 hedge fund is mainly enjoyed by high Net worth Individual and hedge fund company
charge both management fee as well as performance fee simultaneously. The
excellence of Hedge fund is that it reduces the systematic risk or market risk of the
investment. As a result both return and risk will moderate rather than abnormally
high. Generally the strategy adopted by Hedge fund company that they
simultaneously invest in under priced stock as well as they are involved in short
selling of the asset. When Market becomes bullish, profit is derived from under
priced stock but loss will be incurred from short selling. So loss from short selling is
counter balanced by gain from investment in under priced stock. On the contrary
when market becomes bearish , profit is earned from short selling but there is a loss
from under priced stock investment. Loss from investment in under priced stock is
balanced by profit from short selling. In both the cases systematic risk has been
hedged.

44. What do you mean by sinking fund factor and capital recovery factor?
Ans. If a certain amount of fund(Y) is to be realized after certain period of
time(n), what equal amount(X) should be invested at the end of every year- that is
determined by sinking fund factor.
X x FVIFA( r%, n year) = Y
Or X= Y x 1/FVIFA(r%, n year)=Y x sinking fund factor
Sinking fund factor is reciprocal of FVIFA.

If an investor invests a certain amount of fund(Y) in a project in the current period

and willing to realize the fund within a certain period of time that is (n years), the
equal amount of inflow (X)that project is expected to generate- that is determined
by capital recovery factor.
Xx PVIFA(r%, n year)= Y
Or X = Yx 1/ PVIFA(r%, n year) = Y x Capital recovery factor
Capital recovery factor is the reciprocal of PVIFA.

45. What is BASEL II and how it is different from BASEL I ?

Ans. According to Basel I, all the banks are advised to main capital adequacy ratio at
least 8%. Capital adequacy ratio= (Tier I capital + Tier II capital)/ risk weighted asset.

Tier I capital includes equity capital and reserve & surplus. Tier II capital includes hidden
reserve, revaluation reserve, hybrid instruments, subordinated debt etc.

RBI has instructed all Indian Commercial banks to hold capital adequacy ratio at least
9%.

Basel II is the second of the Basel Accords, which are recommendations on banking
laws and regulations issued by the Basel Committee on Banking Supervision. The
purpose of Basel II, which was initially published in June 2004, is to create an
international standard that banking regulators can use when creating regulations about
how much capital banks need to put aside to guard against the types of financial and
operational risks banks face. Advocates of Basel II believe that such an international
standard can help to protect the international financial system from the types of problems
that might arise due to a major bank or a series of banks collapse. In practice, Basel II
attempts to accomplish this by setting up rigorous risk and capital management
requirements designed to ensure that a bank holds capital reserves appropriate to the risk
the bank exposes itself to through its lending and investment practices. Generally
speaking, these rules mean that the greater risk to which the bank is exposed, the greater
the amount of capital the bank needs to hold to safeguard its solvency and overall
economic stability.

The three main pillar of Basel II is

1. Considering Market risk and operation risk apart from credit risk
2. Minimum capital requirement depending on credit rating
3. Continuous disclosure to the market .

46. What is securitisation and subprime crysis?

Ans. Usually commercial Banks provide loan to the borrowes depending on their
credit history and financial capability.If a person’s credit history is poor or he has the
irregularity in income, he is not eligible to get the loan. But specifically in USA, some
financial institutes take loan from the banks in prime lending rate and they are
providing the loan comparatively poorer section at a higher rate for example
PLR+2%.This rate that a sub prime borrower has to pay is known as sub prime
rate.After that the institution, immediately hedge their risk by selling the loan as a
debt security to the Institutional Investors where those Institutional Investors are
entitled to received Equated monthly installment.this is known as securtisation by
which adequate liquidity can be provided to mortgage market of illuquid asset
simultanously hedging can be done against default risk.
The cash realised by this way is immediately paid to the Bank. When market interest
goes up, PLR+2% will also go up.So borrowers make default in payment .Then
Institutional investors make lien on the real estate property and try to sell it.As a
result selling pressure in market has gone up, real estate price started to fall
rapidly,.Therefore institutional Investor started to suffer from liquidity crysis.this is
known as subprime crysis. But intermediate financial institution contnued their credit
creation process as their credit history is always good as they are paying timely to the
banks.Sometimes they are intentionally inflating the borrowers level of income so
that Institutional Investors will be motivated to purchase the debt security. This will
further worsening the situation.
 47 What do you mean by alpha value of an asset?
Ans. Alpha value of an asset implies risk free rate of return from risky security. Alpha
value can be determined with the help of characteristic line. Characteristic line shows
the relationship between stock price movement and the market index movement.
The equation of the characteristic line can be expressed as
Y= alpha + Beta X
Y= Return from the particular stock
X= Return form the market index
If alpha value of the stock is positive, it is underpriced or vice versa.

48. What do you mean by ASBA ?

Ans. ASBA is Application Supported by Blocked Amount. It is a better way of
applying for an IPO or FPO by simply blocking the fund in the bank account. In
this case, the person will continue to earn interest on the amount. The only
constraint is that, they can not withdraw the fund from the account. Amount will
be debited only if share is allotted to the individual. If the person is not allotted
the share, automatically fund will be block free. ASBA is designed by SEBI to
protect the Investor’s interest who are willing to apply for IPO but not at the
expense of interest income loss.

49. What do you mean by inflation and its measurement?

Ans. Inflation is the sustained rise in price. In other words inflation
implies excess of money supply over and above the available goods and
services in the economy.
Inflation can be measured by WPI ( Wholesale Price Index Number) or
CPI ( Consumer Price Index Number).
In WPI, significant weight is given to manufactured article.
In CPI, it incorporates a basket of goods which consumers are usually use
and significant weight is given to food articles.
The Government on 14th September,2010 came out with a new Wholesale
Price Index (WPI) series that measured inflation in August 2010 is 8.5%
although in older system it was 9.5%.
The new inflation computation method with 2004-05 as base year has
more 241 items than the old series with base year 1993-94 as the base year
which only reflected the price rise in 435 articles.
Edible and non edible items widely used by middle class people like ice
cream, mineral water, microwave ovens, washing machines, gold, silver
are reflected in new WPI series.

50. What do you mean by Balance of Payment of a nation?

Ans. BOP is defined as systematic record of financial transactions with the
residents of the member country and the residents of rest of world for a
particular period of time. Balance of payment has two types of
transactions- Autonomous transaction and accommodating transaction.
Autonomous transactions includes all the transactions which are taking
place for the sake of business for example current account and capital
 account transaction. BOP is computed as a double entry accounting
system. Any transaction which creates demand for home currency will be
placed in credit side, any transaction which creates supply of home
currency will be placed in supply side. Any transaction which is used as a
source of fund is placed in credit side and any transaction which is used as
application of fund is placed in debit side. Current account transaction
includes export and import of goods and services and unilateral payment.
Export of goods and service will be posited in credit side and import of
goods and services will be posited in debit side. If credit side of current
account is greater that the debit side of current account, nation has current
account surplus.
Capital account transaction includes inflow and outflow of FDI and FII.
Inflow of FDI and FII is posited in credit side of BOP and outflow of FDI
and FII is posited in debit side of BOP. If credit side in capital account is
greater than debit side of the capital account, nation has capital account
surplus.
If the sum total of credit side of current and capital account is greater than
the sum total of debit side of current and capital account, nation is said to
have a BOP surplus.
Accommodating transaction are those transactions which are taking place
to make the balance of payment always balanced. For example – change if
foreign exchange reserve, change in gold reserve etc.
India is always a current account deficit nation as its value of import is
always higher than value of export. But due to being an emerging
economy, India is the popular destiny of FDI and FII. Therefore Capital
account of India remains always surplus to a such extent that it more than
offset the current account deficit of the nation.( barring the time of global
recession in 2008-09, due to huge withdrawal of funds by FII from Indian
capital market, Capital account balance became adverse).

51. What do you mean by consolidated balance sheet of a company?

Ans. When the asset and liability of the holding company as well as all of its
subsidiaries are expressed in the currency of the parent company, it is known
as consolidated balance sheet of the holding company.
Characteristics of holding company is given as below-
a) Good will or capital reserve has to be mentioned.
b) Minority interest has to be mentioned.
c) Adjustment of common debtor and common creditor has to be maintained.

52. Distinguish between reserve and provision of the company.

Ans. It is a known fact that there will be depreciation of the fixed asset of the
company such as plant & machinery, building, furniture’s etc. Similarly a
certain portion of credit sales of the organization will never be realized which
will become bad debt. Therefore company makes provision for depreciation
and bad debt in the profit and loss account and they are charged in the debit
side of the P/L a/c so that net profit can be reduced and company has to pay
 lower corporate profit tax. Provision can be made for proposed dividend
payment to the shareholder also.

When company earns profit certain amount will be paid to the shareholder a
dividend and remaining amount will be kept as reserve and surplus. Reserves
are of two types- revenue reserve and capital reserve. Revenue reserve
includes reserve for bad debt and reserve for depreciation. Capital reserve
includes capital redemption reserve, share premium account, dividend
equalization reserve.

53. Distinguish between Indian GAAP & USA GAAP .

India USA
Indian GAAP allows deferred revenue USA GAAP does not allow it.
expenditure.
Related party transaction is strictly USA GAAP is liberal in related party
prohibited in India. transaction
Emphasis is given on consolidation norm USA GAAP is more focused on minority
where goodwill or capital reserve has to be interest.
specified.

54. Among inflation and deflation which do you prefer & why?
Ans. Inflation is sustained rise in price which reduces the purchasing power of
money. But despite of its evils, a mild doze of inflation should be injected in
the body of economy because it stimulates aggregate demand. If demand is
higher, price will go up. Producer will be willing to supply more to boo higher
profit. As a result demand for factors will go up and employment goes up. All
economic variable such as output, employment, income will go up.

Deflation means sustained fall in price. As price goes down, producer reduces
production. Demand for factors will go down. Unemployment will go up.
Demand goes down further. Again price moves in the downward direction.
Therefore all variables such as output, price, employment will move in
downward spiral.

Therefore inflation is bad but recession is worst.

55. Distinguish between financial lease & Operating lease.

Ans. A financial lease is structured to include the following characteristics-
• The lessee selects the equipment according to his requirement from
manufacturer or distributor
• The lessee negotiates and settles with the manufacturer or distributor
the price, delivery schedule, installation, maintenance etc
• Financial lease may provide the right or option to the lessee to
purchase the equipment at a future date.
 • The lease period spreads over the expected economic life of the
asset.
• The responsibility of suitability of the equipment, the risk of
obsolesces and liability for repair, maintenance, insurance of the
equipment rests with lessee.
A operating lease is structured as
• Operating lease is generally for a period shorter than the
economic life of the leased asset.
• Operating lease normally includes maintenance clause requiring
the lesser to maintain the leased asset.

56. Distinguish between lease and hire purchase.

Lease Hire purchase
The lessor is the owner and lessee is Ownership of the asset passes on to the
entitled to the economic use of the asset. hirer in case of hire purchase on payment
of last installment.
The depreciation of the asset is charged on Hirer is entitled for depreciation shield.
the book of lessor.
Cost of maintenance is borne by lessee in Cost of maintenance is borne by hirer.
case of financial lease and cost of
maintenance is borne by lesser in case of
operating lease.
Lessor is allowed to claim tax shield on Hirer is allowed to claim tax shield on
depreciation and lessee is entitled to claim depreciation of the asset
tax benefit on lease rental.

57. Distinguish between devaluation and depreciation.

Ans. Devaluation is reduction of the value of home currency in terms of
foreign currency. It is a policy measure to encourage export and discourage
import. The devaluation concept is applicable in fixed exchange rate regime.

Depreciation is also reduction of home currency in terms of foreign currency

but it is applicable in case of flexible exchange rate. In flexible exchange
rate, rate is determined by demand and supply force of the market. There is no
intervention from the Government. Currency with higher inflation rate will
depreciate. It is known as Purchasing Power Parity(PPP) theory. Currency
with higher interest rate will depreciate. It is known as Interest Rate Parity
theory (IRP).

58. What is FMC ?

Ans. The Union cabinet on 17th September 2010 approved long pending
amendment to the Forward Contract (Regulation) Act and it will go for
seeking Parliamentary approval to make the Forward Market Commission, an
independent regulator and allow them to launch option in the commodity
market among a host of other changes. Commodity market regulator is finally
get SEBI like status and power. FMC will be at par with SEBI, both regulator
are likely to get place on each other’s board. It paves the way for commodity
based exchange traded fund, trading on indices and weather based product.
Future and option together will give better liquidity in the market. Farmer’s
participation will increase through option route because they would not only
become insurance in case market goes down but it will give the opportunity to
the farmers to capture best possible price in case of a market rally.

59. What do you mean by FRBM act?

Ans: Fiscal Responsibility & Budget Management Act was passed In
parliament in the year 2003 where it was clearly mentioned that by the
financial year 2009-10, there will be no revenue deficit and fiscal deficit will
be limited to 3.5% of GDP at most.
Revenue payment includes expenditure on salary, interest, subsidy and
defense. Revenue receipt includes tax and not tax revenue. Tax revenue
includes direct tax like income tax and indirect tax includes excise duty,
custom duty, sales tax etc. non tax revenue includes earing from Indian
Railway, Indian Airlines and fee from selling licenses and earning of dividend
from all PSUs.
Capital payment includes expenditure to be incurred to construct or upgrade
the infrastructure like road, highway, hospital, universities etc. Capital receipt
includes public debt, recovery from loan and advances by RBI and
disinvestment proceed. Public debt are of two types- external debt such as
External Commercial Borrowing (ECB) or FCCB ( Foreign Currency
Convertible Bonds) and Internal debt that is collection of fund from domestic
market by issuing treasury bills etc.
When sum total of revenue payment and capital payment exceeds sum total of
revenue income and capital income, Fiscal deficit takes place.
In 2009 after the general election when UPA-II Government came into power,
Finance Minister Mr. Pranab Mukherjee tabled the budget where Fiscal deficit
was excessively high 6.8% of GDP which directly violated FRBM act.
Fiscal deficit was excessively high due to
a) Release of Sixth Pay commission which gives a huge hike to
Central Government Employee
b) Redemption of Rs 170 thousand crore farm loan
c) Huge investment in social infrastructural sector for employment
generation
d) Declaration of bailout package for recession hit sectors.

60. Mention the key features of Union budget placed by Honourable

Finance Minister Mr. Pranab Mukherjee for the financial year 2010-
11.
Ans. The main emphasis of the union budget for 2010-11 is as follows –
a) Income tax exemption has been increased.
Upto income Rs 1,60000 per annum for a male , no tax will be
paid.
Rs 1,60000-Rs 500000- 10% per annum
 Rs 500000-Rs 800000-20% per annum
More than 800000- 30% per annum
For female, upto 1,90000 per annum , no tax will be paid.
For senior citizen, upto Rs 240000 per annum, no tax will be paid.
Another Rs 100000 can be saved, if individual invests in PPF,
ELSS, Employee provided fund, LIC premium, NSC etc.
Additional Rs 200000 will be exempted if person invests in
infrastructural bond.

b) Huge disinvestment target of PSU of Rs 400 billion is taken to

meet the fiscal deficit.
c) Financial inclusion is a major focus area of the budget. By 2012,
target has been taken to provide the banking service to all villages
where population is more than 2000.
d) Rs 16500 crore is proposed to be injected to the PSU banks to
increase their tier I capital to 8% by March 31,2011.
e) Partial rollback of fiscal stimulus given by Government during the
recession time was done by increasing excise duty from 8% to
10% and enhancing Minimum Alternate Tax from 15% to 18%.
f) Budget has given more importance to agricultural sector where
strategies were taken to increase the agricultural productivity by
extending another green revolution in Bengal, Bihar, Jharkhand ,
Eastern UP ; reduction in wastage of agricultural products &
implements; Extending credit Support to farmers and providing
thrust to food processing sectors.

61. After abolition of entry load in mutual fund scheme, what was the immediate
impact?

Ans. It was August 2009 that SEBI banned Entry loads for mutual fund investments.
A year down the line , the mutual fund industry is yet to fully come to terms with
changes which have transformed the industry. Before the SEBI regulation came into
force , an entry load or an upfront commission of close to 2.25% on the amount
invested was charged by the fund houses from investors.
MF housed used to pay commission to distributors in lieu of their services in reaching
out , marketing and selling MF products to the investor from the amount collected
through entry loads. As the commission amount was automatically deducted from the
principal amount of investment, few investors were aware of the fact that their initial
investment would get automatically reduced by about 2.5% and that only the balance
97.5% was getting invested into the scheme
Those who were aware of it would demand that their distributors repay a part of such
commission usually 1 to 1.5% to them in cash. It was to curb this very practice and to
make MF investments more transparent and customer friendly that SEBI introduced
the no load regime last year, where the onus of collecting a fee from the investor fell
on the distributor alone. Today any investor seeking to buy an mutual fund through
distributor has to mutually agree upon the commission payable to a distributor for his
 services. While the intention of the regulator were well meaning, the industry is yet
to reconcile itself to the changes which have been carried out.
The no load regime has forced many small distributors to shut shop, since convincing
an investor to pay money for services rendered while investing in a financial product
such as an MF is not easy.For investors having long been used to getting a part of
their investment as cash back from the distributor , it will take a while for them to get
used to this new regime. Compared to the collections of nearly Rs 30000 to 40000
crore in the years 2006& 2007, the year 2010 has so far witnessed collections of just
about Rs 2000 crore through the sale of NFO.
These collections are worse considering that even during the financial meltdown of
2008, new launches had managed to collect close to Rs 15000 crore.
Many independent distributors offer their service free of charges to their investors.
Their only source of income is the commission paid to them by the MF houses.

62. In recent time, it has been seen two market regulatory body
were involved in conflict : the issue became so serious that matter reached to
Supreme Court- Can you focus some light on it.
Ans. After abolition of entry load in mutual fund schemes, SEBI Instructed for stop
issuing ULIP to all insurance players as premium collected from ULIP are invested
in to the market , therefore SEBI wants to control and regulate the ULIP to protect
the investor’s interest. But IRDA did not take it positive spirit, as ULIP is Unit linked
Insurance Product , therefore IRDA has the supreme authority in issuing ULIP and
IRDA perceived that SEBI is unnecessarily encroaching into their area of
autonomy. The matter went to Supreme court. Supreme court gave the verdict, IRDA
will control ULIP since it is an insurance product but it issued certain guidelines.

Soon all insurance companies will withdraw most of their unit linked insurance plans
and will issuing a new set of such policies.This is in response to ULIP guidelines
issued by IRDA on June 28,2010.
Immediate fall out of latest ULIP guidelines could be that Insurance companies may
tend to go slow on issuing pension plans. The regulator has introduced a minimum
guaranteed return 4.5% on Unit Linked Pension Products . This is to protect lifetime
savings of pensioners and to differentiate pension from other investment products.
A guarantee of minimum return would make it difficult for issuers to invest pension
funds in riskier financial securities. Equities offer superior long term investment return
but not without a risk of loss of capital. Insurance companies will face dilemma while
issuing pension plan with a guaranteed return. Industry observers feel that there will be
very few such pension plans that will be on offer after September,2010. These charges
will be applicable when a policy holder surrenders the policy before the predetermined
lock in period. Another major step taken by IRDA was the standardization of surrender
charges. Earlier in case of policy surrender, the Return on Investment was dependent on
the discretion of the insurers.
3. Distinguish between TRIP & TRIM.
Ans. Trade Related Investment Measures (TRIM) refers to certain conditions or
restrictions imposed by a Government in respect of foreign investment in the country.
TRIMs were widely employed in developing countries.
An agreement on TRIMs provide that no contracting party shall apply any TRIM
which is inconsistent with the WTO articles .An illustrative list identifies that following
TRIMs are inconsistent.
a) Local Content Requirement ( certain amount of local inputs be used in products)
b) Trade balancing requirement( import should not exceed a certain amount of export)
c) Trade and Foreign exchange balancing requirement
d) Domestic sales requirement ( a company shall sell a certain portion of its output
locally).
The agreement requires the notification of all WTO inconsistent TRIMS and their
phasing out within two, five, seven years by industrial, developing and less developed
countries.
Trade Related Aspects of Intellectual Property Right (TRIP) is under the Uruguay
round arrangement of GATT( Now WTO)
TRIP cover seven Intellectual properties-
a) Copyright & related right
b) Trademark
c) Geographical Indications
d) Industrial designs
e) Patents
f) Lay out design of integrated circuits
g) Undisclosed information including trade secrets

4. What is GATT & WTO?

Ans. The General Agreement of Tariff & Trade was born in 1948 as the result of
International desire to liberalize the trade.
The preamble of GATT mentioned the following as its important objectives-
a) Raising standard of life
b) Ensuring full employment and large & steadily growing volume of real income &
effective demand
c) Developing full uses of resources of the world
d) Expansion of production & international trade
GATT adopted the following principles-
• Non discrimination- The principle of non discrimination requires that no
member country shall discriminate between the members of GATT in
conduct of international trade.
• Prohibitive of Quantitative Restrictions: It rules seek to prohibit
quantitative restrictions as far as possible and limit restrictions on trade to
the less rigid tariff
• Consultation: By providing a forum for continuing consultation , it sought to
resolve disagreements through consultation..
 Following the Uruguay round, GATT was converted from a provisional
agreement into a formal International Organization called World Trade
Organisation (WTO) with effect from January 1,1995.
The WTO has the following functions-
• The WTO will facilitate the implementation, administration, operation
and further the objectives of Multilateral Trade Agreement
• The WTO shall provide the forum for negotiations among its members
concerning their multiple trade relations in matter dealt with under
agreement.
• The WTO administers ‘Understanding on Roles & procedures governing
the settlement of disputes.’
• The WTO administers ‘ Trade review Mechanism’
65. What do you mean by venture capital?
Ans. Venture capital is basically equity finance in relatively new companies when it
is too early to go to the capital market to raise funds. However such investment is not
exclusively equity investment. It can be also made in the form of loan finance/convertible
debt to ensure a running yield on portfolio of venture capitalist. Venture capital is a
financial intermediary between investors looking for high potential return and
entrepreneurs who need institutional capital as they are not ready or able to go to the
market.
What is FERA & FEMA?
Ans. Foreign Exchange transactions were regulated in India by Foreign Exchange
Regulation Act (FERA), 1973. This act was sought to regulate certain aspects of conduct of
business outside the country by Indian companies and in India by foreign companies.
The FERA was widely described as draconian law. The main objective of FERA framed
against the background of severe foreign exchange problem and controlled economic
regime , was conservation and proper utilization of the foreign exchange resources of the
country.
In the light of ongoing Economic liberalization of the country and improving foreign
exchange reserve of the nation, a new Foreign Exchange Management Act (FEMA) 1999,
replaced the FERA. Except as provided in terms of the act, or with the general or special
permission of RBI, no person shall deal in any foreign exchange or foreign security other
than authorized person, no person can make any payment to or for the credit of any person
resident outside of India in any manner, No person can receive otherwise through an
authorized person ,any payment by order or on behalf of any person resident outside India
in any manner, No person can enter into any financial transaction as consideration for or
in association with the acquisition or creation or transfer of a right to acquire any asset
outside India by any person.
FEMA permits dealing in foreign exchange through authorized person for current account
transaction. Any person may sell or draw foreign exchange to or from an authorized person
for capital account transaction permitted by RBI in consultation with RBI.
67. What do you mean by sterilization policy ?
Ans. When RBI intervenes in the foreign exchange market through purchases of foreign
exchanges, it injects liquidity into the system through corresponding selling of domestic
currency. Conversely when it sells foreign exchange the domestic liquidity is absorbed from
the system. Neutralizing part or whole of the monetary impact of foreign inflows are known
as sterilization process. Conceptually sterilization process involves decision of RBI to
intervene by substituting foreign currency with domestic currency in case of excess capital
inflow and decision to intervene further in the money or bond market to substitute domestic
currency so released out of the intervention of foreign exchange market with bond or other
eligible papers.
What do you mean by market stabilization scheme?
Ans. The Government can issue Treasury bills or dated securities under MSS for absorbing
liquidity from the system. The Treasury bills or dated securities under MSS are have all the
attributes of existing T bills and dated securities. The Government in consultation with RBI
will fix an annual aggregate ceiling for T bills or dated securities under MSS.MSS are issued
by the auctions to be conducted by RBI. The amounts will be held in a separate identifiable
cash account titled MSS account to be maintained & operated by RBI. The T bills and dated
securities issued for MSS would be matched by an equivalent amount of cash balance held
by the Government with RBI. As a result there is very marginal impact on market interest.
What do you mean by held to maturity?
Ans. The securities acquired by the banks with the intention to hold them till the maturity
period will be classified as held to maturity. The investments included under held to maturity
should not exceed 25% of bank’s total investment. Investments carried out under held to
maturity are not marked to market and will be carried at acquisition cost unless it is more
than the face value , in which case premium will be amortized over the period remaining to
maturity.
70. Define PD, LGD, EAD, Expected loss and unexpected loss.

Ans. Probability of Default (PD) : PD is the likelihood of a borrower defaulting on a contractual

obligation. To calculate the PD, the time horizon must be long enough to be meaningful and short
enough to be feasible given the data available. Several sequential steps are to be followed such as
establishing the time horizon, determining the measurement approach using the quantitative data
such as financial statements, ratios as well as qualitative information such as borrowers’
reputation, equity prices , critically reviewing the available information, analyzing the published
default studies/ secondary data as well as successful use and implementation of transition matrices
to look at the way PDs change over time.
Loss Given Default (LGD) : Loss given default is the estimated percentage of an outstanding
claim that can not be recovered in the event of a default. Recovery rate and Loss given default are
mutually exhaustive with each other as
LGD= 1- Recovery rate
Usually collaterals reduce the risk of an exposure and hence collateralized loans carry lower risk
weights than un-collateralized loans. Cash on deposit, Gold, securities by sovereigns & public
sector entities carrying a minimum rate of BB-, banks and corporate securities rated minimum at
BBB-, Equities listed in major stock indices such as Dow Jones, Nikkei, Sensex etc are
considered as eligible collaterals.
However the value of the collateral C is adjusted by applying so called Hair Cut (H)
CA= C/( 1+H)
Where CA= Collateral Adjusted
The value of H will depend on the value of collateral. It varies from 0% (cash), 4% (sovereign
securities), 15% (gold) and 30% (eligible corporate securities).
Exposure At Default (EAD) : Exposure at default is the maximum amount that a bank can loose
in the event of a default.
Expected Loss (EL) : Expected loss is the amount that a bank can expect to lose on average in the
event of a default. Expected loss is the product of probability of default. loss given default,
exposure at default .
EL= PD x LGD x EAD
Unexpected Loss (UL) : Unexpected loss/ unanticipated loss is computed by subtracting expected
loss from actual loss.
UL= Actual loss –Expected loss

71. What is factoring?

Ans. The arrangement in which receivables created out of sales of goods or services are sold to an
agency, is called factoring. The factor performs the functions of such as purchase of receivables,
marinating the sales or receivables ledgers , submitting sales account to creditors , collection of
debt on due dates, after collection to return the reserve money to the seller and provide
consultancy services to the customers in respect of marketing, finance & production.
72. What is Para Banking activity?
Ans. The main activity of the commercial bank is accepting deposits and credit creation in the
economy. Apart from that, Banks undertake financial services such as credit card business,
insurance business, underwriting, equipment leasing, hire purchase business, factoring services etc.
These are called Para banking activities which can be taken up departmentally or by setting up
subsidiaries.
73. What is NPA and what is the function of Debt Reconstruction company ?

When debtor defaulted one Equated Monthly Installment (EMI), it can be shown as 30
days DPD that is Days Passed Deal. A person who has defaulted two EMI can be treated
as 60 days DPD that is Days Passed Deal. After default of 2nd EMI, calling exercise
should be done with a default script. A person who has defaulted consecutive three EMI
can be shown as 90 days DPD .It becomes a NPA (Non Performing Asset).
Bank usually takes the help of Debt Reconstruction Company (DRC) when they have
accumulated excessive NPA due to non recovery of loan. Debt Reconstruction company
is a trust. They purchase the NPA of the banks by paying certain amount of cash which
is much lesser than the value of NPA. As the bank is selling their NPA to the DRC, banks
will be able to transfer the collection hazard from their shoulder to the DRC. Debt
Reconstruction Company has to undergo a market research to analyze the extent of NPA,
it will be able to realize by applying different standard conventional techniques and
tactics. Depending on that they sell certain amount of ‘Security Receipts’ to the bank.
Security receipt acts almost like Collateral Debt Security where for the bank,these
‘Security receipts’ are considered as contingent liability. Banks will be able to get the
money against these security receipts provided the Debt Reconstruction Company is able
to realize the receivables from NPA. The way Debt Reconstruction Company is
exercising pressure on the nerve of debtors that raises lots of dispute from the moral and
ethical perspectives.
74. What do you mean by credit scoring model ?
Ans. Banking Sector has to use credit scoring model from 1998 onwards. As it is a
known fact that prevention is always better than cure, banks are using credit scoring
models to reduce the probability of piling up of bad debt or non performing assets.
Usually as a common thumb rule, total risk faced by a bank can be decomposed into three
different categories- credit risk 63%, operation risk 25-26% and market risk is 11-12%.
Reasons for using the scoring models are as follows-
• Determination of probability of default and expected loss
• Ensures that good loan proposals are accepted and bad loan proposals
are rejected.
• Helps in pricing the loan according to the risk.
Credit score is nothing but numerical forecast of repayment of future loan.
There are different credit scoring methodologies such as FICO, ONICRA( Onida +
Icra), Z Altman’s score etc.
According to FICO Scoring method, FICO score ranges from 300 to 850.
Higher the score, loan will be available at a lower rate.
For credit scoring certain factors are taken into account-
Payment history- 35%
Amounts owed- 30%
Length of history- 15%
New credit-10%
Account Mix (nature of loan)-10%
Change of job frequently may lower score if no history of late payments- bank specific.
Change of residence to negative area may lower score-bank specific.
Use of credit counseling services if reported by creditors may lower the credit score.
Inquiring for more credit may lower credit score.
ALTMAN Z SCORE MODEL

T1 = Working Capital / Total Assets

T2 = Retained Earnings / Total Assets

T3 = Earnings Before Interest and Taxes / Total Assets

T4 = Market Value of Equity / Total Liabilities

T5 = Sales/ Total Assets

Z Score Bankruptcy Model:

Z = 1.2T1 + 1.4T2 + 3.3T3 + 0.6T4 + .999T5

Zones of Discrimination:
Z > 2.99 -“Safe” Zone

1.8 < Z < 2.99 -“Grey” Zone

Z < 1.80 -“Distress” Zone

75. What is the difference between hypothecation & pledge?

Ans. Hypothecation is an equitable charge where the borrower keeps the possession of
the security on behalf of the creditor. If the borrower fails to return the advance against
the hypothecation of the securities, the bank can take the possession of the securities, the
bank can take the possession of the securities with the consent of the borrower and
becomes a pledgee.

Pledge is bailment or delivery of goods as security for payment of a debt or performance

of a promise. Pledgee may retain the goods until the payment of debt or performance of
the promise is fulfilled. Pledgee can sell the goods by giving a due notice to pledger in
case pledger fails to make the payment of debt.

78. What is Benchmark Prime Lending Rate ?

Ans.: In a move to increase transparency in credit pricing, the Reserve Bank of India has
stipulated banks to migrate to base rate system for determining lending rates from the
current benchmark prime lending rate (BPLR) system from April 1.BPLR, the rate at
which banks lend to prime borrowers, was earlier formulated to be the base rate.

he move is expected to reduce the proportion of sub-PLR loans. As of September 2009,

the share of sub-BPLR lending to total loans stood at 70.4 per cent, clearly suggesting
that the PLR rate is no longer relevant as a reference rate. The move to discontinue BPLR
came in the light of predatory pricing done by banks to gain market share (especially the
teaser loans to housing sector). The RBI's working committee had worked out illustrative
base rate to be 8.55 per cent, which is higher than the current home loan rates of 8 per
cent. All new loans and old loans that come for renewal are expected to be priced with
reference to the base rate. While the implications of this move are uncertain, as the banks
are given free hand on deciding the base rate, margin pressures are expected as banks
would be unable to lend below sub-base rate coupled with the fact that the rates charged
for ‘other borrowers' such as SME lending agriculture and retail lending would see a
decline as a result of this move.

In the banking space, public sector banks and banks with high proportion of low-cost
deposits may be less affected as they have low cost of funds (an important input in
determining the base
79. What is teaser Rate ?

Ans. An adjustable-rate mortgage loan in which the borrower pays a very low
initial interest rate, which increases after a few years. Teaser loans try to entice borrowers
by offering an artificially low rate and small down payments, claiming that borrowers
should be able to refinance before the increases occur.
Teaser loans are considered an aspect of sub prime lending, as they are usually offered to
low-income home buyers. Unfortunately, when these borrowers try to refinance the loan
before the rate increases, most will not qualify for standard mortgages. This leaves
borrowers with increased monthly payments, which many cannot afford. This method of
loaning is considered risky, as default rates are high.

80. What is an Open Market Operation ?

Ans. Often RBI buys and sells their securities to Commercial bank in their own initiative.
During the inflationary time, RBI sells their securities to Commercial banks as a result
credit creating capacity of the commercial banks go down. In recession time, RBI buys
the securities from commercial banks to enhance the liquidity in the market.