Sie sind auf Seite 1von 171

Commercial Banking

For

PGDM

Indian Institute of Management Calcutta

By

Praloy Majumder

(For Classroom discussion only)

1

Index

Chapter No

Particulars

Page No

One

Role of Financial System

3

Two

Bank’s Liability and Asset

13

Three

Sources of Bank Fund

17

Four

Central Bank, Money Supply and Credit

28

Five

Fixed Income Securities Market

32

Six

Bond Portfolio Management

51

Seven

Assessment of Fund Based and Non Fund Based Working Capital

63

Eight

Process of Tying up and Utilisation of Working Capital from bank

97

Nine

Different Corporate Banking Product

106

Ten

Project

123

Financing

Eleven

Trade Finance

144

2

Chapter One

Role of Financial System

Financial system is one of the most important inventions of the modern society. Its primary task is to move scarce loanable funds from those who save to those who borrow to buy goods and services and to make investments in new equipment and facilities so that the overall economy can grow and increase the standard of living enjoyed by the citizens. Without the financial system and the funds it supplies, each of us would lead a much less enjoyable life. The financial system determines both the cost of credit and how much credit will be available to pay for the thousands of different goods and services we purchase daily. The happening in this system has a powerful impact in the health of the overall economy. For example, when credit becomes more costly and less available, total spending for goods and services falls resulting in the increase in unemployment. This will in turn reduce the growth and which will force the business houses to cut back the production and lay off workers. In contrast, when the cost of credit declines the loanable funds become more readily available and this will increase the total spending in the economy. This will in turn creates more jobs and the economy growth accelerates. In fact, the financial system is an integral part of the economy system and we cannot be able to comprehend the economy system without knowing the financial system. Flows within the economic system The basic function of any economy is to allocate scarce resources--- land, labor, management skill and capital – to produce the goods and services needed by the society. The economy system must combine inputs--- land, labor and management skills, capital to produce out put in the form of goods and services. The economy generates a flow of production in return for a flow of payments.

Land & other natural resources

Labor and managerial skills

Capital equipment

Flow of Production

and managerial skills Capital equipment Flow of Production Flow of payments Goods and services sold to

Flow of payments

Goods and services sold to the public.

and managerial skills Capital equipment Flow of Production Flow of payments Goods and services sold to

3

Figure 1.1 : The Economic System

The flows of payments and production within the economic system can be depicted

as a circular flow between producing unit (mainly business and government) and

consuming unit (principally households). In modern economy, household provides

labor, management skill, and natural resources to business firms and governments in

return for income in the form of wages and other payments. Most of the income

received by the household is spent to purchase goods and services from business

and governments. This is shown below in Fig 1.2:

Flow of expenditure for consumption and taxes

Flow of production of goods and service

and taxes Flow of production of goods and service Producing units (mainly business firms and govt)

Producing units (mainly business firms and govt)

Consuming units (mainly households)

Flow of productive services

Flow of income

Fig 1.2: Flow of income, payments and production in the economic system

The Role of Markets in the Economic System

Markets are channel through which buyers and sellers meet to exchange goods,

services and resources. The market place determines what goods and services will

be produced and in what quantity. This is accomplished through changes in the

4

prices of goods and services offered in the market. If the price of an item rises, for

example, this stimulates business firms to produce and supply more of it to

consumers. In the long run, new firms may enter the market to produce those goods

and services experiencing increased demand and rising prices. A decline in price, on

the other hand, usually leads to reduce production of a good or service and in the

long run some firms may leave the market place.

Types of Markets:

There are essentially three types of markets within the economic system. They are

1. Factor Market

2. Product Market

3. Financial Market

1.Factor Market: In the factor market, the consuming units sell their labor and other

resources to those producing units offering the highest prices. The factor market

allocates factors of production --- land, labor and capital---- and distributes income--

- wages, rental payments etc--- to the owners of productive resources.

2. Product Market: In the product market, consuming units use most of their income

to purchase goods and services. Food, shelter, automobiles, theater tickets and

swimming pools are among the many goods and services sold in the product

markets.

3. Financial Market: It may be mentioned that not all the incomes of the consuming unit are used up in the product market. The excess of income over the expenses is saved. This savings are channelised from consuming unit to producing unit through the financial market. In an economy, there are three mainly three entities. They are

Households

Business Firms

Governments

The definition of savings and investments varies in these three entities. They are

explained below:

Nature of Savings:

For Household: This is defined as the surplus of its current income over its current

expenses.

For Business Firms: It is retained earnings plus other non-cash expenses.

For Government: It is defined as current revenue minus current expenditures.

Nature of Investments:

5

For Household: When it purchases new home, furniture, automobiles and other durable goods this is classified as investment. However, purchases of food, clothing, and fuel are considered to be consumption spending (i.e. expenditures on current account). Foe Business Firms: Expenditure on capital goods (fixed assets, such as building and equipment) and for inventories are classified as investment. For Government: When Government spends o build and maintains public facilities, it is classified as investment. Modern economy requires enormous amount of investment to produce goods and services and to keep the economic growth on a continuous basis. However, investment requires huge amount of funds, far beyond the resources available to the investing units mainly Government and Business Firms. The financial markets meet the requirement of funds as it acts as a conduit for the flow of fund from savers to

investors. The investors issue financial claims in the form of instruments of financial markets and the savers lend the money to investors against these instruments. These instruments are financial claims on the future income of the investors and the savers invest the money in anticipation of the future income. This is made possible because of the presence of the financial markets. Functions performed by the financial systems and the financial markets:

The great importance of the financial system in our day-to-day life can be explained by reviewing its different functions. The financial system in a modern economy performs the following basic functions:

Savings Function: As mentioned earlier, financial systems act as a conduit for the public’s savings. Financial instruments in the form of Stock, Bonds etc are sold in the financial markets and this provides a profitable, relatively low risk outlet for the public’s savings. This helps the public’s savings to flow from the savers to investors through the financial markets.

Wealth Function: Financial instruments sold in the financial markets provide an excellent way to store wealth (i.e. preserve the value of the assets we hold) until funds are needed for spending. Although, one might choose to store his wealth in things, such items are subject to depreciation and often carry great risk of loss. However, bonds, stocks and other financial market instruments do not wear out over time and usually generate income. For any individual, business firms and government, wealth is the sum total of it assets held. Some authorities prefer a concept called net wealth that equals

6

all the assets held by an economic unit minus debt (liabilities) it owes. Both wealth and net wealth are built up by a combination of current savings plus income earned on previously accumulated wealth. This can be represented in the form of following equation:

Wt = St +Rt . Wt-1 Wt The change in wealth in the current period
Wt = St +Rt . Wt-1
Wt
The change in wealth in the current period

St

Rt The rate of return of the accumulated wealth

The savings in the current period

Wt-1

Initial value of all accumulated wealth

Liquidity Function: For wealth stored in the financial instruments, the financial market place provides a means of converting those instruments into cash with little risk of loss. Thus, the financial markets provide liquidity for savers who hold financial instruments but are in need of money.

Credit Function: Besides providing the liquidity and facilitating the flow of savings into investment to build wealth, the financial market furnishes credit to finance consumption and investment spending. Credit consists of a loan of funds in return for a promise of future payments.

Payment Function: The financial system also provides a mechanism for making payments for goods and services. Certain financial assets, mainly checking accounts and negotiable instruments serve as a medium of exchange in making payments. Plastic cards issued by banks are another example of financial instruments facilitating payments.

Risk Function: The financial markets offer business, consumers and governments protection against life, health, property and income risks. This is accomplished by the sale of insurance policies.

Policy Function : In recent times , the financial markets are the principal channel through which government has carried out its policy for stabilizing the economy and avoid inflation .By manipulating interest rates and availability of credit, government can affect the borrowing and spending plans

7

of the public, which, in turn , influence the growth of jobs, production and

prices.

Types of Financial Markets within the Financial System:

The financial markets can be classified in different ways. One way of classifying this is to classify in respect of maturity of the instruments. Accordingly, the financial markets can be classified into two main parts. They are

1. Money Market

2. Capital Market

1. Money Market : This is defined as that financial market where the maturity period of financial instruments issued or traded is up to one year .

2. Capital Market : This is defined as that financial market where the maturity

period of financial instruments issued or traded is more than one year.

Within each market, there are several instruments, which can be distinguished in

terms of characteristics. The entire break up of financial markets is shown below:

8

Financial Markets

Financial Markets Money Market Capital Market Negotiable Non Negotiable Debt Market Equity Market Non Government
Financial Markets Money Market Capital Market Negotiable Non Negotiable Debt Market Equity Market Non Government
Financial Markets Money Market Capital Market Negotiable Non Negotiable Debt Market Equity Market Non Government
Financial Markets Money Market Capital Market Negotiable Non Negotiable Debt Market Equity Market Non Government

Money Market

Financial Markets Money Market Capital Market Negotiable Non Negotiable Debt Market Equity Market Non Government
Financial Markets Money Market Capital Market Negotiable Non Negotiable Debt Market Equity Market Non Government
Financial Markets Money Market Capital Market Negotiable Non Negotiable Debt Market Equity Market Non Government
Financial Markets Money Market Capital Market Negotiable Non Negotiable Debt Market Equity Market Non Government

Capital Market

Financial Markets Money Market Capital Market Negotiable Non Negotiable Debt Market Equity Market Non Government
Financial Markets Money Market Capital Market Negotiable Non Negotiable Debt Market Equity Market Non Government
Financial Markets Money Market Capital Market Negotiable Non Negotiable Debt Market Equity Market Non Government
Financial Markets Money Market Capital Market Negotiable Non Negotiable Debt Market Equity Market Non Government

Negotiable

Non Negotiable

Debt Market

Equity Market

Market Negotiable Non Negotiable Debt Market Equity Market Non Government Instrument s Govt Instruments Primary Market
Market Negotiable Non Negotiable Debt Market Equity Market Non Government Instrument s Govt Instruments Primary Market
Market Negotiable Non Negotiable Debt Market Equity Market Non Government Instrument s Govt Instruments Primary Market
Market Negotiable Non Negotiable Debt Market Equity Market Non Government Instrument s Govt Instruments Primary Market
Market Negotiable Non Negotiable Debt Market Equity Market Non Government Instrument s Govt Instruments Primary Market
Market Negotiable Non Negotiable Debt Market Equity Market Non Government Instrument s Govt Instruments Primary Market
Market Negotiable Non Negotiable Debt Market Equity Market Non Government Instrument s Govt Instruments Primary Market
Market Negotiable Non Negotiable Debt Market Equity Market Non Government Instrument s Govt Instruments Primary Market
Market Negotiable Non Negotiable Debt Market Equity Market Non Government Instrument s Govt Instruments Primary Market
Market Negotiable Non Negotiable Debt Market Equity Market Non Government Instrument s Govt Instruments Primary Market
Market Negotiable Non Negotiable Debt Market Equity Market Non Government Instrument s Govt Instruments Primary Market
Market Negotiable Non Negotiable Debt Market Equity Market Non Government Instrument s Govt Instruments Primary Market
Market Negotiable Non Negotiable Debt Market Equity Market Non Government Instrument s Govt Instruments Primary Market
Market Negotiable Non Negotiable Debt Market Equity Market Non Government Instrument s Govt Instruments Primary Market
Market Negotiable Non Negotiable Debt Market Equity Market Non Government Instrument s Govt Instruments Primary Market
Market Negotiable Non Negotiable Debt Market Equity Market Non Government Instrument s Govt Instruments Primary Market
Market Negotiable Non Negotiable Debt Market Equity Market Non Government Instrument s Govt Instruments Primary Market
Market Negotiable Non Negotiable Debt Market Equity Market Non Government Instrument s Govt Instruments Primary Market
Market Negotiable Non Negotiable Debt Market Equity Market Non Government Instrument s Govt Instruments Primary Market
Market Negotiable Non Negotiable Debt Market Equity Market Non Government Instrument s Govt Instruments Primary Market

Non Government Instrument s

Govt Instruments

Primary Market

Secondary Market

Fig: 1.3 Classifications of Financial Markets

Factors integrating all financial markets together:

Each corner of the financial system act as a different financial markets and each of this market is separated by its own characteristics, characteristics of its instruments, investors’ preference and also by rules and regulations. However, there are certain factors that integrate these different markets. They are:

Credit, the common commodity: One unifying factor is the fact that the basic commodity being traded in the most financial market is credit. Borrowers can switch from one market to another depending on the cost of credit. Accordingly, the credit plays an important role to keep the cost of such credit in different markets in sync.

9

Speculation and Arbitrage: Both speculation and arbitrage help to keep the price of securities in different financial markets within short range and there should not be any major variance of such price.

The Evolution of Financial Transaction All financial transactions perform at least one basic function- movement of scarce fund from those who save and lend to those who wish to borrow and invest. However, the transfer of funds from savers to borrowers can be accomplished in at least three different ways . We label these methods of fund transfer as

Direct Finance

Semi direct Finance

Indirect Finance

Direct Finance : In the direct finance, borrower and lender meet each other and exchange funds in return for financial assets. One such example is the borrowal of money from one individual from another in exchange of promissory notes ( signed by the borrower) against money ( given by the lender) . The process is explained below with the help of the following diagram:

Borrowers (deficit budget unit)

Flow of funds

diagram: Borrowers (deficit budget unit) Flow of funds Lenders (surplus budget unit) Primary Securities Fig: 1.4

Lenders (surplus budget unit)

Primary Securities

of funds Lenders (surplus budget unit) Primary Securities Fig: 1.4 Direct Finance (Direct lending gives rise

Fig: 1.4 Direct Finance (Direct lending gives rise to direct claims against borrowers)

Limitation of this type of finance:

Both borrower and lender must meet each other to carry out the transaction. So cost of searching/information is high.

Both borrower and lender must agree to exchange exactly identical amount of money that is difficult.

Lender must have faith on the security issued by the borrower, which is also difficult to achieve.

10

Semi direct Finance: In this type of finance , some individuals and business houses

become security brokers and dealers whose essential function is to bring surplus and

deficit budget units together, thereby reducing information costs. This is explained

below:

Borrowers

(deficit budget

unit)

Primarysecurities

Security brokers, dealers and investment bankers

Primary

Securities

brokers, dealers and investment bankers Primary Securities Flow of funds Lenders (surplus budget unit) Flow of

Flow of funds

Lenders

(surplus budget

unit)

Securities Flow of funds Lenders (surplus budget unit) Flow of funds Fig 1.5 Semi direct Finance

Flow of funds

of funds Lenders (surplus budget unit) Flow of funds Fig 1.5 Semi direct Finance (Direct lending
of funds Lenders (surplus budget unit) Flow of funds Fig 1.5 Semi direct Finance (Direct lending

Fig 1.5 Semi direct Finance (Direct lending with the aid of market makers who assist in the sale of direct claims against borrowers) Semi direct finance is an improvement over the direct finance in the following

manner:

Information cost for participants is reduced to a great extent

The requirement of exact amount of money involved is eliminated as dealers

can split up securities and sale in smaller lots

Both dealers and brokers help in the development of the secondary market

Still semi direct finance has limitations. The most important of them is:

In this process also , the lender has to accept the security offered by the

borrower as an acceptable security.

Indirect Finance: The limitations of both direct and semi direct finance can be

removed in the Indirect Finance . In this form of finance, one financial intermediary

comes in between lenders and borrowers. The financial intermediaries performs the

following functions:

The financial intermediary accepts money from the surplus budget unit in the

form of deposits. In return of the money deposited, the financial intermediary

issues secondary security. Since most of the financial intermediaries are

regulated by financial regulations in terms of financial strength, lenders are

11

more willing to accept this secondary security as gains the primary securities issued by the borrower himself.

The financial intermediary finds out the deficit budget units for giving loans and collects money from the borrowing unit. The information and searching cost are reduced. The entire mechanism of indirect financing is shown below :

 

Primary Security

Secondary Security

 

Ultimate

Ultimate Financial Intermediaries (banks, Financial Institutions) Ultimate lenders ( surplus budget unit)

Financial Intermediaries (banks, Financial Institutions)

Ultimate Financial Intermediaries (banks, Financial Institutions) Ultimate lenders ( surplus budget unit)

Ultimate lenders ( surplus budget unit)

borrowers

(deficit budget

units)

 

Flow of funds

 

Flow of funds

 

Fig 1.6: Indirect Finance (The financial intermediation of funds)

Financial disintermediation : In the process of financial disintermediation , the role of financial intermediary has been eliminated and the borrowers can raise the fund directly from the lender with the help of either public issue or private placement of securities. This can be performed with the help of stock exchanges. Though the financial disintermediation has been progressing rapidly in the developed and matured financial markets like USA , UK etc, it is yet to take momentum in Indian market. This is due to the fact that to work financial disintermediation, stock market has to perform to the satisfaction of the lenders. Considering the maturity stage of our stock market, it is yet a long road to go for establishing financial disintermediation as an established procedure.

12

Chapter Two

Bank’s Liability and Assets

As can be seen from the previous chapter that bank plays the role of an intermediary

where banks collects money from the depositor against issuance of its security and

then it lends to the corporate. Such system would operate as long as the bank is able

to keep its commitment to the investors. Since bank is an important financial

intermediary , the soundness of the bank is of paramount importance in the stability

of financial system. Accordingly, we need to know the basic financial structure of

bank and how it is different from normal corporate.

Let us draw a comparison of ICICI bank balance sheet and Tata Steel balance sheet

as on March 31 2007 . The liability comparison of both the entities are given below :

Comparison of Tata Steel and ICICI Bank

Liability

Sl No

Particulars

Tata Steel

ICICI Bank

1 Equity

11.52%

0.37%

 

Reserves

and

2 Surplus

39.18%

11.35%

3 Loans

33.47%

82.75%

 

Other

4 Liabilities

3.26%

2.96%

 

Current

Liabilities

and

5 Provisions

12.57%

2.58%

 

Total

100.00%

100.00%

Fig : 2.1 Comparison of Tata Steel and ICICI Bank Balance Sheet Liability

Composition

As we see from the above that the capital structure of ICICI Bank is highly levered

compared to Tata Steel balance sheet . This is reflected in lower percentage of equity

13

and reserves of total liability of ICICI bank compared to that of Tata Steel. Since we

know that a highly levered institution is highly risky entity , ICICI bank is a risky

entity compared to that of Tata Steel. This is true for all other banks . But at the

same time we are telling that banks at any point of time would have to keep its

commitment to its depositors and at the same time have to work within the risky

parameters. So bank will always have to operate under strict risk containing

mechanism as prescribed by central bank of a country. When we shall analyse the

bank performance , we have to always keep this in our mind. This is the rational

behind prudential norms, exposure norms, investment valuation norms , capital

adequacy norms, risk management and asset liability management systems of

banks.

After comparing the liability side of bank balance sheet we shall compare the asset

side of bank balance sheet with that of Tata Steel:

Comparison of Tata Steel and ICICI Bank

Asset

Sl No

Particulars

Tata Steel

ICICI Bank

1

Net Fixed Assets

23.44%

1.03%

2

Investment

7.62%

27.88%

3

Current Assets

68.65%

65.95%

4

Misc.expenditure not written off

0.29%

5.15%

Total

100.00%

100.00%

Fig 2.1 : Comparison Tata Steel and ICICI Bank Asset Composition

If we see the above , we find that majority of bank assets comprise of investment

and current assets. In the current assets we have included loan and advances given

by the bank to other entities. From the above , we see that net fixed asset is lower in

the bank balance sheet . This would be due to the reason that bank is created to

channelise fund to the productive sector. That is why banks are having restriction in

investment in Fixed assets. Banks are having significantly higher portion in the form

of investments and loans and advances. In India, Investment includes subscription

14

to Govt of India securities. This is being carried out due to meeting the SLR requirement . Banks need to invest 25% of its net demand and time liabilities in the form of SLR securities which consist of GOI securities. Government issues securities to bridge the fiscal deficit and bank has to invest fund on this instrument in the form of SLR securities. With the implementation of FRBM act we expect that the SLR requirement would go down in the near future as the fiscal deficit would go down with the implementation of FRBM act. If we see, an early indication has been made in this regard by lowering the floor of SLR as per Banking Regulation Act where the floor has been reduced to 20% of NDTL . However, at present banks need to maintain 25% . The effect of reduction of SLR would be good as more fund would be available to the commercial sector and this would be used for increasing goods and services in the country.

While bank raises fund and invest in asset it keeps in mind the following aspects :

1. While borrowing, it is borrowing from the depositor at a particular cost for a particular period. But it does not mean that if the depositor comes before the maturity date , it would deny the payment to the investor. In that case faith on the banking system would be vanished. So Banks should make emergency provisions while deploying such deposit in the form of different assets.

2. While investing in the form of investment , it has to adhere to certain investment norms depending on the nature of investment. Since banks are not permitted to invest freely in the equity securities and in India the restriction is too high, in India bank’s are investing majority amount in the fixed income securities for the reason mentioned above. As we know that interest rate and price of a fixed income security is inversely proportional , banks have to keep this in mind at the time of investment. Investment can be made under three category i.e. Held to Maturity, Held for Trading and Available for Sales category and there are benefits and drawbacks under each method. In the case of Held to Maturity , banks will not be able to derive any trading profit and at the same time would not incur loss on account of adverse movement of interest rates. In the case of Held for Trading ,a bank has to realise the gain or loss within 90 days and depending on its prediction it can earn profit or incur loss. In the case of Available for sale category, the bank can incur losses or earn profit for first 90 days but this is notional in nature. While investing, other important issue is that the bank can borrow

15

against particular type of investment from dedicated lender in case of emergency and this would help bank to overcome the emergency payment requirement. So while investing ,bank would carry out some statistical analysis of its liability and accordingly it would invest in the investment of a particular security to this benefit. 3. While giving loans and advances to corporations, bank would keep in mind the riskiness of the loan . Since different categories of loan are having different risk weight , bank would try to lend to a loan of lower risk weight at a given rate of interest. Besides, for certain category of loan and advances like export credit, term loan to SSI , refinance facility would be available and accordingly bank would be able to overcome sudden liquidity requirement in case of urgency.

After giving proper consideration in the above mentioned factors, bank raises the fund from its depositor and accordingly would invest in loans and advances. However, bank has been permitted to borrow and lend its temporary surpluses in certain other market due to its nature of operation to ensure liquidity. Banks can lend and borrow from inter bank call money market and repurchase market.

16

Chapter Three Sources of Bank Fund

As we have seen in chapter one and two that banks are financial intermediary which help the movement of fund from the savings unit to the investment unit. So the major sources of bank fund would be in from the savings unit i.e. individual . Accordingly , the major sources of bank fund is deposits. There are two types of deposits which banks issue to raise money. One is called demand deposit and the other is called term deposit.

Demand Deposit : This is the deposit which does not have any maturity at the time of raising the fund by the bank. Besides these deposit would not provide any interest to the depositor. If any deposit scheme issued by bank is providing this characteristics such deposit is called as demand deposit. Examples of demand deposit is Current Account and part of Savings Account balance . Current Account and Savings Account deposits are popularly known as CASA.

Current Account : These are accounts opened by the business entity to carry out their day to day transaction . For a bank the benefit of current account is that banks need not to pay interest on current account. So the cost of fund is very low in the case of current account. Here one thing has to be kept in mind that in the case of cost of fund , interest is not the only factors involved. Apart from interest part the issue of cost of servicing the account should also be kept in mind while calculating the cost of deposit.

Savings Account : In the case of savings bank account, individual would maintain account with bank. The uniqueness of saving bank account is that individual keep a portion of their liquidity requirement in the savings account. Since banks have to pay interest at a rate of 3.5% on the minimum balance between 11 and last day of a month, the interest cost of deposit is quite low. The portion of the savings bank account balance between 1 to 10 is called as the demand deposit since this is not interest earning deposit. Each savings bank account would be provided Cheque books and also other facilities like internet banking , ATM services, Debit and Credit Cards and other freebies.

A Bank which is having higher portion of CASA would be considered a good bank.

17

A Bank of higher CASA is prone to lower degree of shock in the increased interest rate scenario. The aim of a bank is to increase the CASA to a great extent. For this banks can draw different strategies. Some of such strategies are given below :

Opening of salary account : Banks can approach its advance clients and accordingly it would ask employees of advance clients to open savings account with the banks. Bank must use data mining techniques to achieve this in a scientific manner.

Opening of accounts of students: Banks can approach schools to open students’ accounts. Here bank must design some product which would provide attractive benefits to students. Students savings account with insurance benefits for income earning parents would be an excellent product for increasing the number of students accounts.

Opening of current accounts of governments : Banks can approach governments for opening of current accounts . This can be clubbed with cash remittances facilities of government disbursement.

Opening of accounts with traders: Banks can target trading communities to

open current accounts with them. This is important as floats available in such account would be of great advantage to the banks. However, increasing of CASA in a competitive market would not be easy. The increase of CASA may take place if concerned banks use the following :

Use of technology to increase the transaction mode with the clients . This includes use of ATM, Internet Banking , Phone Banking and Mobile Banking;

Use of branch net works to improve the flow of fund : Banks must use the branch net work to collect the fund within shortest period of time.

Better customer service : A proper mix of branch banking and remote banking is must to improve the CASA .

Term Deposits :

Term deposit is a deposit which promises to pay interest at the time of opening the deposit and also has a fixed maturity period for opening the deposit. The tenure of term deposits can be from 7 days to 10 years for a bank. However banks take lot of precaution before raising deposit for longer tenure.

18

There are different versions of term deposit possible depending on the following factors namely :

Periodicity of payment of interest;

Periodicity of compounding of interest;

Periodicity of deposits of amount in the deposit account;

Reinvestment Scheme : Under this scheme the interest amount is reinvested at a periodic interval at the contractual rate and on maturity the total amount is paid. If the principal amount of deposit is Rs 10,000/- , the interest rate is 10% p.a. , the periodicity of compounding is half yearly and the tenure of deposit is 2 years , the maturity value is given as below :

Rs 10,000/- [ 1+ (10%/2)] 4 = Rs 12,155/- . Under this scheme the investor would get more money but would not get any intermittent cash flow . So any investor who wants to have some periodic cash flow would not prefer such scheme. However if some one is interested in end of period money, the investor would prefer this scheme. In Indian banking scenario, this scheme is mostly preferred by banks for canvassing retail deposits .

Periodic Interest Scheme: Under this scheme, banks pay interest in periodic interval to investors on annually, half yearly , quarterly and monthly basis. However if the interest is paid on monthly basis , interest amount is paid after discounting. This type of investment is preferred by those investors who want periodic return like the retired person , pensioners etc.

Flexible deposit scheme : Under this scheme , an investor can invest one single amount and can withdraw in multiples of the invested amount at different period of time. For example , an investor can invest Rs 10,000/- for 2 years at an interest rate of 10% p.a. with interest paid at quarterly intervals. However the investor can withdraw amount at a unit of Rs 1000/- at any time and the interest rate to be paid on this withdrawal would be applicable rate for the tenure of the investment . If the investor withdraws Rs 1,000/- after one month and the applicable rate for one month is 6%, the investor would be paid interest rate of 6% on this Rs 1,000/- . However the remaining Rs 9,000/- would continue to attract at an interest rate of 10% p.a.

19

This type of deposit is beneficial for investor who does not want to make rigid investment horizon.

Borrowing in the money market : The bank can also raise resources

from money market . By definition ,a money market instrument is that instrument

where the remaining maturity of the instrument is less than 1 year. Please keep in mind that an instrument which was originally a capital market instrument will become a money market instrument when it enters the last year of its maturity. For example , a GOI security which was issued on 1991 for 15 years would become a money market instrument in the year 2006. In the money market, we have the following instrument:

Call Money Instrument

Notice Money Instrument

Term Money Instrument

Call Money : If the tenure of instrument is overnight, it is called a call money instrument. When money is borrowed under call money then the borrower would issue a receipt and this receipt is called call money receipt. The receipt says that the money would be paid on the next date. This is an example of call money instrument. Notice Money : If the tenure of the instrument is more than overnight but less than seven days , it is called notice money. For example, when a bank borrows money under Liquidity Arrangement Facility ( LAF) for 3 days, then the instrument issued by the bank is an example of the notice money instrument. Term Money : If the tenure of the instrument is equal and more than 7 days , it is called a term money instrument. When a bank raises fixed deposits for 15 days , the deposit receipt it issues is a term money instrument. Call Money Market : To under stand the concept of call money market one needs to understand the bank balance sheet carefully. A sample analysis of consolidated bank balance sheet of schedule commercial banks in India would reveal the following :

20

 

In % of total

Liability

Asset

Capital

0.43%

Cash and Bank Balance with RBI

7.60%

Reserves & Surplus

5.35%

Balance with Bank and call

2.13%

Deposits

81.19%

Investments

26.44%

Borrowings

5.0%

Loans and Advances

59.48%

Other Liabilities

8.02%

Fixed Assets

0.95%

   

Other Assets

3.40%

Total

100.0%

Total

100.0%

Fig 3.1: % composition of liability and assets of PSU Bank.

If we analyse the above, we find that majority of the source of fund for the scheduled commercial banks is deposit which constitutes about 80% of the source of the fund. The onus of the banks is to pay to the deposit holder the interest and principle in time so that the faith reposed on the banking system by these deposit holders are kept intact. So banks would basically try to invest in assets where the repayment is more or less assured and the time of repayment is also known with certainty. Since the major source of fund is of debt in nature, the assets would also be debt in nature. That is exactly is seen in the balance sheet of the banks where more than 83% investments is in the nature of the debt. This ensures that the principal of the deposit holders are intended to be protected as the debt instrument carries a commitment of protection of principal and interest. The next step should address the issues on timing of payment of interest rate. The maturity profile of liability and assets need to be analyzed . The maturity profile of deposits of the banking system would reveal the following :

21

% of Total deposit Type of Public Sector Old Private New Private Foreign Banks Banks
% of Total deposit
Type of
Public Sector
Old
Private
New
Private
Foreign
Banks
Banks
Sector Banks
Sector Banks
Banks
Maturity
Up to 1 year
44.1%
50.9%
57.1%
64.7%
More
than
1
26.5%
35.5%
34.3%
33.3%
year
to
3
years
More
than
3
10.3%
7.7%
2.5%
0.4%
years
to
5
years
More
than
5
19.1%
6.0%
6.0%
1.6%
years

Fig 3.2 The Maturity profile of deposits in the banking system It is obvious from the above that majority of the deposits are maturing within 3 years. So the bank needs to invest in assets ( mainly debt assets ) of this maturity. However this is a very difficult task considering the SLR requirement of 25% of the net demand and time liabilities of the banking system. This shows that about 20% of the banking liability should be in the eligible SLR securities which is predominantly in the long term in nature. So the system should be such that these securities can be sold of before maturity and here lies the importance of secondary market for SLR securities. Besides, the banks may not be able to find other investments for matching the deposit profile and in this case banks should be provided with some access to meet the requirement of the depositors in case depositors ask for money. Previously banks were resorting to inter bank call money market to meet sudden requirement of funds. Accordingly there was high volatility in the call money market. Over the years, the central bank i.e. RBI introduced lot of avenues through which banks can raise funds to meet the sudden requirement of funds from depositors. The aim was to reduce the dependence on the call money market so that the interest rate volatility in the call money market is reduced to a great extent. Besides, in the other market, RBI decides the interest rate through auction mechanism and accordingly RBI can control the call money market indirectly. This mechanism worked out very well in the Indian context. Besides deciding the factors of the call

22

money market, let us first discuss the other sources for meeting the sudden requirement of fund by the banking system.

Bill Rediscounting Facility : When bank gives loans and advances under bill discounting scheme to its clients, it locks the fund up to the tenure of the bills. For example, if a bank has lent Rs 100 crores under Bill Discounting scheme and as on November 1, 2007 , the average maturity of such fund is 50 days then the bank would get this Rs 100 crores after 50 days only. In the mean time if the bank suddenly requires Rs 50 crores, it can get refinance against this facility which it can repay either from realization of bills discounted or from fresh deposits mobilized. This gives an option to bank for raising resources. Export Refinance Facility : Banks can avail refinance against the export finance lent to its customers. This would also help the bank to meet the sudden requirement of funds. SIDBI Refinance Facility : Banks can get refinance from SIDBI for the assistance provided to small scale industry . This also helps the bank to fund the sudden requirement . Liquidity Adjustment Facility : Under this scheme, banks can get fund from RBI for a period ranging from one day to 7 days. They get fund under repo scheme where the approved securities are SLR securities. This refinancing window is made available by RBI on a regular basis and the RBI decided the rate and quantum through auction process. Repo Facility : Under this scheme, the fund is available to be banks by RBI and other banks for more than 7 days against repurchase of approved securities which are mostly SLR securities. Please keep in mind that all the above facilities are borrowing windows for banks to meet sudden demand from the depositors and carries interest rate determined by the market. Because of these several sources, the dependence on inter bank call money market is reduced to a great extent over the years. This is also the reason for reducing the number of participants in the call money markets as entities can park their short term funds in several other short term avenues as mentioned above. The call money market , at present , would be used by banks only for meeting the cash reserve ratio only. As mentioned in the previous chapter, CRR is an important tools for money supply as it effects the high power money. RBI changes CRR from

23

time to time and CRR can be maintained by banks by keeping fund in the current account with RBI. For maintenance of CRR, if bank finds that there is a shortfall, the bank can borrow in the call money market till the time bank concerned arranges deposits or other long term funds. For the lending banks point of view, banks can lend only up to a certain amount linked to its net worth in the call money market. For remaining surplus , it can lend in other short term avenues as mentioned above. CRR and its maintenance : As mentioned earlier ,CRR is the cash reserve ratio. The CRR is maintained on the Net Demand and Time Liabilities of the banking system. Let us explain it with the help of an example :

Suppose on a particular Friday ( assuming it a reporting Friday ) , the total deposits of a bank is say Rs 5000 crores. This consists of the following :

Demand Deposits : The deposits which is paid on demand and on which no interest is paid. Time Deposits: This represents deposits on which interest is paid and the original date of maturity is after a specified period which is determined at the time of receiving the deposits. Let us also assume that the break up of this demand and time liabilities is as follows

:

Demand Deposit : Rs 500 crores

Time Deposit

: Rs 4500 crores.

Another break up of this deposit is carried out. Suppose the demand deposit to the banking system is say Rs 50 crores and the remaining amount , deposit to public is Rs 450 crores. The similar bifurcation for time deposit is Rs 500 crores and Rs 4000 crores respectively . This is represented below :

Demand and Time Liability ( DTL) (Rs 5000 cr)

crores respectively . This is represented below : Demand and Time Liability ( DTL) (Rs 5000
crores respectively . This is represented below : Demand and Time Liability ( DTL) (Rs 5000
crores respectively . This is represented below : Demand and Time Liability ( DTL) (Rs 5000
crores respectively . This is represented below : Demand and Time Liability ( DTL) (Rs 5000
crores respectively . This is represented below : Demand and Time Liability ( DTL) (Rs 5000
crores respectively . This is represented below : Demand and Time Liability ( DTL) (Rs 5000

DTL Public

DTL Bank

24

Demand Deposit (Rs 50 cr) Time Deposit ( Rs 500 cr) Demand Deposit (Rs 450

Demand Deposit (Rs 50 cr)

Time Deposit ( Rs 500 cr)

Demand Deposit (Rs 50 cr) Time Deposit ( Rs 500 cr) Demand Deposit (Rs 450 cr)

Demand Deposit (Rs 450 cr)

Time Deposit (Rs 4000 cr)

Fig 3.4 Break up of Demand Time Liabilities in the Banking System From this Rs 5000 crores of deposits , the banks would invest in assets mainly in the forms of loans and advances and investments. Out of the loans and advances and investments , a bank can give loans and advances to other bank or can invest in the securities of the other banks. These are called as Assets to the banking system . Let us assume that in the above example the inter bank assets are of Rs 500 crores. So the Net Demand and Time Liability (NDTL)= Demand and Time Liability(DTL) – Asset to the Banking System . If we define DTL= DTL to Others (I) + DTL to Bank (II) And Asset to the Banking System as III NDTL= I+II-III if II-III>0 NDTL= I if II-III <0

In the above mentioned case, the NDTL of the bank as on the reporting Friday is Rs 4450 cr + Rs 550 cr – Rs 500 cr = Rs 4500 crores . If the Cash Reserve Ratio (CRR) is 5% then the CRR to be maintained is Rs 4500 crores * 5% = Rs 225 crores. This means that the average balance on the Current account with the Reserve Bank of India would be Rs 225 crores from Saturday to 14 days ending on next reporting Friday. Besides this, the bank needs to maintain 85% or any percentage as stipulated by RBI from time to time on a daily basis and the balance amount can be adjusted on the last day of the fortnight. The banks do not earn interest on the balance maintained on the Current Account of RBI up to the eligible CRR balance at the rate of bank rate. Banks can borrow in the call money market only for maintenance of CRR ,not for other purposes. Whenever , a bank fell short of CRR balance, it would borrow in the call money market to meet the CRR requirement. Similarly, if a bank has a surplus then it can lend for a day in the call money market but there is a ceiling which is linked to the net worth of the lending bank.

25

Notice Money : When bank borrows fund for more than one day but less than 7

days it is called as notice money. Bank generally borrows under notice money when

it visualizes that the mismatch will continue for more than one day but less than

seven days and there is a probability that the call money interest rate would show an upward trend in the next seven days . In such case the bank would borrow under notice money from another bank and would try to replace this borrowing by taking term money . Term Money : When bank borrows for more than 7 days , it is called as term money. When bank raises fixed deposits for more than 7 days it is called as term money. Please keep it in mind that the term money also encompasses capital market since the term money which is maturing over one year will come under term money. Treasury Bills : This is short term money market instrument issued by RBI on behalf of the government to meet the cash flow mismatch in the revenue account. The tenure of T Bills would be from 14 days to 364 days. However , the most popular

T Bill is 91 days T Bill. T Bill is a discounted instruments and it is issued at a discount

to the face value. The yield on treasury bill helps one to build up a risk free pure discount yield curve in the short term.

Certificate of Deposit : Certificate of deposit is also another money market instrument and issued by banks . CD is a negotiable instrument issued by banks to raise fund in large quantum. Banks can pay differential interest on CD. Commercial Paper : Commercial paper is also another money market instrument issued by corporations, primary dealers and financial institution. Liquidity Adjustment Facility (LAF) : Under the scheme , repo auctions ( for injection of liquidity ) and reverse repo scheme ( for absorption of liquidity ) will be conducted on a daily basis. Under the reverse repo auctions, the RBI would sale the securities to the commercial banks against which the banks would give fund. The RBI agrees to buy back the security at a predetermined rate which reflects the interest rate. Let us explain it with an example :

Suppose that RBI conducts reverse repo on November 15 th 2005 for one day. The interest rate would be 5% per annum. If a bank become successful in the reverse repo auction , it would have to give Rs 1 crores. Since the bank would be maintaining a current account with RBI, the account would be debited by this amount . The bank will maintain a Subsidiary General Ledger (SGL) with RBI. Within the SGL account , the bank will maintain Reverse Repo Constituents SGL account. In

26

this account the required amount of security would be credited. On the next day , the current account of the bank will be credited by an amount which is equal to the principal amount of Rs 1 crores plus interest rate @ 5% per annum for a day and corresponding quantity of securities would be debited from the Reverse Repo CSGL. With this mechanism , an amount of Rs 1crores would withdrawn from the banking system on November 15 th 2005 .So with this mechanism the liquidity is withdrawn from the system. Now if RBI wants to increase the interest rate in the call money market, it would increase the repo rate under LAF .So a bank having surplus would invest in the LAF rather than in the call money market. Similarly in the repo transactions, the banks would deposit securities with RBI and would receive money on the first day. On the second day , the bank would return back the money and it would receive the securities . In the first day, the successful bidder’s current account with RBI will be credited by the amount and its Repo Constituents SGL account will be debited by the required quantity of eligible securities. On the next day, the current account of the bank maintained with RBI will be debited and RR Constituents SGL will be credited. So on the first day of the repo of LAF , fund is injected in the system. So when RBI wants to reduce the call money rate , it would reduce the repo rate under LAF , so banks shortage of funds will avail the LAF instead of call money as long as it can avail the fund under LAF. Please keep it in mind that for availing LAF the banks must have eligible security for requisite amount . So first the bank would avail the LAF and then only it would avail the call money market. In this way the call money market interest rate can be influenced by RBI. For operational mechanism of LAF you can visit www.rbi.org.in and can go through related circulars under notification section of the site.

27

Chapter Four

Central Bank, Money supply and Credit

Money Stock Determination : Before understanding the central bank’s role on money supply and credit, let us first defined different nomenclature of money. Depending on the ease of conversion into cash and the different level of maturity of the economy, the money component is arrived at. Presently there are four types of money component:

M 1 = Currency with Public + Demand Deposit

M 2 =M 1 +Post Office Demand Deposit

M 3 = M 1 + Time Deposit of Bank

M 4 = M 3 + Time Deposit of Post Office If you see the components of different money, as we move downward the liquidity decreases and the interest bearing component increases. Among all the money , Reserve Bank of India (RBI) gives the most importance to M 3 ,because this is the component of money which can be changed by RBI policy. So we shall concentrate mainly on the M 3 . If one looks at the component of M 3 which is also called the broad money , it consists mostly of deposits at bank which the RBI does not control directly. In this particular chapter we begin to develop details of the process by which the money supply is determined and particularly the role of the RBI.

Let us define money supply as the following :

M 3 = C p +BD Where C p = Currency with the public BD= Bank deposit The behavior of both the public and the bank affects the money supply .The public’s demand for currency affects the currency component and its demand for bank deposits affects the deposit component. The RBI has a part in determining the money supply. The interactions among actions of the public, the banks and the RBI determine the money supply.

28

The three variables which summarize the behavior of the public, banks and the RBI in the money supply process are the currency deposit ratio, the reserve ratio and the stock of high power money.

The Currency Deposit Ratio : The payment habits of the public determine how much money is held relative to deposits. The currency deposit ratio is affected by the cost and convenience of obtaining cash. It can be assumed that currency deposit ratio is independent of interest rates and constant. The Reserve Deposit Ratio: Bank reserves consist of notes and coin held by banks and deposits the banks hold at the RBI. Bank holds reserves to meet a) the demands of their customers for cash and b) payments their customers make by checks that are deposited in other banks.

If we denote re the ratio of bank reserves to deposits, or the reserve deposit ratio, the reserve deposit ratio is less than 1. This is because the bank would hold more amount out of its deposit into other assets and less amount in the form of reserve. The re is determined by two sets of consideration. First, the RBI sets minimum reserve requirements. Reserves has to be held against deposits. The banks may also want to hold excess reserves beyond the level of required reserves. In deciding how much excess reserve to hold, the following factors are the determining factors :

The market interest rate i, the higher the market interest rate lower would be the excess reserve,

The volatility of the deposits,σ, the higher the volatility, the higher would be the excess reserve.

The reserve requirement, r R , the higher the reserve requirement higher would be the reserve deposit ratio.

The discount rate i D , the higher the discount rate, the higher would be the reserve deposit ratio.

High Power Money : High power money consists of currency and banks deposits with the RBI. Part of the currency is held by the public .The remaining currency is held by banks as part of their reserves. The RBI’s control over monetary base determines the money supply.

29

The Money Multiplier :

In this section, we develop a simple approach to money stock determination, using

key variables of currency deposit ratio, the reserve deposit ratio, and high powered

money. The approach is organized around the supply of and demand for high

powered money. The RBI can control the supply of high powered money. The total

demand for high powered money comes from the public who want to use it as

currency, and the banks which need its reserves.

Before going into the details , we want to think briefly about the relationship

between the money stock and the stock of high powered money. At the top of the

following figure, we show the stock of high powered money .At the bottom we show

the stock of money. They are related by the money multiplier .The money multiplier

is the ratio of the stock of money to the stock of high powered money .

Currency

Reserves

High Powered Money (H)

powered money . Currency Reserves High Powered Money (H) Currency Deposits Money stock Fig 4.1 The
powered money . Currency Reserves High Powered Money (H) Currency Deposits Money stock Fig 4.1 The
powered money . Currency Reserves High Powered Money (H) Currency Deposits Money stock Fig 4.1 The

Currency

Deposits

Money stock

Fig 4.1

The Money Multiplier

The precise relationship among the money stock ,M, the stock of high powered money ,H, the reserve deposit ratio,re, and the currency deposit ratio,cu is derived as follows :

M= [(1+cu)/(re+cu)]H

Where [(1+cu)/(re+cu)] is called as money multiplier.

It is clear that money multiplier is larger the smaller the reserve ratio re.The money multiplier is larger smaller the currency deposit ratio.

The RBI tries to control the money supplier by controlling the high power money.

Controlling the stock of High Powered Money :

The following is the balance sheet of RBI.

30

Liability

Asset

Currency- with public (C p ) With Bank (C b )

Gold and Foreign Exchange (FX RBI )

Bank Deposit at RBI (D)

Reserve Bank Loans given to Govt( LG RBI ) Bank (LB RBI ) Commercial Sector (LC RBI )

Net Other Assets (NO RBI )

Monetary Base

Monetary Base

Fig 4.2 Balance Sheet of RBI

H = C p +(C b ) +D =(FX RBI )+ ( LG RBI )+ (LB RBI )+ (LC RBI )+ (NO RBI ) C p =(FX RBI )+ ( LG RBI )+ (LB RBI )+ (LC RBI )+ (NO RBI )- C b -D

The Bank Balance sheet is given below :

Liability

Asset

Gold and Foreign Exchange (FX B )

Public Deposit with Bank (BD)

Bank Loans given to Govt( BG B ) Commercial Sector (BC B )

Cash Balance with Bank (C b )

Bank Deposit with RBI (D)

Net Other Assets (NO B )

Total

Total

Fig 4.3 Balance Sheet of Bank

M 3 = C p +(C b ) +BD From the above balance sheet of the bank , we get BD = (FX B ) +( BG B ) +(BC B )+ (C B ) +(D) +(NO B ) So, M 3 =(FX RBI )+ ( LG RBI )+ (LB RBI )+ (LC RBI )+ (NO RBI )- C b -D+(FX B ) +( BG B ) +(BC B )+ (C b )+(D) +(NO B ) =(FX RBI )+ ( LG RBI )+ (LB RBI )+ (LC RBI )+ (NO RBI )+(FX B ) +( BG B ) +(BC B )+(NO

(NO R B I )+(FX B ) +( BG B ) +(BC B )+(NO B )
(NO R B I )+(FX B ) +( BG B ) +(BC B )+(NO B )
(NO R B I )+(FX B ) +( BG B ) +(BC B )+(NO B )
(NO R B I )+(FX B ) +( BG B ) +(BC B )+(NO B )

B

)

Whenever RBI wants to change the money stock it can do so either by altering the

cash reserve ratio or by resorting to open market operation.

31

Chapter Five Fixed Income Security Market After the money market we shall discuss the capital market. As can be viewed from previous chapters, the capital market consists of debt market and equity market. In the case of debt market, it can again be classified again into two parts namely Government Securities market and non Government securities market. Since most of the debt markets in India consists of Government of India securities market, we shall discuss in detail about the Government of India securities market. Before we discuss the GoI securities market , we need to know why GoI Securities

are issued at the first place. To find out the reasons for issuance of GoI securities, we shall start with the central budget. The central budget consists of mainly two accounts :

Receipt

Expenditure

Under Receipt we have the following bifurcations :

Revenue Receipt (I)

o

Tax Receipt (II)

o

Non Tax Receipt (III)

Capital Receipt (IV)

o

Recovery of Loan (V)

o

Other Receipt (VI)

o

Borrowings (VII)

Under expenditure we have the following segregations:

Non Plan Expenditure

o

Revenue Account (VIII)

Interest (IX)

Others (X)

o

Capital Account (XI)

Plan Expenditure

o

Revenue Account (XII)

o

Capital Account (XIII)

Revenue Expenditure XIV= XII+VIII

Capital Expenditure XV= XI+XIII Revenue Deficit XVI= XIV-I Fiscal Deficit = XVI+XV-V-VI

32

It is seen from the above that the fiscal deficit is met by borrowings. Gross Primary Deficit = Fiscal Deficit –IX It indicates the amount of fresh borrowing going to meet the interest expenses.

It can be seen from the above that fiscal deficit is met by borrowings. It is also seen from the above that the deficit in the revenue account is not good for an economy where as the deficit in the capital account would go for the building up of productive assets. So when the fiscal deficit would only go for meeting the capital account deficit , it will go for productive investment. So the aim of the central government would be to eliminate the revenue deficit as early as possible. Now we shall see what are the options available to the government for raising funds under the head borrowing mentioned above. Funds can be raised under the head borrowing through the following methods :

Small Savings,EPF and PPF

RBI Bonds

External Borrowings

Market Borrowings

We shall see the pros and cons of all these different methods and then we shall see which methods are mostly used by the government . Small Savings,EPF and PPF : These are the methods by which resources are raised directly from the public. Considering the social security aspect of the country , political issues associated such type of borrowing the interest rate can not be reduced beyond a certain point. The best example would be the hue and cry raised when the EPF rate was reduced in recent times although the rate is quite higher compared to other types of borrowings. Besides, small savings are the major source of funds for states as state gets a certain percentage of funds they mobilize under the small savings scheme. So the interest rate can not be reduced to a great extent under these methods. If government plans to borrow predominantly in this route, it would have to pay more interest on its borrowing. So this will not be the most preferred route of borrowing for government. At present government borrows approximately about 25% of its total borrowing through this route. RBI Bonds: This is a good tool for raising funds from high net worth individual. The interest rate can be made lower compared to that of the previous mode of borrowing. Besides, the borrowing is directly from the public so the securities are widely distributed resulting in the lesser adverse effect on the financial system due to adverse movement in price. Besides the effect of high power money is also

33

reduced if borrowing is carried out through this route. This would increase in share of borrowings of the government in days to come. However, the difficulties in this type of borrowing is that it is difficult to raise such huge funds from retail base within one year. External Borrowing : Another options of the government would be to borrow from external sources. However, for borrowings from external sources, the assistance comes with lots of strings attached . In a democratic country like ours where there are opposition parties, this type of borrowing can raise several issues which can be very embarrassing and politically unwise for the ruling party. So this can be used only as last resorts. Market Borrowing : This is the most preferred method of borrowing for government of India to bridge the fiscal deficit. There is a captive market for this type of borrowing. Schedule commercial banks in our country is supposed to keep minimum 25% of their NDTL as Statutory Liquidity Ratio ( SLR) . It means that 25% of NDTL as on a reporting Friday would be kept in SLR approved securities. Banks can not default on this account. So banks have to keep 25% of NDTL in SLR securities. Government of India (GoI) securities are SLR approved securities .So government has a captive market for GoI securities in the form of schedule commercial banks in the country. As long as SLR stipulation is there, the government would not have any problem in getting fund up to the SLR requirement as banks do not have any option other than investing in the GoI Securities. Besides, Pension Funds , Insurance Companies are also legally bound to invest a certain portion of their portfolio in GoI securities . This also creates a captive market for the government. Besides, treasury profits generated by GoI securities prompts many corporate houses to invest in GoI securities. Due to these factors the market borrowing forms the major portion of borrowings of the central government and at present 70% of the fiscal deficit are bridged in this fashion. The market borrowing can be performed by any or combinations of the following methods :

Issue of securities through Auctions

Issue of securities through pre announced coupon rates

Issue of securities through Tap Sale

Issue of securities by conversion of T Bills/dated securities

Issue of securities by any other modes as decided by Government from time to time.

34

Issue of securities through auction: This is the most popular methods of raising funds under market borrowing programme. Since market borrowing is the major source of borrowing of the Government of India, this method is the mostly used method for bridging the fiscal deficit by the central government. Once the budget is announced in the month of February , the borrowing requirement can be determined from the fiscal deficit figure. Then the government would seat with RBI for finalizing the borrowing programme. The RBI will then announce a tentative borrowing calendar so that this news are factored in the interest rate the beginning of the year. This can be explained with the help of the Rational Expectation theory of interest rate. Now, after the announcement , the RBI can borrow the money under two types of auction process. In both the type of auction process the following steps are followed:

1. The RBI will put a public announcement about the auction process. The announcement would carry the issue size, type of auction, type of warding to the successful bidder, the process of bidding i.e. submission of application form and place and date of submission of application form etc.

2. The advertisement would also state the amount reserved under non competitive biddings. To promote the investment culture among larger number of people, the RBI allocates a certain percentage of the issue size under Non Competitive bidding. In this category , people have to just quote the amount bidding for not the price or interest rate. The bidders would be awarded at the price or interest rate at which the competitive bidders are awarded. This would act as an incentive for an entity to participate in the bidding process as he/she need not to posses the specialist knowledge required for investing in fixed income securities.

3. After the bids are submitted , the bids are opened as per the normal procedures and name of successful bidders are published .

4. The successful bidders are required to deposit the money asked for with the stipulated date as per the process mentioned in the advertisement.

5. On receipt of the money, the RBI credit the securities in the Subsidiary General Ledger (SGL) of the successful bidders who are having the account with RBI , for others who do not maintain a SGL , the security

35

is credited with Constituents Subsidiary General Ledger (CSGL) account maintained or the amount can be issued in the Physical form if the investors asked for it.

Now we shall discuss the different types of auction process first . There are two types of auction process. They are :

Yield Based Auction

Price Based Auction

Yield Based Auction : Under this type of auction , the bidders are asked to quote the biding amount along with the yield at which the amount is quoted. This can be explained with the help of following examples :

As per the Government of India borrowing programme, the RBI is announcing the following auction :

Govt. of India will borrow Rs 5000 crores under uniform price yield based auction for standard coupon bearing securities of 20 years maturity. Out of the above issues size 10% is reserved under non competitive category. This means that the RBI is asking bid under uniform price yield based auction for 20 years period. The coupon would be paid at half yearly interval . The amount reserved for non competitive bidding is Rs 500 crores. It means amount available for competitive bidding is Rs 4500 crores. Now let us take 4 different situations :

The following bidding is put by different banks :

Bank Name

Bid Amount ( Rs Crores)

Type of Bidding

Yield Quoted

(%)

Bank A

2000

C

5.50

Bank B

1500

C

5.45

Bank C

2500

C

5.40

Entity X

1

NC

 

Entity Y

5

NC

 

Entity Z

5

NC

 

C- Competitive NC- Non Competitive Situation I : Now if RBI decides that the cut off yield is 5.38% p.a. , then none of the bidder under the competitive scheme would qualify and only the non competitive bidder would get allotted at the cut of yield . The remaining

36

amount i.e. Rs 4989 crores would be taken by Primary Dealers ( PD) as PDs are the underwriter to the issue. We shall talk more about this issue and role of RBI in the Government borrowing programme separately . Situation II : If RBI decides a cut of yield of 5.40% , those who have quoted at the cut off yield or below would qualify. In this case only Bank C would qualify. Bank C would get Rs 2500 crores at 5.40% . The Non Competitive bidders would get Rs 11 crores at 5.40% and the remaining amount Rs 2489 crores would be taken by PD. When the auction would be over the government of India would issue securities with coupon rate 5.40% for 20 years. If the issue date is 25 th November 2005, then the security would be called as 5.40% 2025 GoI securities and the issuer would pay coupon on each security an amount of Rs 540/- since the face value of a single security is Rs 10000/-. The issuer would pay coupon for this amount on every 25 th May and 25 th November till 2025 and on 25 th November the face value of Rs 10000/- would also be paid by the issuer. The price of the security can be found out from the following equation :

 

C 1

C 40

P 0

P t =

+ …………………+

+

Eqn …5.1

 

[1+(r)] 1

[1+(r)] 40

[1+(r)] 40

This is the famous bond valuation equation. Here C i is called as Coupon amount and

r is yield to maturity (YTM). Please keep it in mind C i is kept constant during the

tenure of the security as this is the amount issuer will pay to the holder of the bond.

But r will keep on changing and r will reflect the market perception of the interest rate for the remaining maturity of the security. Another important factor is that when

r is equal to the coupon , then the present price is equal to the face value of the security . The bond equation can also be represented in the following format :

P t = C i [PVIFA] (r%, n years) + P 0 [PVIF] (r%, n years) Eqn ………….5.2

In the above mentioned case since the coupon would be 5.40% p.a. and this also

reflect the YTM then the issue price of the security would be Rs 10000/- the face value of the security. So in case of uniform price yield based auction successful bidders would be issued security at face value. Situation III : The cut off yield is 5.45% p.a. Here the successful bidders are Bank

B and Bank C as both of them have quoted at or below the cut off yield. So the total

37

amount to be awarded through competitive bidding is Rs 4000 crores and Rs 11 crores would be given to non competitive bidders at 5.45% p.a. and remaining Rs 989 crores would be taken by PD at 5.45% p.a. Now what would be the rate at which

Bank B and Bank C would be offered. Since the auction is uniform price auction, every eligible bidder would get at the cut off yield irrespective of their individual bid. In this case , although Bank C has quoted 5.40% p.a. , it will get 5.45% p.a. Situation IV: If the cut of yield is kept at 5.50% p.a., then all the bidders have quoted at or below the cut off yield. So all the bidders would be successful. Now , since the total bid amount under the competitive category is Rs 6000 crores against the total available amount under the competitive category of Rs 4500 crores , first the vacant amount under non competitive bidding would be allocated to the competitive bidding amount. So the total amount for awarding would be Rs 4500 crores plus Rs 489 crores i.e. total of Rs 4989 crores. Next step would be to find out the eligible amount under competitive bidding. Since the amount is Rs 6000 crores which is more than the total available amount , the allotment would be under the proportional allotment. So Bank A would get (Rs 2000/Rs 6000)*Rs 4989 crores . Similarly Bank B and Bank C would get (Rs 1500/Rs 6000)*Rs 4989 crores and (Rs 2500/Rs 6000)*Rs 4989 crores respectively. Now we take the same example of yield based auction but the awarding type is differential pricing . In this case the following methodology would be pursued :

1. First determine the eligible bidder applying the same logic. Any bidder which is quoting at or below the cut off yield would become eligible. So if we take the situation IV , then all the banks become eligible.

2. Then the awarding would be in the process so that the total cost of the borrowing is the least. In such case, Bank C would get Rs 2500 crores at 5.40% , Bank B would get Rs 1500 crores at 5.45% and bank C would Rs 989 crores at 5.50% p.a. The non competitive bidder would get 5.50%

3. But Government of India would issue securities at uniform coupon rate and the coupon rate would be at cutoff yield. So in this case the Government of India would issue securities at 5.50% coupon and Bank B and Bank C would pay more than the face value so that Government of India pays 5.45% and 5.40% respectively on their investment . The price is found out by putting r at 2.725% for bank B and r at 2.750% for Bank C in equation 7.1 where as the coupon would be Rs 550/- and P 0 is equal to Rs 10000/-. So in case of

38

differential yield based auction, different investor would pay different price at the time of subscription in the primary market. It may be mentioned that the uniform price auction is also called as Dutch Auction and the differential price auction is also called as French Auction. Price Based Auction : In Price based auction, the bidder is asked to bid for the price of a security where the coupon of the security would be mentioned at the time of advertisement . Let us take an example , As per the Government of India borrowing programme, the RBI is announcing the following auction :

Govern of India will borrow Rs 5000 crores under uniform price based mechanism for price based auction for standard 10% standard coupon bearing securities of 20 years maturity. Out of the above issues size 10% is reserved under non competitive category. This means that the RBI is asking bid under uniform price based mechanism for price based auction for 20 years period and the coupon of 10% coupon would be paid at half yearly interval . The amount reserved for non competitive bidding is Rs 500 crores that means amount available for competitive bidding is Rs 4500 crores. Now let us take 4 different situations :

The following bidding is put by different banks :

Bank Name

Bid Amount ( Rs Crores)

Type of Bidding

Price Quoted Per Rs 100

Bank A

2000

C

154.1757

Bank B

1500

C

155.0043

Bank C

2500

C

155.8394

Entity X

1

NC

 

Entity Y

5

NC

 

Entity Z

5

NC

 

The above price has been quoted by these banks by taking into consideration that the interest rate for 20 years as of the date of issue would be 5.40% for bank C,5.45% for bank B and 5.50% for bank C. Now , putting these different values of r in the equation 6.1 while keeping the C value at Rs 500/- and P 0 at Rs 10,000/-, the above mentioned prices are obtained. Situation I : The RBI feels that the 20 years risk free rate is 5.40% p.a. So the cut off price would be Rs 155.8394. So any one who has quoted at or above the cut off

39

price would become eligible for allotment. In this case, Bank C would become eligible. So bank C would get 16,04,216 number of 10% coupon bearing securities maturing at 25 th November 2025. The participants under Non Competitive bidding would get Rs 11 crores at the cut off price. The remaining amount would be issued to PD and PD would give the remaining Rs 2489 crores to the government of India. Situation II : The RBI feels that the 20 years risk free rate would be 5.50% p.a. Then all the banks would become eligible and the process of allotment would be same as mentioned in the yield based auction process. Situation III : In case of uniform price price based auction , if the auction type is differential price price based auction and the cutoff price has been decided as per situation II mentioned above. In this case, the allotment mechanism would be such that the cost of borrowing would be lowest. So C would get the maximum amount , then B and then A and the transfer of non competitive to competitive would follow the same methodology. So from the above we can find out that , the subscription price for an investor in a Government of India securities would be at the face value only when the auction is yield based and uniform price type. The subscription price would be different from the face value if the auction is yield based , differential price type, price based uniform price type and price based differential price type. Now we shall discuss the merits of price based auction compared to that of yield based auction. If one looks at the bond valuation formula as mentioned in equation 2.1 , one can issue a security with identical coupon which was issued earlier by changing the price. If the present interest rate for the period of present borrowing is less than the coupon rate to be offered in the security, the issue price would be more than the face value. Similarly, if the present interest rate for the period of present borrowing is more than the coupon rate to be offered in the security, the issue price would be less than the face value of the security. Due to this property , reissuance of security is possible under the price based auction process. The reissuance means issuance of a security which was earlier issued. Let us take an example. Suppose on 25 th November 1995 Govt. of India borrowed Rs 2500 crores for 20 years under yield based auction by issuing a coupon of 11% p.a. This means that on 25 th November 1995, the interest rate for 20 years was 11% p.a. Now on 25 th November 2005, the Govt. of India wants to borrow for 10 years. Let us assume that 10 years interest rate as on November 25 th 2005 is 4.95% p.a. In such case the

40

Govt. of India can issue 11% 25 th November 2015 at a premium . This serves two purposes .

1. With this mechanism the number of coupon as on a particular date increases as newer securities are issued with the same identical coupon. If the numbers of coupons are increased, all these coupons can be clubbed together and sold as a separate instrument because the total value of such instrument is increased. The principal can be traded separately. This improves the liquidity of the security. Such trading is called Separate Trading for Registered Interest and Principal Securities ( STRIPS).

2. It can be found out that the price sensitivity of a fixed income security is

lower in case of high coupon bond than a low coupon bond. So in such case, even though the interest rate is low, by issuing high coupon security at a premium, the issuer can provide a low price sensitivity to the investor. Considering the mark to market valuation, this is an important factor when the interest rate rises. Issue of Securities through pre announced coupon rate : Government of India can issue securities by announcing the coupon rate at the time of issuance it self. This makes the investors task easy as the investor need not to quote the rate. The securities are issued at par. Issue of securities through tap sale : This is a method by which the securities are sold through a selling window by RBI. The sale can be extended beyond one day and the sale can be closed at any time during the day. This method can be used by RBI to reduce the cost of borrowing for the government. Let us assume that on 1 st November 2008 , RBI announces a borrowing programme of Rs 2500 crores under yield based auctions for 20 years. The RBI fixes the cut off yield at 4.95% p.a. The yield quoted by all the bidders are more than the cut off yield. In such case the RBI would take the entire issue in its books. RBI is also visualizing that there would be some liquidity in the system because RBI is planning to carry out some sterilization mechanism under which it would buy dollars against rupees. This inflow of rupees would increase the money flow in the system and the interest rate would go down. Besides this RBI also visualizing that there would be deposit growth in the next one month which will also increase the money supply. Along with the deposit growth , the banks would be required to invest incremental amount in GoI Securities because of SLR requirement. At that time RBI can sale the securities on tap at the cut of yield at which the issue was devolved on RBI.

41

Issue of securities by conversion of T Bills/dated securities : Though this is one of the methods for issuing of GoI securities but this method is not an efficient method. This is because treasury bills are supposed to the self liquidating in nature . If the treasury bills are converted in to the GoI securities , it shows inefficiency in the system . So this form is not encouraged . Issue of securities by any other modes as decided by Government from time to time : The Government can issue securities by any other modes as decided from time to time. This clause is kept so that the Government can use any newer methods developed in the future .

Price of a Fixed Income Securities :

In the above mentioned examples showing the price of the fixed income securities we have assumed the following :

The coupon payment date and the issue date is same.

In the case of secondary market transaction, the above formulas would able to give the price only at the coupon payment date. But the coupon payment date would come only in once in the six month. So the above mentioned formula would give the price of a fixed income securities accurately once in six months. Then how this problem is addressed. To understand the problem , we have to understand the complete procedure of coupon payment. The coupon is paid to the holder of the securities at the coupon payment date by the issuer of the security. Let us take an example, Suppose A purchase a security from the issuer X on 3 rd of January 2009. The security is for five years and the coupon rate is 5% p.a. and the coupon is paid on half yearly basis. The next coupon is to be paid on 3 rd June 2009. Now suppose A sells the security to B on 4 th of March 2009 and B holds the security to the next coupon payment date. It means that the issuer would pay Rs 250/- ( assuming the face value of the security is Rs 10000/-) to B on 3 rd June 2009. There are two implications of this transaction:

A would not get the coupon from the issuer for the period it hold i.e. between 3 rd January to 3 rd March 2009. So it should get the payment for this period from B.

B would get interest for the period from 4 th March 2009 till it holds and this would be accounted for the price formula by applying the proper time scale in the bond pricing formula.

42

Next step would be the calculation procedure for the time period passed after the

last coupon date. For this period the seller would get accrued interest.

Next step would be the calculation procedure for the time period left from the

purchase date to the next coupon payment date. This would be put in the bond price

formula to get the proper price for the trade.

There are many types of convention for calculating the days as mentioned above .

These are :

30/360 :Each month will have 30 days inclusive of February and total days in

a year is 360

Actual /360 : Each month will have actual days and the total days in a year is

360.

Actual/Actual : Each month will have actual days and the total actual days

between two coupon period

Actual/365 : Each month will have actual days and the total days in a year

are 365 days.

Let us assume that we apply the Actual /360 formula . So the seller holds the

security from 3 rd January to 3 rd March i.e. (29+28+3)=60 days and total days

between two coupon period is 180 days as two coupon would be paid in a year.

So the seller would get the accrued interest for 60 days or he should get an amount

(60/180)* Rs 250/- at the time of selling the security in addition to the price of

selling. This is called the Dirty Price.

The sale price of the security would be found out by the following equation :

P 0

Eqn ………………… 5.3

=

[

C 1 /(1+r) (dnc/dicp) ]

+

[C 1 /(1+r) {1+(dnc/dicp)} ]+………

+

[C n (1+r) {(n-1)+(dnc/dicp)} ]

Here dnc= days between the trading date and the next coupon payment date =

days between two coupon payment date- no of days already passed =180-60=120

days

dicp= days between two coupon payment date =180 days

So dnc/dicp= 120/180=2/3

If the YTM for 4years 10 months is 5.10% , then the price would be Rs 10040.2722.

43

The buyer would pay to the seller on March 4 th 2009, Rs 10400.2722 plus accrued interest of (60/180)* Rs 250/- .

After finding out the ways for arriving at the price, while investing the money in the fixed income securities , one needs to look into the time horizon at which he/she is investing. If one is investing for the entire life of the securities , then he should look for a particular type of criteria . Similarly , if one is investing in a time horizon where he/she would sale before the maturity period , he will look after certain other criteria. For finding out such criteria for second category of investors , one need to understand the price and yield relationship of a fixed income securities. These are given below :

Before we proceed with the rules let us take the example of the following 4 fixed income bonds :

Bond

Coupon

Maturity

Initial YTM

A

12%

5 Years

10%

B

12%

30

Years

10%

C

3%

30

Years

10%

D

3%

30

Years

6%

Face Value of the bond is Rs 1000/- . Coupon is paid annually. If the YTM increases to 12% , then the bond A and B would be traded at par. So when coupon is equal to the YTM of the bond the price of the bond will be the face value. Similarly, if the YTM is more than the coupon, the price of the bond would be lower than the face value. In the above example, in Bond C the coupon is 3% and YTM is 10%. The price is Rs 340.12 less than the face value of the bond which is Rs 1000/-

. In such case, the bond is supposed to be traded at discount. Similarly, when the YTM of the bond is less than the coupon, the bond’s price is more than the face value and the bond is supposed to be traded at premium.

Then the price

Now let us assume that YTM of all the bond becomes 11% would be :

44

 

Bond A

Bond B

Bond C

Bond D

Price

at

YTM

1036.96

1086.94

304.50

503.64

11%

Similarly if the YTM becomes 10% then prices of these bonds would be as follows :

 

Bond A

Bond B

Bond C

Bond D

Price

at

YTM

1075.82

1188.54

340.12

587.06

10%

Now if the YTM becomes 9% then prices of these bonds would be as follows :

 

Bond A

Bond B

Bond C

Bond D

Price

at

YTM

1116.69

1308.21

383.58

692.55

9%

The above table would give you the following rules of between bond price and yield :

1. There is an inverse relationship between price and yield of a fixed income securities. If the YTM goes up price would fall and in case of downward movement of YTM the price would go up.

2. An increase in a bond’s yield would result in smaller price decline than the increase in price with the equal amount of fall in yield .This is explained with the following table :

 

Bond A

Bond B

Bond C

Increase in Price due to decrease in YTM from 10% to

40.87

119.67

43.46

9%

Decrease in Price due to increase in yield from 10% to

38.86

101.60

35.62

11%

3.Long term bonds tend to be more price sensitive than the short term bonds. This will be seen from the following table :

45

 

Bond A

Bond B

Bond C

Bond D

%

change

in

-3.61%

-8.55%

-10.47%

-14.21%

decline price

%

change

in

3.80%

10.07%

12.78%

17.97%

increase

in

price

3. As maturity increases the price sensitivity increases at a decreasing rate.

4. Price sensitivity is inversely related to the coupon rate ( see Bond B and Bond C) .

5. Price sensitivity is inversely related to the YTM at which the bond is selling.

Since the price would change during the holding period ( if the holding period is less than the maturity period of the bond) depending on the holding period horizon one tends to select bond by taking into account the above mentioned factors. Duration of Bond : Another measure of the effective maturity of the bond is the duration of the bond. This would be explained as below :

If we define as the maturity of a debt instrument is the time required to get all the payment from the instrument then you see a unique feature of fixed income securities :

In case of coupon bearing securities you get coupon before the maturity date of the security and you get the principal on the maturity date of the security. So the effective maturity is less than the maturity period of the fixed income instrument as some payments are received before the maturity period. So the concept of weighted average payment period is coming into picture . This weighted average payment period is called the duration of a fixed income securities. This is explained with the help of the following example :

There is a 8% coupon bearing bond with a remaining maturity of 2 years. The YTM of the bond is 10% . The duration of the bond is calculated as below :

Time of

Amount of Payment ( Rs )

Present Value of Cash Flow at

Wt

Effective

Payment (Yrs)

Period

10%

A

B

C

D

E

0.5

40

38.095

0.0395

0.0197

1

40

36.281

0.0376

0.0376

46

1.5

40

34.553

0.0358

0.0537

2.0

1040

855.611

0.8871

1.7742

   

Duration of the bond

1.8852

It is evident from the above that the duration of a fixed income coupon bearing security is less than the maturity period of the securities while for a zero coupon bind it is equal to the maturity period of the securities as no intermediate payments are made. Duration is very important due to the following equation :

P/P=-D[(1+y)/(1+y)]

If we define D * = D/(1+y) then the above equation becomes

P/P =- D * y

…………………………. Eqn 5.4

…………………………. Eqn 2.5

There are several rules for duration of a fixed income securities. These are :

Rule 1: The duration of a zero coupon bond is equal to its maturity. Rule 2: Holding maturity constant, a bond’s duration is higher when the coupon rate is lower . The higher the weight in earlier payment due to higher coupon lower would

be the weighted average maturity of the payment. Rule 3: Holding the coupon rate constant, a bond’s duration generally increases with its time to maturity. Rule 4: Holding other factors constant, the duration of a coupon bearing bond is higher when the bond’s YTM is lower. Rule 5 : The duration of a level perpetuity is as follows :

(1+y)/y ……………………………………………

Eqn 5.6

Rule 6 : The duration of a level annuity is equal to the :

[(1+y)/y]- [T/{(1+y) T -1}]……………… Eqn 5.7 Rule 7 : The duration of corporate bond is equal to :

[(1+y)/y] –([ { (1+y)+T(C-y)}]/[C{(1+y) T -1}+y])… Eqn 5.8

Rule 8 : For coupon bonds selling at par value , the duration can be calculated as follows :

47

{(1+y)/y}[1 –{1/(1+y) T }] ……………

Eqn 5.9

For example , a 10% coupon bond with 20 years to maturity , paying coupon semiannually , would have a 5% semiannual coupon and 40 payment period. If YTM is 4% per half year period , we get [1.04/0.04]-[{1.04+40(0.05-0.04)}/{0.05(1.04 10 -1)+0.04}=19.74 half year = 9.87 years Duration and Convexity :

If one observes the equation 5.4 , he/she can find out that duration is nothing but the slope of the curve obtained by plotting the change in yield in X axis and percentage change in price in the Y axis. This is shown in the following figure :

Percentage change in bond price

Price

Pricing error Due to convexity Duration
Pricing error
Due to convexity
Duration

Change in YTM (%)

Fig : 5.1 Relationship between change in price of a bond and change in YTM

The duration measures assume the linear relation ship between the change in price and change in yield where as actually the relationship is not linear. The relationship is convex. Due to this if the change in yield is more there would be error in the change in price value. If duration is used then it underestimates the increase in bond price and over estimates the decrease in

48

bond price with decrease and increase in YTM respectively. So the effect of convexity needs to be brought it to get the total effect when the change in yield is significant.

We can quantify convexity as the rate of change of the slope of the price yield curve , expressed as a fraction of the bond price . As a practical rule , one can view bonds with higher convexity as exhibiting higher curvature in the price yield relationship. Convexity implies that the duration approximation for bond price changes can be improved. Accordingly the equation 5.4 can be modified as follows :

P/P =- D * y +1/2*Convexity*(y) 2 ……………. Eqn 5.10

Please note that to use the convexity rule one must express interest rates as decimals rather than percentages.

The first term of Eqn 5.10 is the same as the duration rule . The second term is the modification for convexity. For a bond with positive convexity , the second term is positive , regardless of whether the yield rises or falls. Let us use a numerical example to examine the impact of convexity . Suppose a bank has 30 years of maturity , an 8 % coupon and sells at an initial YTM of 8%.Because the coupon rate equals to YTM , the bond sales at par. The modified duration of the bond at an initial yield is 11.26 years and its convexity is 212.4. If the bond’s yield increases from 8% to 10% , the bond price will fall to Rs 811.46 , a decline of 18.85%.The duration rule , would predict a price decline of P/P =- D * y =-11.26*0.02=-0.2252 or –22.52% which is considerably more than the bond price actually falls. The duration with convexity rule is more accurate :

P/P =- D * y +1/2*Convexity*(y) 2 =-0.1827 or –18.27%

The convexity of a bond is calculated with the help of the following formula :

Convexity=[1/{(P)*(1+y) 2 }]*[(CF t /(1+y) t )*(t 2 +t)] Eqn …5.11

49

Where CF t is the cash flow paid to the bondholder at date t. CF t represents either a coupon payment before maturity or final coupon plus par value at maturity date.

50

Chapter Six

Bond Portfolio Management

Once a treasurer invests in fixed income securities he/she creates a fixed income portfolio. For creation of portfolio he would look in to the above mentioned criteria depending on the investment horizon. During the investment horizon , the manager would manage the portfolio of bonds. Now , we shall discuss about the basic strategies followed by bond managers for managing the bond portfolio. The portfolio of any financial securities can be managed by following two strategies. They are :

Passive Portfolio Management Strategy

Active Portfolio Management Strategy.

So an equity portfolio can be managed by following the above mentioned strategy . Similarly , in the case of debt same strategy is followed. In the case of passive bond management strategy the underlying assumption is that

the pricing of the bonds available in the market are properly priced. They take that the bond prices are fairly set and seek to control only the risk of their fixed income portfolio. This can be done by any of the following process:

Indexing Strategy

Immunization strategy

Indexing Strategy: It attempts to replicate the performance of a given bond index. The idea is to crate a portfolio that mirrors the composition of an index that measures the broad market. But there are certain difficulties associated with this strategy. In the case of developed bond index total number of securities are very large. For example , any broad based US bond index consists of more than 5,000 securities. Moreover, the securities are constantly changing as securities having remaining maturity less than one year would go out of the bond index. So manager must rebalance the portfolio. This involves the transaction costs. In practice it is deemed infeasible to precisely replicate the broad bond index. Instead, a stratified approach is often pursued. First the bond market is stratified into several sub classes. The criteria for stratification can be maturity, issuer, bond’s coupon rate, credit risk of the issuer are taken into account. Next the percentage of the entire universe (i.e. the bonds included in the index that is to be matched). Next

51

the sampling is carried out in such a way the selected sample represent most of the characteristics of the bond index. Immunization : In contrast to indexing strategies, many institution try to insulate their portfolios from the interest rate risks altogether. Generally, there are two ways of viewing this risk, depending on the circumstances of the particular investor. Some institutions such as banks, are concerned with protecting the current net worth or net market value of the firm against the interest rate fluctuations. Other investors, such as pensions funds , may face an obligation to make payments after a given number of years. These investors are more concerned with protecting the future values of their portfolios. The common risk with these two types of investors are the interest rate risks. Immunization techniques refer to strategies used by such investors to shield their overall financial status from exposure of interest rate fluctuations. Net Worth Immunizations : Many banks and thrift institutions have a natural mismatch between asset and liability maturity structures. Bank liabilities are primarily the deposits owed to the customers, most of which are very short term in nature and consequently of low duration. Bank assets are composed of largely of outstanding commercial and consumer loans which are of longer duration than deposits and their values are correspondingly more sensitive to interest rates. Let us take an example that an insurance company issues a guaranteed investment contract for Rs 10000/- . If the contract has a five year maturity and a guaranteed interest rate of 8% , the insurance company is obligated to pay Rs 10000*(1.08) 5 =Rs 14693.28 in five years.

52

Payment Number

Years remaining until obligation

Accumulated value of invested payment

A. Rates remain at 8%

   

1

4

800*(1.08) 4 =1088.39

2

3

800*(1.08) 3 =1007.77

3

2

800*(1.08) 2 =933.12

4

1

800*(1.08) 1 =864.00

5

0

800*(1.08) 0 =800.00

Sale of Bond

0

10800/(1.08) = 10000

 

Total

14,693.28

B. Rates falls to 7%

   

1

4

800*(1.07) 4 =1048.64

2

3

800*(1.07) 3 = 980.03

3

2

800*(1.07) 2 =915.92

4

1

800*(1.07) 1 =856.00

5

0

800*(1.07) 0 =800.00

Sale of Bond

0

10800/(1.07) = 10093.46

 

Total

14,694.05

C. Rates increases to 9%

   

1

4

800*(1.09) 4 =1129.27

2

3

800*(1.09) 3 = 1036.02

3

2

800*(1.09) 2 =950.48

4

1

800*(1.09) 1 =872.00

5

0

800*(1.09) 0 =800.00

Sale of Bond

0

10800/(1.09) = 9908.26

 

Total

14,696.02

The above table shows that if interest rates remain at 8% , the accumulated funds will grow to exactly the Rs 14693.28 obligation. Over the five year period, the year end coupon is reinvested at the prevailing market rate i.e. 8% . At the end of the period the bonds can be sold for Rs 10000/- . Total income after five years from reinvestment of bonds and sale of bond would is precisely Rs 14,693.28. If interest rates change however two offsetting influences will affect the ability of the fund to grow to the targeted value of Rs 14,693.28. If interest rates rise, the fund

53

will suffer a capital loss but the coupon reinvested at a higher rate would grow faster. Reverse would happen if the interest rate falls. In other words, the fixed income investors face two offsetting types of interest rate risk : price risk and reinvestment risk. The first type of risk is the price risk and the second type is called the reinvestment risk. When a portfolio duration is set equal to the investor’s horizon date, the accumulated value of the investment fund at the horizon date will be unaffected by interest rate fluctuations. For a horizon equal to the portfolio’s duration , price risk and reinvestment risk exactly cancels out. The following figure depicts the price risk and reinvestment risk in the time horizon :

Accumulated value of invested fund

Funds

t* D t
t*
D
t

Fig 6.1 : The growth of invested fund with time

54

The solid curve represents the growth of the portfolio value at the original interest rate. If interest rate increase at time t*, the portfolio value initially falls but increases subsequently at the faster rate represented by the broken curve. At time D ( duration) the curves crosses. So to protect the interest rate risk one can adopt the immunization technique. However the rebalancing of the portfolio is must. As interest rate and asset durations change, a manger must rebalance the portfolio of fixed income assets continually to realign its duration with the duration of the obligation. Moreover, if interest rate do not change, assets durations will change solely because of the passage of the time. Thus even if an obligation is immunized at the beginning , as time passes the durations of assets and liability will fall at different rates. Without portfolio rebalancing, durations will become unmatched and the goals of immunization will not be realized. Obviously, immunization is a passive strategy only in the sense that it does not involve attempts to identify undervalued securities . Let us take another example about the need for rebalancing of the portfolio. Let us consider a portfolio manager facing an obligation of Rs 19487 in 7 years , which at current market interest rate of 10% , has a present value of Rs 10000/- . If the manager wishes to immunize the obligation by holding only three year zero coupon bonds and perpetuities paying annual coupons. At current interest rates, the perpetuities have a duration of 1.10/10=11 years. The duration of a zero coupon bond is 3 years. For assets with equal yields, the duration of a portfolio is the weighted average of the duration of assets comprising the portfolio. To achieve the desired portfolio duration of 7 years , the managers would have to choose appropriate values for the weights of the zero and the perpetuity in the overall portfolio. Then the weight of investment in zero w must be chosen to satisfy the following equation :

W* 3 +(1-w)*11 =7 years …………………… Eqn 6.1 This implies that w=1/2. The manger invests Rs 5000/- in zero coupon bond and Rs 5000/- in perpetuity. Next year even if the interest rate does not change, rebalancing will be necessary. The present value of obligation has grown to Rs 11000/- , because it is one year closer to maturity. The manager’s fund has also grown to Rs 11000/- .The zero coupon bonds have increased in value from Rs 5000/- to Rs 5500/- with the passage of time , while the perpetuity has paid its annual Rs 500/- coupon and still it is worth of Rs 500/- However, the portfolio weight must be changed . The zero coupon

55

now will have 2 years duration while the perpetuity remains at 11 years. The obligation is now due in 6 years. The weights must now satisfy the equation :

w* 2 +(1-w) *11=6 this implies w=5/9. So the manager must invest a total of Rs 11000*(5/9)= Rs 6111.11 in the zero. This requires that the entire Rs 500/- coupon payment be invested in the zero and that an additional Rs 111.11 of the perpetuity be sold and invested in the zero in order to maintain an immunized position.

However, rebalancing of portfolio entails transaction costs as assets are bought or sold , so one can not rebalance continuously. In practice, an appropriate compromise must be established between the desire for perfect immunization which requires continual rebalancing and the need to control trading costs, which dictates less frequent rebalancing.

Cash Flow Matching and Dedication: Cash flow matching on a multi period basis is referred to as a dedication strategy. In this case, the manager selects either zero coupon or coupon binds that provide total cash flows in each period that match a series of obligations. The advantage of dedications is that it is a once and for all approach to eliminating the interest rate risk. Once the cash flows are matched, there is no need for rebalancing. The dedicated portfolio provides the cash necessary to pay the firm’s liabilities regardless of the eventual path of interest rate. However the problem in such strategies would be the availability of appropriate securities so that exact cash flow matching takes place.

Other problems with conventional immunization :

If we look at the definition of the duration then we note that it uses the bond’s yield to maturity for calculating the weight applied to the time until each coupon payment. Given this definition and limitations on the proper use of yield to maturity , it is perhaps not surprising that this notion of duration is strictly valid only for a flat yield curve for which all payments are discounted at a common interest rate. If the yield curve is not flat , then the definition of duration must be modified and CF t /(1+y) t replaced with the present value of CF t where the present value of each cash flow is calculated by discounting with the appropriate interest rate from the

56

yield curve corresponding to the date of the particular cash flow, instead by discounting with the bond’s yield to maturity. Moreover, even with this modification, duration matching will immunize the portfolios only for the parallel shift in the yield

curve. Clearly, this sort of restriction is unrealistic. As a result, much work has been devoted to generalizing the notion of duration in the shape of the yield curve, in addition to shifts in its level. Finally, immunization can not be an appropriate goal in an inflationary situation. Immunization is essentially a nominal notion and makes sense only for nominal liabilities. It makes no sense to immunize a projected obligation that will grow with the price level using nominal assets such as bonds. Active Bond Management :

Sources of Potential Profit :

Broadly speaking there are two sources of potential value in active bond management. The first is interest rate forecasting which tries to anticipate movements across the entire spectrum of the fixed income market. If interest rate declines are anticipated , managers will increase the portfolio duration ( or vice versa) . The second source of potential profit is identification of relative mispricing within the fixed income market. These techniques will generate abnormal returns only if the analyst’s information or insight is superior to that of the market. In this context it is worth mentioning that interest rate forecasts have a notoriously poor track record. One of the active bond portfolio management strategies is the bond swaps. There are four types of bond swaps. In the first two types of bond swaps the investor typically believes that the yield relationship between bonds or sectors is only temporarily out of alignment. When the aberration is eliminated, gains can be realized on the underpriced bonds. The period of realignment is called the workout period.

1. The substitution swaps : The substitutions swap is an exchange of one bond for a nearly identical substitute. The substitute bonds should be of essentially equal coupon, maturity, quality call features, sinking fund provisions, and so on. This swap would be motivated by a belief that the market has temporarily mispriced the two bonds , and that the discrepancy between the prices of the bonds represents a profit opportunity.

2. The intermarket swaps: It is pursued when an investor believes that the yield spread between two sectors of the bond market is temporarily out of

57

line. For example, if the current spread between corporate and government bonds is considered too wide and is expected to narrow, the investor will shift from government bonds into corporate bonds. If the yield spread does in fact narrow, corporates will outperform governments,. But the investor must be sure that there is actually mispricing between two bonds. The difference is not due to some genuine reasons like credit downgrade etc.

3. The Rate anticipation swaps : It is pegged to interest rate forecasting. In this case, if investors believe that rates will fall , they will swap into bonds of longer duration. Conversely , when rates are expected to rise, they will swap into shorter duration bonds .

4. The pure yield pick up swaps: It is pursued not in response to perceived

mispricing but as a means of increasing return by holding higher yield bonds. When the yield curve is upward slopping , the yield pick up swaps entails moving into longer term bonds. This must be viewed as an attempt to earn an expected term premium in higher yield bonds. The investor is willing to bear the interest rate risk that this strategy entails. The investor who swaps the shorter term bond for the longer one will earn a higher rate of return as long as the yield curve does not shift up during the holding period. Of course, if it does, the longer duration bonds will suffer a greater capital loss. Horizon Analysis :

One form of interest rate forecasting is called horizon analysis. The analysts using this approach selects a particular holding period and predicts the yield curve at the end of the period. Then bond’s end of period price is calculated from the yield curve. Then the analysts add the coupon income and the perspective capital gain of the bond to arrive at the total return on bond in the horizon period.

Suppose a 20 year maturity ,10% coupon bond currently yields 9% and sells at Rs 1092.01. An analyst with a 5 year time horizon would be concerned about the bond’s price and the value of reinvested coupon five years hence .At that time the bond will have 15 years maturity , so the analyst will predict the yield on 15 years maturity at the end of 5 year period to determine the bond’s expected price . If the yield is expected to be 8% , the bond’s end of period price will be –50 * Annuity Factor ( 4% ,30)+1,000 PV Factor ( 4%,30)= Rs 1172.92 . The capital gain on this bond will be Rs 80.91 . Meanwhile the coupon paid by the bond will be reinvested over the five year period. The analyst must predict a reinvestment rate at

58

which the invested coupons can earn interest. Suppose the assumed rate is 4% per half year period. If all the coupons are reinvested at this rate, the value of the ten semiannual coupon payments with accumulated interest rate at the end of the five year will be Rs 600.31. The total return proved by the bond over the holding period is Rs 681.82/Rs 1092.01 i.e. 62.4% . The analyst repeats this procedure for many securities and select the ones promising superior holding period return.

Contingent Immunization :

It is mixed passive –active strategy . Suppose that the interest rate at present is 10% per annum and a manager’s portfolio is worth Rs 10 million right now. At current rate the manager can lock in via conventional immunization techniques, a future portfolio value of Rs 12.1 million after 2 years. Now suppose that the manager wants to pursue active management but is willing to risk losses only to the extent that the terminal value of the portfolio would not drop lower than Rs 11 million.

Because only Rs 9.09 million ( Rs 11million/1.10 2 ) is required to achieve this minimum acceptable terminal value , and the portfolio is currently worth Rs 10 million , the manager can afford to risk some losses at the outset and might start off with an active strategy rather than immediately immunizing. The key is to calculate the value of the fund required to lock in via immunization a future value of Rs 11 million at current rates. If T denotes the time left until the horizon date and r is the market interest rate at any particular point of time , then the value of the fund necessary to guarantee an ability to reach the minimum amount of terminal value is

Rs 11 million/(1+r) T , because this size portfolio if immunized will fetch Rs 11 million. This value becomes the trigger point. When the actual portfolio value dips to the trigger point , active management will cease. Contingent upon reaching the trigger , an immunization strategy is initiated

59

Rs in Million Portfolio Value Trigger Point t* Horizon
Rs in Million
Portfolio Value
Trigger Point
t*
Horizon

t

Fig 1.2 Contingent Immunization

Rs in million Portfolio Value Horizon t*
Rs in million
Portfolio Value
Horizon
t*

60

t

Fig 6.3 : Contingent Immunization consisting of only active bond management strategy

Interest Rate Swaps : An interest rate swap is a contract between two parties to exchange a series of cash flows similar to those that would result if the parties instead were to exchange equal dollar values of different types of bonds. Swaps arose originally as a means of managing interest rate risk. To illustrate how swaps work, let us consider the manager of large portfolio that currently includes Rs 100 million par value of long term bonds paying an average coupon rate of 7%. The manager believes that the interest rates are about to rise. As a result , he would like to sell the bonds and replace them with either short term or floating rate issues. However, it would be exceedingly expensive in terms of transactions costs to replace the portfolio every time the forecast for interest rate is updated. A cheaper and more flexible way to modify the portfolio is for the managers to swap the Rs 7 million a year in interest income the portfolio currently generates for an amount of money that is tied to the short term interest rate. That way, if rates do rise, so will the portfolio’s interest income. A swap dealer might advertise its willingness to exchange or swap a cash flow based on the six month LIBOR rate for one based on a fixed rate of 7%. The portfolio manager would then enter into a swap agreement with the dealer to pay 7% on notional principal of Rs 100 million and receive payment of the LIBOR rate on the amount of notional principal. In other words the manager swaps a payment of 0.07*Rs 100 million for a payment of LIBOR* Rs 100 million. The managers net cash flow from the swap agreement is therefore (LIBOR-0.07)* Rs 100 million. Now consider the net cash flow to the manager’s portfolio in three interest rate scenario:

   

LIBOR Rate

 

6.5%

7.0%

7.5%

Interest income from bond portfolio=(7% of Rs 100 million)

Rs 70,00,000

Rs 70,00,000

Rs 70,00,000

Cash Flow from swap[=(LIBOR-7%)* notional principal of Rs 100 million]

Rs (500,000)

0

Rs 5,00,000

61

Total (=LIBOR*Rs 100 million)

Rs 65,00,000

Rs 70,00,000

Rs 75,00,000

Please note that the total income on the overall position bonds plus swap arrangement is now equal to LIBOR rate in each scenario times Rs 100 million. Financial Engineering and Interest rate derivatives : Some of the more popular mortgage derivative products are interest only and principal only strips. The interest only (IO) strip gets all the interest payments from the mortgage pool and the principal only (PO) strips gets all the principal payments. Both of these mortgage strips have extreme and interesting interest rate exposures. In both cases, the sensitivity is due to the effect of mortgage prepayments on the cash flows accruing to the security holder. PO securities exhibit very long effective durations. It means that their values are very sensitive to interest rate fluctuations. When interest rate fall and mortgage holders prepay their mortgages, PO holders receive their principal payments much earlier than initially anticipated. Therefore, the payments are discounted for fewer years than expected and have much higher present value. Hence PO strips perform extremely well when rates fall. Conversely , interest rate increases slow mortgage prepayments and reduce the value of PO strips. The prices of interest only strips , on the other hand , fall when interest rate fall. This is because mortgage prepayments abruptly end the flow of the interest payments accruing to IO security holders. Because rising interest rates discourage prepayments , they increase the value of IO strips. The IO s have negative effective durations. They are good investments for an investor who wishes to bet on an increase in interest rate, or they can be useful for hedging the value of a conventional fixed income securities.

62

Chapter Seven

Assessment of Fund Based and Non Fund Based Working Capital

By Fund Based ( FB) working capital facility, we mean products of banks through which banks provide fund for meeting working capital requirement of the company . If we recall the concept of building up of working capital discussed in the class, we find that current assets represents the expenses which is incurred but not realized. We have also said that part of the expenses can be deferred and this constitutes the other current liability ( OCL).The expenses which can not be deferred would be paid from borrowings. A part of the expenses are paid from Net Working Capital ( NWC) and the remaining part of expenses would met from borrowing of the banking system. We have also discussed the reason for bank’s being the major provider of working capital facilities in our country. So Fund Based ( FB) working capital represents that portion of current liability which is going to build up that portion of current assets which are not financed by OCL and NWC.

After defining the FB working capital products, we shall now discuss about the entire process of availing the Fund Based Working Capital facility of bank. The sequence of availing the facility from bank is as follows:

1. Company assess its working capital requirement ;

2. After assessment, the company decides the type of banking;

3. Company initiates the process of tying up of fund from banking system;

4. Company avails the fund from the baking system;

5. In the next year, company follows the same process;

Assessment of Working Capital Requirement :

The working capital facility of a company consists of two types of facilities :

1. Fund Based Working Capital Facility

2. Non Fund Based Working Capital Facility

63

While the detail discussion on Non Fund Based facility would be done in the next chapter, in this chapter we shall discuss the fund based facility. Though the final assessment of fund based facility is carried out by the lender, the process starts from company’s end. If company is aware of the process of assessment of working capital , it would be able to sanction its working capital as per its requirement.

Assessment is defined as the process by which one can determine the maximum amount of fund can be availed from institutional lender to meets a company’s working capital requirement. So assessment of working capital for a corporate means the process of arriving at the maximum quantum of working capital requirement of a corporate for a particular period.

Assessment of Fund Based Working Capital

In India, Fund Based working capital is carried out with the help of any of the three following processes :

1. Maximum Permissible Bank Finance ( MPBF) Process

2. Cash Budget Process

3. Turn Over Process

MPBF Process : Under this method , the assessment of fund based working capital is carried out by taking into account figures from Balance Sheet as on a particular date. Before going into detail, let us make one concept very clear. Since a company is carrying out assessment , it is trying to ascertain funds required in the future. The past financials would indicate the company’s achieved performance and also

validates the future financials. But the assessment is carried out on the basis of future financials. When we talk about the future, there are two years. One is the current running year and another is the next coming year. While the figures for the first one is called Estimate , the later one is called the Projections. For example, a corporate carrying out the assessment as on May 1,2008, the company has two choices. If it follows the assessment based on estimates, it will take financial data for the FY 2008-09 and Balance Sheet data as on March 31,2009. If it follows the assessment based on projections, it would use the datas for the FY 2009-10 and also Balance Sheet Data as on March 31,2010.

64

Now coming back to MPBF process, under this process FB working capital

requirement would be carried out in any of the following three methods:

1. Method I

2. Method II

3. Method III

In all the above three methods, all the figures are taken from the balance sheets. The figures are either from “Estimates” or from “Projections” but not from both. While arriving at the assessment figure of Fund Based Working Capital requirement under MPBF method, company needs to submit data in a specified format. This form is called as “Credit Monitoring Arrangement or CMA” forms. CMA form consists of 6 separate forms representing different types of figures taken from Profit & Loss and Balance Sheet of the company .The following tabular representation would make it clear the content and implications of these 6 forms :

Form No

Content of Form

Justification

I

Total Existing Borrowing of the company as on the date of application

The proposed lender would decide to take a fresh exposure depending on the existing leverage and future cash out flows from the existing borrowing of the company

II

Profit and Loss Accounts

Detail analysis of Profit & Loss account of the company.Since the funding for working capital is predominantly for meeting the expenses incurred but not recovered in connection with the production of goods and services, major analysis is carried out for expenses associated with the productions.

III

Analysis of Entire Balance Sheet of the company

Detail Balance Sheet Analysis of the company is carried out.

65

   

Here some adjustment is made to incorporate the effect of certain off balance items and also the immediate effect of cash out flows

IV

Analysis of Current Assets and Other Current Liability

As we have already seen, Working Capital Finance is mainly to take care of Current Assets and Other Current Liability. Form IV aims to carry out detail analysis of Current Assets and Other Current Liabilities in terms of months of holding and other parameters

V

Assessment of Fund Based Working Capital

This calculated the MPBF depending on the methods followed.

VI

Fund Flow Analysis

This explains detail calculation of sources and uses of long term funds and the utilization of NWC towards individual current assets.

Figure 7.1 Form I: Form I contains the existing borrowing of the company. This includes all types of borrowing namely Term Loan, Debenture, Unsecured Loan and also Lease Finance. It must contain data as on the application date .This information would help the proposed lender to take a decision whether it should lend depending on the leverage of the company, repayment capacity towards already existing commitment of the company. Form II : This form and Form III contain the financial data for 4 years. These contain actual data for last 2 years , estimates for the current financial year and projections for the next financial year. For example, a company applying for Fund Based Working

66

Capital under MPBF method on July 1,2009, should give the following 4 sets of data in Form II & III:

1. Actual Data ( Audited Figure) for the financial year ended March 31,2008 and March 31,2009.

2. Estimates Data for the financial year ending March 31,2010.

3. Projections Data for the Financial year ending March 31,2011.

For III is actually representation of Profit & Loss figure of the company with a special

emphasis on the cost associated with the production of goods and services.

Form III : This form comprises of data taken from the Balance Sheet of a company.If one analyse the format of Form III, one can find out the following :

Form III starts with the Current Liability . In this form , current liability is segregated into 2 parts. The first part consists of Bank Borrowing for working capital and the second part consists of Other Current Liability ( OCL) .The Term Liability ( TL) is presented and the total outside liability is arrived at. Then comes the Own Capital .It starts with Equity and then figures representing reserves and other equity type of instruments are taken in to account. The total of Out Side Liability ( Term Liability + Current Liability) and Owned Fund represents the Total Liability of the company .

The Asset Side of the Form III starts with Current Assets. Then comes Gross Fixed Asset , depreciation and Net Fixed Asset. Then the figures representing the Non Current Assets ( NCA) are incorporated. Then, Intangible assets if any is also taken in to account. Taking all these together ( Current Asset+ Net Fixed Asset +Non Current Asset + Intangible Asset) , one arrives at the Total Asset figure of the company.

There are some adjustments required to fill up Form III of CMA form. To understand these adjustments in Form III of CMA form ,let us take the example of the following

:

67

Balance sheet of X Limited as on March 31,2009 All amount in Rs Lacs

Sources of Fund :

Schedule

Amount

Share Capital

1

100

Reserves

2

250

Secured Loans

3

125

Total Source of Fund

475

Uses of Fund :

Schedule

Amount

Fixed Asset

4

200

Less Depreciation

50

Net Fixed Asset

150

Investment

5

100

Current Assets ,Loans and Advances

285

Current Assets

225

Raw Material

6

70

Work In Progress

7

20

Finished Goods

8

30

Receivable

9

100

Cash at Bank

10

5

Loans and Advances

11

60

Loan to Group Companies

20

Loan to Staff

10

Other Advance

10

Tax Deduct at Source

5

Advance Tax Paid

15

Less Current Liability and Provision

60

Current Liability

12

40

Sundry Creditors

30

Advance from Customers

10

68

Provision

13

20

Provision for Taxation

15

Provision for Dividend

5

Net Current Asset

Total Uses of Fund Notes on Contingent Liabilities :

225

475

a. Bill discounted from Bank Rs 15 lacs.

Further Information from Schedules are Available as follows :

Schedule

Description

Amount ( Rs in lacs)

2

Reserves

250

 

Revaluation Reserves

20

 

Free Reserves

230

3

Secured Loan

125

 

Term Loan ( The term Loan to be paid in 5 yearly installment of Rs 10 lacs each )

50

 

Cash Credit for Working Capital

75

5

Investment

100

 

Fixed Deposit in Bank

50

 

Investment in Group Companies

30

 

Investment in Quoted Shares

20

9

Receivable

100

 

Outstanding for more than 180 days

25

 

Outstanding for up to than 180 days

75

Figure 6.2

69

In the actual accounts of a company, we get details of each schedule. In this section, we have made only those schedules which are required for adjustment of figures in filling Form III of CMA form.

1) The First adjustment is the bill discounted amount. When a company sells on credit the following entry is passed :

Dr Receivable

Cr Sales

There is no cash flow associated with this entry. To improve the cash flow the company can sell a part of its credit sales after drawing bill of exchange. So the receivable can be segregated into two groups :

a. Accounts Receivable : This is simple credit and there is no bills of exchange. This is also called as Open Account Sales.

b. Bills Receivable : In this type of credit sales ,

apart from documents required under Open Account Sales , additional document in the form of Bills of Exchange also accompanies the document. The buyer once accepts the bills of exchanges would be liable to pay the bills of exchange. Some additional protection under legal statute is available for the Drawer of Bills of Exchange since Bills of Exchange is a negotiable instrument. To improve the cash flow, the company discounts the bills of exchange to bank. When the bill is discounted , the following entry would appear in the balance sheet of the company :

Dr . Bank Cr Receivable But the amount outstanding under bills discounted will appear as the contingent liabilities in the balance sheets of the company. Now, when one company fills up the

70

Form III, this amount is added both on the liability side and also on the asset side. In the liability side, it is added under the head Bank Borrowing for working capital under Current Liability and in the asset side this amount is added with the receivable figure appearing on the balance sheet. The amount of Rs 15 lacs would be added with the Cash Credit For Working Capital head in the current liability portion of Form III and Rs 15 lacs would be added to the Receivable on the asset side of Form III under the head Receivable. The Second Adjustment : The secured loan consists of Term Loan and Cash Credit for Working Capital .We shall first segregate the two. From schedule we get the following :

Term Loan : Rs 50 lacs Cash Credit : Rs 75 lacs After this, the term loan needs to be segregated further into two parts. One part must mention the installment to be paid within one year and the other part must contain installment to be paid after one year. From the description of the schedule, we can segregate the term loan portion as follows as on March 31,2005 :

Installment payable within 1 year : Rs 10 lacs Installment payable more than 1 year : Rs 40 lacs Now while filing up the Current Liability portion of Form III, this installment of term loan payable within 1 year would be filled up in the current liability and the installment of Term Loan to be payable after 1 year would appear on the term liability .

So after adjustment of Bill Discounting , the total bank borrowing in the Form III would be Rs (75+15)=Rs 90 lacs .

Third Adjustment : Here , the adjustment for Tax would be carried out. The Tax on the Profit of a business entity is calculated as per the Income Tax Act ,1961. At the beginning of the year , the company projects a certain profit as per the Calculation under Income Tax Act 1961 and determines its tax. Let us take an example that during FY 2005-06, the income tax calculated by the company is Rs 12 lacs. The total amount of tax to be paid by the company during the Financial Year 2008-09 would be Rs 12 lacs. However, in certain services provided by a company, as per Income Tax Act,1961 the receiver of service would have to deduct tax on the

71

payment at source ( TDS) and the same is deposited by the service receiving company, against which Form 16A is issued by the service receiving company. The company also makes an assessment of this TDS. The net amount i.e. the estimated

Tax Amount minus the TDS amount would be the amount in cash to be deposited by the company to the exchequer. The company needs to pay this net amount in Quarterly installment as specified under IT Act ,1961 under the head Advance Tax Paid. So whenever there would be payment of tax on account of Advance Tax Paid, the following entry is passed :

Dr . Advance Tax Paid

Cr

Bank A/C

Similarly when TDS is calculated on the service , the following entry is passed :

At the time of booking income while providing service on credit , Dr Receivable say Rs 10 /-

Cr Income

Rs 10/-

Now at the time of payment by the customer, it would deduct TDS , if applicable. If the TDS percentage is 10% on bills value , then the following entry would be passed in the books of selling company during the time of payment by the customer of selling company .

Dr Bank

Rs

9/-

Dr TDS

Rs

1/-

Cr Receivable

Rs 10/-

At the end of the year , say on April 15,2009, the company calculates the actual profit under IT Act,1961 for the FY 2008-09 and the entire amount is provided in the P&L account .The following book entry is passed :

Dr

Profit & Loss Account for provision for taxation

Cr Balance sheet account under the head current liability and provision

Any difference between the Tax Paid ( advance tax paid +TDS) and the provision for taxation would be paid in the bank .

So the head TDS and Advance Tax Paid in the Assets side of the balance sheet would contain the amount of Tax paid by the company and the head provision for taxation in the Current Liability side of the balance sheet would contain the amount of tax required to be paid by the company. The company would not be able to know

72

the exact position in respect to the actual tax payment position unless the assessment is carried out the department. Till the time assessment is over for a particular year , the corresponding amounts would carry on both sides of the balance sheet. Generally, it takes more than 1 year for getting the assessment of a FY . This is because the last date for submission of Tax Return for a company is October 31 st of a particular year. So the tax return to be filled by a company for the financial year ended March31,2009 is on September 30 th ,2009. Generally the assessment would be carried out by September 2010 and during that time the advance tax paid ,TDS amount and Provision For Taxation for the FY 2008-09 would appear on the balance sheet. So at any point of time , the figures in Advance Tax Paid, TDS account and provision for taxation would contain these figures for more than 1 financial year . Now in the above mentioned example the following segregation is available :

Advance Tax Paid : Rs 15 lacs

TDS

Provision for Taxation : Rs 15 lacs

Rs

5 lacs

Rs in lacs

Particulars

FY 2007-08

FY 2008-09

Total

Advance Tax Paid

6

9

15

TDS

1.75

3.25

5

Provision

for

7

8

15

Taxation

Fig 7.3 While filling up the form III , the net of figure ( i.e. the net of figure of Tax Paid , in the form of TDS and Advance Tax Paid and Provision for Taxation is permitted). In the above mentioned example, only Rs 5 lacs would appear on the asset side as TDS because Advance Tax Paid and Provision for taxation cancels out each other.

Fourth Adjustment : In the asset side of the Form III, the investments are first classified in terms of maturity. Besides maturity , the purpose of this investment would also be analysed for its classification under Current Asset in Form III. In the above mentioned example , the following break up is available :

Fixed Deposit in Bank : Rs 50 lacs Investment in Group Companies : Rs 30 lacs

73

Investment in quoted shares : Rs 20 lacs While arriving at the fund based working capital limit, the classification of current assets would be such that the bank finance would be made available for those current assets which are related to production. In the case of a manufacturing company, its main activity is the manufacturing of goods . Assuming the above mentioned company is a manufacturing company . the investment in the form of Group companies and quoted shares would not be classified as current asset even though the maturity is less than 1 year. So under Form III, the fixed deposit in bank amounting to Rs 50 lacs would be included in the current asset. Fifth Adjustment : In the asset side of Form III, next adjustment is made for receivable. In the case of receivable also, bank would also classify those receivable whose maturity is up to 90 days in case of private debtors and in case of government debtors it is 180 days. Any receivable having a maturity of more than this would be classified as non current assets. Assuming the all the debtors outstanding up to 180 days is also outstanding up to 90 days, the classification of receivable would be as follows :

Receivable to be classified as Current Asset : Rs 75 lacs Receivable to be classified as Non Current Asset : Rs 25 lacs Sixth Adjustment : In the asset side of Form III, next adjustment would be under the head of Loans and Advances. Under this head an amount of Rs 20 lacs is given to group company .Applying the same logic as mentioned above, the amount of Rs 20 lacs would not be included in the current asset . So after all these adjustment the current asset as per Form III would be as follows :

Category of head in Form III

Particulars

Amount appearing in Balance Sheet

Amount Appear in Form III

Current Assets :

       

Fixed

Deposits

in

Fixed Deposits kept in Bank

50

50

Bank

Receivable

 

Receivable up to 90 days ( PVT) and 180 days ( Govt) would be classified as Current Asset in

100

90

74

 

Form

III

and

   

receivable

under

Bill

Discounting

Scheme

would

be

added

to

the

receivable

Loans

and

Loans given

to

40

20

Advances

Group Company

would

appear

in

Non Current Asset

 

TDS

and

Advance

20

5

Tax would appear

as

net

basis after

adjustment with

Provision

for

Taxation

Fig 7.4 Seventh Adjustment : This adjustment would be on account of Fixed Asset revaluation . If the reserve contains any revaluation reserve , the same would be deducted from the reserve of the liability side of form III and the same amount would also be reduced from the Fixed Asset side of Form III. So in the liability side of Form III, the reserve amount would be Rs 230 lacs and in the asset side of Form III, the Fixed Asset amount would be Rs 180 lacs.

After all the adjustment , the Form III would contain the following :

Category of head in Form III

Particulars

Amount appearing Balance Sheet ( Rs lacs)

in

Amount Appearing in Form III ( Rs lacs)

Bank Borrowing For Working Capital

Bill discounted portion would also be added

75

90

Other

Current

     

75

Liability

     

Sundry Creditor

All

types

of

Sundry

30

30

creditors is included

Advance

from

All types associated with regular operation of the company are included

10

10

Customer

Term

Loan

As on

the date of the

 

10

installment payable

balance sheet, the term loan outstanding would be

within 1 year

segregated into two parts

one

consisting o

installment payable within

1

year

and

installment

payable more than 1 year

;

installment

payable

within

1

year would

appear here

Provision

for

Depending on the net off figure , either provision for taxation or advance tax would appear in Form III

15

 

Taxation

Provision

for

This would appear in Form

5

5

Dividend

III

Total

Current

 

135

145