Financial System Short Answer Type Questions

Financial System Short Answer Type Questions

Question 1.
Distinguish between capital and money market.
Answer:
→ The subject matter of capital market comprises long-term financial instruments having maturity of more than one year, on the other hand, the thrust of money market is on short-term instruments only.

→ Money market is a wholesale market and the participants in money market are large institutional investors, commercial banks, mutual funds, and corporate bodies. However, in case of capital market even a small individual investor can deal by sale/purchase of shares, debentures or mutual fund units.

→ In capital market, the two common segments are primary market and secondary market. Both these segments are interrelated. Securities emerge in primary segment and their subsequent dealings take place in secondary market. However, in case of money market, there is no such sub-division in general. In efficient money market, secondary market transactions may also take place.

→ Total volume of trade occur per day in money market is many fold that of the volume per day taking place in capital market.

→ In capital market, the financial instruments being dealt with are shares (equity as well as preference),debentures (a large variety), public sector bonds and units of mutual funds. On the other hand, money market has different financial instruments such as treasury bills, commercial papers, call money, certificate of deposits, etc.

Question 2.
State the functions of financial system.
Answer:
Following are the functions of financial system:

  • The main function of financial system is the channelization of the individuals saving and making it available for various borrowers. The borrowers are companies and industries which take loan in order to increase their overall growth of the economy
  • It helps in liquidating one’s savings whenever required
  • It help to pass financial information
  • It Creates an environment for one to invest their funds which involves good return on investment
  • It helps to select best investment based on the pre-determined risk and return.
  • It acts as a regulatory body and monitors the action performed by financial institutions and financial market.
  • It plays vital role to control risks and uncertainties
  • It increases the habit of savings
  • It helps in Mobilizing huge financial resources for the economic growth.
  • It gives some innovative services like smart cards, debit cards, credit cards enable the user to make easy payment and transfer of money.

Question 3.
State the.features of primary market.
Answer:
The various features of primary markets are:
→ This is the market for new long term equity capital. The primary market is the market where the securities are sold for the first time. Therefore it is also called the new issue market (NIM).

→ In a primary issue, the securities are issued by the company directly to investors.

→ The company receives the money and issues new security certificates to the investors.

→ Primary issues are used by companies for the purpose of setting up new business or for expanding or modernizing the existing business.

→ The primary market performs the crucial function of facilitating capital formation in the economy.

→ The new issue market does not include certain other sources of new long term external finance, such as loans from financial institutions. Borrowers in the new issue market may be raising capital for converting private capital into public capital; this is known as “going public.”

Question 4.
Explain the components of financial system.
Answer:
The financial system consists four components. These are financial markets, financial services, financial instruments and financial institutions.
(a) Financial Institution:
Financial Institution can be classified as banking and nonbanking institutions. Banking Institutions are creators and purveyors of credit while non banking financial institutions are purveyors of credit.

(b) Financial Markets:
Financial Markets can be classified, as primary and secondary markets. A Primary Market deals with new issues and secondary markets is meant for trading in existing securities.

(c) Financial Instruments:
A financial instrument is a claim against an institution or a person for payment at a future date of a sum of money in the form of dividend.

(d) Financial Services:
Financial services are those , which help with borrowing and funding, buying and selling securities, lending and investing, making and enabling payments and settlements and managing risk exposures in financial markets.

Question 5.
Write a note on financial assets.
Answer:
A financial asset is an intangiable asset representing the monetary value of paper’ securities. It obtains its monetary value from a contractual agreement. Financial asset is a document that has no fundamental value in itself until it is converted into cash. Financial assets are usually more.liquid than tangible assets types of financial assets include certificates, bonds stocks and bank deposits. – Classification of financial assets:
(a) Stock asset:
Stock includes equity shares and preference shares. These stock assets are issued by companies to raise long term capital. Equity share holders are considered to be the owners of the company but preference share holders are not the owners of the company but they have preferential right over equity in receiving dividend and during the time of liquidation of the company.

(b) Debt Asset:
It is an instrument whereby the business enterprises will enter into a contractual agreement with the debenture holder for a predetermined period and during the period it promises to pay a fixed percentage of invest to investors.

(c) Bonds:
Bonds are sold by government and corporations to raise funds for short term projects bonds are legal documents contains how much interest is guaranteed to be returned to the investor along with the original loan amount

Question 6.
Explain the importance and functions of developed money market. Importance of a developed money market and its various functions are discussed below:
(i) Financing Trade:
Money Market plays crucial role in financing both internal as well as international trade. Commercial finance is made available to the traders through bills of exchange, which are discounted by the bill market. The acceptance houses and discount markets help in financing foreign trade.

(ii) Financing Industry:
Money market contributes to the growth of industries in two ways:
(a) Money market helps the industries in securing short-term loans to meet their working capital requirements through the system of finance bills, commercial papers, etc.

(b) Industries generally need long-term loans, which are provided in the capital market. However, capital market depends upon the nature of and the conditions in the money market. The short-term interest rates of the money market influence the long-term interest rates of the capital market. Thus, money market indirectly helps the industries through its link with and influence on long-term capital market.

(iii) Profitable Investment:
Money market enables the commercial banks to use their excess reserves in profitable investment. The main objective of the commercial banks is to earn income from its reserves as well as maintain liquidity to meet the uncertain cash demand of the depositors. In the money market, the excess reserves of the commercial banks are invested in near-money assets (e.g. short-term bills of exchange) which are highly liquid and can be easily converted into cash. Thus, the commercial banks earn profits without losing liquidity.

(iv) Self-Sufficiency of Commercial Bank:
Developed money market helps the commercial banks to become self¬sufficient. In the situation of emergency, when the commercial banks have scarcity of funds, they need not approach the central bank and borrow at a higher interest rate. On the other hand, they can meet their requirements by recalling their old short-run loans from the money market.

(v) Help to Central Bank:
Though the central bank can function and influence the banking system in the absence of a money market, the existence of a developed money market smoothens the functioning and increases the efficiency of the central bank.

Money market helps the central batik in two ways:
(a) The short-run interest rates of the money market serves as an indicator of the monetary and banking conditions in the country and, in this way, guide the central bank to adopt an appropriate banking policy.

(b) The sensitive and integrated money market helps the central bank to secure quick and widespread influence on the sub-markets, and thus achieve effective implementation of its policy.

Question 7.
Explain the functions of money market.
Answer:

  • It facilitates economic development through provision of short term funds to industrial and other sectors
  • It provides a mechanism to achieve equilibrium between demand and supply of short term funds
  • It facilitates effective implementation of RBIs monetary policy
  • It provides ample avenues for short term funds with fair returns to investors
  • It instills financial discipline in commercial banks
  • It provides funds to meet short term needs
  • It helps in employment generation
  • It provides funds to government to meet its deficit
  • It helps to control inflation

Question 8.
What is financial system? Explain its features.
Answer:
Financial system is a set of inter – related activities or services working together to achieve some predetermined purpose or goal. It includes different markets, institutions, instruments and services and mechanism which influence the generation of savings investment capital formation and economic growth.

Features:

  • It is a set of inter- related activities or services
  • Services are working together to achieve pre-determined goals.
  • It connects the link between savers and borrowers
  • It includes financial institutions, markets, instruments services, practices and transactions
  • Its main objective is to formulate capital investment and profit generation
  • It provides services that are essential in a modern economy.

Question 9.
What is certificate of deposits? Explain the characteristics of certificate of deposits.
Certificate of deposits are those deposits which are issued by banks and it is like a promissory note. The term of a CD generally ranges from One month to five years. Following are the important features of certificate of deposits –

  • Certificate of deposits is considered as risk-less because default risk in them is almost negligible and hence its safe bet for investors.
  • Certificate of deposits is highly liquid and marketable and hence investors can buy or sell it whenever they desire to do so.
  • They are transferable from one party to another which cannot be done with term deposits and hence it is an added advantage for investors who are willing to invest in it.
  • It is a time deposit that restricts holders from withdrawing funds on demand, however if an investor wants to withdraw the money, this action will often incur a penalty.
  • A certificate of deposits may be payable to the bearer or registered in the name of the investor. Most certificates of deposits are issued in bearer form because investors can resell bearer CD’s more easily than registered CD’s.

Question 10.
State the features of a developed money market.
Answer:
The features of developed money market are:
(i) Highly organised Banking System:
The commercial banks are the nerve centre of the whole money market. They are the principal suppliers of short-term funds. Their policies regarding loans
and advances have impact on the entire money market. The commercial banks serve as vital link between the central bank and various segments of the money market, consequently, a well developed money market and a highly organised banking system co-exist.

(ii) Presence of a Central Bank:
Central Bank acts as the banker’s bank. It keeps their cash Reserves and provides them financial accommodation in difficulties by discounting their eligible securities. In other words, it enables the commercial banks and other institutions to convert their assets into cash in times of financial crisis. Through its open market operations the central banks absorbs surplus cash during off¬season and provides additional liquidity in the busy seasons. Thus, the central bank is the leader, guide and controller of the money market.

(iii) Availibility of proper credit Instruments:
It is necessary for the existence of a developed money market a continuous availibility of readily acceptable negotiable securities such as bills of exchange, treasury bills etc., in the market. There should Tie a number of dealers in the money maket to transact in these securities. Availibility of negotiable securities and the presence of dealer and brokers in large numbers to transact in these securities are needed for the existence of a developed money market.

(iv) Existance of Sub-markets:
The number of sub-markets determines the development of a money market. The larger the number of sub- markets, the broader and more developed will be the structure of money market. The several sub -markets together make a Cohernt money market. In an underdeveloped money market, the various sub- markes particularly the bill market, are absent.

(v) Ample Resources;
There must be availibility of sufficient funds to finance transactions in the sub-markets. These funds may come from within the country and also from foriegn countries.

(vi) Existence of secondary market:
There should be an active secondary market in these instruments.

(vii) Demand and supply of funds:
There should be a large demand and supply of short-term funds. It presupposes the existance of a large domestic and foreign trade. Besides it should have adequate amount of liquidity in the form of large amounts maturing with in a short period.

(viii) Other factors:
Other factors also contribute to the development of a money market, Rapid industrial development leading to the emergence of stock exchanges, large volume of international trade leading to the system of bills of exchange, political stability, favourable conditions for foreign investment, price stabilisation etc.

Question 11.
Discuss the primary market for industrial securities.
Answer:
Primary market is a market for new issues or new financial claims. Hence, it is also called new issue market. The primary market deals with those securities which are issued to the public for the first time. In the primary market, borrowers exchange new financial securities for log term funds. Thus, primary market facilitates capital formation.
There are three ways by which a company may raise capital in a primary market. They are –
(i) Public Issue:
In this case, the securities are offered to the public. It means, capital is raised through the sale of securities to the public.

(ii) Rights Issue:
It is the sale of securities first to the existing shareholders on a priority basis.

(iii) Private placements:
It is the sale of securities privately to a small group of investors.

Question 12.
What are the objectives of financial system.
Answer:
Following are the objectives of financial system:
(a) To mobilize the savings:
The financial system mobilizes saving from the small saving community. It collects the fund by offering different schemes which attract the investor to invest their savings in different institutions, services securities etc.

(b) To distribute the savings for the industrial investment:
It collects the funds from small investors and invest the amount in different industries. There by it meets the fund requirement of industrial sector therefore it helps in the growth of industrial sector

(c) To stipulate capital formation:
This is also one of the main object of financial system financial system is supporting the industries by sanctioning the fund needed to them. It also makes the industries to formulate the capital out of their earnings for further capital requirement and industrial investment.

(d) To accelerate the process of economic growth:
The ultimate aim of financial institutions is to support the process of economic growth of a nation. Directing the saving fund to the industrial capital need motivating them for the capital formation support the acceleration of the process of economic growth.

Question 13.
What’s financial market? What are its importance?
Answer:
Financial markets are a the market for purchase and sale of stocks shares bonds bills of exchange commodities, futures and options, foreign currency etc. Financial markets are the market for exchange of credit and capital. It is on essential player in the economic development of a nation. It facilitates the organization in the savings and investment process.

Importance of financial market:

  • It provides facilities for interaction between investors and borrowers
  • It provides Information resulting from buyers and sellers interaction in the market
  • It provides security to deal in financial assets
  • It helps investor to sell their financial assets.
  • It gives financial information to select best investment available among the various alternatives.

Question 14.
What is financial market? State its role.
Answer:
Financial market refers to as those centres and arrangements which facilitate ‘buying and selling of financial assets and claims.
(a) Helpful to Business: Financial markets helpful to the business developments and provide short term financial facilities to such business.

(b) Helpful to commercial banks: It not only provide financial facilities to business but also to commercial banks.

(c) Facilities effective implementation of monetary policy: It helps the central banks for effective implementation of monetary policy. So, central banks can achive its goals.

(d) Helpful to the development of capital market: Financial markets were also helpful to the development of capital markets.

(e) Helpful to the formulation of monetary policy ; It also helpful to the government to the formulation of monetary policy.

(f) Helpful to the government to mobilize finance: Finance markets helpful to the Government to mobilize finance. Finance markets provide funds to govt, in case of shortage of funds.

(g) Opportunity to exchange financial assets ; Financial markets provides an opporutunity to exchange financial assets.

Question 15.
Write a note on Treasury Bill or T- Bills.
Answer:
Treasury Bills are short term financial instruments issued by RBI on behalf of govt departments to over-come short term liquidity short falls. Treasury Bills are borrowing instruments of the Govt of India which enable investors to invest their funds in short term funds while reducing their market risks treasury bills are repaid at par on maturity

Features of Treasury Bills are:

  • Treasury bills are negotiable securities
  • These securities are highly liquid
  • There is absence of default risk
  • These securities have an assured yield on its investment
  • Treasury bills are issued in the form of subsidiary general ledger (SGL) entries in the books of RBI to hold the securities on behalf of the holder
  • Treasury bills are also issued under the market stabilization scheme (MSS)
  • There are two types of treasury bills viz, (a) Regular treasury bills and (b) Adhoc treasury bills
  • These bills are short term investment generally up to one.year.
  • There is no tax deducted at sources
  • Treasury bills are liquid money market instruments

Question 16.
Write a note on role of money market in economic development of the nation.
Answer:
The money market is integral part of a country’s economy will developed money market help in the economic development of a country. A developed money market enables the smooth functioning of the financial system in any economy in the following ways.
(a) Financing the industries: A well developed money market helps the industries to secure short term loans for meeting their working capital requirements.

(b) Financing the trade: Money market plays important role in financing the domestic as well as international trade. Traders can get short term finance from banks by discounting bills of exchange

(c) Development of capital market: The short term rates of interest and the conditions prevail in the money market influence the long term rates of interest as well as mobilization of resources in the capital market.

(d) Profitable investment: The money market helps the commercial banks to earn profit by investing their surplus funds in the purchase of treasury bills and bills of exchange etc. these instrument are sale highly liquid.

(e) Smooth functioning of commercial banks : The money market provides the facilities for temporarily employing their funds in easily realizable assets. Banks can get back the funds easily.

(f) Effective implementation of monetary policy: The well developed money market helps the central bank in shaping and controlling the flow of money in the country.

(g) Encourages economic growth

(h) Well organized money market safeguards the liquidity and safety of financial assets and this encourages for economic growth savings and investments.

(i) Proper allocation of resources: the saving of the community are converted into investment which leads to proper allocation of resources in the country.

Question 17.
What is capital market? Explain its functions.
Answer:
Capital market is a market dealing in medium and long term funds. It provides facilities for marketing and trading of securities. It constitutes all long term borrowings from banks and financial institutions borrowings from foreign markets and raising of capital by issuing various securities such as shares, debentures, bonds etc capital market includes primary market and secondary market.

Functions of capital market –

  • It mobilizes savings and acceleration of capital formation
  • It promotes industrial growth
  • It raises long term capital
  • It facilitates for proper channelization of funds
  • It provides insurance against market risk
  • It enables quick valuation of financial instruments.
  • It provides operation efficiency like lowering settlement time lower transaction cost and simplified transaction procedure.

Question 18.
What are the objectives of capital market.
Answer:
Following are the objectives of capital market:
(a) To connect link between savers and investors: The main objective of capital market is to connect link between savers and investors. It plays an important role in mobilizing the savings and diverting them in productive investment. Therefore capital market plays an important role in transferring the financial resources from surplus areas to productive and deficit areas.

(b) To encourage savings: Capital market encourage people to save more in banking and non- banking financial institutions

(c) To encourage for investment: Capital market provides facilities to business and Govt by lending the money and there by it helps the banks and non banking institution to invest their amount in right investment areas.

(d) To promote economic growth: Capital market connects the link between savers and investors. There fore it facilities the growth of economic conditions of the country various institutions of capital market allocate the resources rationally in accordance with the development needs of the country.

(e) To stabilize security prices: The capital market tends to stabilize the values of stocks and securities and reduce the fluctuations in the prices to the minimum. The process of stabilization is facilitated by providing capital reducing the speculative and unproductive activities.

(f) To give benefits to investors: Capital market helps the investor to invest in long term financial assets

(g) To regulate the market ; Capital market implement policies laws and regulations related to the activities of securities.

(h) To reduce risk; Capital market gives protection to the activities of securities and stock and there by it reduces the risks and uncertainties

Question 19.
Write a note on Organizational structure of Indian capital market.
Answer:
Financial System Short Answer Type Questions 1
(a) Government securities : It also knows as gilt edged market. This refers to the market for government and semi – government securities backed by Reserve Bank of India.

(b) Industrial securities Market: This is a market for industrial securities like shares and debentures of the existing and new corporate firms Industrial securities market helps for buying and selling of such financial instruments. This market is divided into two types. They are primary market for New issues of shares and debentures and secondary market for old and existing issue of shares and debentures. In primary market fresh capital is raised by the companies by issuing new shares bonds, mutual funds units and debentures and in secondary market old shares and debentures are traded.

(c) Development Financial Institutions (DFIs): It is another part of Indian capital market It includes various financial institutions like IFCI, ICICI, SFC, IDBI, IIBI, UIT etc. these financial institutions provide long term finance for the establishment of new industries.

(d) Financial intermediaries: It is last segment of Indian capital market this comprises various merchant banking institutions, mutual funds, leasing finance companies, venture, capital companies and other financial institutions.

Question 20.
Write the role of capital market in economic development?
Answer:
The role of capital market in economic growth of the nation is outlined as follows

  • It increases long term savings for long term investment
  • It enables large scale industries to establish its business without any problems by providing long term capital
  • It enables corporations to raise capital to finance their investment in real assets
  • Capital market helps to increase the productivity and employment
  • It helps to connect link between banking system with industrial investment
  • It Increases the domestic savings and investment ratio and that are essential for rapid industrialization
  • It provides equity capital and infrastructure development capital for the socio economic benefits of the nations.
  • It promotes public – private sector partnerships to encourage participation of private sector in productive investments
  • It assist the public sector to close resourse gap and complement its efforts in financing essential socio-economic development through raising long term project based capital
  • It also attracts foreign portfolio investors who are critical in supplementing the domestic savings level.

Financial System Very Short Answer Type Questions

Financial System Very Short Answer Type Questions

Question 1.
What is a financial system?
Answer:
Financial system is a set of inter-related activities or services working together . to achieve some predetermined purpose or goal.

Question 2.
State the components of Indian financial systems.
Answer:
The components of Indian financial system includes the following:

  • Financial market
  • Financial instruments
  • Financial intermediation
  • Financial service

Question 3.
What is a financial market?
Answer:
A Financial Market can be defined as the market in which financial assets are created or transferred. It is a place or mechanism where funds or savings are transferred from one section to another section of financial system.

Question 4.
What is financial asset?
Answer:
Financial Assets or Financial Instruments represents a claim to the payment of a sum of money sometime in the future and /or periodic payment in the form of interest or dividend.

Question 5.
What is a money market?
Answer:
The money market is a wholesale debt market for low-risk, highly-liquid, short term instrument. Funds are available in this market for periods ranging from a single day up to a year. This market is dominated mostly by government, banks and financial institutions.

Question 6.
What is a capital market?
Answer:
A capital market is a market for securities (debt or equity), where business enterprises (companies) and governments can raise long-term funds. It is defined as a market in which money is provided for periods longer than a year, as the raising of short-term funds takes place on other markets (e.g., the money market). The capital market includes the stock market (equity securities) and the bond market (debt). The capital market is designed to finance the long-term investments. The ransactions taking place in this market will be for periods over a year

Question 7.
Define financial system.
Answer:
According to Robinson the primary function of the system is “to provide a link between savings and investment for the creation of new wealth and to permit portfolio adjustment in the composition of existing wealth.

Question 8.
What is forex market?
Answer:
The Forex market deals with the multicurrency requirements, which are met by the exchange of currencies. Depending on the exchange rate that is applicable, the transfer of funds takes place in this market. This is one of the most developed and integrated market across the globe.

Question 9.
What is credit market?
Answer:
Credit market is a place where banks, FIs and NBFCs provide short, medium and long-term loans to corporate and individuals

Question 10.
What is a commercial paper?
Answer:
CP is a note in evidence of the debt obligation of the issuer. On issuing commercial paper the debt obligation is transformed into an instrument. CP is thus an unsecured promissory note privately placed with investors at a discount rate to face value determined by market forces. CP is freely negotiable by endorsement and delivery.

Question 11.
What is a call money?
Answer:
Call/Notice money is the money borrowed or lent on demand for a very short period. When money is borrowed or lent for a day, it is known as Call (Overnight) Money. Intervening holidays and/or Sunday are excluded for this purpose. Thus money, borrowed on a day and repaid on the next working day, (irrespective of the number of intervening holidays) is “Call Money”.

Question 12.
Define money market.
Answer:
According to Geottery Crowther money market is defined as “The market is a i collective name given to the various firms and institutions that deal in the various grader of near money”.

Question 13.
What is treasury bill?
Answer:
Treasury Bills are short term (up to one year) borrowing instruments of the union government. It is an IOU of the Government. It is a promise by the Government to pay a stated sum after expiry of the stated period from the date of issue (14/91/182/364 days i.e. less than one year). They are issued at a discount to the face value, and on maturity the face value is paid to the holder.

Question 14.
What are hybrid instruments?
Answer:
Hybrid instruments have both the features of equity and debenture. This kind of instruments is called as hybrid instruments. Examples are convertible debentures, warrants etc.

Question 15.
State the various money market instruments.
Answer:
The various money market instruments are:

  • Call/Notice Money
  • Treasury Bills
  • Term Money
  • Certificate of Deposit
  • Commercial Papers

Question 16.
What do you mean by inter bank term money?
Answer:
Inter-bank market for deposits of maturity beyond 14 days is referred to as the term money market. The entry restrictions are the same as those for Call/Notice Money except that, as per existing regulations, the specified entities are not allowed to lend beyond 14 days.

Question 17.
What is primary market?
Answer:
The primary market is that part of the capital markets that deals with the issuance of new securities Companies, governments or public sector institutions can obtain funding through the sale of a new stock or bond issue.

Question 18.
Distinguish between primary and secondary market.
Answer:
In the primary market, securities are offered to public for subscription for the purpose of raising capital or fund. Secondary market is an equity trading venue in which already existing/pre-issued securities are traded among investors: Secondary market could be either auction or dealer market. While stock exchange is the part of an auction market, Over-the-Counter (OTC) is a part of the dealer market.

Question 19.
Name any two objectives of money market.
Answer:
Objectives of money market are:

  • To provide an equilibrium mechanism for solving problems relating to short term surplus and deficits.
  • To provide access to users of short term money to meet their requirements at a reasonable price.

Question 20.
Name any four features of Indian money market.
Answer:
Features of Indian money market are:

  • Highly organized banking system
  • Presence of a central bank
  • Availability of proper credit instruments
  • Existence of sub markets
  • Demand and supply of funds
  • Ample resources

Question 21.
What is secondary market?
Answer:
Secondary market, also called aftermarket, is the financial market in which previously issued financial instruments such as stock, bonds,options, and futures are bought and sold.

Question 22.
What is a repo market?
Answer:
The repo market is one in which two participants agree that one will sell securities to another and make a commitment to repurchase equivalent securities on a future specified date, or on call, at a specified price. In effect, it is a way of borrowing or lending stock for cash, with the stock serving as collateral.

Question 23.
State any two functions of financial market?
Answer:

  • It provides a channel through which new savings flow into capital market which facilitates smooth capital formation in the economy.
  • It facilitates the transfer of real economic resources from lenders to ultimate borrowers in financial system.
  • It provides the borrowers with funds which they will invest in some productive purpose.
  • It provides liquidity in the market through which the claims against money can be resold by investors at any time and there by assets can be converted in to cash.

Question 24.
State the components of Indian financial system.
Answer:
The components of Indian financial system are:

  • Financial institutions
  • Financial instruments
  • Financial markets
  • Financial services

Question 25.
State the characteristics of treasury bills.
Answer:

  • These are issued as a promissory note at discount over their face value.
  • It is used to raise short term funds to bridge seasonal/temporary gaps between receipt and expenditure of the Govt.
  • It is a negotiable instrument.
  • Assured yield and low transaction cost.
  • Eligibility for inclusion in SLR.

Question 26.
What is acceptance market?
Answer:
Investment market based on short-term credit instruments is termed as acceptance market. An acceptance is a time draft or bill of exchange that is accepted as payment for goods. A banker’s acceptance, for example, is a time draft drawn on and accepted by a bank, which is a common method of financing short-term debts in international trade including import-export transaction.

Question 27.
What is a financial asset?
Answer:
Financial Assets of Financial Instruments represents a claim to the payment of a sum of money sometime in the future and /or periodic payment in the form of interest or dividend.

Question 28.
What is a discount market?
Answer:
A discount market is the part of the money market consisting of banks, discount houses and brokers on which bills are discounted.

Question 29.
Explain the components of unorganized money market.
Answer:
The components of unorganized money market comprises of indigenous bankers, money lenders, chit funds, nidhis, loan companies and finance brokers.

Question 30.
Write two differences between money market and capital market.
Answer:
Money Market:

  • It is market for short – term loanable funds for a period of not exceeding one year.
  • This market supplies funds for financing current business operation, working capital requirements of industries and short – period requirements of the government.

Capital Market:

  • It is a market for long-term funds exceeding a period one year.
  • This market supplies funds for financing the fixed capital requirements of trade and commerce as well as the long-term requirements of the Government.

Question 31.
What is call money market?
Answer:
Call money market refers to market for very short term funds not exceeding 7 days.

Question 32.
What do you mean by “ Financial Dualism”?
Answer:
The process which helps in economic development and encourages investment and savings by establishing continuous effective relationship between savings and investment Of the people is called financial dualism.

Question 33.
What do you mean by the malpractice, “Insider Trading”?
Answer:
The process of creating fraud in capital market by some executives in organizations by making use of unpublished information. They make assumption about these information and misuse their positions in the organization.

Question 34.
Expand Repo.
Answer:
Repurchase Agreement.

Question 35.
Who are the important players or participant of money market.
Answer:
Govt, RBI, Banks, Discount and Finance House of India, Financial Institutions, Mutual Funds etc.

Question 36.
What are capital market instruments?
Answer:
Capital market instruments are broadly divided into two types:

  • Equity instruments
  • Debt instruments

Question 37.
Give the meaning of equity instruments.
Answer:
Equity instruments are also called as ownership funds comprises equity shares, preference shares and deferred shares.

Question 38.
What is debt instruments?
Answer:
Debt instruments are also called as creditor ship securities comprises of all interest bearing securities like debentures, bonds, public deposits, bank loans, etc.

Risk Management Notes

Risk Management Notes

Risk: The quantifiable likelihood of loss or less-than-expected returns. Examples: currency risk, inflation risk, principal risk, country risk, economic risk, mortgage risk, liquidity risk, market risk, Opportunity risk, income risk, interest rate risk, prepayment risk, credit risk, unsystematic risk, call risk, business, risk, counterparty risk, purchasing- power risk, event risk.

Internal risk: Internal Risks are those risks which arise from the events taking place within the business enterprise. Such risks arise during the ordinary course of a business. These risks, can be forecasted and the probability of their occurrence can be determined.

External risk: External risks are those risks which arise due to the events occurring outside the business organisation. Such events are generally beyond the control of an entrepreneur. Hence, the resulting risks cannot be forecasted and the probability of their occurrence cannot be determined with, accuracy.

Various sources of risk:

  • Customer risk.
  • Technical risk.
  • Delivery risk.

Risk Management: Risk management can be defined as a process used to manage systematically pure risk exposures. It is a procedure to minimize, the adverse effect of a possible financial loss by –

  • identifying potential sources of loss
  • measuring the financial consequences of a loss occurring
  • using controls to minimize actual losses or their financial consequences.

Risk analysis: Risk analysis is the process of defining and analyzing the dangers to individuals, businesses and government agencies posed by potential natural and human-caused adverse events.

Risk management planning: Risk management planning is the process of developing the risk management plan through the process of identifying risks, assessing risks and developing strategies to manage risks.

Risk control: Risk control is a method, by which firms evaluate potential losses and take action to reduce or eliminate such threats. Risk control is a technique that utilizes findings from risk assessments and implementing changes to reduce risk in these areas.

Transfer of risk: Risk transfer is a risk management and control strategy that involves the contractual shifting of a pure risk from one party to another. One example is the purchase of an insurance policy, by which a specified risk of loss is passed from the policyholder to the insurer.

Hedging: Hedging is an investment made in order to reduce the risk ‘ of adverse price movements in a security, by taking an offsetting position in a related security, such as an option or a short sale.

Hedging Instruments: A hedging instrument is a designated financial instrument whose fair value or related cash flows should offset changes in the fair value or cash flows of a designated hedged item.

Foreign exchange rates fluctuate: The foreign exchange rate fluctuates because of the changes in the demand and supply position of foreign currency in the world market.

Process of risk management:

  • Identify risk
  • Evaluating risks.
  • Select risk management techniques
  • Implement and review decisions.

Foreign exchange risk:

  • Exchange rate movements
  • Foreign – Economic condition
  • Political risk.

Classification of risk:
(1) Systematic Risks.

(2) Unsystematic Risks:
Examples of Systematic Risks:
(i) Market Risk

(ii) Interest Rate Risk

(iii) Purchasing Power Risk.

(iv) Examples of Unsystematic Risks

  • Business Risk.
  • Financial Risk
  • Default or Insolvency Risk

(v) Other types of Risks

  • Industry risk
  • Stock-specific risk
  • Liquidity risk
  • Principal risk
  • Currency risk
  • Inflation risk.

kinds of foreign exchange exposure:

  • Economic exposure
  • Transaction exposure
  • Translation exposure.

Various methods of managing transaction exposures:

  • Forward market hedge.
  • Money market hedge.
  • Options market hedge.
  • Exposure netting.

Various tools and techniques of foreign exchange risk management:

  • Managing transaction exposures
  • Exchange exposures:
  • Information asymmetry
  • Transaction cost
  • Default cost.
  • Managing economic exposures.
  • Marketing Initiatives:
  • Marketing selection
  • Pricing strategy
  • Product strategy
  • Promotional strategy
  • Production Initiatives
  • Product sourcing
  • Plant location
  • Input mix.
  • Raising productivity.

Vindicators of political and economic factors are below:

  • Political risk Indicators
  • Stability of local political environment
  • Consensus regarding priorities
  • Attitude of host government
  • War.
  • Mechanisms for expression of discontent.
  • Economic Risk Indicators
  • Inflation rate
  • Current and potential state of country’s economy
  • Resource Base
  • Adjustment of external shocks.

Business Valuation Notes

Business Valuation Notes

Valuation: Valuation is the process of determining the current worth of an asset or a company; There are many techniques used to determine value. An analyst placing a value on a company looks at the company’s management, the composition of its capital structure, the prospect of future earnings, and the market value of assets.

Share: Shares are units of ownership interest in a corporation or financial asset that provide for an equal distribution of any profits, if any are declared, in the form of dividends. The two main types of shares are common shares and preferred shares.

Efficient market hypothesis: The efficient market hypothesis is the hypothesis that the stock market reacts immediately to all the information that is available. Three forms of the efficient market hypothesis can explain the theory behind share price movements.

Types of efficiencies in the context of the operation of financial markets:

  • Allocative efficiency.
  • Operational efficiency.
  • Informational processing efficiency.

Business Finance Notes

Business Finance Notes

Sources of long term financing: The sources of long term financing include ordinary share capital, preference share capital, debentures, long term borrowings form financial institutions and retained earnings.

Equity Shares: Equity shares are also known as ordinary shares or common shares and represent the owners capital in a company. The holders of these shares are the real owners of the company.

Preference Shares: Preference shares have a preference over the equity shares in the event of liquidation of company. The preference dividend rate is fixed and known. A company may issue preference shares with a maturity period (redeemable preference shares). A preference share may also, provide for the accumulation of dividend. It is called cumulative preference share.

Trading on equity: Trading on equity means to raise fixed cost capital such as borrowed capital and preference share capital, on the basis of equity share capital so as to increasing the income of equity shareholders.

Debenture: According to Section 2(12) of the companies act of 1956. “Debenture is an instrument issued by a company under its common seal, acknowledging the debt to the holder, and containing an undertaking to repay the debt on or after a specified period and to pay interest on the debt at a fixed rate at regular intervals usually, half yearly etc. until the debt is paid.”

Retained earning: Retained Earnings is a technique of financial management under which all profits of a company are not distributed amongst the shareholders as dividend but a part of the profits is retained in the company. This is also known as ploughing back of profits.

Term loan: Term loan refers to loan given for a particular period of time. It , may be short or long period. Short term, which is less than a year. Medium term, which lies between two to five years. Long term, which is„ more than 5 years upto 20 years.

Cost of capital: Cost of capital is defined as the minimum rate of return that a firm must earn on its investments so that market value per share remains unchanged.

Cost of equity capital: It refers to the minimum rate of return that a company must earn on the equity share capital financed portion of an investment project so that the market price of share does not change.

Cost of preferred capital: Cost of preference share capital is the rate of return that must be earned on preference capital financed investments, to keep unchanged the earnings available to the equity shareholders.

Cost of debt capital: Cost of debt refers to the minimum rate of return expected by the suppliers of debt capital.

Weighted average cost of capital: Weighted average cost of capital is nothing but overall cost of capital. In other words in case of WACC proper weightage is given to the cost of each and every source of funds i.e. proper assessment Of relative proportion of each source of funds, to the total, is ascertained by considering either the book value or the market value of each source, of funds.

Capital structure: Capital structure is basically focussed towards the objective of profit maximisation? Capital structure is nothing but the financial structure of a firm, which consists of different combinations of securities. In other words it represents the relationship between the various long term forms of financing such as debentures, preference shares capital on equity etc.

Optimal capital structure: “OCS refers to that Capital structure or combination of debt and equity that leads to the maximum value of the firm”. Hence thereby the wealth of its owners also increases with the minimisation of cost of capital.

Flexible capital structure: Flexible capital structure means the capital structure of the firm should be flexible, so that without much practical difficulties, a firm can change the securities in capital structure.

Capital expenditure: Capital expenditure refers to investment that Involves huqe amount, associated with high risk and the benefits from such investment are derived over a longer period of time.

Leverage: Leverage is the employment of fixed assets or funds for which a firm has to meet fixed costs or fixed rate of interest obligation irrespective of the level of activities attained or profit earned.

Types of leverages:

  • Operating leverage
  • Financial leverage.
  • Combined leverage.

Personal leverage: Personal, leverage refers to an individual replicating the advantages of corporate debt by borrowing on personal account and subscribing for an equivalent amount of shares in an unlevered company.

Financial leverage: The use of long term fixed interest and dividend bearing securities like debentures and preference shares along with equity is called financial leverage or trading on equity.

Operating Leverage: The operating leverage occurs when a firm has fixed costs which must be recovered irrespective of sales volume. The fixed costs remaining same the percentage change in operating revenue will be more than the percentage change in sales. This occurrence is known as operating leverage.

Net income approach (NIA): Under this approach, the cost of equity capital and cost of debt capital are assumed to be independent to the capital structure.

Net operating income approach (NOIA): Under this approach, the cost of equity increases in accordance with leverage. Due to which the weighted average cost of capital remains constant and the value of the firm also remains constant as leverage is changed.

Traditional approach of capital structure: The traditional approach of capital structure states that when the Weighted Average Cost of Capital (WACC) is minimized, and the market value of assets are maximized, an optimal structure of capital exists.

MM approach of capital structure: The Modigliani – Miller (MM) hypothesis is identical to the net operatinq income approach. MM arque, that in the absence of taxes, a firm’s market value and the cost of capital remain invariant to the capital structure changes.

Advantages of equity shares:

  • It is a good source of long – term finance
  • It serves as a permanent source of capital
  • Issuance of equity share capital creates no charge on the assets of the company.

Disadvantages of equity shares:

  • The cost of issuance of equity shares is high
  • Trading on equity is not possible
  • Excessive issue of equity shares may result in over-capitalization..

Advantages of Preference Shares are:

  • Fixed return
  • Absence of charge on assets
  • Capital structure flexibility
  • Widening of the capital market
  • Less capital losses.

Disadvantages of Preference Shares are:

  • Dilution of claim over assets
  • Tax disadvantages
  • Increase in financial burden.

Advantages of debentures:

  • Less costly
  • Tax deduction
  • No ownership dilution
  • Fixed interest
  • Reduced real obligation.

Limitations of debentures:

  • Obligatory payment.
  • Financial risk associated with debenture is higher than equity share’s.
  • Cash out flow on maturity is very high.

Merits of long – term loan:

  • Cash Flow.
  • Save time.
  • Increase flexibility
  • Lower interest rates
  • Build credit.

Disadvantages of long – term loans:

  • Liquidation
  • Risk.
  • Collateral
  • Contract contents.

Basic qualities which a sound capital structure should possess:

  • Profitability.
  • Solvency.
  • Flexibility.

Assumptions of MM Hypothesis:

  • There are perfect capital markets
  • Investors behave rationally
  • Information about the company is available to all without arty cost
  • There are no floatation and transaction costs
  • No investor is large enough to effect the market price of shares
  • There is no risk or uncertainty in regard to the future of the firm.
  • The firm has, a rigid investment policy

Investment Appraisal Notes

Investment Appraisal Notes

Investment appraisal: Investment appraisal is an integral part of capital budgeting (see capital budget)., and is applicable to areas even where the returns may not be easily quantifiable such as personnel, marketing, and training

Inflation: Inflation is the rate at which the general level of prices for goods and services is rises and subsequently, purchasing power falls.

Types Of inflation:

  • Demand pull inflation
  • Cost push inflation
  • Built-in inflation

Risk analysis: Risk analysis is the process of defining and analyzing the dangers to individuals, businesses and government agencies posed by potential natural and human-caused adverse events.

Risk: The quantifiable likelihood of loss or less-than-expected returns. Examples: currency risk, inflation risk, principal risk, country risk, economic risk, mortgage risk, liquidity risk, market risk, opportunity risk, income risk, interest rate risk, prepayment risk, credit risk, unsystematic risk, call risk, business risk, counterparty risk, purchasing- power risk, event risk.

Systematic risk: Systematic risks are associated with external environment , these are non diversifiable and is associated with securities market as well as economic, sociological, political considerations of the prices of all securities in the market. Unsystematic risk: Unsystematic risk is also called unique risk and it is unique to firm or industry. It is caused by factors like labour strike, irregular disorganised management policies and consumer preferences.

Business risk: This relates to the variability of the business, sales, income, profits etc. which in turn depend on the market conditions for the product mix, input supplies, strength of competitors, etc. The Internal Business Risk leads to fall in revenues and in profit of the company, but can be corrected by certain changes in the company’s policies.

Financial risk: This relates to the method of financing, adopted by the company, high leverage leading to larger debt servicing problems or short-term liquidity or process equipment, as well as utilities, support and related assets. It should not be based on the insured value or depreciated value of the assets. It includes the replacement value of the buildings and the grounds if these assets are maintainted by the maintenance expenditures.

Replacement decision: Decision regarding replacement of an existing asset with another is based on the net present value and internal rate of return of the incremental cash flows, i.e. the difference between periodic net cash flows if the existing asset is kept and the periodic net cash flows if the asset is replaced. In Capital budgeting and enqineering economics, the existing asset is called the defender and the asset which is proposed to replace the defender is called the challenger. Estimation of incremental cash flows for such replacement analysis involves calculation of net cash flows of the defender, net cash flows of the challenger and then finding the difference in cash flows for both the assets.

Capital rationing: Capital rationing is the act of placing restrictions on the amount of new investments or projects undertaken by a company. This is accomplished by imposing a higher cost of capital for investment consideration or by setting a ceiling on specific portions of a budget.

Various capital investment appraisal techniques:

  • Net present value.
  • Accounting rate of return.
  • Internal rate of return.
  • Modified internal rate of return.
  • Adjusted present value.
  • Profitability index.
  • Equivalent annuity.
  • Pay back period.

Various types of Capital rationing:

  • Soft Rationing.
  • Hard Rationing.

Different tax system of international risk management:

  • Establishing the context.
  • Identification.
  • Assessment.
  • Potential risk treatments.
  • Risk avoidance.
  • Risk reduction.
  • Risk retention.
  • Risk transfer.

Working Capital Management Notes

Working Capital Management Notes

Working Capital: Working capital is that part of the firms total capital which is required for financing short term assets or current assets such as cash, debtors, inventories, marketable securities. It is also known as circulating capital.

Concept of working capital: Working capital is the amount of funds necessary to cover the cost of operating the enterprise. There are two concepts of working capital:

  • Gross working capital
  • Net working capital

Gross working capital: is the capital invested in total current assets of the enterprise. Net working capital is the excess of current assets over current liabilities.

Different types of working capital:

  • Permanent working capital
  • Temporary working capital
  • Gross working capital
  • Net working capital

Working capital management: Working capital management refers to the administration of all aspects of current assets namely cash, debtors, inventories and marketable securities and current liabilities. This basically determines the levels and compositions of current assets to ensure that right sources are tapped to finance current assets and current liabilities are paid in time.

Conservative approach to working capital financing: Conservative approach to working capital financing depends on long-term funds for financing needs. The firm finances the permanent current assets and a part of the temporary current assets with long-term funds. If the temporary assets are not needed then the long-term funds are invested in the marketable securities. A firm following this approach will face less risk but along with low returns.

Determinants of working capital:

  • Opersational efficiency
  • Growth and Expansion

Operating cycle: The term operating cycle or cash cycle refers to the time duration required to convert the cash to raw materials, raw materials to work-in-progress, work in progress to finished goods, finished goods to debtors and debtors back to cash.

Cash management: Cash management refers to the process of managing cash i.e. its inflow and outflow in an organisation for cash demanding activities and minimising funds committed to cash balances.

Cash cycle: It is the net time interval between cash collections from sale of the product and cash .payment for resources acquired by the firm. It also represents the time interval over which additional funds called working capital, should be obtained in order to carry out the firm’s operations.

Various floats which necessitates management of cash: Float refers to the amount of money tied up between the time a payment is initiated and cleared funds become available in the company’s bank account. The different types of float are:

Various Cash Management Techniques:

  • Budgeting
  • Investing
  • Credit
  • Generating income

Receivables: Receivables are also known as accounts receivables or Book debts. Receivables are the claims against its customers for the goods , sold to the customers in the ordinary.course of business on credit basis. The purpose of lending goods on credit basis is to attract more customers, meet competition and to increase sales and profits.

Receivable management: Receivables management is a decision making process which takes into account the creation of debtors turnover and minimising the cost of borrowing of working capital due to lacking of funds in receivables.

Ageing Schedule: Ageing schedule is a table that classifies accounts receivable and payables according to their dates. It helps in managing cash and analyzing payments.

Debtors Turnover Ratio: A concern may sell goods on cash as well as on credit. Credit is one of the important elements of’ sales promotion. The volume of sales can be increased by following a liberal credit policy.

Inventory Management: Inventory Management refers to the purchase of raw materials from the right source at the right time and at the right price and supplying the materials to the production department as and when required. The main objective of inventory, management is to reduce the order placing, receiving and inventory carrying cost

Objectives of inventory management:

  • Availability of materials
  • Best services to consumers.
  • Wastage minimisation
  • Optimum Investment.

EOQ: Economic Order Quantity is a point at which the; carrying cost and the ordering cost are equal. Economic order Quantity is that ‘ size of the lot to be purchased which is economically viable. This is the quantity of materials which can be purchased at minimum costs.

Benefits of holding inventories:

  • Avoiding Lost Sales
  • Gaining Quantity Discounts
  • Reducing Order Cost.

Techniques of inventory management:

  • Fixation of levels
  • ABC Analysis
  • VED analysis
  • FSN analysis
  • Economic order quantity
  • Perpetual inventory system.

ABC analysis OR Pareto analysis: ABC analysis is a method of material control, wherein the materials are divided into a number of categories. Materials are controlled giving importance to its value. Materials are graded as A, B & C where in materials with ‘A’ grade are costly in value but less in number where as materials with ‘C grade are cheap in value and more in number. Grade ‘B’ materials are moderate in value and moderate number of such items are maintained.

Just-In-Time Management: Just-In-Time (JIT) is a broad philosophy of seeking excellence and eliminatingwaste in the manufacturing process. A major objective of JIT is to have items . only at the right place at the right time i.e. to purchase and produce items only before they are needed so that work-in- rocess inventory is keet low. As a concept, JIT means that virtually no inventories are held at any stage of production and that exact number of units is brought to each successive stages of production at the right time.

Safety stock: The receipt of inventory from the suppliers may be delayed beyond the expected lead time. The delay may be because of strikes, floods, transportation and communication barriers, and also because of seasonal nature of the raw materials. This inturn would disrupt the production schedule. To prevent this situation the firm maintains additional inventory which is known as “safety stock”.

Different principles of Working Capital:

  • Principle of Risk Variation
  • Principle of Cost of Capital
  • Principle of Equity Position
  • Principle of Maturity of Payment.

Various types of working capital:

  • Permanent working capital.
  • Temporary working capital.
  • Gross working capital.
  • Net working capital.

Methods of estimating working capital requirements:

  • Conventional Method or Cash Cycle Method
  • Operating Cycle Method.

Objectives of cash management:

  • Transactionary motive.
  • Precautionary motive.
  • Speculative motive.

Factors influencing size of receivables:

  • Volume of credit sales.
  • New products.
  • Location.
  • Credit policy.
  • Credit worthiness of the customers.
  • Credit collection efforts.

Various Inventory Management Techniques:

  • Fixation of levels
  • ABC analysis
  • VED analysis
  • FSN analysis
  • Economic order quantity
  • Perpetual inventory system.

Determinants of working capital:

  • Operational efficiency.
  • Growth and Expansion.
  • Profit Appropriation.
  • Capital structure of the company.
  • Policies of RBI.
  • Changes in prices.
  • Profitability.
  • Nature and size of the firm.
  • Sales volume.
  • Business terms.

Different sources of finance for funding working capital:
1. Trade Credit:
Accrued Expenses and Deferred Income.

2. Bank Borrowing:

  • Loans
  • Cash Credit
  • Overdrafts
  • Purchasing and Discounting of bills.

Various Cash Management Techniques:

  • Cash Planning.
  • Cash Forecasts and Budgeting.
  • Investment of Surplus Funds.

Management of Accounts Receivable:
(1) Forming of Credit Policy.

(2) Credit Evaluation of Individual Accounts:

  • Credit Information.
  • Credit Investigation.
  • Credit Limit
  • Collection Procedure.

(3) Control of Receivables.

The Finance Function Notes

The Finance Function Notes

Finance: The term “Finance” is understood as provision of funds as and when needed. It refers to the science that describes the management, creation and study of money, banking, credit, investments, assets and liabilities.

Business finance: Business Finance refers to that business activity which is concerned with the acquisition and conservation of capital funds in meeting financial needs and overall objectives of business enterprises.

Financial management: According to IF. Bradley “Financial Management is the area of business management devoted to the judicious use of capital and a careful selection of sources of capital in order to enable a business firm to move in the direction of reaching its goals”.

Functions of financial mangement:

  • Estimation of financial requirements of a firm.
  • Selection of right and appropriate source of funds for raising the funds.
  • After selecting the right source, raising the funds required by the firm.
  • Lastly accumulating, proper allocation of funds to different profitable avenues becomes essential.

Objectives of financial management:
Financial management has three main objectives they are –

  • Maintaining of adequate Liquid Assets
  • Maximisation of profit
  • Maximisation of wealth.

Profit Maximisation is a primary objective and a social obligation. Profit is a tool through which efficiency of the organisation can be measured. The growth and survival of a company depends upon its ability to earn profit. The profit earned can be preserved for meeting future deficiency.

Wealth maximisation: Wealth Maxmisation refers to creation of wealth of the concern. In other words, it refers to the increase in the market value of shares.

Goals of financial management:

  • Profit maximisation
  • Wealth maximisation
  • Maximising firm value
  • Acquiring sufficient fund.

Economic environment for business: Economic Environment refers to all those economic factors, which have a bearing on the functioning of a business. Business depends on the economic environment for all the needed inputs. It also depends on the economic environment to sell the finished goods.

Financial Markets: Financial markets represent an important segment of the financial system. It refers to an outlet where financial products, financial services and financial securities are traded.

Financial markets can be classified:

  • Money market and capital market
  • Primary market and secondary market
  • Organised and unorganised market
  • Foreign exchange market
  • Broad, deep and shallow market.

Secondary market: Secondary market is, a market for all those securities and stock which are already issued to the public. It deals with sale/purchase of already issued equity/debts by corporates and others. It is also known as stock market.

Intermediaries of secondary markets:

  • Market Intermediaries Registration and Supervision Department (MIRSD).
  • Market Regulation Department (MRD).

Capital market: Capital market is, the market for long term finance. Capital market is the medium that channelises the small savings of the community and makes it available for industrial outlets.

Money Market: Money market basically deals with short term financial assets, which are close substitute of money.

Financial Dualism: The financial system of most developing countries are ‘characterised by coexistence and cooperation between the formal ’ and informal financial sectors. The coexistence of these two sectors is known as ‘financial dualism’.

Financial institutions: Financial institutions render financial services of dealing in financial assets i.e. mobilise the savings against financial claims. Financial Institutions range from pawn shops and money lenders to banks, pension funds, insurance companies, brokerage houses, investment trusts and stock exchanges.

Financial instruments: Financial instruments range from the common – coins, currency notes and cheques; mortgages, corporate bills, and stocks – to the more exotic – futures and swaps of high finance.

Aims of finance functions:

  • Acquiring Sufficient and Suitable Funds.
  • Proper Utilization of Funds
  • Increasing Profitability.
  • Maximizing Firm’s Value.

Different goals of financial management:
(a) Specific Goals:

  • Profit Maximisation
  • Wealth Maximisation

(b) Other Goals:

  • Maintaining balanced asset structure
  • Ensuring efficiency in business operations
  • Ensuring financial discipline
  • Planning judicious utilisation of funds
  • Maintaining liquidity of funds.

Decisions of financial management:

  • Investment decisions.
  • Financing Decisions.
  • Dividend Decision.

Role of financial markets:

  • Growth in Income
  • Productive Usage.
  • Capital Formation
  • Price Discovery
  • Sale Mechanism
  • Information Availability.

Features of primary market:

  • New long term capital.
  • Issued by the company directly.
  • Issue new security certificates.
  • Setting up new business.
  • Facilitating capital formation.
  • Converting private capital into public capital.

Functions of primary market:

  • Facilitate capital growth.
  • Issue new stocks.
  • Raise funds from the public.
  • Issuance of new securities by corporations.
  • Methods of issuing securities.

Functions of Capital Market:

  • Allocation functions
  • Liquidity functions
  • Indicative function
  • Savings and investment functions
  • Transfer function
  • Merger function.

Features of money market:

  • Short term financing
  • No fixed place
  • Liquidity adjustment
  • Existence of sub-markets
  • Prevalence of healthy competition
  • Highly developed industrial system
  • International attraction
  • Uniformity of interest rate
  • Highly organised banking system.

Scope of financial management:

  • Financial Estimation.
  • Planning of the capital structure.
  • Selecting right source of funds.
  • Investment of funds.
  • Analysing the financial performance.
  • Planning of profit.
  • Ensuring liquidity.

Objectives of financial management:
1. Specific Objectives:

  • Profit Maximisation.
  • Wealth Maximisation.

2. General Objectives:

  • Balanced asset structure
  • Liquidity
  • Proper planning of funds
  • Efficiency
  • Financial discipline.

Factors constitute economic environment of business:

  • Economic system
  • Economic planning
  • Industry
  • Agriculture
  • Infrastructure
  • Financial & fiscal sectors
  • Removal of regional imbalances.
  • Price and distribution controls.
  • Economic reforms
  • Human resource
  • Per capital income and national income.

Types of financial markets:

  • Money market and capital market.
  • Primary market and secondary market.
  • Organised and Unorganised market.
  • Foreign Exchange market.
  • Broad, deep and shallow market.

Different instruments ‘traded in money market:

  • Treasury bills
  • Commercial bills
  • Certificates of deposits
  • Inter-bank participation certificates
  • Commercial papers
  • Money at call or call money

Risk Management Long Answer Type Questions

Risk Management Long Answer Type Questions

Question 1.
Explain nature and importance of risk management.
Answer:
In today’s world, managing corporate risks is a daunting task. The last few decades have seen a substantial increase in the average rate, as well as the volatility, of inflation. The increased uncertainty about inflation has been followed by greater volatility in interest rates, exchange rates, and commodity prices. Global competition has intensified in the wake of reduced tariff barriers.

The entire process of identifying, evaluating, controlling and reviewing risks, to make sure that the organisation is exposed to only those risks that it needs to take to achieve its primary objectives, is known as ‘risk management.’ Risk management is a proactive process, not reactive. In different markets or sectors there are different types of risks and so, the risk management procedures and techniques vary in their application ways but the target is same; putting the risks under control and accomplishing the mission as expected.

Risk cannot be eliminated. However, it can be:

  • Transferred to another party, who is willing to take risk, say by buying an insurance policy or entering into a forward contract.
  • Reduced, by having good internal controls.
  • Avoided, by not entering into risky businesses.
  • Retained, to either avoid the cost of trying to reduce risk or in anticipation of higher profits by taking on more risk.
  • Shared, by following a middle path between regaining and transferring risk.

There are various tools available to the management to manage risks. Some of them being, derivative products like Forwards, Futures, Options and Swaps. The others involve having better internal controls in place, due diligence exercises, compliance with rules and regulations, etc.

In coping with the challenge of risk management, the following interrelated guidelines should be considered:

  • Understanding the firm’s strategic exposure
  • Employing a mix of real and financial tools
  • Proactively managing uncertainty
  • Aligning risk management with corporate strategy
  • Learning when it is worth reducing risk

Managing risk is considered important; it comes next only to minimizing borrowing costs and maintaining / improving the firm’s, credit. Firms often reduce some exposures, leaving others unhedged, the principal emphasis being on hedging transaction exposures.

Question 2.
Discuss classification of risk.
Answer:
Risks are Classified into Major Categories
(1) Systematic Risks are out of external and uncontrollable factors, arising out of the market, nature of the industry and the state of the economy and a host of other factors.

(2) Unsystematic Risks emerge out of the known and controllable factors, internal to the issuer of the securities or companies.

Examples of Systematic Risks:
(i) Market Risk: This arises out of changes in Demand and Supply pressures in the markets, following the changing flow of information or expectations. The totality of investor perception and subjective factors influence the events in the Market which are unpredictable and give rise to risk, which is not controllable.

(ii) Interest Rate Risk: The return on an investment depends on the interest rate promised on it and changes in market rates of interest from time to time. The cost of funds borrowed by companies or stockbrokers depend oh interest rates. The market activity and investor perceptions change with the changes in interest rates.

(iii) Purchasing Power Risk: Purchasing power risk is also known as inflation risk. This risk arises out of change in the prices of goods and services and technically it covers both inflation and deflation periods. During the last two decades, it has been seen that inflationary pressures have been continuously affecting the Indian economy.

Examples of Unsystematic Risks:
(i) Business Risk:
This relates to the variability of the business,-sales, income, profits etc. which in turn depend on the market conditions for the product . mix, input supplies, strength of competitors, etc. This business Risk is sometimes external to the company due to changes in govt, policy or strategies of competitors or unforeseen market conditions. They may be internal due to fall in production, labour problems, raw material problems or inadequate supply of electricity etc. The Internal Business Risk leads to fall in revenues and in profit of the company, but can be corrected by certain changes in the company’s policies.

(ii) Financial Risk:
This relates to the method of financing, adopted by the company, high leverage leading to larger debt servicing problems or short¬term liquidity problems due to bad debts, delayed receivables and fall in current assets or rise in current liabilities. These Problems could no doubt be solved, but they may lead to fluctuations in earnings, profits and dividends to shareholders. Sometimes, if the company runs into losses or reduced profits, these may lead to fall in returns to investors or negative returns. Proper financial planning and other financial adjustments can be used to correct this risk and as such it is controllable.

(iii) Default or Insolvency Risk:
The borrower or issuer of securities may become insolvent or may default, or delay the payments due, such as interest instalments or principal repayments. The borrower’s credit rating might have fallen suddenly and he became’default prone and in its extreme form it may take to insolvency or bankruptcies. In such cases, the investor may get no return or negative returns. An investment in a healthy company’s share might turn out to be a waste paper, if within a short span, by the deliberate mistakes of Management or acts of God, the Company became sick and its share price tumbled below its face value.

Other Risks:
(i) Industry risk: Changes in the environment of a particular industry may introduce a great deal of risk and cause securities connected to that industry to decline. Diversification can help to counter this risk because industries don’t usually all underperform simultaneously.

(ii) Stock-specific risk: Events that impact a particular company can have a monumental effect on the company’s stock. The potential problems that can arise at-a given company can infuse a great deal of risk into a particular stock. Again, this type of risk can be combated by diversification because not all companies experience problems at the same time.

(iii) Liquidity risk: An investment may need to be sold before its maturity in order to extract the invested funds. Unfortunately, an insufficient secondary market may prevent the liquidation or limit the funds that can be generated from it. There can also be significant fees associated with liquidating some investments before a certain time. By the same token, the need to liquidate will eliminate the possibility of earning returns that would have been expected if the investment were held as long as expected.

(iv) Principal risk: There is always the possibility that through some set of circumstances, invested money will decrease or completely disappear. In this case, principal is lost in addition to returns and expected returns. If the invested money is essential, it will have to be replaced in some way.

(v) Currency risk: If money must be exchanged to make a certain investment, changes in the value of the currency relative to the American dollar will affect the total loss or gain on the investment when the money is converted back. This risk usually affects businesses, but it can also affect individual investors who make international investments.

(vi) Inflation risk: Although all investing decisions involve risk, simply not investing is not the answer. Inflation causes money to decrease in value at some rate. So inflation risk occurs whether you invest or not. It is up to you to choose investments that outpace inflation; otherwise, invested money will gradually lose value even if the principal invested is increasing at some rate. Thus theoritically risk can be minimised and eliminated but practically risk can be minimised but not totally eliminated in investment.

Question 3.
Explain the techniques of risk analysis.
Answer:
Three modern methods of risk analysis:

  • Sensitivity Analysis
  • Probability Analysis
  • Expected Values

1. Sensitivity Analysis:
Sensitivity analysis is a simulation technique in which key variables are changed and the resulting change in the rate of return or [the NPV] is observed. Some of the key variables are cost, prices, project life, market share, etc. The most practical way to do this is to select those variables whose estimated values may contain some significant errors or an element of uncertainty and then to calculate the effect of errors of different sizes on the present value of the project.

The common operating mechanism would be to vary each strategic variable by certain fixed percentages in both positive as well as negative directions in turn, say plus or minus 10% or plus or minus 5% etc. and study the effect of change on the rate of return [or on NPV].
It is an effective tool to handle risk in project appraisal. However, there are certain limitations in using this tool.
(a) Unless the combined effect of change in a set of Inter-correlated variables is examined, single variable sensitivity testing could be worse than useless. It may lead to wrong conclusions. Hence, it is a very difficult task.

(b) The second limitation lies in the fact that the values of the variables are generally changed in an arbitrary manner by say 5% or 10% to examine the effect on the returns. Unless it is done in a meaningful manner, it might mislead the investor.

(c) The third one is that it ignores the chances associated with the different possible values of the components.

2. Probability Analysis:
Probability may be defined as a measure of some one’s opinion about the likelihood that an event (cash flow) will occur. The likelihood of occurrence normally ranges from 1 to 0 i.e., 100 per cent certainty to 100 per cent uncertainty. In this analysis, in the place of one single estimate a range of estimates and their associated probabilities are calculated. A probability distribution in its simplest form could be with a few estimates such as “optimistic”, “pessimistic” and “most likely”.

The real problem; however, is how this probability distribution can be obtained. Two types of probabilities which include objective and subjective are normally used for decision-making under uncertainty.

The objective probability is the probability estimate, which is based on a very large number of observations. Subjective probabilities are those probability measures, which are based on the state of belief of a person rather than the objective evidence of a large number of trials. As the capital expenditure decisions are mostly non-repetitive and not made under identical situations, only.subjective probabilities are useful.

3. Expected Values [EV]:
EV is the sum of products of estimated outcomes and their respective probabilities. In advance, while uncertainty refers to a situation where such probability distribution cannot be objectively known, but only guessed. However, in the case of investment decisions, such a theoretical distinction is hypothetical and may not serve much useful purpose in practice. Even the best estimates of the project manager regarding the probability of the expected cash flows materializing and their magnitude are only subjective guesses. Hence, both risk and uncertainty are used interchangeably to mean the same thing.

Some of the factors, which add to the degree of risk or uncertainty of an investment, are the possibilities of –

  • The process or product becoming obsolete
  • Declining demand for the product
  • Change in government policy on business
  • Price fluctuations
  • Foreign exchange restrictions
  • Inflationary tendencies

Question 4.
Explain briefly exchange rate fluctuations.
Answer:
Exchange rate fluctuations are the increases or decreases in the value of a currency as against the other currency at international levels. These fluctuations are a part of international financial markets. The exchange rate regime is the way a country manages its currency in respect to foreign currencies and the foreign exchange market. The changes in the value of one currency against another country’s currencies is termed to be exchange rate fluctuations.

In India, RBI acts as the Exchange Control Authority. Its one of the important functions is maintenance of external value of the rupee. The dealings in foreign exchange and foreign securities in India, payments to person resident outside and export and import of currency notes, bullion or precious stones etc. are subject to general or special permissions of RBI or are prohibited. The types of transactions that are controlled by the RBI and the government of India are in general and include the following important items :

  • Purchase and sale and other dealings in foreign exchange and maintenance of balances at foreign centres by residents.
  • Procedure for realisation of proceeds of exports of goods and services.
  • Payments to non-residents or to their accounts in India for imports and others.
  • Transfer of securities as between residents and non-residents and acquisition and holding of foreign securities.
  • Foreign travel
  • Export and import of currency, cheques, drafts, travellers cheques and other financial instruments, securities, gold, jewelleries etc.
  • Trading commercial and industrial activities in India of. foreign companies, employment etc.
  • Acquisition, holding and disposal of immovable property in Or outside India by foreigners or Indian residents.

Question 5.
What is foreign exchange exposure? Discuss the three kinds of exposures.
Answer:
Foreign exchange Exposure is sensitivity of real value of an undertaking’s, assets, liabilities, or operating incomes, expenses in its functional currency to unanticipated changes in Exchange rates.

The three kinds of exposures are explained as follows:
(i) Economic exposure: Economic exposure can be defined as the extent to which the value of the firm would be affected by unanticipated changes in exchange rates. Any anticipated changes in. exchange rates would have been already discounted and reflected in the firm’s value.. The changes’ in exchange rates can have a profound effect on the firm’s competitive position* in the world market and thus on its cash flows and market value.

(ii) Transaction exposure: Transaction exposure can be defined as the sensitivity of realized domestic currency values of the firm’s contractual cash flows denominated in foreign currencies to unexpected exchange rate changes. Transaction exposure arises from fixed price contracting in a world where exchange rates are changing randomly.

(iii) Translation exposure: Translation exposure refers to the potential that the firm’s consolidated financial statements can be affected by changes in exchange rates. Consolidation involves translation of subsidiaries’ financial statements from local currencies to the home currency.

Question 6.
Explain the various tools and techniques of foreign exchange risk management.
Answer:
Foreign exchange risk management is linked with unexpected fluctuations in the value of currency. It consists of spot, forward and future market. The various tools and techniques of foreign exchange risk management are as follows:
(i) Managing transaction exposures: A transaction exposure arises, when even a company is committed to a foreign currency denominated transaction entered into before the change “in exchange rate. So it basically refers to the extent to which the future value of firm’s domestic cash flow is affected by exchange rate fluctuation.

The various methods of managing transaction exposures are:

  • Forward market hedge
  • Money market hedge
  • Options market hedge
  • Exposure netting.

In a forward market hedge, a company that is long in a foreign currency will sell the foreign currency forward, where as a company that is short in a foreign currency will levy the currency forward. In this way the company can fix the dollar value of future foreign currency cash flow.

A money market hedge involves simultaneous borrowing and lending activities in two different currencies to lock in the home currency- value of a foreign currency cash flow. Currency option nullify the uncertainty which the firms faces, whether they should yo for hedging of foreign currency cash inflows or outflows.

Lastly, exposure netting involves off-setting exposures in one currency with exposures in the same or other currency, where exchange rates are expected to move in such a way that losses (gains) on the first exposed position should be offset by gains (losses) on the second currency exposure.

(ii) Exchange exposures: There are various methods available by which a firm can hedge exchange exposures if it wishes.
There is no thumb rule that firm should hedge. But at the corporate level there are various resource available in favour of exposure management:

  • Information asymmetry: Management is aware about the firm’s exposure position much better than share holders, so management should manage exchange exposure.
  • Transaction cost: The firm is in a better position to acquire low cost hedges and hence transaction costs can be significantly reduced.
  • Default cost: In corporate hedging, profitability of default is significantly lower. This in turn, can lead to a better credit rating and lower financing costs.

(iii) Managing economic exposures: Economic exposure refers to the extent to which the economic value of a company can decline due to changes in exchange rate. It is basically the overall impact of exchange rate changes due to changes in exchange rate.

Managing economic exposure is very important in the long run health of an for the organisation than managing transaction or translation exposure. The following are some proactive marketing and production strategies which a firm can pursue in response to anticipate or real exchange rate changes

Marketing Initiatives:
(i) Marketing selection: Market selection is the main important factor for an exporter. Foreign currency devaluation and home currency depreciation should be taken care of.

(ii) Pricing strategy: Pricing strategy is another very crucial aspect of managing economic exposure. A firm selling overseas should follow a standard economic proposition of setting the price that maximizes dollar profit.

(iii) Product strategy: Exchange rate changes can also be responded by using the new product development strategy which consists of two major components –

  • Product line decisions
  • Product innovations

(iv) Promotional strategy: Promotional strategy should be taken into consideration for anticipated exchange rate changes. A key issue in any marketing programme is the size of the promotional budget.

Production Initiatives:
(i) Product sourcing: MNC’s with worldwide production systems can allocate production among their several plans in line with the changing home currency cost of production, increasing production in a notion whose currency has devaluated and -decreasing production in a country where there has been a revaluation.

(ii) Plant location: A firm whose currency has devaluated and who exports to other countries find suitable to establish in the third country.

(iii) Input mix: Out sourcing is one of the solutions for devaluing currency and it gives flexibility to shift purchases of intermediate inputs towards suppliers which is least affected by exchange rate changes.

(iv) Raising productivity: Raising productivity through closing inefficient plants, automating heavily and negotiating wage and work rule concession is another alternative to manage economic exposure.

Question 7.
Explain the nature of country risk analysis. OR Discuss the various country risk indicators.
Answer:
Country risk is an indispensable tool for asset management as it requires the assessment of economic opportunity against political odds.
The factors that affect the country risk can be divided into two parts:

  • Political Factors
  • Economic factors

The various indicators of political and economic factors are discussed below:
I. Political risk Indicators : Political risk indicators are very difficult to measure for a particular country. Some of the common forms of political risk indicators include:
(i) Stability of local political environment: The political risk of each of the nations are analysed here. Measures like cognizance of changes in the government, levels of violence, internal and external conflict etc. are used.

(ii) Consensus regarding priorities: This measures the degree of agreement and unity on fundamental objectives of government policy and the extent to which this consensus cuts across party lines.

(iii) Attitude of host government: A variation will be when the MNC’s satisfy the needs, wants and demands of the local people, but faces the hostile attitude of the host government.

(iv) War: If war is possible, then the safety of hired people/employees would be affected and at the same time the cash inflows will be uncertain in nature.

(v) Mechanisms for expression of discontent: This is related to the ability of effecting peaceful change, providing internal continuity to alter direction of policy without major changes of political system.

II. Economic Risk Indicators: Economic factors also should be considered while assessing country risk: Some of the economic factors can be as follows –
(i) Inflation rate: Inflation rate is used to measure the economic instability, disruption and government mismanagement and also affects the purchasing power of consumers.

(ii) Current and potential state of country’s economy: The company, which is having a subsidiary to another country and/or exports is highly concerned, with the country’s demand for the product, as this demand is strongly influenced by country’s economy.

(iii) Resource Base: The resource base of a country consists of its natural, human and financial resources. Effective and efficient use of these resources will have less economic risk and vice versa.

(iii) Resource Base: The resource base of a country consists of its natural, human and financial resources. Effective and efficient use of these resources will have less economic risk and vice versa.

(iv) Adjustment of external shocks: The ability of a country to handle external shocks is another important factor in economic analysis.

Question 8.
Explain the risk return trade-off for current asset financing.
Answer:
A firm can adopt different financing policies in relation to current assets. Three types of financing may be distinguished.
Long Term Financing – The sources of long term financing include ordinary share capital, preference share capital, debentures, long term borrowings from financial institutions and retained earnings.

Short Term financing: It is obtained for a period less than one year. It is arranged in advance from banks and other suppliers of short term finance in the money market.

Spontaneous financing: It refers to the automatic sources of short term funds arising in the normal course of a business. Trade credit and outstanding expenses are examples of this type.

Short Term Vs Long Term Financing: A Risk – Return Trade – off. A firm should decide whether or not it should use short term financing. If short term financing has to be used, the firm must determine its portion in total financing. This decision of the firm will be guided by the risk-return trade – off. Short term financing may be preferred over long term financing for the reasons: (i) the cost advantage and (ii) flexibility. But short term financing is more risky than long term financing.

Cost: The justification for the higher cost of long term financing can be found in liquidity preference theory. This theory state that since lenders are risk averse, and risk generally increases with the length of lending time, most lenders would prefer to make short term loans. The only way to induce these lenders to lend for longer periods is to offer them higher rates of interest. Both short term and long term financing have a leveraging effect on shareholder’s return. But the short term financing ought to cost less than the long term financing; therefore it gives relatively higher return to shareholders.

Flexibility: It is relatively easy to refund short term funds when the need for funds diminishes. Long term funds such as debentures cannot be refunded before time.

Risk: Although short term financing may involve less cost, it is more risky than long term financing. If the firm uses short term financing to finance its current assets, it runs the risk of renewing, borrowings again and again.

It may be difficult for the firm to borrow during stringent credit periods. At times, the firm may be unable to raise any funds and consequently, its operating activities may be disrupted. In order to avoid failure/the firm may have to borrow at most inconvenient terms. These problems are much less with long term funds.

Risk-Return Trade-off: Thus, there is a conflict between long term and short term financing. Short term financing is less expensive but at the same time involves greater risk than long term financing. The choice between long term and short-term financing involves a trade off between risk and return.

Risk Management Short Answer Type Questions

Risk Management Short Answer Type Questions

Question 1.
Explain the process of risk management.
Answer:
The process used to systematically manage pure risk exposures is known as risk management. The risk management process consists of four steps:
(i) Identify risk: There are many potential risks that confront individuals and businesses. The risk management process is concerned primarily with the identification of the relevant exposures to pure risks.

(ii) Evaluating risks: For each source of pure risks that is identified, an evaluation should be performed. In this stage, risk can be categorized as to how often associated loses are likely to occur.

(iii) Select risk management techniques: The results of the analysis in step 2 are used as the basis of making decision regarding ways to handle risks.

(iv) Implement and review decisions: The business or individual must implement the techniques selected.

Question 2.
Explain foreign exchange risk.
Answer:
International business can reduce the international risk exposure to its home market but increases its exposure in following:
(i) Exchange rate movements: Most international business results in the exchange of one currency for another to make payment. Exchange rate fluctuates and due to that, the cash outflow also changes.

(ii) Foreign Economic condition: When multinational companies enter into the foreign markets to sell their product, the demand for these products will depend on the economic conditions in those markets.

(iii) Political risk: When MNC’s establish subsidiaries in foreign countries, they are, exposed to political risk.
It actually represents political actions taken by the host government or the public that affect the MNC’s cash flows.

Question 3.
What are the features of foreign exchange risk management?
Answer:
The foreign exchange risk management consists of spot market, forward and future market. The spot market deals with foreign exchange, delivered within 2 days or less. On the other hand, forward market deals with foreign exchange which is delivered in 3 days or more.

Exchange rate is one of the crucial factor, considered by MNC’s because rate fluctuation directly affect the sales revenue of firm’s exporting goods and services. Foreign exchange risk is the possibility of a gain or loss to a firm that occurs due to anticipated changes in the exchange rate.

The salient features of foreign exchange risk management are as follows:

  • It consists of spot, forward and future market
  • There can be a possible gain or loss because of exchange rate fluctuation.
  • It directly affects the sales revenue of MNC’s
  • It has more importance because MNC’s operate in multiple currencies.

Question 4.
Why do companies involved in international.trade hqve te hedge their foreign exchange exposure.
Answer:
Companies involved in international trade have to hedge their foreign exchange exposure for various reasons. In deciding whether to hedge foreign exchange exposure, Merck focused on the objective of maximizing long term cash flows and on the potential effect of exchange rate movements on the firms ability to meet its strategic objectives. This focus is ultimately intended to maximize shareholders wealth. The company has a large portion of earning generated overseas. While a disproportionate share of costs is incurred in dollars.

Volatile cash flows can adversely affect the firm’s ability to implement the strategic plan, especially investments in RBD that form the basis for future growth. To succeed in a highly competitive industry, the company needs to make a long term commitment’to a high level of research funding. Having selected currency options as the key hedging vehicle, the company still had to formulate an implementation strategy regarding the term of the hedge, the strike price of the currency options of income to be converted.

Question 5.
Discuss Hedging of Transaction Exposure.
Answer:
Transaction Exposure is typically defined as the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values. Such exposure includes obligations for the purchase or sale of goods and services at previously agreed prices and the borrowing or lending of funds in foreign currencies.

A transaction exposure arises, when even a company is committed to a foreign currency denominated transaction entered into before the change in exchange rate. So it basically refers to the extent to which the future value of firm’s domestic cash flow is affected by exchange rate fluctuation.
The various methods of managing transaction exposures are:

  • Forward market hedge
  • Money market hedge
  • Options market hedge
  • Exposure netting.

In a forward market hedge, a company that is long in a foreign currency will sell the foreign currency forward, where as a company that is short in a foreign currency will levy the currency forward. In this way the company can fix the dollar value of future foreign currency cash flow.

A money market hedge involves simultaneous borrowing and lending activities in two different currencies to lock in the home currency value of a foreign currency cash flow. Currency option nullify the uncertainty which the firms faces, whether they should go for hedging of foreign currency cash inflows or outflows.

Lastly, exposure netting involves off-setting exposures in one currency with exposures in the same or other currency, where exchange rates are expected to move in such a way that losses (gains) on the first exposed position should be offset by gains (losses) on the second currency exposure.

Risk Management Very Short Answer Type Questions

Risk Management Very Short Answer Type Questions

Question 1.
What is risk? What are types of risk?
Answer:
The quantifiable likelihood of loss or less-than-expected returns. Examples: currency risk, inflation risk, principal risk, country risk, economic risk, mortgage risk, liquidity risk, market risk, opportunity risk, income risk, interest rate risk, prepayment risk, credit risk, unsystematic risk, call risk, business risk, counterparty risk, purchasing-power risk, event risk.

Question 2.
What is internal risk?
Answer:
Internal Risks are those risks which arise from the events taking place within the business enterprise. Such risks arise during the ordinary course of a business. These risks can be forecasted and the probability of their occurrence can be determined.

Question 3.
What is external risk?
Answer:
External risks are those risks which arise due to the events occurring outside the business organisation. Such events are generally beyond the control of an entrepreneur. Hence, the resulting risks cannot be forecasted and the probability of their occurrence cannot be determined with accuracy.

Question 4.
State various sources of risk.
Answer:
The various sources of business risk are as follows:

  • Customer risk
  • Technical risk
  • Delivery risk

Question 5.
What is risk Management?
Answer:
Risk management can be defined as a process used to manage systematically pure risk exposures. It is a procedure to minimize the adverse effect of a possible financial loss by –

  • identifying potential sources of loss
  • measuring the financial consequences of a loss occurring
  • using controls to minimize, actual losses or their financial consequences.

Question 6.
What do you mean by Risk analysis?
Answer:
Risk analysis is the process of defining and analyzing the dangers to individuals, businesses and government agencies posed by potential natural and human-caused adverse events.

Question 7.
What is risk management planning?
Answer:
Risk management planning is the process of developing the risk management plan through the process of identifying risks, assessing risks and developing strategies to manage risks.

Question 8.
What do you mean by Risk control?
Answer:
Risk control is a method by which firms evaluate potential losses and take action to reduce or eliminate such threats. Risk control is a technique that utilizes findings from risk assessments and implementing changes to reduce risk in these areas.

Question 9.
What is transfer of risk?
Answer:
Risk transfer is a risk management and control strategy that involves the contractual shifting of a pure risk from one party to another. One example, is the purchase of an insurance policy, by which a specified risk of loss is passed from the policyholder to the insurer.

Question 10.
What is hedging?
Answer:
Hedging is an investment made in order to reduce the risk of adverse price movements in a security, by taking an offsetting position in a related security, such as an option or a -short sale.

Question 11.
What are Hedging instruments?.
Answer:
A hedging instrument is a designated financial instrument whose fair value or related cash flows should offset changes in the fair value or cash flows of a designated hedged item.

Question 12.
Why do foreign exchange rates fluctuate?
Answer:
The foreign exchange rate fluctuates because of the changes in the demand and supply position of foreign currency in the world market.