Components of financial system

The word "system", in the term "financial system", implies a set of complex and closely connected or interlined institutions, agents, practices, markets, transactions, claims, and liabilities in the economy. The financial system is concerned about money, credit and finance-the three terms are intimately related yet are somewhat different from each other. There are major three components of financial system. 1.FINANCIAL INSTRUMENTS Money Market Instruments The money market can be defined as a market for short-term money and financial assets that are near substitutes for money. The term short-term means generally a period upto one year and near substitutes to money is used to denote any financial asset which can be quickly converted into money with minimum transaction cost. Some of the important money market instruments are briefly discussed below; 1. Call/Notice Money 2. Treasury Bills 3. Term Money 4. Certificate of Deposit 5. Commercial Papers 1. Call /Notice-Money Market 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". When money is borrowed or lent for more than a day and up to 14 days, it is "Notice Money". No collateral security is required to cover these transactions. 2. Inter-Bank Term Money 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. 3. Treasury Bills. 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. The rate of discount and the corresponding issue price are determined at each auction. 4. Certificate of Deposits

Certificates of Deposit (CDs) is a negotiable money market instrument nd issued in dematerialised form or as a Usance Promissory Note, for funds deposited at a bank or other eligible financial institution for a specified time period. Guidelines for issue of CDs are presently governed by various directives issued by the Reserve Bank of India, as amended from time to time. CDs can be issued by (i) scheduled commercial banks excluding Regional Rural Banks (RRBs) and Local Area Banks (LABs); and (ii) select all-India Financial Institutions that have been permitted by RBI to raise short-term resources within the umbrella limit fixed by RBI. Banks have the freedom to issue CDs depending on their requirements. An FI may issue CDs within the overall umbrella limit fixed by RBI, i.e., issue of CD together with other instruments viz., term money, term deposits, commercial papers and intercorporate deposits should not exceed 100 per cent of its net owned funds, as per the latest audited balance sheet. 5. Commercial Paper 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. A company shall be eligible to issue CP provided - (a) the tangible net worth of the company, as per the latest audited balance sheet, is not less than Rs. 4 crore; (b) the working capital (fund-based) limit of the company from the banking system is not less than Rs.4 crore and (c) the borrowal account of the company is classified as a Standard Asset by the financing bank/s. The minimum maturity period of CP is 7 days. The minimum credit rating shall be P-2 of CRISIL or such equivalent rating by other agencies. (for more details visit www.indianmba.com faculty column) Capital Market Instruments The capital market generally consists of the following long term period i.e., more than one year period, financial instruments; In the equity segment Equity shares, preference shares, convertible preference shares, non-convertible preference shares etc and in the debt segment debentures, zero coupon bonds, deep discount bonds etc. Hybrid Instruments 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.

Types of Financial Instruments

There are many types of financial instruments. Many instruments are custom agreements that the parties tailor to their own needs. However, many financial

instruments are based on standardized contracts that have predetermined characteristics. Some of the most common examples of financial instruments include the following:

Exchanges of money for future interest payments and repayment of principal.

o

Loans and Bonds. A lender gives money to a borrower in exchange for regular payments of interest and principal.

Asset-Backed Securities. Lenders pool their loans together and sell them to investors. The lenders receive an immediate lump-sum payment and the investors receive the payments of interest and principal from the underlying loan pool.

Exchanges of money for possible capital gains or interest. Stocks. A company sells ownership interests in the form of stock to buyers of the stock.
o

Funds. Includes mutual funds, exchange-traded funds, REITs, hedge funds, and many other funds. The fund buys other securities earning interest and capital gains which increases the share price of the fund. Investors of the fund may also receive interest payments.

Exchanges of money for possible capital gains or to offset risk. Options and Futures. Options and futures are bought and sold either for capital gains or to limit risk. For instance, the holder of XYZ stock may buy a put, which gives the holder of the put the right to sell XYZ stock for a specific price, called the strike price. Hence, the put increases in value as the underlying stock declines. The seller of the put receives money, called the premium, for the promise to buy XYZ stock at the strike price before the expiration date if the put buyer exercises her rights. The put seller, of course, hopes that the stock stays above the strike price so that the put expires worthless. In this case, the put seller gets to keep the premium as a capital gain.

Currency. Currency trading, likewise, is done for capital gains or to offset risk. It can also be used to earn interest, as is done in the carry trade. For instance, if a trader believed that the Euro was going to decline with respect to the United States dollar, then he could buy dollars with Euros, which is the same thing as selling Euros for dollars. If the Euro does decline with the respect to the dollar, then the trader can close the position by buying more Euros with the dollars received in the opening trade.

Exchanges of money for protection against risk. Insurance. Insurance contracts promise to pay for a loss event in exchange for a premium. For instance, a car owner buys car insurance so that he will be compensated for a financial loss that occurs as the result of an accident

2. Financial Intermediaries
Financial intermediation consists of channeling funds between surplus and deficit agents. A financial intermediary is a financial institution that connects surplus and deficit agents. The classic example of a financial intermediary is a bank that transforms bank deposits into bank [1] loans. Through the process of financial intermediation, certain assets or liabilities are transformed into [1] different assets or liabilities. As such, financial intermediaries channel funds from people who have extra money (savers) to those who do not have enough money to carry out a desired activity [2] (borrowers). In the U.S., a financial intermediary is typically an institution that facilitates the channeling of funds between lenders and borrowers indirectly. That is, savers (lenders) give funds to an intermediary institution (such as a bank), and that institution gives those funds to spenders (borrowers). This may be in the form of loans or mortgages. Alternatively, they may lend the money directly via the financial markets, which is known as financial disintermediation.

Functions performed by financial intermediaries

Financial intermediaries provide 3 major functions: 1. Maturity transformation Converting short-term liabilities to long term assets (banks deal with large number of lenders and borrowers, and reconcile their conflicting needs) 2. Risk transformation Converting risky investments into relatively risk-free ones. (lending to multiple borrowers to spread the risk) 3. Convenience denomination Matching small deposits with large loans and large deposits with small loans

Advantages of financial intermediaries

There are 2 essential advantages from using financial intermediaries: 1. Cost advantage over direct lending/borrowing 2. Market failure protection the conflicting needs of lenders and borrowers are reconciled, preventing market failure
[citation needed] [citation needed]

The cost advantages of using financial intermediaries include: 1. Reconciling conflicting preferences of lenders and borrowers 2. Risk aversion intermediaries help spread out and decrease the risks 3. Economies of scale using financial intermediaries reduces the costs of lending and borrowing 4. Economies of scope intermediaries concentrate on the demands of the lenders and borrowers and are able to enhance their products and services (use same inputs to produce different outputs)

Types of financial intermediaries

Financial intermediaries include: Banks Building societies Credit unions Financial advisers or brokers Insurance companies Collective investment schemes

Pension funds

3. Financial Markets
In economics, a financial market is a mechanism that allows people to buy and sell (trade) financial securities (such as stocks and bonds), commodities (such as precious metals or agricultural goods), and other fungible items of value at low transaction costs and at prices that reflect the efficient-market hypothesis. Both general markets (where many commodities are traded) and specialized markets (where only one commodity is traded) exist. Markets work by placing many interested buyers and sellers in one "place", thus making it easier for them to find each other. An economy which relies primarily on interactions between buyers and sellers to allocate resources is known as a market economy in contrast either to a command economy or to a non-market economy such as a gift economy. In finance, financial markets facilitate: The raising of capital (in the capital markets) The transfer of risk (in the derivatives markets) The transfer of liquidity (in the money markets) International trade (in the currency markets)

In economics, typically, the term market means the aggregate of possible buyers and sellers of a certain good or service and the transactions between them. The term "market" is sometimes used for what are more strictly exchanges, organizations that facilitate the trade in financial securities, e.g., a stock exchange or commodity exchange. This may be a physical location (like the NYSE) or an electronic system (like NASDAQ). Much trading of stocks takes place on an exchange; still, corporate actions (merger, spinoff) are outside an exchange, while any two companies or people, for whatever reason, may agree to sell stock from the one to the other without using an exchange. Trading of currencies and bonds is largely on a bilateral basis, although some bonds trade on a stock exchange, and people are building electronic systems for these as well, similar to stock exchanges. Financial markets can be domestic or they can be international.

[edit] Types of financial markets

The financial markets can be divided into different subtypes: Capital markets which consist of: o Stock markets, which provide financing through the issuance of shares or common stock, and enable the subsequent trading thereof. o Bond markets, which provide financing through the issuance of bonds, and enable the subsequent trading thereof. Commodity markets, which facilitate the trading of commodities. Money markets, which provide short term debt financing and investment. Derivatives markets, which provide instruments for the management of financial risk. Futures markets, which provide standardized forward contracts for trading products at some future date; see also forward market. Insurance markets, which facilitate the redistribution of various risks. Foreign exchange markets, which facilitate the trading of foreign exchange.

The capital markets consist of primary markets and secondary markets. Newly formed (issued) securities are bought or sold in primary markets. Secondary markets allow investors to sell securities that they hold or buy existing securities. The transaction in primary market exist between investors and public while secondary market its between investors. A Financial Market can be defined as the market in which financial assets are created or transferred. As against a real transaction that involves exchange of money for real goods or services, a financial transaction involves creation or transfer of a financial asset. 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. Money Market- The money market ifs a wholesale debt market for low-risk, highly-liquid, shortterm 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. Capital Market - The capital market is designed to finance the long-term investments. The transactions taking place in this market will be for periods over a year. Forex Market - 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. Credit Market- Credit market is a place where banks, FIs and NBFCs purvey short, medium and long-term loans to corporate and individuals.

Q2.Regulatory bodies
Reserve Bank of India (RBI) RBI is established under the Reserve Bank of India Act, 1934 to regulate general banking, foreign exchange, money market operations. RBI also monitors investment ceilings for non-resident investors in India under the Portfolio Investment Scheme (PIS). Securities and Exchange Board of India (SEBI) SEBI was established under The Securities and Exchange Board of India Act,1992, to regulate capital market intermediaries and is the Securities market regulator. SEBI is also responsible for ensuring investor protection and overseeing the operations of intermediaries such as Mutual Funds, Merchant Banks, Foreign Institutional Investors (FIIs) and Custodians, amongst others. SEBI has issued regulations for FIIs, Custodians, Depositories, Portfolio Managers, Mutual Funds, Underwriters, Merchant Bankers and other Capital Market intermediaries. In addition to registering and regulating intermediaries and service providers, SEBI is also vested with powers to issue directions to any person/persons related to the securities market or to companies in matters related to issuance of capital, transfer of securities and disclosures. Stock Exchanges: Stock Exchanges are constituted as self-regulatory organisations and are supervised by SEBI. They regulate members on most policy-related and operational issues including regulating trading to prevent excessive speculation and avoid member defaults. The regulatory measures include imposition of margins and defining price bands (circuit filters), suspension of trading in specific instruments and in extreme cases, halt trading. A Governing Board, represented by non-broker public representatives and SEBI nominees manage the day-to-day operations of the exchanges. BSE and NSE are the major exchanges for trading and contribute over 99% of the market share. 23 stock exchanges are granted recognition. Depositories: National Securities Depository Ltd (NSDL) and Central Depository Services Ltd (CDSL) are recognised depositories empowered by the Depositories Act and SEBI (Depositories and Participants) Regulations. Such powers include provision of depository services through Depository Participants and enabling settlement of trades through the depository mode.

Regulations of financial institutions differ from one country to another. The financial institution regulations are delineated by the government authorities of differ objective of these government authorities is to regulate the financial activities going on The financial regulatory bodies control the stock markets, bond markets, foreign exchange markets, and various other

segments

The financial regulations are laid out for the purpose of creating a fair and customer-friendly environment in the financial market of a particular country, which is con Some of the examples of financial regulatory bodies are the Federal Reserve Bank (United States), Reserve Bank of India (RBI), Securities and Exchange Board o Services Authority (FSA) in the United Kingdom, the Securities and Exchange Commission (SEC) in the United States and many others. The statutory objectives of the regulatory bodies of financial institutions include the following:

Market confidence: Sustaining confidence in the financial markets is one of the most important objectives of the financial regulatory bodies Consumer protection: Ensuring the most suitable level of customer protection Public awareness: Encouraging public awareness about the financial market through imparting educational programs Eliminating financial crime: The financial regulations are designed for the purpose of reducing financial crimes and frauds

The regulatory principles that are followed by the regulators of financial institutions include the following:

Role of management: Regulatory measures on the senior management of the financial institutions so that they do not take decisions that are detrimental to Innovation: Innovation should be facilitated with restriction so that the financial products and services launched are compliant to the rules and regulations International aspects: Strict monitoring should be there to see whether the international standards are maintained or not Efficiency and economy: The financial resources of a country should be used in the most prudent and effective way Proportionality: The financial regulations that are imposed should be proportional to the advantages that are anticipated from the regulations Competition: There should be strict supervision on the financial market for the purpose of minimizing harmful effects of competition.

Regulatory bodies
Financial sector in India has experienced a better environment to grow with the presence of higher competition. The financial system in India is regulated by independent regulators in the field of banking, insurance, mortgage and capital market. Government of India plays a significant role in controlling the financial market in India.
Ministry of Finance, Government of India controls the financial sector in India. Every year the finance ministry presents the annual budget on 28th February. The Reserve Bank of India is an apex institution in controlling banking system in the country. It's monetary policy acts as a measure weapon in Indias financial market.

Securities and Exchange Board of India (SEBI) is one of the regulatory authorities for India's capital market.

Here in this section we have covered major financial regulatory bodies in India's financial market.

The bodies that are established as an independent organization by government to regulate the activities of companies in an industry is termed Regulatory Bodies. The Financial sector in India saw tremendous growth due to the growing competition in market. The financial system controls banking, insurance, and mortgage and capital market. India has a complex governmental framework of regulatory bodies governed by a variety of ministries. The finances are controlled by ministry of Finance. The ministry presents the annual budget on 28th February every year.

The broad objective of regulatory bodies is to enable efficient functioning of the financial sector. This efficiency can be facilitated by setting a regulatory framework for [3]:

1. 2. 3. 4.

Managing the functioning of the overall economy. Avoiding contagion or crisis and information asymmetry Protecting individual interests

Ensuring adherence to the norms, rules, guidelines and policy

Q3.classification of financial assets

Financial assets (AF.) are economic assets, comprising means of payment, financial claims and economic assets which are close to financial claims in nature.

classification
In the previous article (discussing the recognition issue) it was established that financial instruments should be recognized based on when the enterprise becomes contractually committed. This article and the next will focus on the measurement issue. Initially, financial assets and liabilities should be measured at cost, which is the fair value of the

consideration given (in the case of an asset) or received (in the case of a liability) for it. I To determine the measurement criteria subsequent to initial recognition, I AC133 identifies four categories of financial assets,iii being:

* Financial assets held for trading * Held-to-maturity instruments * Loans and receivables originated by the enterprise * Available-for-sale financial assets.
This classification is also used to determine where the fair value changes, if any, should be recognised. Financial assets held for trading A financial asset held for trading is one that was acquired principally with the intention of generating a profit from short-term price fluctuations.iv Furthermore: * a financial asset should be classified as held for trading if, regardless of why it was acquired, it is part of a portfolio for which there is evidence of a recent actual pattern of short-term profit taking, and * Derivative financial assets are always deemed held for trading unless they are designated and effective as hedging instruments. All financial assets held for trading should be measured at fair valuev and the change in fair value should be included in net profit or loss for the period.vi Held-to-maturity investments Held to maturity investments are financial assets with: * Fixed or determinable payments; * A fixed maturity; and * That an enterprise has the positive intent and ability to hold to maturity, excluding loans and receivables originated by the enterprise.vii An enterprise does not have the positive intent to hold to maturity an investment if:viii * the enterprise has the intent to hold the financial asset for only an undefined period * the enterprise stands ready to sell the financial asset in response to changes in market interest rates or risks, liquidity needs, changes in the availability of and the yield on alternative investments, changes in financing sources and terms, or changes in foreign currency risk * the issuer has a right to settle the financial asset for an amount significantly below its amortised cost. Held to maturity investments should be measured at amortised cost using the effective interest method.ix The effective interest rate is the rate that exactly discounts the expected streams of future cash payments to the current net carrying amount, including all fees payable or receivable.x The effective interest rate is also called the level yield to maturity or the internal rate of return. The amortised cost is:xi * The amount of the initial recognition * Minus principal repayments * Plus or minus the cumulative amortisation * Minus any write-down for impairment or uncollectibility. The amortisation and any write down should be recorded in net profit or loss.xii

Loans and receivables originated by the enterprise Loans and receivables originated by the enterprise are financial assets that are created by the enterprise by providing money, goods or services directly to a debtorxiii. It includes trade receivables and loans granted by a bank but excludes loans or receivables that are originated with the intention of selling immediately or in the short-term (these should be classified as held for trading and recognised at fair value). Loans and receivables originated by the enterprise are measured at amortised cost.xiv Originated loans and receivables that do not have a fixed maturity should be measured at cost. Available-for-sale financial assets Available-for-sale financial assets are all other financial assets, which do not meet any of the requirements of the first three categories.xv It includes the following non-trading instruments: * Investments in equity securities * Investments in bonds and debentures not classified as held-to-maturity. All financial assets classified as available-for-sale are carried at fair value.xvi The changes in fair value are recognised depending on the accounting policy of the enterprise. An enterprise has a one-time choice to recognise unrealised gains and losses on available for sale financial assets, either * In net profit or loss, or * Directly in equity, through the statement of changes in equity. If the later is chosen, the unrealised gains and losses are kept in equity until the financial asset is sold, collected or otherwise disposed of or impaired (below the cost price). Then, the cumulative gain or loss should be included in net profit or loss. Reliable measurement of fair value not available Any financial asset that does not have a quoted market price in an active market and whose fair value cannot be reliably measured could not be measured at fair value. Such financial assets that have a fixed maturity should be measured at amortised cost. Those that do not have a fixed maturity should be measured at cost.xvi Summary The future intention of the standard setters is that all financial instruments should be measured at fair value. As a first step, AC133 sets out four categories of financial instruments which should be measured as follows: * Held for trading: measured at fair value with unrealised gains or losses recognised in the income statement * Held-to-maturity: measured at amortised cost, with the amortisation in the income statement * Loans and receivables originated by the enterprise: measured at amortised cost, with the amortisation in the income statement * Available-for-sale: measured at fair value with a one off choice to recognise the unrealised gains or losses in the income statement or in equity

Types of financial assets

The households questioned provided information on the following types of financial assets:

Balance on a savings account with a building and loan association: Balance of savings agreements not paid out yet, including any other private credit balances with building and loan associations. Savings deposits: Money deposited with banks (incl. Postbank) and savings banks in Germany and abroad and characterised by issuing a document (savings bank book) and not intended for payments.

Other assets with banks/savings banks: Fixed-term deposits and time deposits (incl. bank savings bonds) of domestic and foreign credit institutions. This includes balances on call money accounts. Securities: They include shares, bonds, share-based funds as well as other securities and equity participations. Shares: Domestic and foreign securities in which equity interests in a public limited company (AG, KgaA are evidenced. Bonds: Current bearer bonds of domestic and foreign issuers (institutions issuing the securities). They include in particular mortgage bonds, municipal bonds, other bank bonds (e.g. federal, Land or municipal loans, federal obligations and federal savings bonds) as well as industrial bonds. Investment funds: They include funds managed by investment trust companies, as for instance share-based funds, real estate funds, pension funds, money market funds and other funds (mixed funds, index tracker funds, old-age provision funds, funds of funds; hedge funds). Other securities and equity participations: for instance, time sharing and shares in companies unless the latter are public limited companies (e.g. shares in partnerships, co-operatives and limited liability companies). In addition to the above types of financial assets, the financial assets lent by households to individuals have been included. The financial assets also include the households credit balances with insurance companies (see below). Items excluded from financial assets are cash holdings, claims of household members against enterprises regarding employee old-age pension schemes (including direct insurance), claims against pension funds, burial funds and pension systems of the professions, etc. as well as the stock of current accounts.

Q4.long term financing Long Term Financing

Long term financing is a form of financing that is provided for a period of more than a year. Long term financing services are provided to those business entities that face a shortage of capital. It is different from short term financing. Short term financing is normally used to provide money that has to be paid back within a year. The period may be shorter than one year as well. Examples of long-term financing include a 30 year mortgage or a 10-year Treasury note. Equity is another form of long-term financing, such as when a company issues stock to raise capital for a new project. Purpose of long term finance To Finance fixed assets To finance the permanent part of working capital Expansion of Companies Increasing Facilities Construction Projects on a big Scale Provide Capital for funding the Operations. This helps in adjusting the cash flow.

Factors determining long-term financial requirements Nature of Business

Nature of goods produced Technology used

Types of Long Term Financing The kind of long term financing that is provided to a particular company depends on its type. For example, the long term financing that is provided to a solo proprietorship is different from the long term financing that a partnership would receive. Uses of Long Term Financing Long term financing is used in separate ways by different types of business entities. The business entities that are not corporations are only supposed to use long term financing for the purposes of debt. However, the corporations can use long term financing for both debt and equity purposes. Sources of Long Term Financing a. Shares: These are issued to the general public. The holders of shares are the owners of the business. These may be of two types: (i) Equity and (ii) Preference. b. Debentures: These are also issued to the general public. The holders of debentures are the creditors of the company. c. Public Deposits: General public also like to deposit their savings with a popular and well established company which can pay interest periodically and pay-back the deposit when due. d. Retained earnings: The company may not distribute the whole of its profits among its shareholders. It may retain a part of the profits and utilize it as capital.

e. Term loans from banks: Many industrial development banks, cooperative banks and commercial banks grant medium term loans for a period of three to five years. f. Loan from financial institutions: There are many specialized financial institutions established by the Central and State governments which give long term loans at reasonable rate of interest. Long Term Financing Products The following products are provided as part of long term financing services: Debentures Interest Rate Swaps Secured Notes Forward Rate Agreements (FRA's) Unsecured Notes Interest Only Futures Convertible Notes Option on Future Contracts Fixed Deposit Loans

Subordinated Debt Mortgages Preference Shares Euro-issues

short term financing

Short-term financing opportunities are available in a variety of ways to firms in global business. The majority of short-term transactions covered by financing are for periods of 180 days or less. Short-term financing requirements result from the need to increase inventory. Inventory is then converted to sales which, if extended payment terms are given, create accounts receivable. Inventory and accounts receivable are short-term in nature and provide a collateral base for a lender to provide financing. A company may need financing when the inventory and accounts receivable grow at a fast pace as a result of continually increasing sales. Then there is a greater need for funds to support the increase in the accounts that are growing at a faster rate than the accounts receivables can be converted to cash. The key factors in determining eligibility for shortterm financing are whether the product is to be re-sold or used by the buyer. Financing is limited by the product's useful life and whether or not it is considered capital equipment or inventory. Capital equipment can usually be financed for periods greater than one year, whereas most manufactured goods and agricultural products cannot. There are always exceptions to this rule; for example, many governments promote the export of agricultural products by offering guarantees on medium-term financing. In the US, such guarantees are offered by the Commodity Credit Corporation.

Much of corporate finance focuses on longer-term finance. In this section we will focus more on the day to day operations and see how they can affect the long-run health of the business.

When we say short-term financing we are looking at short-term assets and short-term liabilities. Terms used in conjunction with Short term Financial Management 1. Working Capital: Current Assets 2. Net Working Capital: Current assets - current liabilities. 3. Factoring: Selling of A/R

Current Assets Cash: Must know if you are talking about cash or cash and other safe, liquid securities such as money market securities Advantages: Flexibility, liquidity, Disadvantages: low return, slack might lead to agency costs,

Inventory-- both finished good and work in process

Advantages: fewer "outs", might be able to take advantage of volume discounts, more economical production runs Disadvantages: Must be financed, spoilage, it can hide problems

Accounts Receivable: also called trade credit. Customers owe you money.

Advantages: credit sales may increase sales Disadvantages: May not be paid, must be financed

Must decide on who to lend to, for how long, under what terms. All three must be managed. Costs of having too much include excess need for financing, possible increased agency costs, and "spoilage." Current Liabilities

Short-term financing can come from banks, commercial paper markets, and trade credit. Advantages: Speed, Flexibility, often lower rate Disadvantage: Volatile, downside if you can not refinance

Accounts Payable: The reverse of accounts receivables This is the most important source of short-term financing for many firms. Beware that increased use of Accounts payables (such as by not paying off when you should) can be expensive as most firms offer favorable terms for prompt payment and delaying payments can also upset your suppliers. Short-term loans: Bank Loans Commercial paper Commercial paper vs Bank Loans Large, credit-worthy, firms generally prefer to issue commercial paper as the rates are cheaper, but for most smaller firms bank and trade credit are the only sources of short-term debt financing. Banks often require compensating balances for these unsecured loans.

Link between Long-term and short- term financing (Fig 29.1 from Brealey and Myers text)

All firms need capital. This capital requirement can be met with either long term or short term capital. Since it is cheaper to issue long-term capital in "big chunks" and the total needs are not totally predictable, the financing tends to be out of sync with the actual needs. Firms can choose to always have enough excess cash on hand so that they never need to borrow short-term, or firms can arrange their financing such that they are always borrowing shortterm. Other firms manage their financing needs such that there will be occasional surpluses and occasional deficits.

Q5. Financial risk and return

Financial risk management is the practice of creating economic value in a firm by using financial instruments to manage exposure to risk, particularly credit risk and market risk. Other types include Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation risks, etc. Similar to general risk management, financial risk management requires identifying its sources, measuring it, and plans to address them. Financial risk management can be qualitative and quantitative. As a specialization of risk management, financial risk management focuses on when and how to hedge using financial instruments to manage costly exposures to risk. In the banking sector worldwide, the Basel Accords are generally adopted by internationally active banks for tracking, reporting and exposing operational, credit and market risks
The risk/return tradeoff could easily be called the "ability-to-sleep-at-night test." While some people can handle the equivalent of financial skydiving without batting an eye, others are terrified to climb the financial ladder without a secure harness. Deciding what amount of risk you can take while remaining comfortable with your investments is very important. In the investing world, the dictionary definition of risk is the chance that an investment's actual return will be different than expected. Technically, this is measured in statistics by standard deviation. Risk means you have the possibility of losing some, or even all, of our original investment. Low levels of uncertainty (low risk) are associated with low potential returns. High levels of uncertainty (high risk) are associated with high potential returns. The risk/return tradeoff is the balance between the desire for the lowest possible risk and the highest possible return. This is demonstrated graphically in the chart below. A higher standard deviation means a higher risk and higher possible return.

A common misconception is that higher risk equals greater return. The risk/return tradeoff tells us that the higher risk gives us the possibility of higher returns. There are no guarantees. Just as risk means higher potential returns, it also means higher potential losses. On the lower end of the scale, the risk-free rate of return is represented by the return on U.S. Government Securities because their chance of default is next to nothing. If the risk-free rate is currently 6%, this means, with virtually no risk, we can earn 6% per year on our money.

The common question arises: who wants to earn 6% when index funds average 12% per year over the long run? The answer to this is that even the entire market (represented by the index fund) carries risk. The return on index funds is not 12% every year, but rather -5% one year, 25% the next year, and so on. An investor still faces substantially greater risk and volatility to get an overall return that is higher than a predictable government security. We call this additional return the risk premium, which in this case is 6% (12% - 6%). Determining what risk level is most appropriate for you isn't an easy question to answer. Risk tolerance differs from person to person. Your decision will depend on your goals, income and personal situation, among other factors.

Types of risk [edit] Credit risk

Main article: Credit risk Credit risk, also called default risk, is the risk associated with a borrower going into default (not making payments as promised). Investor losses include lost principal and interest, decreased cash flow, and increased collection costs. Investment risk has been shown to be particularly large and particularly damaging for very large, one-off investment projects, so-called "megaprojects". This is because such projects are especially prone to end up in what has been called the "debt trap," i.e., a situation where due to cost overruns, schedule delays, etc. the costs of servicing debt becomes larger than the [6] revenues available to pay interest on and bring down the debt.

[edit] Market risk

Main article: Market risk This is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices: Equity risk is the risk that stock prices and/or the implied volatility will change. Interest rate risk is the risk that interest rates and/or the implied volatility will change. Currency risk is the risk that foreign exchange rates and/or the implied volatility will change, which affects, for example, the value of an asset held in that currency. Commodity risk is the risk that commodity prices (e.g. corn, copper, crude oil) and/or implied volatility will change.

[edit] Liquidity risk

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

Asset liquidity - An asset cannot be sold due to lack of liquidity in the market - essentially a sub-set of market risk. This can be accounted for by: o Widening bid-offer spread o Making explicit liquidity reserves o Lengthening holding period for VaR calculations Funding liquidity - Risk that liabilities:

o o o

Cannot be met when they fall due Can only be met at an uneconomic price Can be name-specific or systemic

You Can't Have One Without the Other Risk Just the thought of it can give investors sleepless nights. However, through careful planning for your financial future, you can help manage risk. Risk is something you encounter everyday. Even crossing a busy street involves some risk. With investments, balancing risk and return can be a tricky operation. All investors want to maximize their return, while minimizing risk. Let's face it, putting your hard earned dollars on the line can be downright frightening. Some investments are certainly more "risky" than others, but no investment is risk free. Trying to avoid risk by not investing at all can be the riskiest move of all. That would be like standing at the curb, never setting foot into the street. You'll never be able to get to your destination if you don't accept some risk. In investing, just like crossing that street, you carefully consider the situation, accept a comfortable level of risk, and proceed to where you're going. Risk can never be eliminated, but it can be managed. Let's take a look at the different types of risk, how different asset categories perform, and the ways and means to help manage risk. Types of Risk When most people think of "risk" they translate it as loss of principal. However, there are many kinds of risk. Let's take a look at some of them: Capital Risk: Losing your invested monies. Inflationary Risk: Investment's rate of return doesn't keep pace with inflation rate. Interest Rate Risk: A drop in an investment's interest rate. Market Risk: Selling an investment at an unfavorable price. Liquidity Risk: Limitations on the availability of funds for a specific period of time. Legislative Risk: Changes in tax laws may make certain investments less advantageous. Default Risk: The failure of the institution where an investment is made.

How Do Different Assets Perform? It may seem that there are countless types of investment products to choose from but, basically, there are three types of core investments: cash (or cash equivalents), bonds, and stocks.

Cash Investments such as bank savings and checking accounts, Certificates of Deposit (CDs), and Treasury Bills. The prices generally don't fluctuate very much. To investors concerned with loss of capital risk, cash would appear to be the most secure choice, as principal is guaranteed and/or insured. Savings and checking accounts are highly liquid, as they can be readily converted into cash. With CDs, you may face liquidity risk, as they must be held for a predetermined period of time or may be subject to penalties for premature withdrawal. Although risk to principal may be minimal, loss of purchasing power, or inflationary risk, must be taken into consideration. When inflation and taxation are taken into account, returns can be considerably lower. Hypothetically, let's say in 1981 you earned 14% in an investment. It sounds astronomical; however, the inflation rate at one point that year soared to 15%. That's a net loss of value of at least 1% and that's before taxes take another bite. Bonds Commonly called "fixed income investments," they are basically loans or "IOUs." Interest is earned on the money you lend. The prices of bonds do move up and down, but normally not as much as stocks. Many people think of bonds as conservative investments, but the returns can have a high degree of volatility. The fluctuation of interest rates is called interest rate risk, and a downturn in the bond prices could significantly decrease the overall return of any particular bond. Stocks Represent equity in, or partial ownership of, a company. An easy way to remember the difference between stocks and bonds is: "With stocks, you own. With bonds, you loan." The price of a stock or share can move up or down, sometimes a lot. The returns of stocks from year to year can be quite volatile, but, as the graph illustrates, the returns from stocks have significantly outpaced inflation, and topped the returns from cash and bonds as well, over this twenty-year period.

Finding Your Comfort Zone It's possible to achieve higher returns through stocks rather than bonds, and through bonds rather than through cash, but you can't expect to get higher returns without taking on some degree of unpredictability. If you seek higher returns, you have to be willing to live with higher risk. "How much risk is right for me?" The answer will affect your investment decisions. Although past performance is not a guarantee of what will happen in the future, historical results over a long period of time can help you make your investment decisions. The Ways to Manage Risk There are a number of strategies that can help limit risk while offering the potential of higher returns. Diversification Investing in a variety of investments, or simply following the old adage "Don't put all your eggs in one basket." With a portfolio spread among several different investments, you benefit when each type is doing well, and also limit exposure when one or more investment is performing poorly.

Asset Allocation Building upon the diversification concept, with asset allocation you create a customized portfolio consisting of several asset categories (cash, stocks, bonds) rather than individual securities . Changing economic conditions affect various types of assets differently; consequently, each asset category's return may partially offset the others'. Dollar Cost Averaging Systematically investing a fixed dollar amount at regular time intervals. When this disciplined program is adhered to and market fluctuations are ignored, it attempts to "smooth out" the ups and downs of the market over the long haul. Dollar cost averaging, however, cannot guarantee a positive return in a declining market and you must consider your ability to continue investing on a regular basis under all market conditions.

The Means to Manage Risk Most investors find it difficult to diversify effectively across the full spectrum of cash and individual stocks and bonds. That is why so many investors have chosen variable products to apply the strategies previously mentioned. Mutual funds, variable annuities, variable universal life insurance products offer the potential for maximizing investment performance, investment flexibility, and convenience. They allow you to allocate investments among several asset categories to tailor the mix to suit your needs. In addition they offer professional investment management, and allow you to leave the day-to-day decisions to the "experts." Of course, like any investment, these products involve risk and you should read a prospectus carefully to see if they are right for you before investing. Plant Your Tree Today An old proverb states, "The best time to plant a tree was yesterday. The second best time to plant a tree is today." This "power of time" concept applies to personal finance as well. The sooner you implement your investment plan, the greater the wealth you can potentially accumulate. In addition, the longer your time horizon, the easier it is to ride out the ups and downs of your investments. The length of time investors hold onto their portfolios is one of the crucial factors determining the likelihood of obtaining a positive return. Financial history indicates that investors are amply rewarded in the long-term for assuming risk. Regrettably there's no magic potion for eliminating risk. But by carefully creating a long-term, diversified investment program you can help manage risk. For assistance, contact us to put you together with a NYLIFE Securities Inc. registered representative professionally trained and experienced who can help you analyze your needs and assist you in putting together an investment program that fits your needs at no charge to you

Risk and Return Analysis

Return expresses the amount which an investor actually earned on an investment during a certain period. Return includes the interest, dividend and capital gains; while risk represents the uncertainty associated with a particular task. In financial terms, risk is the chance or probability that a certain investment may or may not deliver the actual/expected returns.

The risk and return trade off says that the potential return rises with an increase in risk. It is important for an investor to decide on a balance between the desire for the lowest possible risk and highest possible return. Risk Analysis Risk in investment exists because of the inability to make perfect or accurate forecasts. Risk in investment is defined as the variability that is likely to occur in future cash flows from an investment. The greater variability of these cash flows indicates greater risk. Variance or standard deviation measures the deviation about expected cash flows of each of the possible cash flows and is known as the absolute measure of risk; while co-efficient of variation is a relative measure of risk. For carrying out risk analysis, following methods are used

Payback [How long will it take to recover the investment] Certainty equivalent [The amount that will certainly come to you] Risk adjusted discount rate [Present value i.e. PV of future inflows with discount rate]

However in practice, sensitivity analysis and conservative forecast techniques being simpler and easier to handle, are used for risk analysis. Sensitivity analysis [a variation of break even analysis] allows estimating the impact of change in the behavior of critical variables on the investment cash flows. Conservative forecasts include using short payback or higher discount rates for discounting cash flows. Investment Risks Investment risk is related to the probability of earning a low or negative actual return as compared to the return that is estimated. There are 2 types of investments risks: 1. Stand-alone risk This risk is associated with a single asset, meaning that the risk will cease to exist if that particular asset is not held. The impact of stand alone risk can be mitigated by diversifying the portfolio. Stand-alone risk = Market risk + Firm specific risk Where,

Market risk is a portion of the security's stand-alone risk that cannot be eliminated trough diversification and it is measured by beta o Firm risk is a portion of a security's stand-alone risk that can be eliminated through proper diversification 2. Portfolio risk
o

This is the risk involved in a certain combination of assets in a portfolio which fails to deliver the overall objective of the portfolio. Risk can be minimized but cannot be eliminated, whether the portfolio is balanced or not. A balanced portfolio reduces risk while a non-balanced portfolio increases risk. Sources of risks
o o o o o o

Inflation Business cycle Interest rates Management Business risk Financial risk

Return Analysis An investment is the current commitment of funds done in the expectation of earning greater amount in future. Returns are subject to uncertainty or variance Longer the period of investment, greater will be the returns sought. An investor will also like to ensure that the returns are greater than the rate of inflation. An investor will look forward to getting compensated by way of an expected return based on 3 factors

Risk involved Duration of investment [Time value of money] Expected price levels [Inflation]

The basic rate or time value of money is the real risk free rate [RRFR] which is free of any risk premium and inflation. This rate generally remains stable; but in the long run there could be gradual changes in the RRFR depending upon factors such as consumption trends, economic growth and openness of the economy. If we include the component of inflation into the RRFR without the risk premium, such a return will be known as nominal risk free rate [NRFR] NRFR = ( 1 + RRFR ) * ( 1 + expected rate of inflation ) - 1

Third component is the risk premium that represents all kinds of uncertainties and is calculated as follows Expected return = NRFR + Risk premium Risk and return trade off Investors make investment with the objective of earning some tangible benefit. This benefit in financial terminology is termed as return and is a reward for taking a specified amount of risk. Risk is defined as the possibility of the actual return being different from the expected return on an investment over the period of investment. Low risk leads to low returns. For instance, incase of government securities, while the rate of return is low, the risk of defaulting is also low. High risks lead to higher potential returns, but may also lead to higher losses. Long-term returns on stocks are much higher than the returns on Government securities, but the risk of losing money is also higher. Rate of return on an investment cal be calculated using the following formulaReturn = (Amount received - Amount invested) / Amount invested He risk and return trade off says that the potential rises with an increase in risk. An investor must decide a balance between the desire for the lowest possible risk and highest possible return.