Lecture 1 & 2 – Saturday 14th Jan 2023

Module 1 Financial System in India

1.1: Financial System – Role of money, what is money. What is the definition of Financial System, what
constitutes it – its constituents, what are the different systems in the overall financial system, how are we
touched by it on a day-to-day basis.
Aspects of the system – Control or Influence or Facilitation by participants / Availability or Liquidity / End
Use or Uses / Mode of Transfer or Transmission / Cost of financing / Aim or Goal of Financier V/s. Goal of
the Financed User / Regulation or Rules or Laws or Covenants / Effect to the common man.
Functions of financial system – Flow / Liquidity / Facilitation / Availability – A system that makes money
available to those who need it at a cost and on conditions of how and when to use it and when to return
it.
RBI – Monetary Policy
Inflation and Bond Behaviour
Inflation and Impact on Monetary System

Meaning and Importance –

Role of financial system in economic development –
Structure and Components of financial system in India –
Introduction to financial Institutions –
Banking – Non Banking Institutions.
1.2: Financial Markets – Money Market and Capital Market – Financial Instruments on the basis of Term
of instruments – Types of Securities, Financial services – fund based services and fee based services.
Lecture 3 & 4: 21-Jan-2023
Lecture 1 – 8.00 an to 10.00 am
Revisit the yield curve: first 15-20 mins
Ask questions on what they understood on the curve rising up or going down.
Ask when they think the move happens.
Anticipation / Expectation / Reality – Market is Supreme.

International Monetary Systems: 15-20 mins

Brettenwoods / Gold Standard / Current Monetary Systems.
The Currency Peg – Gold Standard / Brettenwoods / Now.

Break – 10 mins
Resume – 15 mins
Game on the Currency Peg – Make teams and have them choose currency to Gold Value – then make the
relative currency value?

Explaining the BIS - Bank of International Settlements

Origin and the evolvement now.
How much GDP it covers ?.

Member countries and roles.

Role of RBI and financial system in India – Debt / Equity

Currency reserves – Gold why gold is important?
Lecture 5 & 6 – Saturday 28th Jan 2023
Banking Regulation Act 1949:

Was initially passed as Banking Companies Act 1949 and later changed to Banking Regulation Act 1949 in
the year 1966.

It became applicable in J&K in 1956.

Was applicable initially only to Banking Companies, later in 1965 it was expanded to cover Co-Operative
Banks & add more changes.

In 2020 it was amended to bring the cooperative banks under the supervision of the RBI.

The Act gives the Reserve Bank of India (RBI) the power

 to license banks, - latest banking licences given

 have regulation over shareholding and voting rights of shareholders;
 supervise the appointment of the boards and management;
 regulate the operations of banks;
 lay down instructions for audits;
 control moratorium,
 mergers and liquidation;
 issue directives in the interests of public good
 issue directives banking policy,
 and impose penalties.

The Government of India and the RBI decided to open the banking sector to new banks as part of
the 1991 reforms.

In 1993, the RBI received 143 applications for establishing new banks, of which 23 were deemed
worthy, and finally 10 banks saw the light of the day.
In 2013, the RBI received 26 applications, of which only two were given universal bank licences.
1991 Economic Crisis let to the seed of Banking Reform.

Led by Maidavolu Narasimham – known as the Father of Banking Reforms. Former RBI Governor
in 1977.

Bank structures and mergers

Bank mergers toward creation of strong public sector mega-banks were first recommended by
the Narasimham committee of 1991. India's recent merger of ten public sector banks in 2020
was building on recommendations from this committee.[7][9]

Asset reconstruction
Some of the recommendations around creation of Asset Reconstruction Companies as means to
securitize bad debt are built on the recommendations from his committee.[7] His committee also
introduced the notion of an asset reconstruction fund to take over bad loans. As a follow-up, six
special debt recovery tribunals were set up. This served as the foundation for India's current
Insolvency and Bankruptcy Code which was codified in 2016.[7]

Rural Banking
Earlier in 1976, he had also been the author of the Regional Rural Bank report which was the basis
for the setup of regional rural banks in India, building on his blueprint and recommendations of
having these banks maintain a local appeal while bringing the professionalism from large
commercial banks.

Capital Adequacy
The first committee report of 1991 introduced the notion of a capital adequacy ratio while
proposing a phased reduction in mandatory bond investment and cash reserve ratios in an
attempt to encourage lending. The committee also introduced rules around non-performing
assets (NPA) classification and also had the Reserve Bank of India (RBI) requiring banks make
provisions for bad loans.

Private Banks And Modernization Of Public Sector Banks

Some of the other recommendations from Narasimham included creation of new generation
private sector banks including ICICI Bank, HDFC Bank, and Kotak Mahindra Bank. His
recommendations also had banks raising money from the capital markets. Interest rates were also
de-regulated fostering competition between banks. Amongst the other Public sector banks (PSB),
the committee recommended that the government separate ownership from management and
also led to technology upgradation and modernization.
 The Committee on the Financial System (1991)
Narasimham Committee 1991
History of the Committee
The banks were not functioning properly during India’s economic liberalisation in 1991.
India felt the need for an efficient banking system that is required for a nation’s economic
development.

That is why ex-Finance Minister of India Dr. Manmohan Singh established the Narasimham
committee to examine the functioning of banks.

On 14th August 1991, Government of India appointed a nine-member team called the
Narasimham Committee I. Its chairman was Maidavolu Narasimham.

From 2nd May 1977 to 30th November 1977, Narasimham remained the 13th governor of RBI.
The first report was introduced on 17th December 1991 in the parliament.

Recommendations of Narasimham Committee I

 Reduction in SLR and CLR
At that time, both Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR) were extremely
high. The SLR was 38.5%, and CRR was 15%. To increase the bank’s productivity rates, the
committee recommended reducing these high proportions. Accordingly, they suggested reducing
SLR rates from 38.5% to 25% and CRR from 15% to 3-5%.

 Phasing out Directed Credit Programme

The Government of India implemented credit programmes that compelled banks to set aside
funds for the needy and poor sectors at decreased rates. The committee suggested phasing out
this program as it was not profitable for them.

 Interest Rate Determination

Narasimham committee insisted on determining interest rates based on market forces such as
the supply and demand for funds. Earlier it was regulated by the Government of India. They
suggested eliminating this process.

 Establishment of the ARF Tribunal

The proportion of Non-Performing assets and bad debts of the public sector banks and
developmental institutions was very alarming then. The committee suggested the establishment
of an Asset Reconstruction Fund (ARF) to take over the proportion of bad and doubtful debts from
banks and financial institutions.
 Removal of Dual Control
Both RBI and the Banking Division under the Ministry of Finance regulated the banks at that time.
The committee suggested removing this system and asked only RBI to regulate the banking sector.

 More Freedom to Banks

The committee suggested more freedom for banks. It suggested that every bank should be free
and perform autonomously. Each bank should change its working technology to align with the
evolving world. On the sole basis of professionalism and integrity, the Chief Executive and board
of directors will be appointed.

 Reorganisation of the Banking Sector

The committee proposed to reduce the number of public sector banks through the process of
acquisition and mergers. The broad pattern, according to the committee, should consist of:

Three or four large public sector banks like SBI should become international. The rest should
remain local banks and operate in a specified region.
The committee recommended national recognition of 8 to 10 banks nationwide.

RBI will permit the establishment of new banks under the private sector if they conform to the
minimum start-up capital. But, on the other hand, no new banks would be called national banks.

Foreign banks can operate in India as either subsidiaries or fully owned banks. Foreign banks can
also set up joint ventures with Indian banks regarding investment banking.

The Committee of Banking Sector Reforms (1998).

Narasimham Committee-II (1998)
In order to intimate the second generation of financial sector reforms a committee on Banking
Sector Reforms was formed in 1998 again under the chairmanship of M. Narasimham. The
committee was submitted its report on 23rd April 1998 by the finance minister of Government of
India. Many of them have been accepted and are under implementation. These mainly
concentrate on strengthening the foundation of the banking system by structure, technological
upgradation and human resource development.

Recommendations of Narasimham Committee II

Some of the recommendations of Narasimham Committee II are as follows:

 The Committee suggests that pending the emergence of markets in India where market risks can
be covered, it would be desirable that capital adequacy requirements take into account market
risks in addition to the credit risks.
  There is an additional capital requirement of 5% of the foreign exchange open position limit. Such
risks should be integrated into the calculation of risk weighted assets. The Committee
recommends that the foreign exchange open position limits should carry a 100% risk weight.
Introduction of the norm of 90 days for income recognition in a phased manner.

 Banks have been advised to take effective steps for reduction of NPAs and also put in place risk
management systems and practices to prevent re-emergence of fresh NPAs.

 Banks are permitted to issue bonds for augmenting their Tier II capital. Guarantee of the Govt. for
these bonds is not considered necessary.

 The public sector banks have been permitted to recruit from the open market or by way of campus
recruitment, skilled personnel in areas like information technology, risk management, treasury
operations, etc.

Two Kinds of Banks:

Universal Banks (UBs) are financial entities like commercial banks, financial institutions, NBFCs,
etc. that undertake multiple financial transactions.
UBs were underscored as a development financial institution (DFI) by the Narsimham Committee.

Small Finance Banks (SFBs) are focused financial institutions registered as a public limited
company providing banking and credit services to unserved & unbanked regions of the country
like marginal farmers, MSMEs, and other non-risk sharing financial activities with RBI’s prior
approval. Concept of SFBs was laid down in Raghuram Rajan Committee.

On Tap Banking Licence from 2016 & later in 2019.

 In the first stage, the applications are screened by RBI to ensure prima facie eligibility.
 Post-screening, it is forwarded to the Standing External Advisory Committee (SEAC) constituted
of industry experts and eminent persons with experience in the Banking, Financial Services and
Insurance (BFSI) sector, appointed for three years.
 SEAC’s recommendations shall then be examined by the Internal Screening Committee (ISC)
consisting of Governor and Deputy Governors.
 ISC’s observations shall be forwarded to the Central Board (CB) of RBI that exercises the final
discretion to grant in-principle approval for 18 months.
 Upon the culmination of this period, RBI shall on satisfaction with compliances grant the regular
license for commencement of banking business.

Who can avail :

 UBs: Any individual/entity with at least 10 years of experience in banking and finance at the senior
level or private entities with 10 years of successful track record are eligible to apply for on-tap
licensing as UBs.
  Secondly, aspiring entities ought to have assets of Rs. 5000 crore or above.
 Thirdly, the required net worth is Rs. 500 crore that has to be maintained at all times.
 However, large industrial houses are restricted to only invest in UBs up to 10% only.

While the guidelines do not restrict applicants to only corporate entities, they vest discretion upon RBI to
look for a strong promoter with significant experience and a proven track record. RBI emphasizes the
entity’s track record in conforming to the best international and domestic standards of customer service,
integrity, and efficiency. It implies that RBI would grant the licenses on the basis of discretional
prudential factors, in addition to rule-based eligibility criteria.

Small Finance Bank: For an application for SFB:

 The individual entity must have 10 years of experience in the BFSI sector at the senior level.
 In the case of a corporate entity applicant, it must have at least 5 years of successful track record.
 Corporate applicants also encompass NBFCs, microfinance institutions, local banks and
cooperative banks also. This aids such entities to expand their business on the liability side.
 Secondly, the minimum paid-up voting equity capital or net worth is Rs. 200cr., considering the
size of operations and limited scope of activities.
 In the case of urban cooperative banks (UCBs) voluntarily transitioning as SFB shall have an
initial net worth of Rs. 100 crore only but shall be increased to Rs 200 crores within five years
from the commencement of business. (However, this conversion model is plagued by ambiguities
in promoter identification, investment plans and capital infusion by promoter groups.)

Summarily, there are five aspects that applicants ought to fulfill:

(i) financial inclusiveness,
(ii) soundness of business & technological model,
(iii) strong management track record,
(iv) sustainable governance, and
(v) adequate capital structure.

The idea is that local players would be able to align themselves with respective target customer segments.
Thus, it is imperative for the remainder and future applicants who fulfill the eligibility criteria that they
maintain sustainable financial principles.
Lecture 7 & 8 – Saturday 25th Feb 2023
Detail on the Adani – Hindernburg Issue - Markets – Inflation – Commercial Papers / Bonds; GOI Bonds
vs Corp Bonds Yields – concept of Spread

Detail on the Adani – Hindernburg Issue.

How markets are spooked by Inflation and continued hawkish (aggressive) stance of FED and as a
consequence other Central Banks.
UK target inflation rate is 2% while current inflation is at 10%.
Indian inflation stands around 6.50 – 7.00% whereas growth is targeted at 8%. However, if growth is below
target then we may degrow.
Inflation is wreaking havoc in economies such as Pakistan / Sri Lanka and Singapore too is witnessing the
heat. Singapore has seen the rentals and property prices rise due to influx of Chinese money. Rentals have
jumped 30-40% where as property prices too have jumped by 25-30%.

GOI Bonds vs Corporate Bonds - Yield Spread

Ideally Government Bonds (GOI) have the lowest default risk hence they yield the lowest and corporate
bond depending on their rating and their credit perception will be either at a thin or a thick spread over
the GOI yield. The above diagram illustrates yield curves and spread. The spread can be as low as a few
basis points (bps) or
Commercial Paper: Is a form of a promissory note sold to investors by Corporates. They need to have it
rated and it should be carved out of their working capital limits as decided by its main / lead banks. First
set of CPs were introduced on 01st January 1990 and were based on recommendations of the Working
Group on Money Markets chaired by N. Vaghul in 1987.

Features:
 Negotiable Instrument with endorsement and delivery, payable on maturity to the holder.
 Investors can resell once it is purchased in open market and can change hands numerous times
till maturity.
 Discounted instrument meaning no coupon. It is issued below par and the par value is paid on
maturity.
 Minimum 15 days and Maximum up to a year. Not over a year. But a CP should be within the
period rated for by a Credit Rating Agency.
 CP bears a certificate from the Bankers verifying the signature of the expectants.
 RBI frames the guidelines on CPs. SEBI also regulates some aspects,
 All eligible participants shall obtain the credit rating for issuance of Commercial Paper from either
the Credit Rating Information Services of India Ltd. (CRISIL) or the Investment Information and
Credit Rating Agency of India Ltd. (ICRA) or the Credit Analysis and Research Ltd. (CARE) or the
FITCH Ratings India Pvt. Ltd. or such other credit rating agencies as may be specified by the
Reserve Bank of India from time to time, for the purpose. The minimum credit rating shall be P-2
of CRISIL or such equivalent rating by other agencies. The issuers shall ensure at the time of
issuance of CP that the rating so obtained is current and has not fallen due for review.
 CP can be issued in denominations of Rs.5 lakh or multiples thereof. Amount invested by a single
investor should not be less than Rs.5 lakh (face value).
 CP can be issued as a "stand alone" product. The aggregate amount of CP from an issuer shall be
within the limit as approved by its Board of Directors or the quantum indicated by the Credit
Rating Agency for the specified rating, whichever is lower.
 An FI can issue CP within the overall umbrella limit fixed by the RBI, i.e., issue of CP together with
other instruments, viz., term money borrowings, term deposits, certificates of deposit and inter-
corporate deposits should not exceed 100 per cent of its net owned funds, as per the latest
audited balance sheet.
 Only a scheduled bank can act as an Issuing and Paying Agents (IPA) for issuance of CP.
 CP may be issued to and held by individuals, banking companies, other corporate bodies
registered or incorporated in India and unincorporated bodies, Non-Resident Indians (NRIs) and
Foreign Institutional Investors (FIIs). However, investment by FIIs would be within the limits set
for their investments by Securities and Exchange Board of India (SEBI).
 CP can be issued either in the form of a promissory note (Schedule I) or in a dematerialised form
through any of the depositories approved by and registered with SEBI.
 No issuer shall have the issue of CP underwritten or co-accepted (a form of undertaking to pay by
bank a bank etc.)
  Every issuer must appoint an IPA for issuance of CP. The issuer should disclose to the potential
investors its financial position as per the standard market practice. After the exchange of deal
confirmation between the investor and the issuer, issuing company shall issue physical certificates
to the investor or arrange for crediting the CP to the investor's account with a depository.
Investors shall be given a copy of IPA certificate to the effect that the issuer has a valid agreement
with the IPA and documents are in order.

US 10-year Note yield chart. In less than 2 years it has jumped from 0.50% to to 4.25%. Now hovering
around 3.92%. Imagine sitting on a portfolio full of 10 plus years of US treasury and Corp bonds
and this movement.

In yield terms its 3.75% move but in floating rate interest terms its a multiple of 3.75 times in interest out
go per year ! Imagine the cost of funds if it was a floating bond linked to the US 10-year note !
The Adani & Hindenburg Saga

https://www.scobserver.in/journal/sco-shorts-adani-hindenburg-
controversy/#:~:text=What%20are%20the%20allegations%20against,entities%20controlled%20by%20th
e%20Group.

SCO Shorts: Adani-Hindenburg Controversy

Joyston D'Souza | 3rd Mar 2023

An SC-appointed expert committee and SEBI will investigate allegations of fraud levelled against the Adani
Group of companies.

On January 25th, 2023, U.S.-based short-seller Hindenburg Research published a report accusing the
Adani group of companies of committing the ‘largest con in corporate history’. Soon after the Hindenburg
Report was published, Adani Group stocks plummeted by USD 140 billion. Hindenburg Research, however,
profited from this crash in prices since it took a ‘short position’ against the Adani Group’s U.S. holdings.

What is Short-Selling?
Short-selling refers to selling a stock that the seller does not own at the time of the trade, with the
intention of buying it back at a lower price later in the future. Short sellers ‘borrow’ shares and sell them
at market value, and buy them back when the share price falls. The difference in value is the profit. To put
it simply, a short-seller bets on the price of the stock going down in order to make a profit.

What are the allegations against the Adani Group?

The Hindenburg Report accused the Adani group of engaging in large-scale stock price manipulation,
falsely overinflating the value of their assets, and controlling over 75% of their shares through different
offshore shell entities controlled by the Group. All of these are prohibited by the Securities Contracts
(Regulation) Rules, 1957 in order to protect investors.

Hindenburg also accused the Adani Group of taking on substantial debt by overleveraging their assets to
obtain several large loans amounting to ₹2.2 lakh crores. If the Adani Group is unable to pay back its loans,
the lending banks will be unable to recover the debt amount putting them in a precarious position.

Why does it matter?

The allegations levelled against the Adani Group imply that the Indian regulatory framework failed to stop
large-scale stock manipulation and accounting fraud over the course of decades. If the allegations are
true, it would mean that the Adani Group, and Mr. Gautam Adani, raked in over $100 billion in net worth
through illegal means.

Alternately, even if the Hindenburg report is found to be false, the damage is already done. Soon after the
report’s release, the Adani Group’s share prices saw a massive crash to the tune of USD 140 billion,
drastically affecting investor confidence and allowing Hindenburg Research to rake in substantial profits.
What is the Supreme Court’s role?
A wide range of petitions were filed before the SC over the Adani-Hindenburg controversy. One batch of
petitions alleged a conspiracy by Hindenburg Research to fraudulently make profits by crashing Adani
stock prices. A second batch of petitions sought an investigation by an expert committee to investigate
the possibility of fraud by the Adani Group.

On March 2nd, 2023, the SC formed a 6-member committee led by Justice (retd.) A.M. Sapre to investigate
the allegations against the Adani group and claims of regulatory failure. Notably, the SC refused to
consider the Union’s sealed cover recommendations for members of the panel, stating that it would select
the experts by itself and ‘maintain full transparency’.

What next?
Upon hearing various petitions seeking an investigation into the allegations made by Hindenburg
Research, the SC formed a 6-member expert committee to investigate the allegations. The committee led
by former SC Justice A.M. Sapre comprises the following members:

Justice (retd.) J.P. Devadhar

Mr. O.P. Bhat
Mr. Nandan Nilekani
Mr. Somasekharan Sundaresan
Mr. K.V. Kamath
The expert committee is tasked with the following:

To conduct an overall assessment of the situation

To suggest measures to increase investor awareness
To investigate claims of regulatory failure
To suggest measures to strengthen the regulatory framework
An investigation into the claims of regulatory failure implies that the Securities and Exchange Board of
India (SEBI) may be under scrutiny by the SC. The committee will submit its report in a sealed cover within
two months.

At the same time, the Bench also ruled that SEBI may continue to conduct a separate investigation. The
SC directed SEBI to submit its report within two months.

What is the corporate governance in India?

Corporate governance refers to a code of conduct to which the Board of Directors must abide by while
running the corporate enterprise. Corporate governance refers to a set of systems, procedures and
practices which ensure that the company is managed in the best interest of all corporate stakeholders.
Below information is Data Sourced from: www.investopedia.com
Macaulay Duration:
Macaulay Duration is the weighted average of the time to receive the cash flows from a bond. It is
measured in units of years. Macaulay duration tells the weighted average time that a bond needs to be
held so that the total present value of the cash flows received is equal to the current market price paid
for the bond. It is often used in bond immunization strategies.

How to Calculate Macaulay Duration

In Macaulay duration, the time is weighted by the percentage of the present value of each cash flow to
the market price of a bond. Therefore, it is calculated by summing up all the multiples of the present
values of cash flows and corresponding time periods and then dividing the sum by the market bond price.

Macaulay Duration

Where:

PV(CFt) – Present value of cash flow (coupon) at period t

t – Time period for each cash flow
C – Periodic coupon payment
n – Total number of periods to maturity
M – Value at maturity
Y – Periodic yield
For example, a 2-year bond with a $1,000 par pays a 6% coupon semi-annually, and the annual interest
rate is 5%. Thus, the bond’s market price is $1,018.81, summing the present values of all cash flows. The
time to receive each cash flow is then weighted by the present value of that cash flow to the market price.

The Macaulay duration is the sum of these weighted-average time periods, which is 1.915 years. An
investor must hold the bond for 1.915 years for the present value of cash flows received to exactly offset
the price paid.

Macaulay Duration - Sample Table

Factors that Affect Macaulay Duration

The Macaulay duration of a bond can be impacted by the bond’s coupon rate, term to maturity, and yield
to maturity. With all the other factors constant, a bond with a longer term to maturity assumes a greater
Macaulay duration, as it takes a longer period to receive the principal payment at the maturity. It also
means that Macaulay duration decreases as time passes (term to maturity shrinks).

Macaulay duration takes on an inverse relationship with the coupon rate. The greater the coupon
payments, the lower the duration is, with larger cash amounts paid in the early periods. A zero-coupon
bond assumes the highest Macaulay duration compared with coupon bonds, assuming other features are
the same. It is equal to the maturity for a zero-coupon bond and is less than the maturity for coupon
bonds.

Macaulay duration also demonstrates an inverse relationship with yield to maturity. A bond with a higher
yield to maturity shows a lower Macaulay duration.

Modified Duration:
Modified duration is a formula that expresses the measurable change in the value of a security in response
to a change in interest rates. Modified duration follows the concept that interest rates and bond prices
move in opposite directions. This formula is used to determine the effect that a 100-basis-point (1%)
change in interest rates will have on the price of a bond.

Modified duration is an extension of the Macaulay duration, which allows investors to measure the
sensitivity of a bond to changes in interest rates. Macaulay duration calculates the weighted average time
before a bondholder receives the bond's cash flows. In order to calculate modified duration, the Macaulay
duration must first be calculated.

What Modified Duration Can Tell You

Modified duration measures the average cash-weighted term to maturity of a bond. It is a very important
number for portfolio managers, financial advisors, and clients to consider when selecting investments
because—all other risk factors equal—bonds with higher durations have greater price volatility than
bonds with lower durations. There are many types of duration, and all components of a bond, such as its
price, coupon, maturity date, and interest rates, are used to calculate duration.

Here are some principles of duration to keep in mind. First, as maturity increases, duration increases and
the bond becomes more volatile. Second, as a bond's coupon increases, its duration decreases and the
bond becomes less volatile. Third, as interest rates increase, duration decreases, and the bond's sensitivity
to further interest rate increases goes down.
Example of How to Use Modified Duration
Assume a $1,000 bond has a three-year maturity, pays a 10% coupon, and that interest rates are 5%. This
bond, following the basic bond pricing formula would have a market price of:

This result shows that it takes 2.753 years to recoup the true cost of the bond. With this number, it is now
possible to calculate the modified duration.

To find the modified duration, all an investor needs to do is take the Macaulay duration and divide it by
1 + (yield-to-maturity / number of coupon periods per year). In this example that calculation would be
2.753 / (1.05 / 1), or 2.62%. This means that for every 1% movement in interest rates, the bond in this
example would inversely move in price by 2.62%.

Macaulay Duration vs. Modified Duration

Modified duration is another frequently used type of duration for bonds. Different from Macaulay
duration, which measures the average time to receive the present value of cash flows equivalent to the
current bond price, Modified duration identifies the sensitivity of the bond price to the change in interest
rate. It is thus measured in percentage change in price.

Modified duration can be calculated by dividing the Macaulay duration of the bond by 1 plus the periodic
interest rate, which means a bond’s Modified duration is generally lower than its Macaulay duration. If a
bond is continuously compounded, the Modified duration of the bond equals the Macaulay duration.
In the example above, the bond shows a Macaulay duration of 1.915, and the semi-annual interest is 2.5%.
Therefore, the Modified duration of the bond is 1.868 (1.915 / 1.025). It means for each percentage
increase (decrease) in the interest rate, the price of the bond will fall (raise) by 1.868%.

Another difference between Macaulay duration and Modified duration is that the former can only be
applied to the fixed income instruments that will generate fixed cash flows. For bonds with non-fixed cash
flows or timing of cash flows, such as bonds with a call or put option, the time period itself and also the
weight of it are uncertain.

Therefore, looking for Macaulay duration, in this case, does not make sense. However, Modified duration
can still be calculated since it only takes into account the effect of changing yield, regardless of the
structure of cash flows, whether they are fixed or not.

Macaulay Duration and Bond Immunization

In asset-liability portfolio management, duration-matching is a method of interest rate immunization. A
change in the interest rate affects the present value of cash flows, and thus affects the value of a fixed-
income portfolio. By matching the durations between the assets and liabilities in a company’s portfolio,
the change in interest rate will move the value of assets and the value of liabilities by exactly the same
amount, but in opposite directions.

Therefore, the total value of this portfolio remains unchanged. The limitation of duration-matching is that
the method only immunizes the portfolio from small changes in interest rate. It is less effective for large
interest rate changes.

What Is Convexity?

Convexity is a measure of the curvature, or the degree of the curve, in the relationship between bond
prices and bond yields.

Convexity is thus a measure of the curvature in the relationship between bond prices and interest rates.
It reflects the rate at which the duration of a bond changes as interest rates change. Duration is a measure
of a bond's sensitivity to changes in interest rates. It represents the expected percentage change in the
price of a bond for a 1% change in interest rates.

Understanding Convexity

Convexity demonstrates how the duration of a bond changes as the interest rate changes. Portfolio
managers will use convexity as a risk-management tool, to measure and manage the portfolio's exposure
to interest rate risk.
Convexity and Risk

Convexity builds on the concept of duration by measuring the sensitivity of the duration of a bond as
yields change. Convexity is a better measure of interest rate risk, concerning bond duration. Where
duration assumes that interest rates and bond prices have a linear relationship, convexity allows for other
factors and produces a slope.

Duration can be a good measure of how bond prices may be affected due to small and sudden fluctuations
in interest rates. However, the relationship between bond prices and yields is typically more sloped, or
convex. Therefore, convexity is a better measure for assessing the impact on bond prices when there are
large fluctuations in interest rates.

As convexity increases, the systemic risk to which the portfolio is exposed increases. The term systemic
risk became common during the financial crisis of 2008 as the failure of one financial institution
threatened others. However, this risk can apply to all businesses, industries, and the economy as a whole.
The risk to a fixed-income portfolio means that as interest rates rise, the existing fixed-rate instruments
are not as attractive. As convexity decreases, the exposure to market interest rates decreases and the
bond portfolio can be considered hedged. Typically, the higher the coupon rate or yield, the lower the
convexity—or market risk—of a bond. This lessening of risk is because market rates would have to
increase greatly to surpass the coupon on the bond, meaning there is less interest rate risk to the investor.
However, other risks, like default risk, etc., might still exist.

Example of Convexity

Imagine a bond issuer, XYZ Corporation, with two bonds currently on the market: Bond A and Bond B.
Both bonds have a face value of $100,000 and a coupon rate of 5%. Bond A, however, matures in 5 years,
while Bond B matures in 10 years.

Using the concept of duration, we can calculate that Bond A has a duration of 4 years while Bond B has a
duration of 5.5 years. This means that for every 1% change in interest rates, Bond A's price will change by
4% while Bond B's price will change by 5.5%.

Now, let's say that interest rates suddenly increase by 2%. This means that the price of Bond A should
decrease by 8% while the price of Bond B will decrease by 11%. However, using the concept of convexity,
we can predict that the price change for Bond B will actually be less than expected based on its duration
alone. This is because Bond B has a longer maturity, which means it has a higher convexity. The higher
convexity of Bond B acts as a buffer against changes in interest rates, resulting in a relatively smaller price
change than expected based on its duration alone.

Beta ( β ) – one volatility measure to use for stocks

Beta loosely can be defined as the corelation measure of a stock to a index or other benchmark stock.
There is usually a correlation between stocks of same industry or of that to the index of that industry. The
measure of Beta determines the volatility. High Beta stocks more when the benchmark index moves and
vice-versa.

Delta (Δ) – one volatility measure to use for derivatives

Delta (Δ) is a risk metric that estimates the change in price of a derivative, such as an options contract,
given a unit change in its underlying security.
Mark-To-Market

What is mark-to-market in simple words?

Mark to market is an accounting practice that involves adjusting the value of an asset to reflect its value
as determined by current market conditions. The market value is determined based on what a company
would get for the asset if it was sold at that point in time.

NAVs are nothing but the mark-to-market values of the total value of shares and / or bonds or held by the
mutual fund scheme divided by the total number of outstanding units, thus giving us the price per unit at
a particular time interval.

A unit can be is defined as: Units represent your holding in a mutual fund scheme and are the smallest
portion of its ownership. Sometimes, they are also referred to as shares. Mutual fund units are issued by
fund companies according to the amount of money invested by investors. As an investor in a mutual fund
scheme, you are known as a unitholder. It is these units which help you determine the value of your
investment and form the base of all transactions in schemes. Whether you are buying, selling, or using
facilities like Systematic Investment Plan (SIP), Systematic Withdrawal Plan (SWP), or Systematic Transfer
Plan (STP), units form the foundation of executing these trades.
Primary Market

The primary market is a subset of the capital market in which entities such as corporations, governments,
and other institutions raise funds by selling debt and equity-based securities. Securities are created for
the first time in a primary market for investors to purchase.

IPO or Initial Public Offering: Is a process by which a private company becomes public. A company
becomes 'public' when it starts selling its shares in the market for the first time. Selling shares is like selling
a portion of its stake to the investors for the company. There are two types of market. Primary Market.

Follow-On Public Offer: A follow-on public offer (FPO), also known as a secondary offering, is the
additional issuance of a company's shares after its initial public offering (IPO). Companies usually
announce FPOs to raise equity or reduce debt.

Difference between authorised capital and paid-up capital

The maximum value of shares that a company can issue to its shareholders is authorised capital. The total
value of the shares issued to the public is called paid-up capital.
Rights Issue

Section 62(1) of the Companies act, 2013 provides for further issue of share capital by a Company, if it
proposes to increase its subscribed capital by the way of fresh issue of shares. Such shares should be first
offered to existing shareholders at the date of the offer, are holders of equity shares of the company in
proportion, by sending a letter of offer subject to the following conditions.

The object is, of course, to ensure equitable distribution of Shares and the proportion of voting rights is
not affected by issue of Fresh shares.

When an issue of shares or convertible securities is made by an issuer to its existing shareholders as on a
particular date fixed by the issuer (i.e. record date), it is called a rights issue. The rights are offered in a
particular ratio to the number of shares or convertible securities held as on the record date.

ESOP or Sweat Equity

What is 'ESOP'

Definition: An employee stock ownership plan (ESOP) is a type of employee benefit plan which is intended
to encourage employees to acquire stocks or ownership in the company.

Description: Under these plans, the employer gives certain stocks of the company to the employee for
negligible or less costs which remain in the ESOP trust fund, until the options vests and the employee
exercises them or the employee leaves/retires from the company or institution.

These plans are aimed at improving the performance of the company and increasing the value of the
shares by involving stock holders, who are also the employees, in the working of the company. The ESOPs
help in minimizing problems related to incentives.

ESOPs are most commonly used abroad to facilitate succession planning, allowing a company owner to
sell his or her shares and transition flexibly out of the business.

Type of Issue Direct / Immediate Impact on

Share Capital & Reserves

1. IPO / Private Placement Increases Issued Capital and also reserves if shares
are issued at a premium. Net increase in Owned
Capital.

2. FPO / Private Placement Increases Issued Capital and also reserves if shares
are issued at a premium. Net increase in Owned
Capital.

3. Rights Issue Increases Issued Capital and also reserves if shares

are issued at a premium. Net increase in Owned
Capital.
4. ESOPs Increases Issued Capital and also reserves if shares
are issued at a premium only when the ESOP is
vested. Net increase in Owned Capital.

5. Bonus Issue Issued Capital Increase but reserves decrease

proportionately. NO CHANGE in Owned Capital.

6. Share Split Issued Capital does not change, only the share
face value is split while reserves remain same.

NO CHANGE in Owned Capital.

7. Preference Share Issue Increases Issued Capital and also reserves if shares
are issued at a premium. Net increase in Owned
Capital.

8. Corporate Bond / Debenture / Issued Capital does not change, Reserves remain
Commercial Paper Issue same. NO CHANGE in Owned Capital.