Financial institutions and markets


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Financial institutions and markets

  1. 1. An Economic Analysis ofFinancial Structure (Q & A)Submitted ByAnuj GoyalNMIMS
  2. 2. 1. Do you support “too big to fail” theory? If your answer is YES give one reason why you are for it. If you answer is NO give one reason why you are against it.The banks or any other institutions which are benefitted from this policy have the govt backup in case of any difficulty. The govt backs up these institutions because they are so large thattheir failure implicitly affects the economy i.e there is a huge social cost associated with thefailure of these institutions.I don‟t support too big to fail theory because a financial institution that tries seeking benefitfrom this protective policy. They may seek position in high- risk high return transactionspresuming that in case of any failure ,they have a govt support to bail them out.Hence there is a moral hazard associated with this theory.Businesses use mostly internal financing and secondly external financing in the form ofbank loans. Why?Advantages of Internal Financing over External Financing in the form of Bank Loans. 1. Retained Earnings in the form of profits can be put back into the business to help it grow and can be utilised for capex requirements and working capital. 2. The main advantage of using internal sources of funds is that it comes at no cost unlike Bank Loans. Bank Loans have very high rate of interest alongwith other processing fees. Many corporates find it inconvenient to borrow from banks due to the above reasons. Following charges are associated with bank borrowings. a. Interest Charges b. Processing Fees c. Late payment penalties d. Arrangement Fees e. Exchange differences (if any)These charges make it even more inconvenient for the corporate to borrow from banks incase of urgent requirement of funds. Although banks have facilities such as Overdraft etc.,these facilities are provided to corporate which have existing relationship with the banks andnot to new companies. 3. Loans are given to companies based on the financials and many a times the amount falls short of the requirement. Thus many corporates prefer internal sources of funds rather than bank loans. 4. Application formalities for bank loans are very cumbersome. 5. Sale of underused or unused assets are also an important way of internal source of funds and it makes sense to make use of such sources of funding.
  3. 3. 6. Unlike bank loans, internal sources of funds don‟t have to be repaid. If for some reason, the business is not doing well, bank loans repayment becomes even more difficult. Internal funding arrangements are more suited in such instances.10 Functions of Financial System:1. To facilitate trades of goods and services. An efficient financial system reducesinformation and transaction costs in trade and helps the payments.2. To increase saving mobilization by an improvement of the savers confidence.3. To produce information on the investment projects. It can be difficult to obtain reliableinformation on the projects or on the borrowers. The financial system can reduce this issue bydevoting some agents to the screening of projects.4. To afford a better repartition and diversification of risk, and finally a better riskmanagement. A higher diversification allows risk adverse people to invest in riskier projectswith higher returns. In addition, a well-performing financial system reduces liquidity risk:some products used to finance risky projects can be easily converted into money.5. To favor the monitoring during all the investment process, and develop a corporategovernance control.6. The financial markets provide protection against life, health and income risks. These areaccomplished through the sale of life and health insurance and property insurance policies.The financial markets provide immense opportunities for the investor to hedge himselfagainst or reduce the possible risks involved in various investments.
  4. 4. 7. The financial markets provide the investor with the opportunity to liquidate investmentslike stocks bonds debentures whenever they need the fund.8.The government intervenes in the financial system to influence macroeconomic variableslike interest rates or inflation so if country needs more money government would cut rate ofinterest through various financial instruments and if inflation is high and too much money isthere in the system then government would increase rate of interest.9. Public saving find their way into the hands of those in production through the financialsystem. Financial claims are issued in the money and capital markets which promise futureincome flows. The funds with the producers result in production of goods and servicesthereby increasing society living standards.10. Financial system has to deal with two kinds of information asymmetries: a) The adverse selection problem: if a lender is not able to evaluate the quality of some investment projects, he will ask for an average return. This price will be too high for the less risky projects, hence only risky projects will be financed. It can result in a significant reduction of the capital market size. b) Moral hazard arises because an individual or institution does not bear the full consequences of its actions. In finance, borrowers may not act prudently when they invest or spend funds. This contingency can prevent the contract conclusion. To resolve these issues we have 2 types of systems namely : Bank based systems and Market based sysytems19. What is the main argument against „Investor fee paying‟ model in credit ratingbusiness?Main argument against investor fee paying model in credit rating business is that it will led tofree riding problem.
  5. 5. As the fewer investors will pay for obtaining the original copy of the rating of security doneby the credit rating agencies rest will use the same by information sharing for their benefitwithout paying.Ultimately credit rating agencies will face a downturn in their business hence resulting inlosses. To compensate the same they have to cut down the cost of their staff and otherresources which will deteriorate the quality of security investigation and hence the ratingdone by them.For more details please refer the attached link 1. Peter Thiel, a prominent Facebook investor, said it was generally desirable for technology companies to defer an IPO for as long as possible. He said Google set a good example by not going public for a nearly six years, until it dominated the search wars. What in your opinion is the main reason? (give only ONE rationale which you think is the most important)ANSWER: As per my opinion, Mr. Peter is correct. We need to look after the futureperformance of the technology companies too because whenever a new techno companycomes with a n idea it may hit the market for that time only and enjoy some benefit ofmonopoly but in long run it may not deliver the expected performance as there will be manyother firms who would like to play in the same area. It may also happen that at the beginningthe user finds it very useful but when a other company comes with some extra feature, theusers will have a high intention to switch to the new company as there is no cost involved forthe users to switch.For example, the same happen with ORKUT it was very popular few years back but asfacebook came with new attractive feature, people switched to facebook and orkut is havingvery low market share in this segment.The main reason for my opinion is investor‟s should be protected at much as possible. Sinceinitial investment with techno companies is like to be risky, its better to watch theirperformance for few years and the allow then to collect money from the public.A company like google is less likely to fall because of its operation for long time proved thatit has enough back up to sustain in future.
  6. 6. 14. "If a company does not do better than its competitors but the stock market goes up,executives do very well from their stock options. This makes no sense".Discuss this viewpoint. Can you think of alternatives to the usual employee stock optionplan that takes the viewpoint into account.Ans: A phantom share essentially reflects the commercial effect of an ESOP, except that noshares are issued in reality but the benefit to the employee is paid in cash by a charge to therevenue account of the company. The employee is granted options on a notional number ofphantom shares in the same manner as real shares in the case of conventional ESOPs. Onexercising the options, the employee is entitled to the growth in the value of the underlyingreal shares exactly in the same manner as exercise of ESOPs, except that the growth in valueis paid out in cash and no new shares are issued.If the employee is bullish about the company he/she may continue to hold thevested/exercised shares. In the case of phantom shares, the cash received from the companycan be used to purchase its shares from the market with the same economic consequences.Thus phantom share plans can be structured on the same lines as employee stock optionschemes and can pass on the same economic benefits to employees that an ESOP scheme can.Phantom shares are often used in the case of closely held companies and in companies thathave exhausted certain share issue limits or those who do not wish to upset existingshareholding structures.Critics have argued that phantom shares do not provide the employee with the same sense ofownership that real shares do and as a result may fail to effectively motivate the employee.While there may be some merit in the argument, there is no denying the fact that thefundamental reason for owning any financial asset is to realise economic benefits.This purpose is well served by the phantom share mechanism and it is possible to own realshares from the cash compensation that an employee gets from exercising the phantomshares.
  7. 7. -A bond issued by Standard Oil some time ago worked as follows. The holder receivedno interest. At the bonds maturity the company promised to pay $1000 plus anadditional amount based on the price of oil at that time. The additional amount wasequal to the product of 170 and the excess (if any) of the price of a barrel of oil atmaturity over $25. The maximum additional amount paid was $2250(whichcorresponds to a price of $40 per barrel). Show that the bond is a combination of aregular bond, a long position in call options on oil with a strike price of $25, and a shortposition in call options on oil with a strike price of $40.Let ST denote the price of oil at the bond‟s maturity. The additionto $1000 the standard oil pays0 ST < $25170(ST − 25) 25 < ST < 402, 550 40 < STThis is a payoff from 170 call options on oil with a strike price of 25 less the payoff from 170call options on oil with a strike price of 40. Thus the the bond is equivalent to a regular bondplus a long position in 170 call options on oil with a strike price of $25 plus a short positionin 170 call options on oil with a strike price of $40. 1. Why debt contracts are complicated legal documents with restrictive covenants?Covenants are type of formal agreement that the certain activities will be carried out.Covenants can cover everything from minimum dividend payments to levels that must bemaintained in working capital. Throughout the world, debt contracts typically take the formof lengthy legal documents with extensive restrictive covenants, i.e., provisions restricting thebehavior of the borrower. For example, a borrower receiving a real estate loan may berequired to carry liability insurance covering accidents at his construction site.Why Debt contracts are complicated?A debt contract is intended to be a productive activity in the sense that a contractuallydetermined amount of loaned funds (input) is used by a borrower to produce a stream ofreturns (output) that is expected to cover debt payment obligations (input costs) while leavingsome positive net return (profit) for the borrower.
  8. 8. A debt contract entails two distinct types of transaction costs: (a) the organizational costsassociated with finding and bringing together the borrower and lender; and (b) theorganizational costs associated with the actual writing up and signing of the debt contract. Inaddition, a debt contract typically involves information costs in that the behaviour of theborrower must be monitored in an attempt to ensure that the borrower meets the terms of thedebt contract as specified in its payment schedule and restrictive covenants.The concept of "transaction costs" is actually quite tricky to define in a manner that is bothclear and useful. Roughly speaking, transaction costs are the costs associated with theorganization of productive activities, such as the costs arising from the need to search forcustomers and to prepare contracts for longer-term customer-supplier relationships. Incontrast, production costs are the costs arising from the need to pay for direct inputs toproduction, such as salaries (the price of labor services) and rental payments (the price ofcapital services generated by rented capital equipment).The concept of "information costs" is more straightforward. Information costs are the costsincurred when attempts are made to reduce moral hazard and adverse selection problemsarising from conditions of asymmetric information.Due to the presence of all these costs in a debt contract, they become complicated withrestricted covenants. • Basically Restrictive Covenant is a Tools to Help Solve Moral Hazard in Debt Contracts 1. Net Worth 2. Monitoring and Enforcement of Restrictive Covenants. Examples are covenants that … 1. discourage undesirable behavior 2. encourage desirable behavior 3. keep collateral valuable 4. provide information • Covenants to discourage undesirable behavior • Some covenants mandate that a loan can be used only to finance specific activities, such as the purchase of particular equipment or inventories. • Covenants to encourage desirable behavior • They encourage the borrower to engage in desirable activities that make it more likely that the loan will be paid off • Life insurance that pays off the mortgage upon the borrower‟s death
  9. 9. • Covenants to keep collateral valuable • Restrictive covenants can encourage the borrower to keep the collateral in good condition and make sure that it stays in the possession of the borrower • Insurance on the home • Covenants to provide information • Restrictive covenants can require a borrower to provide information about its activities periodically • Balance sheet, income reports • A debt contract is a contractual agreement by the borrow to pay the lender fix dollar amount. • the risk that one party to a transaction will engage in behavior that is undesirable from the other party‟s point of view. •How Moral Hazard Influences Financial Structure in Debt Markets • Debt Contracts are still subject to moral hazard even with the advantages • Borrowers have an incentive to take on investment projects that are riskier than lenders would like.Tools to Help Solve Moral Hazard • Net Worth and Collateral • Monitoring and Enforcement of Restrictive Covenants • Financial Intermediation • Restrictive covenants are directed at reducing moral hazard either by ruling out undesirable behavior or by encouraging desirable behaviorForms of Covenants 1. to discourage undesirable behavior 2. to encourage desirable behavior
  10. 10. 3. to keep collateral valuable 4. to provide informationCovenants to discourage undesirable behavior • Function in two forms: - restricting the use of money so that it can only be used on certain criteria - barring the use of the capital so it can not be used for certain purposes.Covenants to encourage desirable behavior. • Require a firm to maintain certain good business practices, such as minimum holdings and insurance.Covenants to keep collateral valuable • Require proper protection of the asset, an example would be homeowners insurance as part of a mortgageCovenants to provide information • Require the provision of information by the borrower to the lender, making it easier to monitor the firm.How does the free-rider problem aggravate adverse selection and moral hazardproblems in financial markets?As described in Mishkin on page 189, one partial solution to the problem of lenders(purchasers of securities) having less information than borrowers of funds is to have privatecompanies collect and produce information that helps lenders distinguish between good andbad firms selling securities. The free rider problem arises here when some people purchasethe information about firms and the people that do not purchase it take advantage of theinformation the others have paid for. Lenders who have purchased information will purchasesecurities from high quality, undervalued firms and in doing so will reveal to free-ridinginvestors which firms are the ones they should invest in. If many investors free ride, this willpush up the price of good firms‟ securities and make it less profitable to purchase informationin the first place. If many investors find it unprofitable to purchase information, then it maynot be gathered and produced by private firms: “The weakened ability of private firms toprofit from selling information will mean that less information is produced in themarketplace, and so adverse selection (the lemons problem) will still interfere with theefficient functioning of securities markets” (Mishkin, p. 189).
  11. 11. As decribed in Mishkin on page 194, free riding can also aggravate the moral hazardproblem. The principle-agent problem is a problem of moral hazard that occurs becausemanagers have more information about their activities and actual profits than stockholdersdo. Stockholders can partially overcome this problem by spending time and money onfrequent audits of the firms they have invested in and closely monitoring what management isdoing. Similar to the adverse selection case, free riding can reduce the amount of informationabout managment and firm activities produced by stockholders through costly audits or otherforms of monitoring. Each stockholder will be unwilling to invest in monitoring activities,preferring to free ride on the monitoring expenditures of other stockholders. If allstockholders think this way, however, none of them will invest in monitoring and little or noinformation about management and firm activities will be produced. Less information forstockholders means the moral hazard problem will be aggravated. Rachana‟s Questions 1. Discuss Adverse Selection and Moral Hazard as impediment to a well functioning financial system. Discuss how „free-rider problem‟ aggravates the problem of Moral Hazard and Adverse Selection? Ans: A crucial impediment to the efficient functioning of the financial system is asymmetric information, a situation in which one party to a financial contract has much less accurate information than the other party. For example, borrowers who take out loans have much better information about the potential returns and risk associated with the investment projects they plan to undertake than lenders do. Asymmetric information leads to two basic problems in the financial system: Adverse selection(hidden information) Adverse selectionoccurs before the transactionoccurs when potential bad credit risks are the ones who most actively seek out a loan. Thus,the parties who are the most likely to produce an undesirable (adverse) outcome are mostlikely to be selected. For example, those who want to take on big risks are likely to be themost eager to take out a loan because they know that they are unlikely to pay it back. Sinceadverse selection makes it more likely that loans might be made to bad credit risks, lendersmay decide not to make
  12. 12. any loans even though there are good credit risks in themarketplace. This outcome is afeature of the classic “lemons problem”.Moral hazard(hidden action)MHis where one party is responsible for the interests another, but has anincentive to puthis or her own interests first.Financial examples I might sell other a financial product not because I want cash but because it is of lowquality.I might pay myself excessive bonuses out of funds that I am managing on other behalf.I might take risks that other people then have to bear.Any situation in which one personmakes the decision about how much risk to take,while someone else bears the cost if things go badly.Asymmetric information and adverse selection, moral hazard may preventfinancialmarkets from functioning efficiently during a crisis. It calls for governmentintervention and for regulation to ensure the continuous functioning of financialmarkets. If someone takes a risk, someone has to bear it. If I take a risk, then it shouldbe ensured that I be made to bear it. But if I take a risk at others expense, then that‟smoral hazard and that‟s bad. As the late, great Milton Friedman might have put it:“there ain‟t no such thing as afree risk.”Free ridingOne solution to Ass Info is to have private companies collect and produce informationthat helps lenders distinguish between good and bad firms selling securities. The freerider problem arises here when some people purchase the information about firms andthe people that do not purchase it take advantage of the information the others have paidfor. Lenders who have purchased information will purchase securities from highquality, undervalued firms and in doing so will reveal to free-riding investors whichfirms are the ones they should invest in. If many investors free ride, this will push upthe price of good firms‟ securities and make it less profitable to purchase information inthe first place. If many investors find it unprofitable to purchase information, then itmay not be gathered and produced by private firms: “The weakened ability of privatefirms to profit from selling information will mean that less information is produced inthe marketplace, and so adverse selection (the lemons problem) will still interfere withthe efficient functioning of securities markets”. Free riding can also aggravate the moral hazard problem. The principle-agent problemis a problem of moral hazard that occurs because managers have more informationabout their activities and actual profits than stockholders do. Stockholders can partiallyovercome this problem by spending time and money on frequent audits of the firms
  13. 13. they have invested in and closely monitoring what management is doing. Similar to the adverse selection case, free riding can reduce the amount of information about managment and firm activities produced by stockholders through costly audits or other forms of monitoring. Each stockholder will be unwilling to invest in monitoring activities, preferring to free ride on the monitoring expenditures of other stockholders. If all stockholders think this way, however, none of them will invest in monitoring and little or no information about management and firm activities will be produced. Less information for stockholders means the moral hazard problem will be aggravated. 2. Define Hedging, Insurance and Diversification – the three dimensions of Risk Management. Discuss how the Investors payoffs vary with each of these techniques.Ans Diversification- It mixes a wide variety of investments within a portfolio. The rationale behind this technique is that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio. Diversification strives to smooth out unsystematic risk events (industry or company specific risk) in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlate. However a firm shall still be exposed to systematic risk ( market risk). Hedging-It allows for elimination of risk through the spot sale of risk, or through a transaction in aninstrument that represents an obligation to sell the risk in future.Making an investment to reduce the risk of adverse price movements in an asset. Normally, ahedge consists of taking an offsetting position in a related security, such as afuturescontractAn example of a hedge would be if you owned a stock, then sold a futurescontract stating that you will sell your stock at a set price, therefore avoiding market
  14. 14. fluctuations. Investors use this strategy when they are unsure of what the market will do. Aperfect hedge reduces your risk to nothing (except for the cost of the hedge).Insuring. • Insurance is a precise approach to risk managementActuarial insurance is the traditional product offered by insurance companies that helps individuals manage risks associated with their tangible wealth or human capital, e. life, health, homeowner of automobiles insurance.Guarantees provide the same pattern of risk protection as actuarial insurance.Options, like calls and put options are another example of a type of insurance contract. Exclusions are losses that might seem to meet the conditions for coverage under the insurance contract but are specifically excluded.Caps are limits placed on compensation for particular losses covered under an insurance contract.A deductible is an amount of money that the insured party must pay out of his or her own resources before receiving any compensation from the insurer.A copayment feature means that the insured party must cover a fraction of the loss • When you hedge, you eliminate the risk of loss by giving up the potential for gain. • When you insure, you pay a premium to eliminate the risk of loss and retain the potential for gain. 3. The functional perspective views financial innovation as driving the financial system toward the goal of greater economic efficiency. Give five examples in support. Pooling of resources Managing Risks Managing Incentive Problems Payment system of goods and services Transfer of resouces across time and space 4. List out 10 activities in the financial system, which are multi-functional in nature. Clearly mention the activity and the functions involved. Banks use options and future markets trasactions toprovide stock to bond value insurance that guarantees a minimum return oncustomer portfolios. Banks dealing in securities dealing
  15. 15. Banksengaged in real estate business5. Do you agree that demand for pooling by the deficit units viz., businesses is reflected in multiple bilateral contracting and demand for pooling by the surplus units viz., households is reflected in multilateral contracting. Yes.6. What is the relationship between economic growth and financial development? Market Frictions(information costs,Trasactions costs) are present- Financial Markets and Intermediaries provides Financial Functions(6 functions)leads to growth channel(Capital Acumulatiion and technological innovations)Economic Grwoth Economic growth depends on two major factor- Savings and Investment. Savings denotes the surplus side and Investment Denotes the Deficit side.Financial institutions and markets can foster economic growththrough several channels, i.e. by (i) easing the exchange of goods and services through the provision of payment services, (ii) mobilising and pooling savings from a large number of investors, (iii) acquiring and processing information about enterprises and possible investment projects, thus allocating savings to their most productive use, (iv) monitoring investment and carrying out corporate governance, and (v) diversifying, increasing liquidity and reducing intertemporal risk. Each of these functions can influence saving and investment decisions and hence economic growth. In economies,however,there exists certains frictions and imperfections. Such things are offset by the introduction of Financialintermediearies. Financial Development increase savings in the form of financial assets.7. Businesses use mostly internal financing and secondly external financing in the form of bank loans. Why?8. Why issuing marketable securities not primary funding source?Because it may lead to the problem of adverse section and moral hazard. It will create alemons problem, where the new firms with high risk enter the market where there aregood firms. With information assymentry,the investor will invest at average return notknowing the actual price. So the lemon firms will jump to the offer where as the peachfirms will not accept and leave. This will increase the quality of securities availiable inthe market and eventually less investors will start to invest after sometime.
  16. 16. 9. Why indirect finance (financial intermediation) is more important? 10. Is financial system is heavily regulated? If yes, why? 11. Why only large, well-established firms have access to securities markets? 12. Why debt contracts are complicated legal documents with restrictive covenants?Restrictive Covenants for bonds, bank loans or mortgages can minimize or eliminate moralhazard:1. Restrictions in loan to prevent borrower from engaging in risky activity. Restrictions onwhat the money can be used for - only certain investments are allowed. Restrictions ondividends.Restrictions on altering real estate.2. Encourage desirable behavior. Require insurance and taxes to be paid to the mortgagecompany. Require high net worth - example 20% down for house. Requirement to maintaincertain asset base for businesses. Require a sinking fund.3. For secured loan, Requirement to keep collateral in good condition. Property orequipment.Example: collision insurance is required for car loans. Home: keep house insaleable condition, maintain insurance.4. Requirement to provide information to bondholders or bank on a regular basis so they canbe monitored. Example: small company has to provide quarterly income statements to bank,company may have to provide quarterly financial statements to bondholders.Point: restrictive covenants can reduce moral hazard problem 13. Do mature financial markets experience turbulence? 14. What will technology do to financial structure? 15. Do you support “too big to fail” theory? If your answer is YES give one reason why you are for it. If you answer is NO give one reason why you are against it. AnsFinancial bail-outs of lending institutions by governments, central banksor other institutions can encourage risky lending in the future, if those that take the riskscome to believe that they will not have to carry the full burden of potential losses. Lendinginstitutions need to take risks by making loans, and usually the most risky loans have the potential for making the highest return.So-called "too big to fail"
  17. 17. lending institutions canmake risky loans that will pay handsomely if the investment turns out well, while being bailed out by the taxpayer if the investment turns out badly.16. Peter Thiel, a prominent Facebook investor, said it was generally desirable for technology companies to defer an IPO for as long as possible. He said Google set a good example by not going public for a nearly six years, until it dominated the search wars. What in your opinion is the main reason? (give only ONE rationale which you think is the most important)17. Why debt contracts are complicated legal documents with restrictive covenants?18. Many participants in the market are forecasting GOLD to beat $2000 in the next year. What are they essentially betting against? 19. What is the main argument against „Investor fee paying‟ model in credit rating business? Ans. The main income for credit rating agencies is the fees they collect from giving ratings. In the investor fee paying model, the investor subscribes to rating released by the agencies and these subscriptions revenues are the main souce of income. Back in 1970, this model was wildly used.If the credit rating business offers an investor fee paying model, where the investors pay, this might result in a problem of free riding where once investor pays for the subscriptions gets the publication and shares this with others. This will reduce the number of prospected subscribers for the rating agencies and reduce revenue of the firm. Also with the invention and growth of photocopiers,the reports were Xeroxed,reduing the number subscriptions even more further.jence rating agenies adopt issuer fee model where the issuer himself pays for the rating.20. Why venture capitalists insist on having hybrid securities? Ans.Venture Capitalist Features High return expectation due to high risk Consultants to the firm as new firm is inexperienced. Active Governance- One partner always sits on the board of the firm Funds through stages. Severity of penalties for not performing provides the entrepreneur powerful incentiveto work. The securities that the venture capitalistreceives in exchange for investing funds in the portfolio firm are more complicated thansimple debt or equitycontract.The venture capitalist usually receives convertiblepreferred stock. Like a debt contract,
  18. 18. preferredstock requires the firm to make fixed paymentsto the stock‟s holder.And the promisedpayments must be made before any commonstockholder gets dividend payments, that is, thepreferred stockholder has priority over commonstockholders. Hence, the venture capitalistcan make sure that the entrepreneur is notpaying himself a high salary disguised as dividends.It also means that if things turn out badlyand the firm is liquidated, the venture capitalistgets back her investment in the firm beforethe entrepreneur gets paid anything.Unlike preferred stockholders in many other settings, the venture capitalist usually has votingrights.the venture capitalist can cash out shares at some predetermined price whenever it wants. The right to convert the financial calims into shares focuses the vision of VC in maximizing the firms value. This helps in creating harmony between the entrepreneur and theVC as max firms value will max their wealth. 21. Lending is a multi-functional activity. Agree? Mention all the functions involved in lending.AnsTo illustrate application of the functional perspective to a financial activity, consider lending.Lending isoften treated as a homogeneous activity in both private sector and public sectordecision-making. Butfrom a functional perspective, lending in general is multi-functional,involving two of the six basicfunctions of the financial system.Lending in its “purest” form is free of default risk, so it falls under a single basic functionalcategory:theintertemporal transfer of resources. But, of course, with few exceptions, paymentspromised in loanagreements are subject to some degree of default risk. Lending therefore alsoinvolves a second basicfunctional category: risk management. When a loan is made, animplicit guarantee of that loan (a formof insurance) is involved.To see this, consider the fundamental identity, which holds in both a functional and avaluationsense:Risky Loan + Loan Guarantee = Default-Free LoanRisky Loan _ - Default-Free Loan _ = Loan GuaranteeThus, whenever lenders make dollar-denominated loans to anyone other than the UnitedStates government, they are implicitly also selling loan guarantees. The lending activitytherefore consists oftwo functionally distinct activities: pure default-free lending (theintertemporal transfer function), andthe sale of default risk insurance by the lender to theborrower (an example of the risk managementfunction.The relative weighting of these twofunctions varies considerably across the various debtinstruments. A high-grade bond (ratedAAA) is almost all default-free loan with a very small guaranteecomponent. A below-investment-grade or “junk” bond, on the other hand, typically has a largeguaranteecomponent.Free-float Concept:Understanding Free-float Methodology Concept
  19. 19. Free-float Methodology refers to an index construction methodology that takes into consideration onlythe free-float market capitalization of a company for the purpose of index calculation and assigningweight to stocks in the Index. Free-float market capitalization takes into consideration only thoseshares issued by the company that are readily available for trading in the market. It generallyexcludes promoters holding, government holding, strategic holding and other locked-in shares thatwill not come to the market for trading in the normal course. In other words, the market capitalizationof each company in a Free-float index is reduced to the extent of its readily available shares in themarket.Subsequently all BSE indices with the exception of BSE PSU index have adopted the free-floatmethodology.Major Advantages of Free-float Methodology A Free-float index reflects the market trends more rationally as it takes into consideration only those shares that are available for trading in the market. Free-float Methodology makes the index more broad-based by reducing the concentration of top few companies in Index. A Free-float index aids both active and passive investing styles. It aids active managers by enabling them to benchmark their fund returns vis-à-vis an investible index. This enables an apple-to-apple comparison thereby facilitating better evaluation of performance of active managers. Being a perfectly replicable portfolio of stocks, a Free-float adjusted index is best suited for the passive managers as it enables them to track the index with the least tracking error. Free-float Methodology improves index flexibility in terms of including any stock from the universe of listed stocks. This improves market coverage and sector coverage of the index. For example, under a full-market capitalization methodology, companies with large market capitalization and low free-float cannot generally be included in the Index because they tend to distort the index by having an undue influence on the index movement. However, under the free-float Methodology, since only the free-float market capitalization of each company is considered for index calculation, it becomes possible to include such closely held companies in the index while at the same time preventing their undue influence on the index movement. Globally, the free-float Methodology of index construction is considered to be an industry best practice and all major index providers like MSCI, FTSE, S&P and STOXX have adopted the same. MSCI, a leading global index provider, shifted all its indices to the Free-float Methodology in 2002. The MSCI India Standard Index, which is followed by Foreign Institutional Investors (FIIs) to track Indian equities, is also based on the Free-float Methodology. NASDAQ-100, the underlying index to the famous Exchange Traded Fund (ETF) - QQQ is based on the Free-float Methodology.Definition of Free-floatShareholdings of investors that would not, in the normal course, come into the open market for tradingare treated as Controlling/ Strategic Holdings and hence not included in free-float. Specifically, thefollowing categories of holding are generally excluded from the definition of Free-float: Shares held by founders/directors/acquirers which has control element Shares held by persons/ bodies with "Controlling Interest" Shares held by Government as promoter/acquirer Holdings through the FDI Route Strategic stakes by private corporate bodies/ individuals Equity held by associate/group companies (cross-holdings) Equity held by Employee Welfare Trusts Locked-in shares and shares which would not be sold in the open market in normal course.The remaining shareholders fall under the Free-float category.