Banking Foundation Course v2.1 - [DOC Document] (2023)

Banking Foundation Course v2.1 - [DOC Document] (1)

Foundation Course in Banking

Foundation Course in Banking

Version : 2.1

Date : 04-August-2005

Cognizant Technology Solutions 500 Glenpointe Centre West

Teaneck, NJ 07666Ph: 201-801-0233

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“Money is a standardized unit of exchange”. The practical form of money is currency. It varies across countries whereas money remains the same. For example, in India, the currency is the In-dian Rupee (INR) and in the US, it is the US Dollar (USD).

Due to various economic factors, the value of each country’s currency is not equal. For example, if the exchange rate between US Dollars (USD) and Indian Rupees (INR) is USD 1 = INR 46.70, it implies that one U.S dollar is equivalent to 46.70 Indian Rupees. The USD is normally taken as a benchmark against which to compare the value of each currency.


Interest is the amount earned on money; there is such an earning because present consumption of the lender is being sacrificed for the future; you are letting somebody else use the money for present consumption. Using an analogy, interest is the ‘rent’ charged for delaying present con-sumption of money. Interest rates are not constant and will vary depending on different economic factors

Simple interest

Simple interest is calculated only on the beginning principal. Simple Interest = P*r*t/100 where: P is the Principal or the initial amount you are initially borrowing or depositing, to earn or charge in-terest on, r is the interest rate and t is the time period.


If someone were to receive 5% interest on a beginning value of $100, the first year they would get:

0.05*$100 = $5

If they continued to receive 5% interest on the original $100 amount, over five years the growth in their investment would look like this:

Year 1: (5% of $100 = $5) + $100 = $105

Year 2: (5% of $100 = $5) + $105 = $110

Year 3: (5% of $100 = $5) + $110 = $115

Year 4: (5% of $100 = $5) + $115 = $120

Year 5: (5% of $100 = $5) + $120 = $125


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Compound interest

With compound interest, interest is calculated not only on the beginning interest, but on any inter-est accumulated with the initial principal in the meantime. Compound interest = [P*(1+r/100)^t – P], where: P is the Principal or the initial amount you are initially borrowing or depositing, to earn or charge interest on, r is the interest rate and t is the time period.


If someone were to receive 5% compound interest on a beginning value of $100, the first year they would get the same thing as if they were receiving simple interest on the $100, or $5. The second year, though, their interest would be calculated on the beginning amount in year 2, which would be $105. So their interest would be:

.05 x $105 = $5.25

If this were to continue for 5 years, the growth in the investment would look like this:

Year 1: (5% of $100.00 = $5.00) + $100.00 = $105.00

Year 2: (5% of $105.00 = $5.25) + $105.00 = $110.25

Year 3: (5% of $110.25 = $5.51) + $110.25 = $115.76

Year 4: (5% of $115.76 = $5.79) + $115.76 = $121.55

Year 5: (5% of $121.55 = $6.08) + $121.55 = $127.63

Note that in comparing growth graphs of simple and compound interest, investments with simple interest grow in a linear fashion and compound interest results in geometric growth. So with com-pound interest, the further in time and investment is held the more dramatic the growth becomes.


Inflation captures the rise in the cost of goods and services over a period of time. For example, if Rs.100 today can buy 5 kg of groceries, the same amount of money can only buy 5/(1+I) kgs. Of groceries next year, where I refers to the rate of inflation beyond today.

Thus, if the inflation rate is 5%, then everything else being equal (that is, same demand & supply and other market conditions hold), next year, you can only buy 5/(1.05) worth of groceries.

A quantitative estimate of inflation in a particular economy can be calculated by measuring the ra-tio of Consumer Price Indices or CPI of two consecutive years. That’s right, the CPI that you hear of, is the weighted average price, of a predefined basket of basic goods. The % increase of the CPI this year vs. the CPI of last year, gives the inflation, or rise in price of consumer goods, over last year.


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Inflation results in a decrease in the value of money over time. The link between the interest rates, nominal and real, and inflation enables you to identify this impact.

Nominal Interest

Nominal rate of interest (N) refers to the stated interest rate in the economy. For example, if counter-party demands 110 rupees after a year in return for 100 rupees lent today, the nominal rate of interest is 10%. This, as you see, includes the inflation rate.


You’ve lent out 100 rupees, at 10%, for one year. On maturity, you get a profit, so you think, of 10 rupees. But this sum of 110 rupees buys less than 110 rupees did a year ago, due to inflation! Thus, the value of 110 rupees today is actually, or really, less than the value of 110 rupees a year ago, and it is less by the inflation rate. Thus the real interest you earned is less than 10%.

Real rate of Interest

Real rate of interest (R) refers to the inflation-adjusted rate of interest. It is less than the nominal rate of interest for economies having positive rate of inflation.

The relationship between the R (real rate of interest), N (nominal rate of interest) and I (rate of in-flation) is as:

R= N-I

(This is a widely used approximation; the exact formula takes into account time value of inflation etc.)

Why is it important to know the real rate of return? Take an example where a business is earning a net profit of 7% per annum. But, inflation is also standing at 7%. So, real profit is actually at zero.


Nominal rate (N) = 10%, Inflation (I) = 5%

Therefore, real interest is:

R = N – I = 5%

Therefore, the real rate of return is not 10% but 5%.


Time value of money, which serves as the foundation for many concepts in finance, arises from the concept of interest. Because of interest, money on hand now is worth more than the same money available at a later point of time. To understand time value of money and related concepts

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like Present value and future value, we need to understand the basic concepts of simple and compound interest described above.

Future Value

Future Value is the value that a sum of money invested at compound interest will have after a specified period.

The formula for Future Value is:

FV = PV*(1 + i)n


FV : Future Value at the end of n time periods

PV : Beginning value OR Present Value

i : Interest rate per unit time period

n : Number of time periods


If one were to receive 5% per annum compounded interest on $100 for five years,

FV = $100*(1.05)5 = $127.63

Intra-year compounding

If a cash flow is compounded more frequently than annually, then intra-year compounding is be-ing used. To adjust for intra-year compounding, an interest rate per compounding period must be found as well as the total number of compounding periods.

The interest rate per compounding period is found by taking the annual rate and dividing it by the number of times per year the cash flows are compounded. The total number of compounding pe-riods is found by multiplying the number of years by the number of times per year cash flows are compounded.




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Suppose someone were to invest $10,000 at 8% interest, compounded semiannually, and hold it for five years.,

Interest rate for compounding period = 8%/2 = 4%

Number of compounding periods = 5*2 = 10

Thus, the future value FV = 10,000*(1+0.04)^10 = $14,802.44

Present value

Present Value is the current value of a future cash flow or of a series of future cash flows. It is computed by the process of discounting the future cash flows at a predetermined rate of interest.

If $10,000 were to be received in a year, the present value of the amount would not be $10,000 because we do not have it in our hand now, in the present. To find the present value of the future $10,000, we need to find out how much we would have to invest today in order to receive that $10,000 in the future. To calculate present value, or the amount that we would have to invest to-day, we must subtract the (hypothetical) accumulated interest from the $10,000. To achieve this, we can discount the future amount ($10,000) by the interest rate for the period. The future value equation given above can be rearranged to give the Present Value equation:

PV = FV / (1+I)^n

In the above example, if interest rate is 5%, the present value of the $10,000 which we will receive after one year, would be:

PV = 10,000/(1+0.05) = $ 9,523.81

Net Present Value (NPV)

Net Present Value (NPV) is a concept often used to evaluate projects/investments using the Dis-counted Cash Flow (DCF) method. The DCF method simply uses the time value concept and dis-counts future cash flows by the applicable interest rate factor to arrive at the present value of the cash flows. NPV for a project is calculated by estimating net future cash flows from the project, discounting these cash flows at an appropriate discount rate to arrive at the present value of fu-ture cash flows, and then subtracting the initial outlay on the project.

NPV of a project/investment = Discounted value of net cash inflows – Initial cost/investment. The project/investment is viable if NPV is positive while it is not viable if NPV is negative.


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An investor has an opportunity to purchase a piece of property for $50,000 at the beginning of the year. The after-tax net cash flows at the end of each year are forecast as follows:

Year Cash Flow

1 $9,000

2 8,500

3 8,000

4 8,000

5 8,000

6 8,000

7 8,000

8 7,000

9 4,500

10 51,000 (property sold at the end of the 10th year)

Assume that the required rate of return for similar investments is 15.00%.

NPV = - 50000 + 9000/(1+0.15)^1 + 8500/(1+0.15)^2 + ….. +51000/(1+0.15)^10 = $612.96

However, if we assume that the required rate of return is 16.00%,

NPV = - 50000 + 9000/(1+0.16)^1 + 8500/(1+0.16)^2 + ….. +51000/(1+0.16)^10 = ($1360.77)

Thus, it can be seen that the NPV is highly sensitive to required rate of return. NPV of a project:

Increases with increase in future cash inflows for a given initial outlay

Decreases with increase in initial outlay for a given set of future cash inflows

Decreases with increase in required rate of return

Internal Rate of Return (IRR)

Internal Rate of Return (IRR), also referred to as ‘Yield’ is often used in capital budgeting. It is the implied interest rate that makes net present value of all cash flows equal zero.

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In the previous example, the IRR is that value of required rate of return that makes the NPV equals zero.

IRR = r, where

NPV = - 50000 + 9000/(1+r)^1 + 8500/(1+r)^2 + ….. +51000/(1+r)^10 = $0.00

IRR can be calculated using trial and error methods by using various values for r or using the IRR formula directly in MS Excel. Here, IRR = 15.30%. In other terms, IRR is the rate of return at which the project/investment becomes viable.

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Corporations need capital to finance business operations. They raise money by issuing Securities in the form of Equity and Debt. Equity represents ownership of the company and takes the form of stock. Debt is funded by issuing Bonds, Debentures and various certificates. The use of debt is also referred to as Leverage Financing. The ratio of debt/equity shows a potential investor the ex-tent of a company’s leverage.

Investors choose between debt and equity securities based on their investment objectives. In-come is the main objective for a debt investor. This income is paid in the form of Interest, usually as semi-annual payments. Capital Appreciation (the increase in the value of a security over time) is only a secondary consideration for debt investors. Conversely, equity investors are primarily seeking Growth, or capital appreciation. Income is usually of lesser importance, and is received in the form of Dividends.

Debt is considered senior to equity (i.e.) the interest on debt is paid before dividends on stock. It also means that if the company ceases to do business and liquidate its assets, that the debt hold-ers have a senior claim to those assets.


Security is a financial instrument that signifies ownership in a company (a stock), a creditor rela-tionship with a corporation or government agency (a bond), or rights to ownership (an option). Fi-nancial instruments can be classified into:






Debt is money owed by one person or firm to another. Bonds, loans, and commercial paper are all examples of debt.


An investor loans money to an entity (company or government) that needs funds for a specified period of time at a specified interest rate. In exchange for the money, the entity will issue a certifi-cate, or bond, that states the interest rate (coupon rate) to be paid and repayment date (maturity date). Interest on bonds is usually paid every six months (semiannually).

Bonds are issued in three basic physical forms: Bearer Bonds, Registered As to Principal Only and Fully Registered Bonds.

Bearer bonds are like cash since the bearer of the bond is presumed to be the owner. These bonds are Unregistered because the owner’s name does not appear on the bond, and there is no record of who is entitled to receive the interest payments. Attached to the bond are Coupons. The bearer clips the coupons every six months and presents these coupons to the paying agent to re-ceive their interest. Then, at the bond’s Maturity, the bearer presents the bond with the last coupon attached to the paying agent, and receives their principal and last interest payment.

Bonds that are registered as to principal only have the owner’s name on the bond certificate, but since the interest is not registered these bonds still have coupons attached.

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Bonds that are issued today are most likely to be issued fully registered as to both interest and principal. The transfer agent now sends interest payments to owners of record on the interest Payable Date. Book Entry bonds are still fully registered, but there is no physical certificate and the transfer agent keeps track of ownership. U.S. Government Negotiable securities (i.e., Trea-sury Bills, Notes and Bonds) are issued book entry, with no certificate. The customer’s Confirma-tion serves as proof of ownership.

Principal and Interest

Bondholders are primarily seeking income in the form of a semi-annual coupon payment. The an-nual rate of return (also called Coupon, Fixed, Stated or Nominal Yield) is noted on the bond cer-tificate and is fixed. The factors that influence the bond's initial coupon rate are prevailing eco-nomic conditions (e.g., market interest rates) and the issuer's credit rating (the higher the credit rating, the lower the coupon). Bonds that are In Default are not paying interest.

The principal or par or Face amount of the bond is what the investor has loaned to the issuer. The relative "safety" of the principal depends on the issuer’s credit rating and the type of bond that was issued.

Corporate bond

A bond issued by a corporation. Corporations generally issue three types of bonds: Secured Bonds, Unsecured Bonds (Debentures), and Subordinated Debentures.

All corporate bonds are backed by the full faith and credit of the issuer, but a secured bond is fur-ther backed by specific assets that act as collateral for the bond.

In contrast, unsecured bonds are backed by the general assets of the corporation only. There are three basic types of Secured Bonds:

Mortgage Bonds are secured by real estate owned by the issuer

Equipment Trust Certificates are secured by equipment owned and used in the issuers business

Collateral Trust Bonds are secured by a portfolio of non-issuer securities. (usually U.S. Government securities)

Secured Bonds are considered to be Senior Debt Securities, and have a senior creditor status; they are the first to be paid principal or interest and are thus the safest of an issuer’s securities. Unse-cured Bonds include debentures and subordinated debentures. Debentures have a general credi-tor status and will be paid only after all secured creditors have been satisfied. Subordinated debentures have a subordinate creditor status and will be paid after all senior and general credi-tors have first been satisfied.

Example IBM can issue 10 year bonds with a coupon of 5.5%. Priceline can issue similar 10 year bonds at 8% The difference in coupon is due to their credit rating!

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Municipal bond (Munis)

A bond issued by a municipality. These are generally tax free, but the interest rate is usually lower than a taxable bond.

Treasury Securities

Treasury bills, notes, and bonds are marketable securities the U.S. government sells in order to pay off maturing debt and raise the cash needed to run the federal government. When an investor buys one of these securities, he/she is lending money to the U.S. government.

Treasury bills are short-term obligations issued for one year or less. They are sold at a discount from face value and don't pay interest before maturity. The interest is the difference between the purchase price of the bill and the amount that is paid to the investor at maturity (face value) or at the time of sale prior to maturity.

Treasury notes and bonds bear a stated interest rate, and the owner receives semi-annual in-terest payments. Treasury notes have a term of more than one year, but not more than 10 years.

Treasury bonds are issued by the U.S. Government. These are considered safe investments be-cause they are backed by the taxing authority of the U.S. government, and the interest on Trea-sury bonds is not subject to state income tax. T-bonds have maturities greater than ten years, while notes and bills have lower maturities. Individually, they sometimes are called "T-bills," "T-notes," and "T-bonds." They can be bought and sold in the secondary market at prevailing mar-ket prices.

Savings Bonds are bonds issued by the Department of the Treasury, but they aren't are not mar-ketable and the owner of a Savings Bond cannot transfer his security to someone else.

Zero coupon bonds - interest rate at maturity

Zeros generate no periodic interest payments but they are issued at a discount from face value. The return is realized at maturity. Zeros sell at deep discounts from face value. The difference be-tween the purchase price of the zero and its face value when redeemed is the investor's return. Zeros can be purchased from private brokers and dealers, but not from the Federal Reserve or any government agency.

Case Study Enron set up power plant at Dabhol, India The cost of the project (Phase 1) was USD 920 Million Funding

o Equity USD 285 mioo Bank of America/ABN Amro USD 150 mioo IDBI & Indian Banks USD 95 mioo US Govt – OPIC USD 100 mioo US Exim Bank USD 290 mio

Enron US declared bankruptcy in 2002 Enron India’s assets are mortgaged to various banks as above. Due to interest payments and depreciation, assets are worth considerably less than

USD 920 mio. Who will get their money back? And how much?

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The higher rate of return the bond offers, the more risky the investment. There have been in-stances of companies failing to pay back the bond (default), so, to entice investors, most corpo-rate bonds will offer a higher return than a government bond. It is important for investors to re-search a bond just as they would a stock or mutual fund. The bond rating will help in deciphering the default risk.

Commercial paper

An unsecured, short-term loan issued by a corporation, typically for financing accounts receivable and inventories. It is usually issued at a discount to face value, reflecting prevailing market inter-est rates. It is issued in the form of promissory notes, and sold by financial organizations as an al-ternative to borrowing from banks or other institutions. The paper is usually sold to other compa-nies which invest in short-term money market instruments.

Since commercial paper maturities don't exceed nine months and proceeds typically are used only for current transactions, the notes are exempt from registration as securities with the United States Securities and Exchange Commission. Financial companies account for nearly 75 percent of the commercial paper outstanding in the market.

There are two methods of marketing commercial paper. The issuer can sell the paper directly to the buyer or sell the paper to a dealer firm, which re-sells the paper in the market. The dealer market for commercial paper involves large securities firms and subsidiaries of bank holding com-panies. Direct issuers of commercial paper usually are financial companies which have frequent and sizable borrowing needs, and find it more economical to place paper without the use of an in-termediary. On average, direct issuers save a dealer fee of 1/8 of a percentage point. This sav-ings compensates for the cost of maintaining a permanent sales staff to market the paper.

Interest rates on commercial paper often are lower than bank lending rates, and the differential, when large enough, provides an advantage which makes issuing commercial paper an attractive alternative to bank credit.

Commercial paper maturities range from 1 day to 270 days, but most commonly is issued for less than 30 days. Paper usually is issued in denominations of $100,000 or more, although some companies issue smaller denominations. Credit rating agencies like Standard & Poor rate the CPs. Ratings are reviewed frequently and are determined by the issuer's financial condition, bank lines of credit and timeliness of repayment. Unrated or lower rated paper also is sold in the mar-ket.

Investors in the commercial paper market include private pension funds, money market mutual funds, governmental units, bank trust departments, foreign banks and investment companies. There is limited secondary market activity in commercial paper, since issuers can closely match the maturity of the paper to the investors' needs. If the investor needs ready cash, the dealer or issuer usually will buy back the paper prior to maturity.


Equity (Stock) is a security, representing an ownership interest. Equity refers to the value of the funds contributed by the owners (the stockholders) plus the retained earnings (or losses).

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Common stock

Common stock represents an ownership interest in a company. Owners of stock also have Lim-ited Liability (i.e.) the maximum a shareholder can lose is their original investment. Most of the stock traded in the markets today is common. An individual with a majority shareholding or con-trolling interest controls a company's decisions and can appoint anyone he/she wishes to the board of directors or to the management team.

Corporations seeking capital sell it to investors through a Primary Offering or an Initial Public Of-fering (IPO). Before shares can be offered, or sold to the general public, they must first be regis-tered with the Securities and Exchange Commission (SEC). Once the shares have been sold to investors, the shareholders are usually free to sell or trade their stock shares in the Secondary Markets (such as the New York Stock Exchange – NYSE). From time to time, the Issuer may choose to repurchase the stock they previously issued. Such repurchased stock shares are re-ferred to as Treasury Stock, and the shares that remain trading in the secondary market are re-ferred to as Shares Outstanding. Treasury Stock does not have voting rights and is not entitled to any declared dividends. Corporations may use Treasury Stock to pay a stock dividend, to offer to employees.

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Stock Terminology

Public Offering Price (POP) – The price at which shares are offered to the public in a Primary Of-fering. This price is fixed and must be maintained when Underwriters sell to customers.

Current Market Price – The price determined by Supply and Demand in the Secondary Markets.

Book Value – The theoretical liquidation value of a stock based on the company's Balance Sheet.

Par Value – An arbitrary price used to account for the shares in the firm’s balance sheet. This value is meaningless for common shareholders, but is important to owners of Preferred Stock.

Preferred Stock

Preference shares carry a stated dividend and they do not usually have voting rights. Preferred shareholders have priority over common stockholders on earnings and assets in the event of liq-uidation. Preferred stock is issued with a fixed rate of return that is either a percent of par (always assumed to be $100) or a dollar amount.

Although preferred stock is equity and represents ownership, preferred stock investors are pri-marily seeking income. The market price of income seeking securities (such as preferred stock and debt securities) fluctuates as market interest rates change. Price and yield are inversely re-lated.

There are several different types of preferred stock including Straight, Cumulative, Convertible, Callable, Participating and Variable. With straight preferred, the preference is for the current year’s dividend only. Cumulative preferred is senior to straight preferred and has a first prefer-ence for any dividends missed in previous periods.

Convertible preferred stock can be converted into shares of common stock either at a fixed price or a fixed number of shares. It is essentially a mix of debt and equity, and most often used as a means for a risky company to obtain capital when neither debt nor equity works. It offers considerable opportunity for capital appreciation.

Non-convertible preferred stock remains outstanding in perpetuity and trades like stocks. Utili-ties represent the best example of nonconvertible preferred stock issuers.


When Cognizant Technology Solutions came out with its Initial Public Offering on NASDAQ in June 1998, the Public Offering Price (POP) was set at $10 per share. The stock was split twice, 2-for-1 in March-2000 and 3-for-1 again in April 2003. As of Dec 6, 2003, the Current Market Price stood at $46.26. However, if the stock-splits are taken into consideration the actual market price would stand at 6 times the Current Market Price at whopping $253.56!!

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American Depository Receipts (ADR)

The purpose of an ADR is to facilitate the domestic trading of a foreign stock. An ADR is a receipt for a specified number of foreign shares owned by an American bank. ADRs trade like shares, ei-ther on a U.S. Exchange or Over the Counter. The owner of an ADR has voting rights and also has the right to receive any declared dividends. An example would be Infosys ADRs that are traded in NASDAQ.


Hybrids are securities, which combine the characteristics of equity and debt.

Convertible bonds

Convertible Bonds are instruments that can be converted into a specified number of shares of stock after a specified number of days. However, till the time of conversion the bonds continue to pay coupons.


Warrants are call options – variants of equity. They are usually offered as bonus or sweetener, at-tached to another security and sold as a Unit. For example, a company is planning to issue bonds, but the market dictates a 9% interest payment. The issuer does not want to pay 9%, so they “sweeten” the bonds by adding warrants that give the holder the right to buy the issuers stock at a given price over a given period of time. Warrants can be traded, exercised, or expire worthless.


A derivative is a product whose value is derived from the value of an underlying asset, index or reference rate. The underlying asset can be equity, foreign exchange, commodity or any other item. For example, if the settlement price of a derivative is based on the stock price, which changes on a daily basis, then the derivative risks are also changing on a daily basis. Hence de-rivative risks and positions must be monitored constantly.

Forward contract

Case Study

Tata Motors Ltd. (previously know as TELCO) recently issued convertible bond aggregating to $100 million in the Luxemburg Stock Exchange. The effective interest rate paid on the issue was just 4% which was much lower than what it would have to pay if it raised the money in India, where it is based out of. The company would use this money to pay-back existing loans borrowed at much higher interest rates.

Why doesn’t every company raise money abroad if it has to pay lower interest rates? Will there is

Will there be any effect on existing Tata Motors share-holders due to the convertible issue? If ‘Yes’, when will this be?

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A forward contract is an agreement to buy or sell an asset (of a specified quantity) at a certain fu-ture time for a certain price. No cash is exchanged when the contract is entered into.

Futures contract

A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Index futures are all futures contracts where the underlying is the stock index and helps a trader to take a view on the market as a whole.

Hedging involves protecting an existing asset position from future adverse price movements. In order to hedge a position, a market player needs to take an equal and opposite position in the fu-tures market to the one held in the cash market.

Arbitrage: An arbitrageur is basically risk averse. He enters into those contracts were he can earn risk less profits. When markets are imperfect, buying in one market and simultaneously sell-ing in other market gives risk less profit. Arbitrageurs are always in the look out for such imperfec-tions.


An option is a contract, which gives the buyer the right, but not the obligation to buy or sell shares of the underlying security at a specific price on or before a specific date. There are two kinds of options: Call Options and Put Options.

Call Options are options to buy a stock at a specific price on or before a certain date. Call op-tions usually increase in value as the value of the underlying instrument rises. The price paid, called the option premium, secures the investor the right to buy that certain stock at a specified price. (Strike price) If he/she decides not to use the option to buy the stock, the only cost is the option premium. For call options, the option is said to be in-the-money if the share price is above the strike price.

Put Options are options to sell a stock at a specific price on or before a certain date. With a Put Option, the investor can "insure" a stock by fixing a selling price. If stock prices fall, the investor can exercise the option and sell it at its "insured" price level. If stock prices go up, there is no need to use the insurance, and the only cost is the premium. A put option is in-the-money when the share price is below the strike price. The amount by which an option is in-the-money is re-ferred to as intrinsic value.

The primary function of listed options is to allow investors ways to manage risk. Their price is de-termined by factors like the underlying stock price, strike price, time remaining until expiration (time value), and volatility. Because of all these factors, determining the premium of an option is complicated.

Types of Options

There are two main types of options:


The Infosys stock price as of Dec 6th, 2003 stood at Rs.5062. The cost of the Dec 24th, 2003 expiring Call option with Strike Price of Rs.5200 on the Infosys Stock was Rs.90. This would mean that to break-even the person buying the Call Option on the Infosys stock, the stock price would have to cross Rs.5290 as of Dec 24th, 2003!!

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American options can be exercised at any time between the date of purchase and the expiration date. Most exchange-traded options are of this type.

European options can only be exercised at the end of their life.

Long-Term Options are options with holding period of one or more years, and they are called LEAPS (Long-Term Equity Anticipation Securities). By providing opportunities to control and man-age risk or even speculate, they are virtually identical to regular options. LEAPS, however, pro-vide these opportunities for much longer periods of time. LEAPS are available on most widely-held issues.

Exotic Options: The simple calls and puts are referred to as "plain vanilla" options. Non-stan-dard options are called exotic options, which either are variations on the payoff profiles of the plain vanilla options or are wholly different products with "optionality" embedded in them.

Open Interest is the number of options contracts that are open; these are contracts that have not expired nor been exercised.


Swaps are the exchange of cash flows or one security for another to change the maturity (bonds) or quality of issues (stocks or bonds), or because investment objectives have changed. For ex-ample, one firm may have a lower fixed interest rate, while another has access to a lower floating interest rate. These firms could swap to take advantage of the lower rates.

Currency Swap involves the exchange of principal and interest in one currency for the same in another currency.

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Forward Swap agreements are created through the synthesis of two different swaps, differing in duration, for the purpose of fulfilling the specific timeframe needs of an investor. Sometimes swaps don't perfectly match the needs of investors wishing to hedge certain risks. For example, if an investor wants to hedge for a five-year duration beginning one year from today, they can enter into both a one-year and six-year swap, creating the forward swap that meets the requirements for their portfolio.

Swaptions - An option to enter into an interest rate swap. The contract gives the buyer the option to execute an interest rate swap on a future date, thereby locking in financing costs at a specified fixed rate of interest. The seller of the swaption, usually a commercial or investment bank, as-sumes the risk of interest rate changes, in exchange for payment of a swap premium.

Case Study The World Bank borrows funds internationally and loans those funds to develop-

ing countries. It charges its borrowers a cost plus rate and hence needs to borrow at the lowest cost.

In 1981 the US interest rate was at 17 percent, an extremely high rate due to the anti-inflation tight monetary policy of the Fed. In West Germany the correspond-ing rate was 12 percent and Switzerland 8 percent.

IBM enjoyed a very good reputation in Switzerland, perceived as one of the best managed US companies. In contrast, the World Bank suffered from bad image since it had used several times the Swiss market to finance risky third world countries. Hence, World Bank had to pay an extra 20 basis points (0.2%) compared to IBM

In addition, the problem for the World Bank was that the Swiss government imposed a limit on the amount World Bank could borrow in Switzerland. The World Bank had borrowed its allowed limit in Switzerland and West Germany

At the same time, the World Bank, with an AAA rating, was a well established name in the US and could get a lower financing rate (compared to IBM) in the US Dollar bond market because of the backing of the US, German, Japanese and other governments. It would have to pay the Treasury rate + 40 basis points.

IBM had large amounts of Swiss franc and German deutsche mark debt and thus had debt payments to pay in Swiss francs and deutsche marks.

World Bank borrowed dollars in the U.S. market and swapped the dollar repay-ment obligation with IBM in exchange for taking over IBM's SFR and DEM loans.

It became very advantageous for IBM and the World Bank to borrow in the market in which their comparative advantage was the greatest and swap their respective fixed-rate funding.

Case Study The World Bank borrows funds internationally and loans those funds to developing coun-

tries. It charges its borrowers a cost plus rate and hence needs to borrow at the lowest cost.

In 1981 the US interest rate was at 17 percent, an extremely high rate due to the anti-in-flation tight monetary policy of the Fed. In West Germany the corresponding rate was 12 percent and Switzerland 8 percent.

IBM enjoyed a very good reputation in Switzerland, perceived as one of the best managed US companies. In contrast, the World Bank suffered from bad image since it had used several times the Swiss market to finance risky third world countries. Hence, World Bank had to pay an extra 20 basis points (0.2%) compared to IBM

In addition, the problem for the World Bank was that the Swiss government imposed a limit on the amount World Bank could borrow in Switzerland. The World Bank had borrowed its allowed limit in Switzerland and West Germany

At the same time, the World Bank, with an AAA rating, was a well established name in the US and could get a lower financing rate (compared to IBM) in the US Dollar bond market because of the backing of the US, German, Japanese and other governments. It would have to pay the Treasury rate + 40 basis points.

IBM had large amounts of Swiss franc and German deutsche mark debt and thus had debt payments to pay in Swiss francs and deutsche marks.

World Bank borrowed dollars in the U.S. market and swapped the dollar repayment obli-gation with IBM in exchange for taking over IBM's SFR and DEM loans.

It became very advantageous for IBM and the World Bank to borrow in the market in which their comparative advantage was the greatest and swap their respective fixed-rate funding.

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A financial transaction is one where a financial asset or instrument, such as cash, check, stock, bond, etc are bought and sold. Financial Market is a place where the buyers and sellers for the fi-nancial instruments come together and financial transactions take place.


Primary Markets

Primary market is one where new financial instruments are issued for the first time. They provide a standard institutionalized process to raise money. The public offerings are done through a prospectus. A prospectus is a document that gives detailed information about the company, their prospective plans, potential risks associated with the business plans and the financial instrument.

Secondary markets

Secondary Market is a place where primary market instruments, once issued, are bought and sold. An investor may wish to sell the financial asset and encash the investment after some time or the investor may wish to invest more, buy more of the same asset instead, the decision influ-enced by a variety of possible reasons. They provide the investor with an easy way to buy or sell.

The Different Financial Markets

A financial market is known by the type of financial asset or instrument traded in it. So there are as many types of financial markets as there are of instruments. Typical examples of financial mar-kets are:

Stock market

Bond (or fixed income) market

Money market

Foreign exchange (Forex or FX for short) market (also called the cur-rency market).

Stock and bond markets constitute the capital markets. Another big financial market is the deriv-atives market.


Why businesses need capital?

All businesses need capital, to invest money upfront to produce and deliver the goods and ser-vices. Office space, plant and machinery, network, servers and PCs, people, marketing, licenses etc. are just some of the common items in which a company needs to invest before the business can take off. Even after the business takes off, the cash or money generated from sales may not be sufficient to finance expansion of capacity, infrastructure, and products / services range or to diversify or expand geographically. Some financial services companies need to raise additional capital periodically in order to satisfy capital adequacy norms.

What is the role of Capital Markets?

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For businesses to thrive and grow, presence of vibrant and efficient capital markets is extremely important. Capital markets have following functions:

1. Channeling funds from “savings pool” to “investment pool” - channeling funds from “those who have money” to “those who need funds for business purpose”.

2. Providing liquidity to investors - i.e. making it easy for investors, to buy and sell financial as-sets or instruments. Capital markets achieve this in a number of ways and it is particularly im-portant for institutional investors who trade in large quantities. Illiquid markets do not allow them to trade large quantities because the orders may simply not get executed completely or may cause drastic fluctuations in price.

3. Providing multitude of investment options to investors – this is important because the risk pro-file, investment criteria and preferences may differ for each investor. Unless there are many investment options, the capital markets may fail to attract them, thus affecting the supply of capital.

4. Providing efficient price discovery mechanism – efficient because the price is determined by the market forces, i.e. it is a result of transparent negotiations among all buyers and sellers in the market at any point. So the market price can be considered as a fair price for that instru-ment.


Stock markets are the best known among all financial markets because of large participation of the “retail investors”. The important stock exchanges are as follows:

New York Stock Exchange (NYSE)

National Association of Securities Dealers Automated Quotations (NASDAQ)

London Stock Exchange (LSE)

Bombay Stock Exchange (BSE),

National Stock Exchange of India (NSE)

Stock Exchanges provide a system that accepts orders from both buyers and sellers in all shares that are traded on that particular exchange. Exchanges then follow a mechanism to automatically match these trades based on the quoted price, time, quantity, and the order type, thus resulting in trades. The market information is transparent and available real-time to all, making the trading ef-ficient and reliable.

Earlier, before the proliferation of computers and networks, the trading usually took place in an area called a “Trading Ring” or a “Pit” where all brokers would shout their quotes and find the “counter-party”. The trading ring is now replaced in most exchanges by advanced computerized and networked systems that allow online trading, so the members can log in from anywhere to carry out trading. For example, BOLT of BSE and SuperDOT of NYSE.

What determines the share price and how does it change?

The share price is determined by the market forces, i.e. the demand and supply of shares at each price. The demand and supply vary primarily as the perceived value of the stock for different in-vestors varies. Investor will consider buying the stock if the market price is less than the per-ceived value of the stock according to that investor and will consider selling if it is higher. A large number of factors have a bearing on the perceived value. Some of them are:

Performance of the company

Performance of the industry to which it belongs

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State of the country’s economy where it operates as well as the global economy

Market sentiment or mood relating to the stock and on the market as a whole

Apart from these, many other factors, including performance of other financial markets, affect the demand and supply.


As the name suggests, bonds are issued and traded in these markets. Government bonds consti-tute the bulk of the bonds issued and traded in these markets. Bond markets are also sometimes called Fixed Income markets. While some of the bonds are traded in exchanges, most of the bond trading is conducted over-the-counter (OTC), i.e. by direct negotiations between dealers. Lately there have been efforts to create computer-based market place for certain type of bonds.

Participants in the Bond Market

Since Government is the biggest issuer of bonds, the central bank of the country such as Federal Reserve in US and Reserve Bank of India in India, is the biggest player in the bond market. Like stock markets, one needs to be an authorized dealer of Govt. securities, to subscribe to the bond issues. Typically, the Govt. bond issues are made by way of auctions, where the dealers bid for the bonds and the price is fixed based on the bids received. The dealers then sell these bonds in the secondary market or directly to third parties, typically institutions and companies.

If the interest rate is fixed for each bond, why do the bond prices fluctuate?

Bond prices fluctuate because the interest rates as well as the perceptions of investors on the di-rection of interest rates change. Remember, bond pays interest at a fixed coupon rate determined at the time of issue, irrespective of the prevailing market interest rate. Market interest rates are benchmark interest rates, such as Treasury bill rates, which are subject to change because of various factors such as inflation, monetary policy change, etc. So when the prevailing market in-terest rates change, price of the bond (and not the coupon) adjusts, so that the effective yield for a buyer at the time (if the bond is held to maturity) matches the market interest rate on other bonds of equal tenure and credit rating (risk).

So when the market interest rates go up, prices of bonds fall and vice-versa. Thus, since price of bonds changes when market interest rate changes, all bonds have an interest rate risk. If the market interest rates shoot up, then the bond price is affected negatively and an investor who bought the bond at a high price (when interest rates were low) stands to lose money or at least makes lesser returns than expected, unless the bond is held to maturity.

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Foreign exchange markets are where the foreign currencies are bought and sold. For example, importers need foreign currency to pay for their imports. Government needs foreign currency to pay for its imports such as defense equipment and to repay loans taken in foreign currency.

Foreign exchange rates express the value of one currency in terms of another. They involve a fixed currency, which is the currency being priced and a variable currency, the currency used to express the price of the fixed currency. For example, the price of a US Dollar can be expressed in different currencies as: USD (US Dollar) 1 = Indian Rupee (INR) 46, USD 1 = Great Britain Pound (GBP) 0.6125, USD 1 = Euro 0.8780 etc. In this example, USD is the fixed currency and INR, GBP, Euro are the variable currencies.

US Dollar, British Sterling (Pound), Euro and Japanese Yen are the most traded currencies worldwide, since maximum business transactions are carried out in these currencies.

The exchange rate at any time depends upon the demand – supply equation for the different cur-rencies, which in turn depends upon the relative strength of the economies with respect to the other major economies and trading partners.


Only authorized foreign exchange dealers can participate in the foreign exchange market. Any in-dividual or company, who needs to sell or buy foreign currency, does so through an authorized dealer. Currency trading is conducted in the over-the-counter (OTC) market.

The role of the Central Bank in the foreign exchange market

The central bank regulates the markets to ensure its smooth functioning. The degree of regulation depends on the economic policies of the country. The central bank may also buy or sell their cur-rency to meet unusual demand – supply mismatches in the markets.

The foreign exchange rate and transactions are closely monitored because the fluctuations in forex markets affects the profitability of imports and exports of domestic companies as well as


Bond Price calculation can be summed by an easy formula:

where B represents the price of the bond and CFk represents the kth cash flow which is made up of coupon payments. The Cash Flow (CF) for the last year includes both the coupon payment and the Principal.

What would be the bond price for a 3-Year, Rs.100 principal, bond when the interest rate (i) is 10% and the Coupon payments are Rs.5 annually?

Would the bond price increase/decrease if the coupon is reduced? What would be happen to bond price if the interest rates came down?

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profitability of investments made by foreign companies in that country. Regulators try to ensure that the fluctuations are not caused by any factor other than the market forces.


Money market is for short term financial instruments, usually a day to less than a year. The most common instrument is a “repo”, short for repurchase agreement. A repo is a contract in which the seller of securities, such as Treasury Bills, agrees to buy them back at a specified time and price. Treasury bills of very short tenure, commercial paper, certificates of deposits etc. are also consid-ered as money market instruments.

Since the tenure of the money market instruments is very short, they are generally considered safe. In fact they are also called cash instruments. Repos especially, since they are backed by a Govt. security, are considered virtually the safest instrument. Therefore the interest rates on re-pos are the lowest among all financial instruments.

Money market instruments are typically used by banks, institutions and companies to park extra cash for a short period or to meet the regulatory reserve requirements. For short-term cash re-quirements, money market instruments are the best way to borrow.


Whereas in stock market the typical minimum investment is equivalent of the price of 1 share, the minimum investment in bond and money markets runs into hundreds of thousands of Rupees or Dollars. Hence the money market participants are mostly banks, institutions, companies and the central bank. There are no formal exchanges for money market instruments and most of the trad-ing takes place using proprietary systems or shared trading platforms connecting the participants.


There are many reasons why the financial markets are regulated by governments:

Since the capital markets are central to a thriving economy, Govern-ments need to ensure their smooth functioning.

Governments also need to protect small or retail investors’ interests to ensure there is participation by a large number of investors, lead-ing to more efficient capital markets.

Governments need to ensure that the companies or issuers declare all necessary information that may affect the security prices and that the information is readily and easily available to all participants at the same time.


The Bank of Japan plays the role of central bank in Japan. It strictly monitors the exchange rates to ensure that the importers/exporters are not hurt due to any exchange rate fluctuations. Still, the USD/JPY, which is the second most traded currency pair in the world, maintains a long-standing reputation of sharp increases in short-term volatilities.

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Typically the government designates one or more agencies as regulator(s) and supervisor(s) for the financial markets. Thus India has Securities and Exchange Board of India (SEBI) and the US has Securities and Exchange Commission (SEC). These regulatory bodies formulate rules and norms for each activity and each category of participant. For example,

Eligibility norms for a company to be allowed to issue stock or bonds,

Rules regarding the amount of information that must be made avail-able to prospective investors,

Rules regarding the issue process,

Rules regarding periodic declaration of financial statements, etc.

Regulators also monitor the capital market activity continuously to ensure that any breach of laws or rules does not go unnoticed. To help this function, all members and issuers have to submit cer-tain periodic reports to the regulator disclosing all relevant details on the transactions undertaken.


The demands of the capital market transactions, the need for tracking and managing risks, the pressure to reduce total transaction costs and the obligation to meet compliance requirements make it imperative that the functions be automated using advanced computer systems. Some of the major types of systems in capital market firms are briefly described below.

Trading Systems

The volume of transactions in capital markets demands advanced systems to ensure speed and reliability. Due to proliferation of Internet technology, the trading systems are also now accessible online allowing even more participants from any part of the world to transact, helping to increase efficiency and liquidity. The trading systems can be divided into front-end order entry and back-end order processing systems.

Order entry systems also offer functions such as order tracking, calculation of profit and loss based on real-time price movements and various tools to calculate and display risk to the value of investments due to price movement and other factors.

Back-office systems validate orders, route them to the exchange(s), receive messages and notifi-cations from the exchanges, interface with external agencies such as clearing firm, generate management, investor and compliance reports, keep track of member account balances etc.

Exchange systems

The core exchange system is the trading platform that accepts orders from members, displays the price quotes and trades, matches buy and sell orders dynamically to fill as many orders as possible and sends status messages and trade notifications to the parties involved in each trade. In addition, exchanges need systems to monitor the transactions, generate reports on transac-tions, keep track of member accounts, etc.

Portfolio Management Systems

These systems allow the investment managers to choose the instruments to invest in, based on the requirements or inputs such as amount to be invested, expected returns, duration (or tenure) of investment, risk tolerance etc. and analysis of price and other data on the instruments and is-suers. The term “portfolio” refers to the basket of investments owned by an investor. A portfolio of investments allows one to diversify risks over a limited number of instruments and issuers.

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Accounting Systems

The accounting systems take care of present value calculations, profit & loss etc.- of investments and funds and not the financial accounts of the firms.

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Financial markets facilitate financial transactions, i.e. exchange of fi-nancial assets such stocks, bonds, etc.

Financial markets bring buyers and sellers in a financial instrument together, thus reducing transaction costs, channeling funds, improv-ing liquidity and provide a transparent price discovery mechanism.

Each financial market is segmented into a Primary market, where new instruments are issued and a Secondary market, where the pre-viously issued instruments are bought and sold by investors.

Stock markets, bond markets, money markets, foreign exchange markets and derivatives markets are prominent examples of financial markets.

Shares (stock) of a company are issued and traded in the stock mar-kets.

Bond markets are where bonds such as treasury bonds, treasury notes, corporate bonds, etc. are traded.

Money markets, like bonds markets, are also fixed income markets. Instruments traded in money markets have very short tenure.

Foreign exchange markets trade in currencies.

Derivatives markets trade derivatives, which are complex financial in-struments, whose returns are based upon the returns from some other financial asset called as the underlying asset.

Price of any financial instrument depends basically on demand and supply, which in turn depend upon multiple different factors for differ-ent markets.

Each financial instrument has a differing level of inherent risk associ-ated with it. Money market instruments are considered the safest due to their very short tenure.

Regulators play a very important role in the development and viability of financial markets. Regulators try to ensure that the markets func-tion in a smooth, transparent manner, that there is sufficient and timely disclosure of information, that the interest of small investors is not compromised by the large investors, and so on, which is critical for overall vibrancy, efficiency and growth of the market and the economy.

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The term ‘Bank’ is used generically to refer to any financial institution that is licensed to accept deposits and issue credit through loans.

Banks are the backbone of any economy, as all monetary transactions end up touching banks. The main functions of banks are to:

Channelize Savings

Provide credit facilities to borrower

Provide investment avenues to investors

Facilitate the trade and commerce dealings

Provide financial backbone to support economic growth of the coun-try

Minimize Cash Transactions

Provide Services


They provide a return (pay interest) on our saving

Safety of principal and interest

Convenience of being able to write checks and use debit cards

Raising funds when we need

From the business or economic point of view, however, banks are the primary source of finance. Since the deposits of the small investors are protected, bank deposits are considered a low risk investment avenue. Due to their access to a large source of funds at very low cost, owing largely to the low interest rate on savings and term deposits, banks are in the best position to lend to businesses and individuals at competitive interest rates.


The Central bank of any country can be called the banker’s bank. It acts as a regulator for other banks, while providing various facilities to facilitate their functioning. It also acts as the Govern-ment’s bank. The Federal Reserve is the central bank of the United States, while Reserve Bank of India is the central bank in India.

The main objective of a central bank is to provide the nation with a safer, more flexible, and more stable monetary and financial system. They have the following responsibilities:

Conducting the nation's monetary policy. Central banks define the monetary policy and then take necessary actions to create an envi-ronment to make those policies feasible. E.g. if the central bank wants to maintain soft interest rate, they can reduce the CRR to pump in more money in the economy.

Supervising and regulating banking institutions and protecting the rights of consumers

Maintaining the stability of the financial system, i.e. stability of inter-est rates and foreign exchange rate.

Ensuring that the interest rates remain at such a level as to make business viable

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Ensuring that sufficient funds are available for long term investment to businesses as well as government, without causing inflation to rise

Providing certain financial services to the government, the public, fi-nancial institutions, and foreign official institutions

Monitoring the foreign currency assets and liabilities and monitoring the inflow and outflow of foreign currency


Banks facilitate the creation of money in the economy. The primary function of banks is to put ac-count holders' money to use by lending it out to others who can then use it to buy homes, busi-nesses etc.

Let’s look at an example as how banks do this. The amount of money that banks can lend is di-rectly affected by the reserve requirement set by the Central Bank. That is, every bank needs to maintain a certain percentage of its total deposits as cash, to ensure liquidity. This reserve re-quirement is also known as the CRR (Cash Reserve Ratio). When a bank gets a deposit of $100, assuming a reserve requirement of 10%, the bank can then lend out $90. That $90 goes back into the economy, purchasing goods or services, and usually ends up deposited in another bank. That bank can then lend out $81 of that $90 deposit, and that $81 goes into the economy to pur-chase goods or services and ultimately is deposited into another bank that proceeds to lend out a percentage of it. In this way, money grows and flows throughout the community in a much greater amount than physically exists. This is also called multiplier effect. In the picture below, an initial deposit of $100 has created a reserve of $27, and loan of $244. Thus, banks facilitate the invest-ing/spending of money that multiply funds through circulation and this is known as “Money Multi-plier” effect.

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Banks are like any other regulated business; the product they deal with is “Money”. So they bor-row money from individual or businesses “who have money”, and lend it to those “who need money”, by adding a mark up, to pay for expenses and profit. The difference between the rates, which banks offer to depositors and lenders, is generally referred to as “Spread”. Understandably, the spread in this business is low; hence increasing the turnover (volume) is the key to making profit. Hence, in practice, banks offer a number of options – often termed as “products” - to both investors and borrowers to meet their different requirements and preferences and thus increase business. They also provide fee-based services such as managing cash for corporate clients, to increase business and improve profit margin.


Service offerings of banks are organized along following divisions:

Corporate Banking

o Trade Finance

o Cash Management

Retail Banking

o Electronic Banking

o Credit Card services

o Retail Lending – Personal Loans, Home Mortgages, Consumer Loans, Vehicle Loans

o Private Banking

o Asset Management

Investment Banking

o Private Equity

o Corporate Advisory

o Capital Raising

o Proprietary Trading

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o Emerging Markets

o Sales, Trading & Research

Equity Fixed Income Derivatives


As of March 2004 ($ Million)Si no. Company Name Total Assets Total Deposits

1 Citigroup, Inc. 1,317,877 499,1892 J.P. Morgan Chase & Co. 1,120,668 502,8263 Bank of America Corporation 1,016,247 573,3564 Wachovia Corporation 410,991 232,3385 Wells Fargo & Company 397,354 248,3696 U.S. Bancorp 192,093 118,9647 SunTrust Banks, Inc. 148,283 96,6618 National City Corporation 128,400 77,1229 ABN AMRO North America Hold-

ing Company* 127,154 53,28910 HSBC North America Inc.* 125,950 86,24811 Citizens Financial Group, Inc.* 118,986 84,76412 BB&T Corporation 94,282 64,12513 Fifth Third Bancorp 93,732 55,25014 State Street Corporation 92,896 53,51215 Bank of New York Company, Inc. 92,693 55,96116 KeyCorp 84,448 49,93117 Regions Financial Corporation 80,275 54,17018 PNC Financial Services Group,

Inc. 74,115 48,12519 Merrill Lynch Bank USA* 66,643 53,20820 MBNA Corporation* 59,126 31,86121 Comerica Incorporated 54,468 43,52322 SouthTrust Corporation 52,673 35,51523 M&T Bank Corporation 50,832 33,34124 AmSouth Bancorporation 47,415 31,54525 UnionBanCal Corporation 46,102 39,00626 BancWest Corporation* 43,814 30,79427 Northern Trust Corporation 40,179 28,44828 Bankmont Financial Corp.* 38,767 21,90829 Popular, Inc. 38,102 18,60330 Marshall & Ilsley Corporation 35,476 23,15131 Mellon Financial Corporation 33,898 20,30632 Huntington Bancshares Incorpo-

rated 33,875 20,93533 Zions Bancorporation 29,790 21,48634 Compass Bancshares, Inc. 27,481 16,52435 First Horizon National Corporation 27,084 17,71236 Banknorth Group, Inc. 26,880 17,958

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Si no. Company Name Total Assets Total Deposits37 North Fork Bancorporation, Inc. 26,178 19,16438 Commerce Bancorp, Inc. 24,955 22,88339 Capital One Bank 24,515 12,21340 Synovus Financial Corp. 22,286 16,21441 American Express Centurion

Bank 20,413 8,85842 Associated Banc-Corp 19,254 12,37543 RBC Centura Banks, Inc. 19,232 9,34744 Discover Bank 19,107 13,49045 Hibernia Corporation 18,717 14,88246 TD Waterhouse Group, Inc. 17,007 9,63047 Colonial BancGroup, Inc. 16,499 10,05048 Webster Financial Corporation 15,090 8,63849 Commerce Bancshares, Inc. 14,485 10,25350 Merrill Lynch Bank & Trust Com-

pany 14,377 12,252

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The universal banking concept permits banks to provide commercial bank services, as well as in-vestment bank services at the same time.

Glass-Steagall Act of 1933, created a Chinese wall between commercial banking and securities businesses in US. That act was intended to address the perceived causes of bank failures during the Great Depression of 1929.

Today, Glass-Steagall restrictions have become outdated and unnecessary. It has become clear that promoting stability and best practices cannot be done through artificially separating these business areas. Over the years, banks and securities firms have been forced to find various loop-holes in the Glass-Steagall barriers. The restrictions undermined the ability of American banks to compete with the other global banks which were not covered by such legislation.

Most of Glass-Steagall provisions have been repealed in the US in 1990s enabling the banks to offer a full range of commercial and investment banking services to their customers.


In the late 1990s, before legislation officially eradicated the Glass-Steagall Act’s restrictions, the investment and commercial banking industries witnessed an abundance of commercial banking firms making forays into the I-banking world. The mania reached a height in the spring of 1998. In 1998, NationsBank bought Montgomery Securities, Société Génerale bought Cowen & Co., First Union bought Wheat First and Bowles Hollowell Connor, Bank of America bought Robertson Stephens (and then sold it to BankBoston), Deutsche Bank bought Bankers Trust (which had bought Alex. Brown months before), and Citigroup was created in a merger of Travelers Insurance and Citibank.

While some commercial banks have chosen to add I-banking capabilities through acquisitions, some have tried to build their own investment banking business. J.P. Morgan stands as the best example of a commercial bank that has entered the I-banking world through internal growth. J.P. Morgan actually used to be both a securities firm and a commercial bank until federal regulators forced the company to separate the divisions. The split resulted in J.P. Mor-gan, the commercial bank, and Morgan Stanley, the investment bank. Today, J.P. Morgan has slowly and steadily clawed its way back into the securities business, and Morgan Stanley has merged with Dean Witter to create one of the biggest I-banks on the Street.

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Banks are an integral part of any economy channelizing savings from lenders to borrowers

Bank deposits are low risk investments

The Central bank is the “Bankers’ Bank” and it regulates other banks in an economy.

Central banks define a nation’s monetary policy

A bank makes a profit by investing or lending money that is earning a higher rate of interest than it pays to its depositors.

A bank is required to keep a certain amount of "cash reserves" by regulation to maintain liquidity, i.e. to ensure that the banking system does not face a cash crunch due to higher withdrawals, which can lead to panic among investors and a run on a bank.

Banks create a “Money Multiplier” effect

Banks are generally organized as corporate banking, investment banking, retail banking, and private banking functions.

Universal banks provide commercial banking as well as investment bank services under one roof

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Banking Accounts

Banking account can classified as below based on their features, cost and usefulness.

Checking Accounts

Quick, convenient and, frequent-access to the money.

Checks are used to withdraw money, pay bills, purchasing, transfer money to another accounts and many other common usage.

Some banks pay interest while many do not.

Institutions may impose fees on checking accounts, besides a charge for the checks ordered. Any combination of the following three ways can be used by the banks:

o Flat fee regardless of the balance maintained or number of transactions.

o Additional fee if average balance goes down below a specified amount.

o A fee for every transaction conducted.

Money Market Deposit Accounts

An interest-bearing account with checks writing facility, called a money market deposit account (MMDA).

Pays a higher rate of interest than a checking or savings account

MMDAs often require a higher minimum balance to start earning in-terest

Each month, numbers of transactions are limited to six transfers to another account or to other people, and only three of these transfers can be by check.

Most institutions impose fees on MMDAs.

Savings Account

Allows making withdrawals, but checks writing facility is not there.

Number of withdrawals or transfers one can make on the account each month is limited.

Passbook savings – The pass book must be presented when you make deposits and withdrawals

Statement savings – Institution regularly mails a statement that shows withdrawals and deposits for the account.

Institutions may assess various fees on savings accounts, such as minimum balance fees.

Time Deposits (Certificates of Deposit)

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Guaranteed rate of interest for a term or length of time specified by the account holder.

Once the term specified, one cannot withdraw the principal without attracting penalties.

One can withdraw the interest earned on the principal.

The rate of interest is often higher than savings or any other account

CDs renew automatically, so if not notified before maturity, CDs will roll over for another term. Most of the institutions notify the account holder before maturity.

Basic or No Frill Banking Accounts

Checking accounts, but with a limit on the number of checks one can write and the number of deposits and withdrawals one can make

Interest is generally not paid.

Fees is generally lower than checking accounts

Branch Banking

A banking system in which there is a head office and interconnected branches providing financial services in different parts of the country

Today 70% of customers use more than one contact channel

o However, 51% of customers still prefer branch banking – branch loyalty

Evidence from the trends of new branch openings

o 550 over three years at Bank of America

o 100 over five years at JPMorgan Chase

o 250 this year alone at Washington Mutual

Branch networks have re-emerged as combined centers for advice-based product sales and service, as well as more traditional banking transactions

Customers are looking for a full-service center for all their needs -- from banking products to brokerage services

Branches are being transformed from transaction processing centers into customer-centric, financial sales and service centers

This transformation is helping Banks to achieve bottom line business benefits like

o Increased customer profitability

o Retention of most profitable customers

o Increased branch revenue

o Increased staff productivity

o Reduced operational costs

A typical Retail branch at a Bank provides two primary functions

o Teller Operations - Accept and process customer transactions at the teller win-dow

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o Sales and customer service Operations - Tasks, such as new account opening, account maintenance and product sales

Teller Operations

Teller functionality

o Cash advances

o Consumer /mortgage loan payments

o Currency and coin orders

o Deposits, including commercial deposits

o Fee collection

o Foreign currency exchange

o Payments

o Stop payments

o Transfers

o Wire transfers

o Withdrawals

Sales and Customer Service

Sales and Service Platform Functions

o Account and contact histories

o Bank information and fee schedules

o Campaign management

o Complaint reporting and tracking

(Video) seeing wife face for first time #shorts

o Customer contact and event tracking and management

o Customer profile and relationships

o Decision tracking

o Lead generators

o Marketing and sales planners

o Profiling

o Referral processing

Multi-branch banking

It is a special facility that allows a customer to operate his SB or Current Account through a network of branches of the bank where he has an account. All Multi Branch Banking account holders are eligible for Multi City Cheque (Pay At par Cheque) facilities.

Multi-branch banking functions

o Under this service, the customer of one branch is able to transact on her ac-count, from any other networked branch of the Bank.

o Typical services provided through “Multi Branch Banking” include

o Cash Deposits

o Cash Payments

o Transfer of funds

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o Balance Inquiry

o Marking Stop Payment of a Check

ATM Banking

Banking enabled through a terminal used to make transactions without a human teller. In recent years it has become one of the most popular banking media.

ATM growth was 9.3 percent per year from 1983 to 1995 but in-creased to 15.5 percent from 1996 to 2002

o Off-premise ATMs account for nearly 60 percent of total U.S. ATMs

Access to ATM by means of a card, typically a dual ATM/debit card

Transaction directly linked to the consumer’s bank account - amount debited against the funds in that account

Typical Services

o Cash withdrawal – Limit per day restricted by respective bank guidelines

o Money Transfer between accounts

o Cash/ Check Deposits

o Utility Bill Payments

o Balance enquiry /Account Statements

Types of ATMs

Proprietary System

o Operated by a financial institution that purchases or leases ATMs,

o Acquires the necessary software or develops it in-house, installs the system and markets it, and issues cards of its own design

Shared / Regional System

o A network that comes into being when customers of one or more financial institu-tions have access to transaction services at ATMs owned or operated by other fi-nancial institutions.

National / International System

o A network which enables an ATM machine in New York to connect with another in Los Angeles. Through service agreements with regional and proprietary net-works, national networks link ATM machines coast to coast.

Money Transfer


o Bearer Checks

o Account Payee Checks

o Travelers’ Checks

o Bankers Checks

Debit Cards

ATM Systems

Proprietary Systems

Shared/Regional Systems

National/International Systems

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Demand Drafts

Automated Clearing House (ACH)

Standing Instructions

Electronic Transfer

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Electronic banking, also known as electronic fund transfer (EFT), uses computer and electronic technology as a substitute for checks and other paper transactions. EFTs are initiated through de-vices like ATM cards or codes that let one to access your account. Many financial institutions use ATM or debit cards and Personal Identification Numbers (PINs) for this purpose. ‡‡

The federal Electronic Fund Transfer Act (EFT Act) covers most (not all) electronic customer transactions. The Act does not cover “stored value” cards like prepaid telephone cards, mass transit passes, and some gift cards. These "stored-value" cards, as well as transactions using them, may not be covered by the EFT Act.


EFT offers the following services to the customers:

Automated Teller Machines (ATMs)

ATMs are electronic terminals that let customers bank almost any time. The customer generally inserts an ATM card and enters his/her PIN to withdraw cash, make deposits, or transfer funds between accounts, Some financial institutions and ATM owners charge a fee, particularly to cus-tomers who don't have accounts with them or on transactions at remote locations.

Direct Deposit

Customers can authorize specific deposits, such as paychecks and Social Security checks, to their account on a regular basis.

Direct Debits/Electronic Bills Presentment

Customers can pre-authorize direct withdrawals (ECS under Indian context) so that recurring bills, such as insurance premiums, mortgages, and utility bills, are paid automatically.

Pay-by-Phone Systems

They let customers call their financial institution with instructions to pay certain bills or to transfer funds between accounts. For such transactions, customers need to have an explicit agreement with their banks.

Personal Computer Banking

Customers do many banking transactions through their personal computer. For example, cus-tomers can view their account balance, request transfers between accounts, and pay bills elec-tronically.

‡‡ Excerpted from Federal Trade Commission website

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Point-of-Sale Transfers

Customers can pay for their purchases with a debit card, which also may also double up as the ATM card. Debit card purchase transfers money - fairly quickly - from the customer’s bank ac-count to the store's account. So the customer should have the required funds in his/her account before the use of debit card.

Electronic Check Conversion

ECC converts a paper check into an electronic payment at the point of sale or elsewhere. In a store, the customer can present a check to a store cashier. The check can be processed through an electronic system that captures the banking information and the amount of the check. Once the check is processed, the customer signs a receipt authorizing the store to present the check to the bank electronically and deposit the funds into the store’s account. The customer gets a re-ceipt of the electronic transaction and the check is returned to the customer. It should be voided or marked by the merchant so that it can't be used again.



The documents (usually fine print) supplied by the issuer of the “access device” cover the legal rights and responsibilities regarding an EFT account. Before using EFT services, the institution must tell the customer the following information:

A summary of customer’s liability for unauthorized transfers.

The telephone number and address of the person to be notified in the event of an unauthorized transfer, a list of the institution's "busi-ness days", and the number of days to report suspected unautho-rized transfers.

The type of transfers, fees for transfers, and any limits on the fre-quency and dollar amount of transfers.

A summary of right to receive documentation of transfers, to stop payment on a pre-authorized transfer, and the procedures to follow to stop payment.

Procedures to report an error on a receipt for an EFT or periodic statement and to request more information about a transfer listed on the statement, and the number of days to report.

A summary of the institution's liability if it fails to make or stop certain transactions.

Circumstances under which the institution will disclose information to third parties concerning customer’s account.

Charges for using ATMs where the customer does not have an ac-count.

Receipts and Statements

The customers are entitled for terminal receipts and periodic statements. Customers are entitled to a terminal receipt when they initiate an electronic transfer, whether it is an ATM or a point-of-sale electronic transfer. The receipt must show the amount and date of the transfer, and its type, such as "from savings to checking."

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No terminal receipts would be issued for regularly occurring electronic payments that are pre-au-thorized, like insurance premiums, mortgages, or utility bills. Instead, these transfers will appear on your periodic statement.

Customers are also entitled to a periodic statement for each statement cycle in which an elec-tronic transfer is made. The statement must show the amount of any transfer, the date of credit or debit to their account, the type of transfer and type of account(s) to or from which funds were transferred, and the address and telephone number for inquiries.


Customers have 60 days from the date a statement is received to notify errors to the bank. The best way is to notify the financial institution by way of a certified letter, return receipt requested. Under US federal law, the institution has no obligation to conduct an investigation if the customer missed out the 60-day deadline.

The financial institution has 10 business days to investigate the error. The institution has to com-municate the results of its investigation within three business days after completion and must cor-rect the error within one business day after detecting the error. If the institution needs more time, it may take up to 45 days to complete the investigation - but only if the money in dispute is re-turned to the customer’s account with due notification of the credit. At the end of the investigation, if no error has been found, the institution may take the money back after sending a written expla-nation.

Lost or Stolen ATM or Debit Cards

Unlike a credit card, if someone loses the ATM or debit card, customer can lose much more. If the customer reports the loss of an ATM or debit card to the card issuer before it's used without his/her permission, he/she can't be held responsible for any unauthorized withdrawals.

If unauthorized use occurs before reporting, the liability of the customer varies depending on the delay in reporting the loss to the card issuer.

Within two business days – Liability limited to $50 for unauthorized use.

Between 2 - 60 days – Liability limited to $500 because of an unau-thorized transfer.

If the loss is not reported within 60 days, the liability has no limits.

If the customer failed to notify the institution within the time periods allowed because of extenuat-ing circumstances, such as lengthy travel or illness, the issuer must reasonably extend the notifi-cation period. In addition, if state law or the individual contract imposes lower liability limits, those lower limits apply instead of the EFT act limits.

Limited Stop-Payment Privileges

The EFT Act does not give the right to the customer to stop payment. If a purchase is defective or an order is not delivered, it's up to the customer to resolve the problem with the seller.

The customer can stop payment only for regular payments out of his/her account to third parties, such as insurance companies. The institution has to be notified at least three business days be-fore the scheduled transfer.

Although federal law provides only limited rights to stop payment, individual financial institutions may offer more rights or state laws may require them.

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IntroductionElectronic Billing Presentation and Payment (EBPP) is the use of electronic means, such as email or a short message, for rending a bill.


The advantage of EBPP over traditional means is primarily the savings to the operator in terms of the cost to produce, distribute, and collect bills.

Use in Mobile Communications

EBPP may be used in lieu of a standard paper bill as a means to reduce operational costs. Some operators may view EBPP as an alternative to prepay as some operators view prepay service strictly as an alternative to traditional billing, but it usually has most value as an alternative mech-anism for billing post-paid customers. However, EBPP can also be used simply as an informa-tional tool to inform the customer of charges levied against the account.

Billing and Charging to Third Parties

EBPP is an efficient mechanism to bill or inform third parties of charges. For example, the father of a son in college may want to know how much the child is spending on mobile phone service prior to the bill becoming to high.

Paying the Bill

Some EBPP systems require software for payment while others require only standard browser software for accesses a web site for secure payment. Alternatively, the billing arrangement can be made in advance for funds to be automatically debited from a customer’s account with a finan-cial institution. However, the more attractive model for most will be to have control over when the bill is actually paid, rather than have it be paid at a predetermined date.

Future of EBPP

EBPP is expected to become an increasingly attractive alternative as mobile operators continue to search for ways to reduce operational costs. However, the extent to which EBPP is proliferated will depend entirely on user acceptance and diligence to actually pay for bills in a timely and (preferably) electronic fashion.

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Fedwire is an electronic transfer system developed and maintained by the Federal Reserve Sys-tem. The system connects Federal Reserve Banks and Branches, the Treasury and other govern-ment agencies, and more than 9,000 on-line and off-line depository institutions and thus plays a key role in US payments mechanism. The system is available on-line depository institutions with computers or terminals that communicate directly with the Fedwire network. These users origi-nate over 99 percent of total funds transfers. The remaining customers have off-line access to Fedwire for a limited number of transactions.

Fedwire transfers U.S. government and agency securities in book-entry form. It plays a significant role in the conduct of monetary policy and the government securities market by increasing the ef-ficiency of Federal Reserve open market operations and helping to keep the market for govern-ment securities liquid.

Depository institutions use Fedwire mainly to move balances to correspondent banks and to send funds to other institutions on behalf of customers. Transfers on behalf of bank customers include funds used in the purchase or sale of government securities, deposits, and other large, time-sen-sitive payments.

Fedwire and CHIPS, a private-sector funds transfer network specializing in international transac-tions, handle most large-dollar transfers. In 2000, some 108 million funds transfers with a total value of $380 trillion were made over Fedwire -- an average of $3.5 million per transaction.

All Fedwire transfers are completed on the day they are initiated, generally in a matter of minutes. They are guaranteed to be final by the Fed as soon as the receiving institution is notified of the credit to its account.

Until 1980, Fedwire services were offered free to Federal Reserve member commercial banks. However, the Depository Institutions Deregulation and Monetary Control Act of 1980 required the pricing of Fed services, including funds and securities transfers, and gave nonmember depository institutions direct access to the transfer system. To encourage private-sector competition, the law requires the Fed's fees to reflect the full cost of providing the services, including an implicit cost for capital and profitability.

How Fedwire Works

Transfers over Fedwire require relatively few bookkeeping entries. Suppose an individual or a pri-vate or government organization asks a bank to transfer funds. If the banks of the sender and re-ceiver are in different Federal Reserve districts, the sending bank debits the sender's account and asks its local Reserve Bank to send a transfer order to the Reserve Bank serving the receiver's bank. The two Reserve Banks settle with each other through the Inter-district Settlement Fund, a bookkeeping system that records Federal Reserve inter-district transactions. Finally, the receiving bank notifies the recipient of the transfer and credits its account. Once the transfer is received, it is final and the receiver may use the funds immediately. If the sending and receiving banks are in the same Federal Reserve district, the transaction is similar, but all of the processing and ac-counting are done by one Reserve Bank.


Clearing House Interbank Payment System (CHIPS) is a private sector funds transfer network mainly for international transactions. CHIPS transfers are settled on a net basis at the end of the day, using Fedwire funds transfers to and from a special settlement account on the books of the

New York Fed.

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In addition to Fedwire, the Federal Reserve Banks provide net settlement services for participants in private-sector payments systems, such as check clearing houses, automated clearing house associations (ACH), and private electronic funds transfer systems that normally process a large number of transactions among member institutions. Net settlement involves posting net debit and net credit entries provided by such organizations to the accounts that the appropriate depository institutions maintain at the Federal Reserve.

An automated clearing house processes and delivers electronic debit and credit payments among participants.

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Retail banking is banking services provided for individuals. Common services include –

o Branch Banking

o Customer Care

o Teller Services

o Deposit and Loan Products

o Online Banking

o Financial Advisory

ATM banking has become increasingly popular over the last few decades

There are many types of Banking Accounts

o Checking Accounts

o Money Market Deposit Accounts

o Savings Account

o Time Deposits (Certificates of Deposit)

o Basic or No Frill Banking Accounts

Electronic banking, also known as electronic fund transfer (EFT), uses computer and electronic technology as a substitute for checks and other paper transactions.

EFT’s are initiated through devices like ATM cards or codes that let one to access your account. Many financial institutions use ATM or debit cards and Personal Identification Numbers (PINs) for this purpose.

The federal Electronic Fund Transfer Act (EFT Act) covers most (not all) electronic customer transactions.

EFT offers the following services to the customers:

o Automated Teller Machines (ATMs)

o Direct Deposit

o Direct Debits/Electronic Bills Presentment

o Pay-by-Phone Systems

o Personal Computer Banking

o Point-of-Sale Transfers

o Electronic Check Conversion

EBPP is an upcoming mode of transaction involving the use of elec-tronic means, such as email or a short message, for rending a bill.

FedWire is an electronic transfer system developed and maintained by the Federal Reserve System. The system connects Federal Re-serve Banks and Branches, the Treasury and other government agencies, and depository institutions and thus plays a key role in US payments mechanism

Clearing House Interbank Payment System (CHIPS) is a private sector funds transfer network mainly for international transactions. CHIPS transfers are settled on a net basis at the end of the day, using Fedwire funds transfers to and from a special settlement ac-count on the books of the New York Fed.

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Retail Lending is one of the most important functions performed by a bank. It encompasses the following:

Personal loans, consumer loans

Asset based loans - auto loans, home loans

Open ended loans

Lease, Hire Purchase

Credit cards

Personal Loans / Consumer Loans

Personal loans are amount borrowed by individuals to cover their personal expenses. The details of such expenses are never of any interest to the lenders.

The financer is not interested in the intention of the loan.

No security

Short term loans

Rate of interest is very steep.

Ideally should be used only in case of an emergency

All banks/finance companies offer these loans

Loan amount is directly linked to borrower’s repayment capacity.

Asset Based Loans

Such loans are amount borrowed by individuals to buy some asset, which is hypothecated to the lender. Thus the lender is fully aware of the purpose of the loan. The interest rate charged is lower than personal loans because the loan is secured by the hypothecation of the asset to the lender.

Two main types – auto loans, housing loans

Interest rate is lower as compared to Personal loans

Hypothecation of the Asset to the financer.

Repayment through EMI’s.

Thumb rules for calculation of Maximum loan amount

a. Not greater than 3 times the yearly income OR

b. The EMI should be less than 60 pct of the gross monthly income.

Loan against Securities

Overdraft facility can be availed against pledge of equity Shares, Mu-tual Fund units.

Drawing power is usually 60-70 % of the value of the pledged instru-ments.

Open Ended Loans- secured

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Open ended loan allow the borrower to borrow additional amount subject to the maximum amount less then a set value.

Similar to overdraft facilities provided by banks.

Interest is calculated on the daily outstanding balance.

Usually a card (similar to a Credit Card) is issued by the lending insti-tution.

The lending institution has tie-ups with various merchant establish-ments.

Also allow you to withdraw Cash.

Important Terms;

c. Limit (L) – max outstanding allowed

d. Margin (M) – percentage of limit that can be drawn

e. Asset value (AV) – value of underlying asset

f. Drawing Power (DP) - lower of L and (1-M)*AV


Limit =$ 1000; Margin = 30%; Asset Value (initial) = $1000

Date Asset Value (AV) Drawing Power (DP)

1st Jan 2004 $1000 $700

1st Feb 2004 $1600 $1000

1st Mar 2004 $2000 $1000

1st Apr 2004 $500 $350

Lease / Hire Purchase

Lease is a long-term rental agreement for the asset, while Hire Purchase is allows the user to own the asset after all the payments have been made to the lender.


Two main types – operating, financial

The Financier owns the asset.

Depreciation is claimed by the financier.

Tax deduction can be claimed for the full value of the rental paid.

Financier takes care of maintenance, insurance etc.

Hire Purchase

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The asset is owned by the financier.

Depreciation can be claimed by the borrower.

Tax deduction can be claimed only to the extent of the interest re-payment.

Retail Lending Cycle

1. Loan application management and processing

Receipt of loan/card application

Application Processing

o Duplicate check

o Negative list check

o Document Verification

o Calculate loan eligibility, IRR, processing fees

o Credit scoring

o Field Investigation

o Credit Approval


o Cheque issuance

o Credit to account

o Payment to third party

Formulating the repayment schedule.

2. Loan repayments and termination

Post-Dated Cheques

o PDC’s are collected & their information captured.

o Cheques are presented in clearing on due dates

o Bounced/ hold cheques are marked for further action.

Salary deductions

o Employer wise receipt batches are created.

o Employer cheque details are captured

o Payment receipt is marked for corresponding employees.

Direct receipts

o Cash/Cheque information is captured

o Cheques are cleared in batches.

Auto payments / Direct debits

o Bank wise receivable batches are created.

o Short receipts are marked.

o Release receipt batch to mark receipts

Kinds of repayments

o EMI – same installment amount

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o Fixed Principal – constant principal, decreasing interest amt

o Step-up – principal amount increases in steps

o Step-down – principal amount decreases in steps

o Balloon – notional amount initially, large last payment

o Bullet – interest payment initially, entire principal at one shot

o Random – schedule & amount of installments undecided

o Special products – combination of above

3. Delinquencies identification and collections

Case Processing

o Categorization of cases based on predefined rules

o Allocation of cases to collectors

Standard Cases

o Collector follow-up (desk/field)

o Repayment by customer

o Cheque issuance

Exception Cases (death/fraud etc.)

o Initiate process based on case specifics (legal/other means)

o Track/follow up the case developments till repayment

o Case closed

Interest Rates

Fixed Rate of Interest

The rate of interest applicable is guaranteed not to change during the fixed rate period. Borrower & bank protected from adverse interest rate movements.

Floating Rate of Interest

The rate of interest is linked to one of the rates prevailing in the market, for example it can be linked to PLR (Prime Lending Rate) or LIBOR (London Interbank Offered Rate). Borrower benefits from falling int. rate, exposed to upward movement of int. rate.

Submit Proposal OK Appraisal



Disbursement Compliance Conditions for borrower


NORepayment Follow-up/Action


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Important terms are; Cap, floor, collar, benchmark/base/anchor rate, mark-up/spread rate, reset date & frequency









Current rate

Base rate



An asset than can be repossessed by the lender if the borrower defaults. They are of the follow-ing types

Primary (same asset for which finance is taken)

Secondary (asset backing the loan different)

Charge Types

Pledge – gold, bank has possession

Hypothecation – vehicle, borrower has possession

Lien – against bank deposits

Assignment – insurance policies, rights get transferred to bank

Shares - periodic drawing power calculation

Mortgage – immovable property


A loan secured by the collateral of some specified real estate property that obliges the borrower to make a predetermined series of payments. If the borrower doesn’t keep up the loan repay-ments, the lender can repossess the real estate property and sell it in order to get the money back.

The rate of interest applicable is lower than personal loans and comparable to other asset based loans.

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To compare the cost of different Mortgages deals one should look at the APR – Annual Percent-age Rates. All firms that quote an APR must calculate it in a standard way, so one can compare like with like. The APR for a loan is a single figure, which takes into account:

The amount of interest you are charged

When and how often the interest must be paid

Other charges – for example, an arrangement fee or compulsory payment protection insurance – if they must be bought from the lender as a condition of the loan

When and how often these charges must be paid

Kinds of Mortgages

Mortgages can be classified based on the interest rates deals:

Interest Rate Deal How it works

Standard variable rate

The payments go up and down as the mortgage rate changes.

Standard variable rate with cash back

Same as a standard variable rate loan - but one receive a substantial cash sum (Example 3–5% of the amount borrowed) when you take up the loan.

Base rate trackerSimilar to a standard variable rate mortgage but the interest rate is guaranteed to be a set amount above the base rate and alters in line with changes in that rate.

Fixed interest rate

The payments are set at a certain level for a set period of time – for example, one year, two years, or five years. At the end of the period, one is usually charged the lender’s standard variable rate (or sometimes a new fixed rate is offered).

Discounted interest rate

The payments are variable, but they are set at less than that lender’s going rate for a fixed period of time. At the end of the period, one is charged the lender’s standard variable rate.

Capped rate

The payments go up and down as the mortgage rate changes but are guaranteed not to go above a set level (the ‘cap’) during the period of the deal.

Sometimes, they cannot fall below a set minimum level either (the ‘collar’ or ‘floor’). At the end of the period, one is charged the lender’s standard variable rate.

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Repayment Methods

Repayment mortgage

Monthly payments over the agreed number of years (Called the mortgage ‘term’) goes partly towards the interest and partly towards the principal.

If all the monthly payments agreed with the lender are made, the whole loan will be repaid by the end of the term.

Monthly payments could increase if interest rates rise.

Interest-only mortgage

The monthly payments to the lender cover only the interest on the loan. They do not pay off any amount one has borrowed.

One usually makes separate payments into a savings scheme each month to build up a lump sum, which is then used to pay off the whole amount one has borrowed, in one go at the end of the mort-gage term or sooner.

This involves some investment risk in building up a sum of money to repay the loan.

It is one’s responsibility to save enough money to repay the loan at the end of its term.

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Endowment mortgage

To repay an interest-only loan, one can take an endowment policy, which is designed to end at the same time as the mortgage.

The money one pays into an endowment policy is invested in stocks and shares and other investments. At the end of a set number of years (the policy ‘term’), the policy ‘matures’ and one gets a lump sum, which is used to repay the mortgage loan.

An endowment policy provides life insurance and sometimes other insurance benefits too.

Interest-only mortgage combined with stakeholder pension

Alongside an interest-only loan, one can make payments into a per-sonal or stakeholder pension. When one start to take the pension (between age 50 and 75), one can take part of the pension fund as a tax-free lump sum, which is used to pay off the mortgage loan.

Important US Institutions in Mortgage Market

Freddie Mac, Ginnie Maes & Fannie Mae

Federal National Mortgage Association (FNMA or Fannie Mae), Government National Mort-gage Association (GNMA or Ginnie Mae) and Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) are all "secondary market lenders".

Banks issue loans/mortgages with some collateral for security. These loans/mortgages are bought by the “secondary market lenders” from the banks thus freeing them to turn around and is-sue mortgage to new customers.

Their core business consists of mortgage loan securitization. They buy mortgages from banks and pool them into bonds to be sold or held. These companies guarantee the credit-

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worthiness of these bonds, but not the interest-rate risk. They hedge their own exposure to in-terest-rate risk through derivative contracts.

Often many retail lenders actually receive their funds from a secondary market lender. These sec-ondary lenders have assisted the national mortgage market by allowing money to move easily from state-to-state. The movement of loan funds helps to avoid a situation where mortgages are only available in certain areas or states. Also, the secondary lenders have established regulations and guidelines that help the general public.


Auto Loans is basically lending to the individual customers for a two or four wheeler or their personal use. The following section describes the multiple mechanisms by which the financing for auto loans is normally done.

Types of Financing Mechanism

Direct Lending: The Bank or the finance company directly lends to the buyer or the borrower in this case. A number of lending institu-tions are offering such loans on their websites.

Dealer financing: This is a type of loan available through the dealer. The lending and repayments are done by/to the dealer. Basically the dealer tells the customer how much down payment and monthly In-stallment is to be paid against the vehicle. The effective cost to the customer most of the times is generally more than the original price.

Leasing : Vehicle/ Auto lease is a contract between the borrower and a auto leasing company. The borrower agrees to pay the leasing company for the use of the vehicle for a certain amount of time, usu-ally 24 to 36 months. During that time the borrower agrees to make monthly lease payments, keep the car in good repair, insure the car and not drive the car more miles that stipulated in the contract.

The Key entities in a lease agreement are the lessee or the lessor.

Lessee or the borrower: The party to whom the vehicle is leased. In a consumer lease, the lessee is the consumer. The lessee is required to make payments and to meet other obligations specified in the lease agreement.

Lessor or the lender or the lending institution is the original owner of the vehicle or property being leased

The lease can be closed ended or open ended as defined below:

Closed end lease - A lease agreement that establishes a non-nego-tiable residual value for the leased auto and fee amounts due at the end of the lease term.

Open End lease - A lease term that requires the lessee to pay the difference between residual value and fair market value at the end of the lease term if the fair market value is lower

In a lease, the factors such as the ownership, up front costs and monthly payments as against the direct lending are:

Ownership: You do not own the vehicle. You get to use it but must return it at the end of the lease unless you choose to buy it.

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Up-front costs: Up-front costs may include the first month's payment, a refundable security deposit, a capitalized cost reduction (like a down payment), taxes, registration and other fees, and other charges.

Monthly payments: Monthly lease payments are usually lower than monthly loan payments because you are paying only for the vehicle's depreciation during the lease term, plus rent charges (like interest), taxes, and fees.

The Key Entities in an Auto Loan system are:

Borrower: is the one who needs to use/own the automobile and ap-proaches a dealer/lender for getting financing for the same

Dealer: Typically a franchisee of the manufacturer, involved in selling and delivery of the vehicle to the buyer

Lender: Provides capital to the borrower for buying the vehicle. This can be the bank or the dealer or any financing institution.

Credit bureau: Tracks and maintains credit history of borrowers and forward it to lenders during new application processing. This is used for deciding whether the loan should be provided to a customer or not.

Appraiser: Assesses and establishes the fair market value of a collat-eral offered as underlying security to the credit asked for.

Insurer: The Insurance company insures the vehicle owner against specific liabilities caused to and from the vehicle during the course of its use upon the payment of a premium and signing of a contract

Loan servicer: is the one who provides various services during the life cycle of a loan starting from loan origination to loan closure.


Student Loans are Loans availed by eligible students to pursue graduate and post graduate studies in US Schools/Colleges/Universities. These loans are usually provided by banks, Credit Unions and other financial institutions which are guaranteed by state sponsored Guarantors

Types of Student Loans

Students Loans offered can be categorized broadly into two types:

Federally sponsored loans – These loans are federally insured and provide protection against default. The department of Education guarantees upto 98% and even 100% in some cases

Non-federally sponsored loans – These are insured by the private sector and have no government backing. The guarantee in this case is only from the private insurers or from the reserves pledged to se-curitization

Federally sponsored loans are of two types

Federal Family Education Loan Program (FFELP)- These loans are made by financial institutions primarily with a floating rate that is ad-

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justed once a year. The interest rate is capped at 8.25% and the Fed subsidizes the difference between the actual loan rate and the rate cap through Special Allowance Payments(SAP). The rates are usu-ally specified by indexing them to the US Treasury bill rates.

Federal Direct Loan (FDLP)- where the department of Education di-rectly provides the loans

FFELP or the Federal Family Education Loan Program can further be divided into three types

Federal Stafford –Federal Stafford loans are the most common source of education loan funds in the US. This is available to both graduate and undergraduate students. This loan could be either sub-sidized or unsubsidizedby the federal government. The interest rate is a floating rate that is indexed to the 91 day T-Bill and is capped at 8.25%. Sample rates of during the year 2003-04 were

o 2.82% in school, grace and deferment

o 3.42% in repayment and forbearance

Federal PLUS - PLUS loans are availed by the parents of a full- or half-time undergraduate student .This requires a credit check and hence the parent must have a good credit history and should have been a citizen or permanent resident of US. The loans don’t require any collateral and the interest payments are tax deductible.

Consolidation loans - A consolidation loan involves two or more ex-isting federally sponsored loans into one single loan. The interest rate for this is determined by the weighted average of the loan rates prevailing at that time and capped at 8.25%

There are three principal advantages

Convenience – By combining loans the borrower is able to focus on repaying one single loan than handle multiple loans

Interest rate – In a low rate scenario the borrower can reduce his cost of borrowing by taking a new loan at the low prevailing low rates

Repayment – The repayment period is extended to 30 years and this reduces the installment to paid each month

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The Key Entities in the Student Loan System are Federal government, Schools, Lenders Ser-vicers and guarantors and the borrower.

Federal government: Sponsors and authorizes funds for grants and loan programs.

School: The school is certified by the department of education as an eligible school to participate in the FFELP or FDLP loan programs. Schools are responsible for determining borrower’s eligibility, recom-mends and certifies loan amounts, monitors the enrollment status

Lenders : are the institutions approved by the DOE for voluntary par-ticipation in any or all of the FFELP student loan programs. Typical lenders are usually Banks, credit unions, S&L institutions, insurance companies and other institutions.

Servicer: is an entity who collects payments on a loan and performs other administrative tasks associated with maintaining a loan portfo-lio. The normal functions include disburse loans funds, monitor loans while the borrowers are in school, collect payments, process defer-ments and forbearances, respond to borrower inquiries and ensuring regulatory compliance.

Guarantor is a state agency, which guarantees or insures the loan and is a not-for-profit agency. It protects the lenders against loss due to borrower default, death of borrower, total and permanent dis-ability, bankruptcy, closed school, and ineligible borrower.

Borrower : is the student who avails of the loan.

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The loans given to retail customer come under Consumer Lending. There are four major types of Consumer Lending –

o Personal loans

o Mortgages

o Auto Loans

o Student Loans

Personal loans normally have the highest interest rates charge while mortgages have the lowest.

Retail lending cycle includes -

o Loan application management and processing

o Loan repayments and termination

o Delinquencies identification and collections

Types of interest rates

o Fixed interest rate

o Flexible interest rate

o Hybrid interest rates

Mortgages are Loans given to consumers for the purpose of pur-chase, construction or repair of real estate.

Auto loans are loans financed for vehicles for personal use

Student loans are loans provided to eligible students to pursue grad-uate and post graduate studies in US Schools/Colleges/Universities

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Corporate Lending refers to various forms of loans extended by banks to corporate bodies like proprietorship, partnership, private limited companies or public limited companies. Banks lend to such entities on the strength of their balance sheet and business cash flows. Corporate loans are provided by banks for various purposes like new projects, capacity expansion or plant moderniza-tion, daily cash flow requirements (working capital) etc. Depending on the nature of the require-ment, loans may be long-term or short-term in nature.

Loans can be either secured or unsecured in nature. In case of secured loans, if the corporate defaults on payment of principal or interest on the loan, the bank can take possession of the se-curity and sell off the same to meet principal or interest payment on the loan. Security is usually in the form of land, buildings, plant and machinery, physical stock of the raw material, goods for sale etc.


The following is the typical stages in a corporate lending process:

Corporate approaches the relationship manager of the bank with a request for a loan. The corporate provides details like: past financial statements, details of the loan requirement, cash flow projection for the period of the loan, details of the security being provided etc. De-pending on the loan type and bank requirements, various other infor-mation would need to be provided by the corporate.

The concerned division of the bank prepares the detailed analysis of the corporate financial statements. A detailed study is also done on the corporate’s products, market segment, competitors etc to ascer-tain the strength of the corporate’s business. A report is prepared to capture the above details.

Based on the above report, the concerned division of the bank as-signs a rating to the corporate. The rating captures various factors like strength of business, financial state of the corporate, ability to repay the loan based on cash flow projections, promoter background etc.

A committee of the bank evaluates the loan proposal and decides to sanction/reject the same.

Once sanctioned, the bank provides a sanction letter to the corporate providing details of the loan terms and conditions.

After the corporate accepts the same, a loan agreement is signed between the bank and the corporate. The loan agreement captures various conditions of the loan like repayment mode, repayment pe-riod, interest payable, security provided, other conditions etc. The loan becomes ‘committed’ at this stage.

The bank disburses the required amount under the loan committed. This amount is called the ‘disbursed amount’ under the loan. Give the money

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Interest is usually paid on the disbursed amount of the loan. In some cases, a nominal interest if also payable on the committed amount of the loan. Also, in most cases, the corporate would have to pay a certain amount as processing fees for the loan. This would cover the bank’s overhead costs in the loan process.


Before sanctioning a loan to a corporate, the bank does a detailed assessment of its financials and business strength as discussed in the earlier section. This process ends with the bank as-signing a rating to the corporate for the loan facility.

Ratings are usually specified in alphanumeric terminologies. Rating levels might vary from AAA (highest), AA+, AA- to default ratings like D. Rating terminologies might vary across banks and across various loan tenures. The rating level specifies a certain probability of default of the loan. It also takes in to account the protection offered by the security of the loan.

For corporates with higher ratings, banks provide loans at lower interest rates and vice versa. In most cases, banks do a rating process for each of its corporate clients at the end of say, every year or every quarter. This helps banks to continuously track the financials and market position of the corporate.

Credit enhancements

Credit enhancement is a mechanism used to increase the original rating of a loan for a corporate. Credit enhancements can be in the form of pledge of shares, cash collateral, corporate or bank guarantees etc.

Example: A corporate rated BB (low rating) requires a loan of USD 5.0 million from a bank. To enhance the loan rating and thus reduce interest payable on the loan, the promoters pledges their share holding in the company with the bank. Thus, whenever there is a default on repayment of the loan, the bank has the right to sell the shares in the market. Based on the historic volatility of the shares and the current market value of USD 6.0 mn, the bank upgrades the rating of the loan to BBB+.


Term loans

These loans can either be short term loans or long term loans.

Long-term loans are extended for purposes like new projects, capacity expansion or plant mod-ernization. These loans are usually repayable over a 2-7 year period after an initial moratorium period (period during which loan repayments are not required) to help the corporate complete im-plementation of the project before revenue generation takes place.

ExampleOn April 15, 2004, AT&T borrows a term loan of USD 200 million from Citibank for funding their IT modernization project across the nation. The loan is repayable in 16 quarterly installments starting April 15, 2005, after an initial moratorium of 4 quarters. The interest

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payable would be LIBOR+0.5% payable quarterly. The loans would be secured by AT&T equipment at their HQ, worth USD 300 mn.

Short term loans are extended usually for meeting working capital requirements. The loans can be repayable in various tenures starting from a week to as long as 1 year. The loans are either re-payable in fixed installments or in one bullet installment at the end of the period. In some cases, short term loans are backed by promissory notes which are legal instruments that guarantee payment of a certain amount on a specified due date.

Corporate bonds

Corporate bonds are used for the same purpose as term loans, but the loan is backed by a trans-ferable instrument which guarantees payment from the corporate as per specified conditions. Thus, corporate bonds are tradable and banks can sell them to a third party who receives the right to get payments from the corporate. Bonds are rated depending on the rating of the corpo-rate and depending on the rating, the market demands varying amounts of interest. A certain class of bonds called junk bonds is issued by corporates with very low credit ratings and carries very high rates of interest.

Working Capital

For any business, there would be current assets in the form of cash, receivables, raw material in-ventory, goods for sale inventory etc while there would be current liabilities in the form of payables and other short term liabilities. Part of the current assets would be funded through cur-rent liabilities while the rest would have to be funded through a mixture of short term and long term loans. As per norms, 25% of the working capital gap would have to be funded by long term sources like equity or term loans while the rest 75% can be funded through short term loans and overdraft limits.

Banks conduct a detailed assessment of the current assets and liabilities for a corporate and ar-rive at a suitable working capital limit. For purpose of calculating limits, banks typically include only receivables which are less than 6 months old. Also within the specified limit, banks keep re-viewing the current asset and current liability position of a company to arrive at the drawing power for each month. Corporates are allowed to borrow up to the working capital limit or the drawing power, whichever is lower.

Overdraft limits are extended to help the corporate manage the day-to-day cash flow needs of the business. The bank makes available a certain sum of money for a period of time (say, USD 20.0 million for a period of 1 year). There would be a separate account called the overdraft account created to monitor withdrawals under this loan. Whenever the corporate has a deficit in its main business account, it can draw money from the overdraft account (up to the limit of USD 20.0 mil-lion). It can also put back money in the overdraft account as and when they have surpluses in the business account. Interest is calculated by the bank on the various end-of-day deficits in the over-draft account and is usually payable by the corporate at the end of every month.

Lines of credit

These are short term loans sanctioned for a fixed validity period, allowing the corporate to draw the loan as and when required within the validity period and repay the loan after a certain period (repayment period). Interest is either repayable in certain intervals or in one bullet installment at the end of the repayment period. In many cases, the lines of credit are of a revolving nature. The same is explained via the example provided below:

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ExampleCitibank sanctions a line of credit of USD 10.0 mn to AT&T, valid for a period of 3 years. Within the 3 year period, AT&T can borrow any amount at any point of time, such that the cumulative outstanding is below USD 10.0 mn on any date. Each of these borrowals are repayable with interest at the end of 30 days from the date of borrowal. Since AT&T can thus ‘revolve’ the limit any number of times within the specified limit and validity period, these are called revolving lines of credit.

Bill discounting

Bill discounting is another form of working capital financing. A bill (Bill of Exchange) is a financial instrument by which one party promises to pay the other party a certain amount of money on a specified due date. This is transferable and the final holder of the bill holds the right to receive the payment from the concerned party. The corporate would have bills of exchange which are drawn on their dealers, which entitle the corporate to receive certain amounts of money from the dealer after a pre-defined credit period. The corporate can then transfer the bill to the bank and get a discounted amount upfront. The bank collects the interest on the bill amount for the specified pe-riod upfront in this process called bill discounting. On the due date, the bank collects the payment from the concerned party directly.

Commercial Paper

Commercial Paper (CPs as commonly known) is an instrument by which a corporate borrows money from banks for short periods of time. A CP binds the corporate to make a payment equal to the face value of the CP to the issuing bank on a specified due date. In this sense, a CP is like a short term unsecured loan. However, a CP is tradable in the market – the bank can sell the CP to a third party. For this reason, banks charge lesser interest on CPs than normal short term loans. However, since CPs are unsecured and are to be tradable in the market, banks provide CP lending to only highly rated corporates.


Leasing is another form of bank financing. In leasing, the bank purchases real estate, equipment, or other fixed assets on behalf of the corporate and grants use of the same for a specified time to the corporate in exchange for payment, usually in the form of rent. The owner of the leased prop-erty is called the lessor, the user the lessee. Lease payments (which include principal and interest payments usually) can be shown by corporates as operating expenses and hence leases are used by some corporates as a substitute for loans to get better tax benefits.

Supplier and dealer loans

These are short term loans provided by banks to suppliers and dealers of large companies. These loans usually have conditions which ensure that there is sufficient support from the corpo-rate in case the supplier or a dealer defaults. Thus, using the support from the corporate, the sup-pliers/dealers can borrow money from the bank at a lower rate of interest than otherwise possible. Such loans help the corporates to develop a stronger base of suppliers and dealers, which often helps them in improving their business.

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Asset Securitisation loans

Asset Securitisation loans are loans which are backed by specified future cash flows or other as-sets of the corporate. These loans help corporates to release excess cash flows from existing re-ceivables or future receivables.

ExampleCitibank provides a loan of USD 250.0 mn to Royal Dutch Shell, securitizing cash flows from future monthly sale of oil explored from its specified offshore rig. In this case, there would be a mechanism to ensure that money from monthly sale of oil explored from the specified rig for the period of the loan would be used to service payment of interest and principal of the loan to Citibank. Citibank would do a detailed assessment of oil exploration potential, study oil prices and ensure proper cash flow trapping mechanisms before disbursing the loan to Royal Dutch Shell.


1. Classification of Drawn Loans

Loans are classified and accounted for as follows:

Accrual—Loans that management has the intent and the ability to hold for the foreseeable future or until maturity/loan payoff. Accrual loans are reported on the balance sheet at the principal amount outstanding, net of charge-offs, allowance for loan losses, unearned income, and any net deferred loan fees.

Held-for-sale—Loan or loan portfolios that management intends to sell or securitize.

Trading—Loans where management has the ability and intent to trade or make markets (i.e., sell/hedge the credit risk.) Loans held for trading purposes are included in Trading Assets and are carried at fair value, with the gains and losses included in Trading Revenue provided that the cri-teria outlined in this policy are met.

2. Classification of Undrawn Loan Commitments

Loan commitments are generally classified as accrual and recorded off-balance sheet.

Differences between loan and commitment are as follows; -

Loans are reflected in the asset side of the bank’s balance sheet. Commitments are ‘off-balance sheet’ items and are reflected in the contingent asset side of the balance sheet.

The amount of the loan that is disbursed is credited to the account of the borrower. In case of a commitment, there is no disbursement or credit to a borrower’s account.

The fee charged on a loan is a function of the disbursed amount. The fee charged on commitment is a function of the amount of commitment that is not utilized.

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Credit derivatives are financial contracts that transfer credit risk from one party to another, facili-tating greater efficiency in the pricing and distribution of credit risk among market players.


The holder of a debt security issued by XYZ Corp. enters into a contract with a derivatives dealer whereby he will make periodic payments to the dealer in exchange for a lump sum payment in the event of default by XYZ Corp. during the term of the derivatives contract. As a result of such a contract, the investor has effectively transferred the risk of default by XYZ Corp. to the dealer. In market parlance, the corporate bond investor in this example is the buyer of protection, the dealer is the protection seller, and the issuer of the corporate bond is called the reference entity.

Uses of Credit Derivatives

Like any other derivative instrument, credit derivatives can be used either to take on more risk or to avoid (hedge) it. A market player who is exposed to the credit risk of a given corporation can hedge such an exposure by buying protection in the credit derivatives market. Likewise, an in-vestor may be willing to take on that credit risk by selling protection and thus enhance the ex-pected return on his portfolio.

Credit derivatives can be used to create positions that can otherwise not easily be established in the cash market. For instance, consider an investor who has a negative view on the future prospects of a given corporation. One strategy for such an investor would be to short the bonds issued by the corporation, but the corporate repo market for taking short positions in corporates is not well developed. Instead, the investor can buy protection by way of credit default swap. If the corporation defaults, the investor is able to buy the defaulted debt for its recovery value in the open market and sell it to its credit derivatives counterparty for its face value.

Banks use credit derivatives both to diversify their credit risk exposures and to free up capital from regulatory constraints. As an example, consider a bank that wants to diminish its exposure to a given client, but does not want to incur the costs of transferring loans made to that client to another bank. The bank can, without having to notify its client, buy protection against default by the client in the credit derivatives market: Even though the loans remain on the bank's books, the associated credit risk has been transferred to the bank's counterparty in the credit derivative con-tract.

The above example can also be used to illustrate banks' usage of credit derivatives to reduce their regulatory capital requirements. Under current Basle standards, for a corporate borrower, the bank is generally required to hold 8 percent of its exposure as a regulatory capital reserve. However, if its credit derivatives counterparty happens to be a bank located in an OECD country, and the bank can demonstrate that the credit risk associated with the loans has been effectively transferred to the OECD bank, then the bank's regulatory capital charge falls from 8 percent to 1.6 percent.

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Types of Credit Derivatives

Credit derivatives can be classified in two main groups: Single name instruments are those that involve protection against default by a single reference entity. Multi-name credit derivatives are contracts that are contingent on default events in a pool of reference units.


Let us visualize a bank, say Bank A which has specialized itself in lending to the office equip-ment segment. Out of experience of years, this bank has acquired a specialized knowledge of the equipment industry. There is another bank, Bank B, which is, say, specialized in the cotton textiles industry. Both these banks are specialized in their own segments, but both suffer from risks of portfolio concentration. Bank A is concentrated in the office equipment segment and bank B is focused on the textiles segment. Understandably, both the banks should diversify their portfolios to be safer.

One obvious option for both of them is: Bank A should invest in an unrelated portfolio, say tex-tiles. And Bank B should invest in a portfolio in which it has not invested still, say, office equip-ment. Doing so would involve inefficiency for both the banks: as Bank A does not know enough of the textiles segment as bank A does not know anything of the office equipment segment.

Here, credit derivatives offer an easy solution: both the banks, without transferring their portfo-lio or reducing their portfolio concentration, could buy into the risks of each other. So bank B buys a part of the risks of the portfolio that is held by Bank A, and vice versa, for a fee. Both continue to hold their portfolios, but both are now diversified. Both have diversified their risks.

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The Treasury Services department is concerned with managing the financial risks of the bank. Hence, the treasurer's job is to understand the nature of these risks, the way they interact with the business, and to minimize or to offset them. In many cases, the treasury services depart-ment also provides cash management solutions for customers of the bank. The Treasury services department of a bank performs the following functions:

Managing the cash position of the bank, managing liquidity and as-sociated risks

Forex services: provides forex services to corporates, enters in to deals with multiple counterparties to maintain a risk-managed posi-tion for the bank.

Risk management services: provides risk management products like swaps, options etc to corporates and enters in to multiple deals with various counterparties to maintain a risk-managed position for the bank.

Conducts research on various market factors, monitors interest rate and economic scenario etc

Cash Management services for corporates – managing collections and payments

Typically, the treasury has a front office desk which enters in to trades (in forex, money markets, equity, treasury securities etc) with various market participants and a middle office/back office desk which monitors positions and provides operational support.

Most large investment banks provide Treasury Services to their clients. Treasury domain in-cludes

Fixed Income : An investment that provides a return in the form of fixed periodic payments and eventual return of principle at maturity. Unlike a variable-income security where paymentschange based on some underlying measure, such as short-term interest rates, fixed-in-come securities payments are known in advance.

Money Markets : The money market is a subsection of the fixed in-come market. The difference between the money market and the fixed income market is that the money market specializes in very short-term debt securities (debt that matures in less than one year). Money market investments are also called cash investments be-cause of their short maturities. Some of the popular money market instruments include Certificates of Deposit (CD), Commercial Paper (CP), Treasury Bills (T-Bills)

Foreign Exchange : The market for buying and selling of currencies is called the Foreign Exchange market (FX ). It is a 24 hour non-stop market. Some of the major Currency traded include – The US Dol-lar (USD), The Japanese Yen (JPY), The Euro (EUR), The Great Britain Pound (GBP), The Swiss Frank (CHF). FX rates express the value of one currency in terms of another currency. They involve

o The commodity currency - the currency being priced, usually 1 unit or a fixed amount of currency.

o The terms currency - the currency used to express the price of the commodity, in vary-ing amounts of

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OTC Derivatives : Over the counter (OTC) markets are a form of Secondary markets. World over Secondary markets are classified as Listed and OTC. Listed markets typically are exchanges where a security is listed and traded. A decentralized market of securities not listed on a exchange where market participants trade over the tele-phone, facsimile or electronic network instead of a physical trading floor or electronic order matching systems. There is no central ex-change or meeting place for this market. Typically Currency instru-ments are traded OTC. A derivative contract derives its value based on the value of some basic underlying. The underlying may be any instrument like a bond, a stock or a market index, currency or inter-est rates. Some of the instruments traded OTC include

o Forward Rate Agreement (FRA) - A contract that determines the rate of interest, orcur-rency exchange rate,to be paid, or received, on an obligation beginning at a some future start date. It is also referred to as Future Rate Agreement.

o Interest Rate Swap (IRS) - A deal between banks or companies where borrowers switch floating-rate loans for fixed rate loans in another country. These can be either the same or different currencies. The motive may be the competitive advantage of one company to have access to lower fixed rates than another company. The other company may be competitively placed to have access to lower floating rates. A swap would be beneficial to both. The swap is measured by its notional principal.

FX Options : Forex Options give the holder the right to buy or sell a currency in terms of another currency at a particular rate on a partic-ular date or within a period of time. The option to buy is called as a Call Option and the option to sell is called as a Put Option.

Equity Options – These are similar to FX options the only difference is the underlying. The underlying in case of Equity Options are stocks or stock market indices. When the underlying is a stock mar-ket index the term used is Index Option and the term used to refer options on individual stocks is Stock Option

Credit Derivatives - Privately held negotiable bilateral contracts that allow users to manage their exposure to credit risk. Credit Deriva-tives are financial assets like forward contracts, swaps, and options for which the price is driven by the credit risk of economic agents (private investors or governments). For example, a bank concerned that one of its customers may not be able to repay a loan can protect itself against loss by transferring the credit risk to another party while keeping the loan on its books.

Functions of the Treasury Manager

Ensure availability of funds – An integrated treasury typically would include debt market, money market and forex transactions. Treasury manager needs to ensure that adequate funds are available to cover the settlement obligations of the said transactions.

Manage all foreign currency transactions for the bank

Manage various risks:

o Liquidity – Risk of asset and liability cash flow mismatch. A bank may not have adequate funds for the settlement of its transactions or to pay its customers because of mis-matches in the tenor of its receivables

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o Interest rate – Risk due to volatility of interest rates. A bank may have borrowed at float-ing rates of interest and lent at fixed rate of interest and the interest rates moves up

o Currency – Risk due to volatility in exchange rates. A bank may have its payment obliga-tions in a currency say USD and the rate to purchase the said currency goes up

Commodity – Risk due to volatility in commodity prices. A bank may have an obligation to deliver a commodity in the future and the price of the commodity moves up

Cash Management Services - CMS is a service provided by banks to its corporate clients for a fee to reduce the float on collections and to ease the bulk payment transactions of the client. The three elements of CMS are:

o Receivables Management –Helps the company to manage collection of its sale proceeds from remote upcountry regions

o Payables Management – Helps the company to manage its payments to its regular sup-pliers without keeping numerous bank accounts for various locations and then reconciles them periodically in a highly manual / paper-based environment

o Liquidity Management – Helps the company by ensuring direct and instant access to its bank accounts. It should not happen that a company has excess funds in one bank ac-count and it needs to pay through another bank account where there are no funds

Managing Liquidity & Interest Rate risks

o Asset Liability Management – A bank’s assets and liabilities need to necessarily match. If they don’t the bank may have liquidity problems which would endanger its solvency. The long term assets should not be financed by short term sources of funds. The bank would not be able to serve its lenders if the timings of its inflows do not match its out -flows. A bank typically uses mathematical tools like Duration, Gap Analysis to find out mismatches and take corrective actions


A bank borrows USD 100MM at 3.00% for one year The bank uses this borrowed money to lend to a highly-rated borrower for 5 years at 3.20%.

For simplicity, assume interest rates are annually compounded and all interest accumulates to the maturity of the respective obligations. The net transaction appears profitable—the bank is earning a 20 basis point spread—but it entails considerable risk.

At the end of one year, the bank will have to find new financing for the loan, which will have 4 more years before it matures. Assume interest rates are at 4.00% at the end of the first year.

The Bank willnow have to pay a higher rate of interest (4.00%) on the new financing than the fixed 3.20 it is earning on its loan. It is going to be earning 3.20% on its loan and paying 4.00% on its financing.

The problem in this simple example was caused by a maturity mismatch between assets and lia-bilities. As long as interest rates experienced only modest fluctuations, losses due to asset-liabil-ity mismatches are small or trivial. However, in a period of volatile interest rates, the mismatches would become serious.

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The treasury asset-liability management (ALM) group assesses asset-liability risk and all banks have ALM committees comprised of senior managers to address the risk. Techniques for assess-ing asset-liability risk came to include gap analysis, duration analysis and scenario analysis. Gap analysis looks at amount of assets and liabilities in various maturity buckets while Dura-tion analysis looks at weighted average maturity of cash flows to compare assets and lia-bilities. Since liquidity management is closely linked to asset-liability management, assessment and management of liquidity risk is also a function of ALM departments and ALM committees. ALM strategies often include securitization, which allows firms to directly address asset-liability risk by removing assets or liabilities from their balance sheets. This not only eliminates asset-lia-bility risk; it also frees up the balance sheet for new business.

Interest rate risk management

o Manage risks due to volatility of interest rates - Demand and supply of money go on changing from time to time making interests rates volatile. A bank may have accepted deposits at a fixed rate of interest historically. However current market rates may be lower when it wishes to lend. The bank’s portfolio value of investments in bonds and treasury also varies inversely with the interest rates. A higher interest rate diminishes the value of a bank’s portfolio and vice versa. Instruments like interest rate swaps and cur-rency swaps help to address Interest Rate risks

Causes of interest rate risk

The causes of interest rate risk might vary:

Repricing risk: The primary form of interest rate risk arises from tim-ing differences in the maturity (for fixed rate) and repricing (for float-ing rate) of bank assets, liabilities and off-balance-sheet (OBS) posi-tions. For instance, a bank that funded a long-term fixed rate loan with a short-term deposit could face a decline in both the future in-come arising from the position and its underlying value if interest rates increase.

Yield curve risk: Yield curve risk arises when unanticipated shifts of the yield curve (a plot of investment yields against maturity periods) have adverse effects on a bank's income or underlying economic value. Yield curves can shift parallel or change in steepness, posing different risks. For instance, the underlying economic value of a long position in 10-year government bonds hedged by a short position in 5-year government notes could decline sharply if the yield curve steepens, even if the position is hedged against parallel movements in the yield curve.

Basis risk: Basis risk arises from imperfect correlation in the adjust-ment of the rates earned and paid on different instruments with oth-erwise similar repricing characteristics. For example, a strategy of funding a one year loan that reprices monthly based on the one month U.S. Treasury Bill rate, with a one-year deposit that reprices monthly based on one month Libor, exposes the institution to the risk that the spread between the two index rates may change unexpect-edly.

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Optionality: An additional and increasingly important source of inter-est rate risk arises from the options embedded in many bank assets,

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liabilities and OBS portfolios. Options may be stand alone instru-ments such as exchange-traded options and over-the-counter (OTC) contracts, or they may be embedded within otherwise standard in-struments. They include various types of bonds and notes with call or put provisions, loans which give borrowers the right to prepay bal-ances, and various types of non-maturity deposit instruments which give depositors the right to withdraw funds at any time, often without any penalties. If not adequately managed, the asymmetrical payoff characteristics of instruments with optionality features can pose sig-nificant risk particularly to those who sell them, since the options held, both explicit and embedded, are generally exercised to the ad-vantage of the holder and the disadvantage of the seller.

Managing interest rate risk

Bank treasuries measure interest rate sensitivity of securities (assets or liabilities) through Dura-tion analysis. Duration is a mathematical concept which can be used to measure the sensitivity of a financial instrument’s price to changes in interest rate. On the basis of duration analysis, banks can increase/decrease holdings of long term and short term securities in response to anticipated changes in interest rate.

Banks also use derivative instruments like interest rate swaps and options to manage interest rate risks (A derivative is a generic term often used to categorize a wide variety of financial instru-ments whose value “depends on” or is “derived from” the value of an underlying asset, reference rate or index). Some of them are:

o Interest Rate Swap: An agreement to exchange net future cash flows. In its commonest form, the fixed-floating swap, one counterparty pays a fixed rate and the other pays a floating rate based on a reference rate, such as Libor. There is no exchange of principal. The interest rate payments are made on an agreed no-tional amount.

o Forward Rate Agreement (FRA): A FRA allows purchasers / sellers to fix the in-terest rate for a specified period in advance. One party pays fixed, the other an agreed variable rate. Maturities are generally out to two years and are priced off the underlying yield curve. The transaction is done in respect of an agreed nomi-nal amount and only the difference between contracted and actual rates is paid.

o Interest Rate Guarantee: An option on a forward rate agreement (FRA), also known as a FRAtion. Purchasers have the right, but not the obligation, to pur-chase a FRA at a predetermined strike. Caps and Floors are strips of interest rate guarantees.

o Swaption: An option to enter an interest rate swap. A payer swaption gives the purchaser the right to pay fixed (receive floating), a receiver swaption gives the purchaser the right to receive fixed (pay floating).

Forex Management – Similar to interest rates, the forex rates of countries who have not pegged their currencies vary from time to time. This exposes its market participants to risk of adverse move-ments of exchange rates. FX Forwards and Forex Options provide a means of reducing exchange rate risks by entering into contracts at fixed rates thereby making the outcome predictable

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Foreign exchange is essentially about exchanging one currency for another. Forex rates between two currencies at any point of time are influenced by a variety of factors like state of the economy, interest rates & inflation rate, exchange rate systems (fixed/floating), temporary demand-supply mismatches, foreign trade position etc.

Foreign exchange exposures for a financial entity arise from many different activities. A company which borrows money in a foreign currency is at risk when the local currency depreciates vis-à-vis the foreign currency. An exporter who sells its product in foreign currency has the risk that if the value of that foreign currency falls then the revenues in the exporter'shome currency will be lower. An importer who buys goods priced in foreign currency has the risk that the foreign cur-rency will appreciate thereby making the cost in local currency greater than expected. Generally the aim of foreign exchange risk management is to stabilise the cash flows and reduce uncer-tainty from financial forecasts.

Since a bank is usually a counter party to the above transactions, it faces similar forex Risk when the reverse happens.

Basics of forex

Currencies are quoted in one of the two ways:

Direct Quotation (1 USD = INR 45.26) &

Indirect Quotation (INR 100 = USD 2.21).

‘Direct’ or ‘Indirect’ are always vis-à-vis the US dollar perceptive. In practice, all currencies except the British Pound are quoted in the direct quotation method. Since rates for all currencies are quoted vis-à-vis the US dollar, cross currency rates (example: INR/Euro) would be obtained by combining the two primary currency quotes vis-à-vis the US dollar.

Also, quotes usually have two parts: the bid rate (rate at which the bank will purchase US dollars against home currency in case of direct quotes) and the ask rate (rate at which the bank will sell US dollars against home currency in case of direct quotes). The bid rate will always be lesser than the ask rate to cover for operational charges and profit margins of the banks. Examples are:

INR/USD quote: 45.26/.36 (here, 0.01 is the smallest count, referred to as one ‘pip’)

EUR/USD quote: 1.2458/.2461 (here, 0.0001 is the smallest count, referred to as one ‘pip’)

While the derived cross currency rate would be:

INR/Euro quote: (45.26*1.2461)/ (45.36*1.2458) = 56.40/.51

Foreign currency deals in a particular currency necessary have to be settled in the home nation of the currency. Hence, banks taking part in international transactions need to maintain accounts in various countries to enable transacting in those currencies. These accounts are of multiple types:

Nostro (Our/my account with you): Current account maintained by one bank with another bank abroad in the latter’s home currency

Vostro (Their account with me/us): Current account maintained in the home currency by one bank in the name of another bank based abroad

Typically, banks have vostro/nostro accounts with multiple foreign banks.

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Spot and Forward Foreign Exchange Contracts

The most basics tools of forex risk management are 'spot' and 'forward' contracts. These are con-tracts between end users and financial institutions that specify the terms of an exchange of two currencies. In any forex contract there are a number of variables that need to be agreed upon and they are:

The currencies to be bought and sold - in every contract there are two currencies the one that is bought and the one that is sold

The amount of currency to be bought or sold

The date at which the contract matures

The rate at which the exchange of currencies will occur

The exchange rates advertised either in the newspapers (and that mentioned above) or on the various information services assume a deal with a maturity of two business days ahead - a deal done on this basis is called a spot deal. In a spot transaction the currency that is bought will be receivable in two days whilst the currency that is sold will be payable in two days. This applies to all major currencies with the exception of the Canadian Dollar.

Most market participants want to exchange the currencies at a time other than two days in ad-vance but would like to know the rate of exchange now. This is done through a forward contract to exchange the currencies at a specified exchange rate at a specified date. In determining the rate of exchange in six months time there are two components:

the current spot rate

the forward rate adjustment

The spot rate is simply the current market rate as determined by supply and demand. The for-ward rate adjustment is a slightly more complicated calculation that involves the interest rates of the currencies involved.

Forward rate (Local currency/USD) = Spot rate *(1+ interest rate in US) / (1+ local interest rate), with interest rates adjusted for the period of the forward rate. The concept behind this equa-tion is that if you defer the value date of a spot transaction each party will have the funds that they would have paid to invest. The difference between a forex spot rate and the forward rate for a particular tenure is called the forward premium for that tenure. Currencies can have forward pre-miums or forward discounts vis-à-vis the US dollar.

Forex risk can also be covered through forex future contracts. Futures are exactly similar to for-wards, except for the fact that these deals are brokered through an exchange, non-customizable (only standard deals available) and hence, not prone to counter-party risk.

Bifurcation of All major markets (Equities, Bond, FX, Derivatives)

Small and Larger Orders – Equity markets are characterized by smaller orders as compared to the markets for other financial instru-ments because of more retail participation

Liquidity – Exchange traded instruments are more liquid

Investor Profile – Equity markets have a more retail investor profile as compared to markets for other financial instruments

Routing – Deals in the Equity markets are routed to multiple desti-nations where as deals in forex as well as debt markets are “matched” internally

Public v/s Private - Markets for equities are listed whereas certain Derivatives are OTC

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Treasury applications segments & vendors

Treasury Management Systems – Inter-bank

Cross-Asset Trading and Risk

Sungard / Front Arena - FRONT ARENA is the definitive integrated solution for sales, trading and risk management, operations and dis-tribution across multiple asset classes. Its rich functionality enables traders to make critical decisions with assurance. It is flexible across a range of business areas gives which gives traders a competitive edge in trading activities.

Summit - Summit is a core solution for treasury management for both financial and corporate institutions. Summit’s trading applica-tions interact with operations and risk management platforms to pro-vide a straight-through-processing solution. This allows front to back management of all products within four primary business areas viz Treasury, Fixed Income, Derivatives and Commercial lending

Calypso - Calypso Technologies the world’s leading software provider of credit derivatives, crossasset trading, risk management, and processing. It offers a front-to-back office system that allows traders flexibility to plug in their own products.

Wall Street Systems - Wall Street Systems delivers single-server, enterprise-wide solutions to the world's leading financial institutions and corporations The Wall Street System financial trading and trea-sury engine provides a multi-entity, multi-currency, multi-asset class environment which supports all front, middle and back office opera-tions.

Treasury Sales – Bank to Customer

Single-bank platform

Cognotec – Cognotec is the world's leading provider of automated trading solutions to financial enterprises across the globe. They pro-vide forex dealing solutions. They have partnered with world-leading technology providers, multi-bank platforms and industry organiza-tions.

Integral - Integral is at the forefront of the eFX market in developing new, highly innovative products. Integral is the provider of integrated electronic trading systems, offering intuitive and innovative products that automate and streamline the entire trading cycle.

Multi-bank platform

Reuters RET - Reuters Electronic Trading provides a comprehen-sive FX and money markets trading solution for banks.. It includes Automated Dealing, an internet based FX and money market auto-mated dealing capability, to enable the Bank's dealing room to price, execute, confirm and manage FX and money market trading.

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Cash Management Service (CMS) is a service provided by banks to its clients for a fee to re-duce the float on collections and to ease the bulk payment transactions of the client. Large Cor-porations like GM or Ford need to manage cash well since they have:

Payments to multiple parties at various locations – Payments need to be made to suppliers across the country. Typically these have sup-pliers across the country to reduce dependence on one or a few sup-pliers

Collections from multiple parties at various locations - How does a company collect its sale proceeds from remote upcountry regions?

Multiple banking accounts at various locations

o Ensure local deficits and surpluses are managed – A corporate may be paying its em-ployees salaries out of one bank account whereas it may be banking its receivables in another bank account another location leading to surpluses and deficits in their bank ac-counts

o Ensure net surplus is invested properly – If a corporate is unable to identify surpluses, a corporate may risk keeping money idle leading to loss of interest income if it does not prudently invest its net surpluses leading to

o Reduce operational costs associated with payments & collections – A CMS would help optimize wasted operational cost on payments and collections

Cash Management solutions help corporations:

o Devise an effective account & investment strategy to manage surpluses and deficits – Pooling, Netting, Zero-balance structures

o Automate collections and payments process flows

o Outsource collections and payments administration & reconciliation


Consider a consumer goods company in Mid-west US, with dealerships spread through 12 states. The company has a manufacturing facility in Michigan and 4 depots, one each in Ohio, Michigan, Illinois and Texas. The company transports goods to the 4 depots which serves the respective local dealers and in some cases dealers in neighboring states. All the depots are treated as independent cost centers, with sales from respective regions and salaries and general expenses for these regions marked to the depot concerned. Collections from dealers in various locations are managed by local sales teams, one team for each state. The company wants to:

Ensure daily monitoring of collections from various states Sweep all local collections daily to a central bank account at Michigan Ensure that local accounts do not remain in debit when the central account is in credit. Provide facility for temporary intra-day overdraft for the local accounts Ensure that surplus money in the central account is invested in an optimal fashion while al-

lowing sufficient liquidity All payments from local accounts above $10,000 require an approval from the CFO sitting in


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This is a typical case where the company needs the services of a bank to manage its cash collec-tions and payments. The company needs both cash management facilities and MIS of collections and payments that can allow it to track revenue and expenses in the manner required.

Companies rarely fail because they are insolvent. They do fail because they are illiquid. Compa-nies must focus on precise working capital management as a critical component of treasury strat-egy. Companies require:

rich information, to parallel the company’s cash flow cycle

global cash concentration, through pooling mechanisms

automated internal funding mechanisms for deficit positions

Investment options to match individual profiles for liquidity, risk and return.

Some of the offerings in Cash Management Services are -

Payment / Disbursement Offerings

Payment service for corporations/retail customers

o Banks process payments on behalf of corporations – CMS provides its customers the payment processing services which help corporations to reduce administrative hassles and costs in doing so.

o Instruments - Checks/demand drafts/ Electronic Fund Transfer (EFT) help in processing payments

Payment Initiation

o Manual instruction – Banks can act on manual instructions given by the corporations to their bankers for processing payments. They typically take the form of cheques or drafts

o Floppy/Electronic media instructions – A list of beneficiaries and the corresponding amounts are given in either a floppy or an other electronic media to their banks in the re-quired formats which are used by the banks for processing payments

o Electronic banking applications – Electronic applications like ECS / EFT or individual bank specific software packages can be made use of by corporations to effect transfers

Bulk payments

CMS is very beneficial for processing repetitive / bulk payments in the nature listed below. Economies of scale and reduction of administrative and related costs can be gained by cor-porations

o Payroll processing

o Dividend warrants

o Redemptions

Collections Services

Collect funds around the globe – CMS provides accurate and timely collection of receivables worldwide

Funds are credited to the cash management account

o Local collections – Refer to collections from suppliers / debtors who issue local cheques

o Outstation collections - Refer to collections from customers not in the base location of the corporation

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Banks have responded to the call for evolved cash management concepts. Accelerating accounts receivable and streamlining accounts payable via a single banking system interface provide the stepping stone to achieve optimal cash flow management. Some banks also provide aligned cash management with liquidity and investment offerings. They do so by:

developing optimal account structures

applying cash concentration techniques like pooling and sweeping

providing investment vehicles to maximize cash flows

implementing foreign exchange and interest rate exposure netting systems

Establishing regional treasury and shared service centers.

The final objective of most of these cash management solutions is to effectively outsource the corporate’s receivables and payables process and ensure the best possible liquidity and short term investment management strategy. Moreover, increasingly, cash management (both pay-ments and collections) are moving over to a web-based environment where the corporate can manage his receivables, payables and liquidity position online. In many cases, there is almost-complete integration between the bank and the company’s supply chain/ERP system which man-ages collection and payments data internally. Some of the common methods used for cash man-agement are described below.

Cheque Collections – Lock Box service

There are possibilities for optimizing and streamlining a company’s incoming payment flows. The most common collection mechanism is a Cheques lock box service – a collecting service which enables companies to collect and settle cheques locally (In a typical case, each of the corporate’s debtors would send cheques along with accepted invoices to a designated post box, hence the lock box name). Banks undertake to collect cheques at various pre-defined locations on behalf of the customer, send them for clearing and credit the amount s to a specified customer account. Once the cheques are collected by the bank through person, courier or delivered by the company representative:

the cheques are sorted and batched

post dated cheques are kept for processing on the value date

the image of the cheques and the remittance advices are captured and sent to the corporate

cheques are sent for clearing, if required

realized cheques are tallied and amounts credited to the corporate’s bank account

the information on cheques collected is transmitted to the corporate for electronic reconciliation

In enhanced versions of this facility, the bank manage the receivable books of the corporate - managing collections, monitoring receivables ageing and providing reconciled collection reports which can be directly uploaded to corporate information/supply chain systems.

Zero balance structure - Pooling

Pooling allows a company or several companies belonging to the same group profit from efficient liquidity management, centralized treasury and credit-line management and optimization of inter-est results. Banks offer both domestic and cross border zero balancing whereby all value bal-

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ances of a set of 'participating' accounts are centralized at the end of each day in one central ac-count. Thus the participating accounts will not bear any credit or debit interest, and all balances are concentrated in the central account enabling optimal management of your cash position.


Netting is the fundamental method for centralising and offsetting intra company and third party payments. Netting not only significantly reduces payment flows and costs, but also provides in-valuable management information. Banks offer both domestic and cross-border netting solutions.

Clearing services

Banks offer clearing services to other banks. In such cases, a bank with strong local branch cov-erage offers to participate in clearing arrangements on behalf of other banks with no physical presence at these locations. Also clubbed under correspondent banking services, this facility pri-marily helps use the branch networks of various banks on a complimentary basis.

New Act - Check 21

The Check Clearing for the 21st Century Act (Check 21) was signed into law on October 28, 2003, and became effective on October 28, 2004. The law facilitates check truncation by cre-ating a new negotiable instrument called a substitute check, which permits banks to truncate original checks, to process check information electronically, and to deliver substitute checks to banks that want to continue receiving paper checks. A substitute check is the legal equiva-lent of the original check and includes all the information contained on the original check. The law does not require banks to accept checks in electronic form nor does it require banks to use the new authority granted by the Act to create substitute checks.

o Electronic transmission of cheques by Check imaging - Banks find that exchanging elec-tronic images of checks with other banks is faster and more efficient than physically transporting paper checks. To address this need, Check21 allows a bank to create and send a substitute check that is made from an electronic image of the original check.

o Faster / efficient cheque realization – Since the electronic image of the cheque can be quickly transmitted electronically, time required for transporting the physical paper cheques is greatly reduced thereby effecting faster cheque realizations


Asset Securitisation

Financial institutions and banks need to raise fresh capital to fund continuous asset growth and portfolio management. This has become a major challenge for many financial institutions and banks due to tough capital market conditions and other market related factors. Asset securitisa-tion can offer an alternative cost efficient financing tool, enabling them to better manage liquidity and funding requirements.

Asset securitisation transactions have one basic concept: the identification and isolation of a sep-arable pool of assets that generate revenue streams independently from the originating entity. The securities issued on these assets are then sold to investors who base their returns exclu-sively on the underlying assets’ performance. The structure is illustrated below:

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All these entities need not be present in every transaction. The number of entities depends on the complexity of the transaction. An example would help understand the concept better.


Bank of America (Originator) has 5000 home loans totaling more than $600 million. The individual loans are of various credit profiles and various repayment periods. Bank of America is con-strained by lack of funds and wishes to sell off its loans to raise money. Thus, it decides to ‘sell’ about 2000 home loans totaling $200 million. The steps followed are shown below:

Bank of America conducts an internal study of the portfolio and ascertains that the average maturity of the pool of loans is about 12 years and the average credit rating would be AA-. It realizes that historically 10% of the total home loan owners default. So it would only realize $180 million instead of $200 million.

Bank of America wants to enhance the rating so that it can ‘sell’ the loans at a better price. It decides to provide a cash security of $10 million (Credit enhancement) in the scenario of any repayment default by home loan borrowers.

Bank of America appoints Credit rating agency X which analyses the pool of loans, and taking into account the cash security provided rates it AA+.

Bank of America ‘sells’ the pool of housing loans amounting to $200 million to a independent firm, Plexus SPV Ltd.

Backed by these home loan’s future cash flows, Plexus SPV Ltd. issues debt certificates for $200 million to investors. Plexus pays back the investors the money from the repayments done by the home loan borrowers.

Plexus SPV Ltd. pays $198 million to Bank of America after deducting service charges to cover operational costs.

From now on, all EMI repayments on these home loans made by retail investors would flow through Plexus SPV Ltd and then reaches the investors.

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The above example captures the gist of any securitisation transaction, but there are a lot of struc-turing issues and legal and regulatory challenges involved in any such transaction.

Fannie Mae and Ginnie Mae are examples of institutions specializing in securitisation transac-tions of mortgage loans for US banks. They help US banks in having enough fresh funds for home loan disbursements.

Real Time Gross Settlement (RTGS)

The current payment system involves settlement of payments on a ‘settlement day’ and interest is invariably computed to accrue on a daily basis. Even in the wholesale markets for foreign ex-change and money markets contracts, ‘spot’ transactions mean two-business days. Settlement for clearing cheques presented to the clearing houses takes place on a netting basis at a particu-lar time either same day or on the next day. This system gives rise to risks such as credit risk, liq-uidity risk, legal risk, operational risk and systemic risk.

RTGS is a system provides online settlement of payments between financial institutions. In this system payment instructions between banks are processed and settled individually and continu-ously throughout the day. This is in contrast to net settlements where payment instructions are processed throughout the day but inter-bank settlement takes place only afterwards typically at the end of the day. Participant banks will have to maintain a dedicated RTGS settlement account with the central bank for outward and inward RTGS payments.

RTGS systems do not create credit risk for the receiving participant because they settle each payment individually, as soon as it is accepted by the system for settlement. RTGS system can require relatively large amounts of intraday liquidity because participants need sufficient liquidity to cover their outgoing payments.

Continuous Linked Settlement (CLS)

The average daily turnover in global forex transactions stand at almost USD 2 trillion, with partici-pants in the market spread across various geographies and time zones. However, the difference in time zones and hence lack of synchronization of transactions has resulted in considerable amount of systematic risk. Typically, one leg of a forex trade is affected at one point of time and there would be a delay before the other leg is executed because of time-zone differences. In such a situation, there is a heightened risk of one party defaulting.

CLS eliminates this ‘temporal’ settlement risk, making same-day settlement both possible and fi-nal. This is made possible by leveraging on the fact that there are significant overlaps between the main time zones. CLS provides a specific time window in which various settlement time zones can interact and pass settlement messages. The CLS system consists of the following entities:

CLS Bank: The CLS bank is the central node for the CLS system. CLS Bank is owned by nearly 70 of the world’s largest financial groups throughout the US, Europe and Asia Pacific, who are respon-sible for more than half the value transferred in the world's FX mar-ket.

Settlement Members: They are shareholders of the CLS bank, who can each submit settlement instructions directly to CLS Bank and re-ceive information on the status of their instructions. Each Settlement Member has a multi-currency account with CLS Bank, with the ability to move funds. Settlement Members have direct access and input deals on their own behalf and on behalf of their customers. They can

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provide a branded CLS service to their third-party customers as part of their agreement with CLS Bank.

User Members: User Members can submit settlement instructions for themselves and their customers. However, User Members do not have an account with CLS Bank. Instead they are sponsored by a Settlement Member who acts on their behalf. Each instruction sub-mitted by a user member must be authorized by a designated Settle-ment Member. The instruction is then eligible for settlement through the Settlement Member's account.

Third parties: Third parties are customers of settlement and user members and have no direct access to CLS. Settlement or user members must handle all instructions and financial flows, which are consolidated in CLS.

Nostro agents: These agents receive payment instructions from Settlement Members and provide time-sensitive fund transfers to Settlement Members' accounts at CLS Bank. They receive funds from CLS Bank, User Members, third parties and others for credit to the Settlement Member account.

The benefits of the CLS system are many:

Traders can expand their FX business with counterparty banks with-out increasing limits.

Treasury managers have more certainty about intraday and end-of-day cash positions.

Global settlement can rationalize nostro accounts and leverage multi-currency accounts.

The volume and overall value of payments is reduced, as are cash-clearing costs.

Costly errors are minimized and any problems can be resolved fast.

Automated Clearing House facilities (ACH)

ACH transactions are electronic clearing transactions in which information about debits and cred-its are passed across the clearing system through electronic data files rather than physical instru-ments like cheques, drafts etc. ACH electronic transactions are distinguished from wire transfers in that they are high volume, regularly scheduled, usually between the same parties, and are initi-ated via specifically formatted electronic files. Such transactions must usually be initiated one to two days prior to the settlement date, since they are batch processed and not for immediate pay-ment. The most common ACH payment applications are:

Direct deposit of payroll, where the bank debits the corporate ac-count and credits employee accounts on the basis of a electronic file transmitted/provided by the corporate

Corporate Disbursement Service, where the bank debits a client's account to initiate payments to vendors on their behalf

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Corporate Collection Service, where the bank enables it’s clients to collect payments and remittance data from vendors or trading part-ners.

Collection of consumer payments over the telephone, through the In-ternet or via check-to-ACH conversion.

ACH Accounts Receivable Check Conversion enables converting checks collected at a lockbox or remittance-processing center to ACH electronic debits, speeding payment collections and improving funds availability.

These services allow the customer to increase transaction speed and improve accuracy and ease of reconciliation by electronic means and avoidance of physical instruments and clearing delays. ACH has been an area of very strong growth, with over 8.5 billion transactions being effected through this route in 2002. However, several security issues remain to be resolved in this area.

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The main objective of trade finance is to facilitate transactions. There are many financing options available to facilitate international trade such as pre-shipment finance to produce or purchase a product, and post-shipment finance of the receivables.


Banks provide Pre-shipment finance - working capital for purchase of raw materials, processing and packaging of the export commodities.


Post-shipment financing assists exporters to bridge their liquidity needs where exports are made under deferred payment basis. A typical example of post-shipment financing is bills discounting.

Bills discounting facility serves to provide liquidity to an exporter by advancing him/her a portion of the face value of a trade bill drawn by the exporter, accepted by the buyer and endorsed to the Bank.

In competitive supply situations, favorable terms of payment often ensure that the order is won.An exporter usually wants to get paid as quickly as possible and an importer will want to pay as late as possible – preferably after they have sold the goods. Trade finance is often required to bridge these two disparate objectives.


Costs: The cost of different financing methods can vary, both in terms of interest rates and fees. These costs will impact the viability of a transaction

Time Frame: Depending on the need, short, medium and long-term finance facilities may be available. The different possibilities should be explored with the finance provider prior to concluding a transac-tion. Long-term requirements should also be considered to ensure fees are not being paid out on a revolving facility that could be saved by using a different financing structure

Risk Factors: The nature of the product or service, the buyers’ credit rating and country/political risks can all affect the security of a trading transaction. In some cases it will be necessary to obtain ex-port insurance or a confirmed letter of credit. Increased risks will nor-


Pre-shipment finance is liquidated only through realizations of export bills or amounts received through export incentives. Pre shipment finance should not normally remain outstanding be-yond the original stipulated shipment date. In case it remains outstanding, can the non-ad-justed amount be then transferred as post shipment finance?

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mally correspond to increased cost in a transaction and will normally make the funding of a particular transaction, harder to obtain

Government Guarantee Programs: These can sometimes be ob-tained where there is some question over the exporter’s ability to perform or where increased credit is needed. If obtained, these may enable a lender to provide more finance than their usual underwriting limits would permit.

Exporters’ Funds: If the exporter has sufficient resources, he/she may be able to extend credit without the need for third party financ-ing. However, an established trade finance provider, offers other benefits like expert credit verification and risk assessment as well as an international network of offices and staff to ensure that the trans-action is completed safely and satisfactorily


A bill of lading or BOL is:

A contract between a carrier and a shipper for the transportation of goods.

A receipt issued by a carrier to a shipper for goods received for transportation.

Evidence of title to the goods in case of a dispute.

The BOL grants the carrier the right to sub-contract its obligations on any terms and would bind a shipper even if it meant that the shipper's goods could be detained and sold by the sub-contrac-tor.


Insuring payment starts long before a contract is signed. The seller, or his representative, per-forms ‘due diligence’ or a reasonable assessment of the risks posed by the potential buyer. The sources of information include:

Chambers of commerce, Business Bureaus or their equivalents

Credit rating services such as TRW and Dun & Bradstreet which have international affiliates

Trade associations and trade promotion organizations

Freight forwarders, brokers, and banks

Direct references from the buyer


Once acceptable risks have been determined then the most appropriate payment method can be selected. The most common payment methods are described below:

Cash in advance

Letter of credit

Documentary collection

Open account or credit

Counter-trade or Barter

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Cash in advance is risk-free except for potential non-delivery of the goods by the seller. It is usu-ally a wire transfer or a check. Although an international wire transfer is more expensive, it is of-ten preferred because it is speedy and does not bear the danger of the check not being honored. The check can be at a disadvantage if the exchange rate has changed significantly by the time it arrives, clears and is credited. On the other hand, the check can make it easier to shop for a bet-ter exchange rate between different financial institutions.

For wire transfers the seller must provide clear routing instructions in writing to the buyer or the buyer’s agent. These include:

Full name, address, telephone, and telex of the seller’s bank

Bank’s SWIFT and/or ABA numbers

Seller’s full name, address, telephone, type of bank account, and ac-count number.


The letter of credit (LC) allows the buyer and Seller to contract a trusted intermediary (a bank) that will guarantee full payment to the seller provided that he has shipped the goods and com-plied with the terms of the agreement.


The LC serves to evenly distribute risk between buyer and seller. The seller is assured of payment when the conditions of the LC are met and the buyer is reasonably assured of receiving the goods or-dered. This is a common form of payment, especially when the con-tracting parties are unfamiliar with each other.

Since banks deal with documents and not with products, they must pay an LC if the documents are presented by the seller in full compli-ance with the terms, even if the buyer never receives the goods. Goods lost during shipment or embargoed are some examples. Iraq for example, never received goods that were shipped before its em-bargo but the LCs had to be paid anyway.

LCs are typically irrevocable, which means that once the LC is estab-lished it cannot be changed without the consent of both parties. Therefore the seller, especially when inexperienced, ought to present the agreement for an LC to an experienced bank or freight forwarder so that they can verify if the LC is legitimate and if all the terms can be reasonably met. A trusted bank, other than the issuing or buyer’s bank can guarantee the authenticity of the document for a fee.


If there are discrepancies in the timing, documents or other require-ments of the LC the buyer can reject the shipment. A rejected ship-ment means that the seller must quickly find a new buyer, usually at a lower price, or pay for the shipment to be returned or disposed.

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One of the most costly forms of payment guarantee – Usual cost is 0.5% to 1%. Sometimes, the costs can go up to 5 percent of the total value.

LCs take time to draw up and usually tie up the buyer’s working capi-tal or credit line from the date it is accepted until final payment, rejec-tion for noncompliance, expiration or cancellation (requiring the ap-proval of both parties)

The terms of an LC are very specific and binding. Statistics show that approximately 50% of submissions for LC payment are rejected for failure to comply with terms. For example, if one of the required documents is incomplete or delivered late, then payment will be with-held even if all other conditions are fulfilled and the shipment re-ceived in perfect order. The buyer can sometimes approve the re-lease of payment if a condition is not fulfilled; but changing terms af-ter the fact is costly, time consuming and sometimes impossible.

The mechanism

Usually, four parties are involved in any transaction using an LC:

1. Buyer or Applicant

The buyer applies to his bank for the issuance of an LC. If the buyer does not have a credit arrangement with this issuing bank then he must pay in cash or other negotiable securities.

2. Issuing bank

The issuing or applicant’s bank issues the LC in favor of the beneficiary (Seller) and routes the document to the beneficiary’s bank. The applicant’s bank later verifies that all the terms, conditions, and documents comply with the LC, and pays the seller through his bank.

3. Beneficiary’s bank

The seller’s or beneficiary’s bank verifies that the LC is authentic and notifies the beneficiary. It, or another trusted bank, can act as an advising bank. The advising bank is used as a trusted bridge between the applicant’s bank and the beneficiary’s bank when they do not have an active relationship. It also forwards the beneficiary’s proof of performance and documentation back to the issuing bank. However, the advising bank has no liability for payment of the LC. The beneficiary, or his bank, can ask an advising bank to confirm the LC. The confirming bank charges a fee to ensure that the beneficiary is paid when he is in compliance with the terms and conditions of the LC.

4. Beneficiary or Seller

The beneficiary must ensure that the order is prepared according to specifications and shipped on time. He must also gather and present the full set of accurate documents, as required by the LC, to the bank.

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Letter Of Credit Diagram §§

1. Buyer and seller agree on a commercial transaction.

2. Buyer applies for a letter of credit.

3. Issuing bank issues the letter of credit (LC)

4. Advising bank advises seller than an LC has been opened in his or her favor. Seller sends merchandise and documents to the freight forwarder.

5. Seller sends copies of documents to the buyer.

6. Freight forwarder sends merchandise to the buyer’s agent (customs broker).

7. Freight forwarder sends documents to the advising bank.

8. Issuing bank arranges for advising bank to make payment.

9. Advising bank makes payment available to the seller.

10. Advising bank sends documents to the issuing bank.

11. Buyer pays or takes loan from the issuing bank.

12. Issuing bank sends bill of lading and other documents to the customs broker.

13. Customs broker forwards merchandise to the buyer.

§§ Letter of Credit Diagram and the 14 steps have been reproduced from

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Letters of credit can be flexible. Some LC variations include: Revolving, Negotiable, Straight, Red Clause, Transferable, and Restricted. But perhaps the safest type of letter of credit from the seller’s point of view, is the Standby letter of credit.


An Asian Buyer from a Swedish Exporting company stated when he convinced the Ex-porter to sell to them on open account terms. The Asian Buyer obtained 60 days credit, which was to be calculated from the date of the invoice. The value of the order was USD 100, 000 and the goods were dispatched and invoiced by the Swedish Exporter on the 15th July 2003.

The payment from Asia was due on the 14th Sept 2003. The payment eventually arrived on the 21st Nov 2003, over two months late. The delay in payment cost the Exporter USD 1700 as it resulted in his account being overdrawn by this amount for 68 days at 9% per annum.

What if confirmed Letter of Credit had been required?

If Swedish Exporter had insisted on receiving a confirmed Letter of Credit through Allied Swedish Banks plc. The following costs (approximations) would have applied:

Confirmation Fee USD $250

Acceptance Commission (@ 1.5% pa for 60 days) USD $250

Negotiation / Payment Fee USD $150

Out of Pocket Expenses (estimate) USD $60

Total Letter of Credit Cost USD $710

Interest Cost as a result of late payment USD ($1,700)

Benefit of using Letter of Credit USD $990

Advantages of Letter of Credit

A Guarantee of payment on the due date from Allied Swedish Banks. (Provided the terms and conditions of the Letter of Credit were com-plied with).

A definitive date for the receipt of funds, particularly important for de-vising proper currency hedging strategies.

The opportunity to receive the payment in advance of the due date through non-recourse discounting of the receivable.

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Also note that the costs incurred in chasing the debt from the Asian buyer has not been ac-counted for the Irish Exporter. In addition if the Exporter had sold his foreign currency receivable on a forward basis to his bank for the original due date, they may have incurred a further cost in canceling or rearranging the forward contract. Letters of Credit provide real and tangible benefits to companies. In this case the Swedish exporter only lost US$ 1700. Of course if the Asian buyer had not paid at all they would have lost the whole USD 100,000

The standby LC is like a bank guarantee. It is not used as the primary payment method but as a fail safe method or guarantee for long-term projects. This LC promises payment only if the buyer fails to make an arranged payment or fail to meet pre-determined terms and conditions. Should the buyer default, the seller must then apply to the bank for payment - a relatively simple process without complicated documentation. Since the standby LC can remain valid for years (Evergreen Clause) it eliminates the cost of separate LCs for each transaction with a regular client.

Back to Back LC allows a seller to use the LC received from his buyer as collateral with the bank to open his own LC to buy inputs necessary to fill his buyer’s order.


The seller sends a draft for payment with the related shipping documents through bank channels to the buyer’s bank. The bank releases the documents to the buyer upon receipt of payment or promise of payment. The banks involved in facilitating this collection process have no responsibil-ity to pay the seller should the buyer default unless the draft bears the aval (ad valutem) of the buyer’s bank. It is generally safer for exporters to require that bills of lading be “made out to ship-per’s order and endorsed in blank” to allow them and the banks more flexible control of the mer-chandise.

Documentary collection carries the risk that the buyer will not or cannot pay for the goods upon receipt of the draft and documents. If this occurs it is the burden of the seller to locate a new buyer or pay for return shipment. Documentary collections are viable only for ocean shipments, as the bill of lading for ocean freight is a valid title to the goods and is a negotiable document whereas the comparable airway bill is not negotiable as an ownership title.


A draft (sometimes called a bill of exchange) is a written order by one party directing a second party to pay a third party. Drafts are negotiable instruments that facilitate international payments through respected intermediaries such as banks but do not involve the intermediaries in guaran-teeing performance. Such drafts offer more flexibility than LCs and are transferable from one party to another. There are two basic types of drafts: sight drafts and time drafts.

Sight Draft

After making the shipment the seller sends a sight draft, through his bank to the buyer’s bank, ac-companied by agreed documentation such as the original bill of lading, invoice, certificate of ori-gin, phyto-sanitary certificate, etc. The buyer is then expected to pay the draft when he sees it and thereby receive the documentation that gives him ownership title to the goods that were shipped. There are no guarantees made about the goods other than the information about quanti-ties, date of shipment, etc. which appears in the documentation. The buyer can refuse to accept the draft thereby leaving the seller in the unpleasant position of having shipped goods to a desti-nation without a buyer. There is no recourse with the banks since their responsibility ends with the exchange of money for documents.

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Time Drafts/Bankers' acceptances

Bankers' acceptances are negotiable instruments (time drafts) drawn to finance the export, im-port, domestic shipment or storage of goods. It demands payment after a specified time or on a certain date after the buyer accepts the draft and receives the goods. A bankers' acceptance is "accepted" when a bank writes on the draft its agreement to pay it at maturity. A bank may accept the draft for either the drawer or the holder.

An ordinary acceptance is a draft or bill of exchange order to pay a specified amount of money at a specified time. A draft may be drawn on individuals, businesses or financial institutions.

An acceptance doesn't reduce a bank's lending capacity. The bank can raise funds by selling the acceptance. Nevertheless, the acceptance is an outstanding liability of the bank and is subject to the reserve requirement unless it is of a type eligible for discount by the Federal Reserve Bank.


In practice, international payment methods tend to be quite flexible and varied. Frequently, trad-ing partners will use a combination of payment methods. For example: the seller may require that 50% payment be made in advance using a wire transfer and that the remaining 50% be made by documentary collection and a sight draft.


Open account means that payment is left open to an agreed-upon future date. It is one of the most common methods of payment in international trade and many large companies will only buy on open account. Payment is usually made by wire transfer or check. This can be a very risky method for the seller, unless he has a long and favorable relationship with the buyer or the buyer has an excellent credit rating. Still, there are no guarantees and collecting delinquent payments is difficult and costly in foreign countries especially considering that this method utilizes few legally binding documents. Contracts, invoices, and shipping documents will only be useful in securing payment from a recalcitrant buyer when his country’s legal system recognizes them and allows for reasonable settlement of such disputes.




Banker’s Acceptances sell at a discount from the face value:

Face value of Bankers Acceptance $1,000,000

Minus 2% per annum commission for one year -$20,000

Amount received by exporter in one year $980,000

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The consignment method requires that the seller ship the goods to the buyer, broker or distributor but not receive payment until the goods are sold or transferred to another buyer. Sometimes even the price is not pre-fixed and while the seller can verify market prices for the sale date or hire an inspector to verify the standard and condition of the product, he ultimately has very little recourse.

Credit Card

Some banks offer buyers special lines of credit that are accessible via credit card to facilitate even substantial purchases. It is convenient for both parties - but the seller should confirm the bank charges and also bear in mind that the laws that govern domestic credit card transactions differ from those govern international use.

Counter-trade and Barter

Counter-trade or barter is most often used when the buyer lacks access to convertible currency or finds that rates are unfavorable or can exchange for products or services desirable to the seller. Counter-trade indicates that the buyer will compensate the seller in a manner other than transfer or money or products.


Factoring is a discounting method without recourse. It is an outright sale of export accounts re-ceivable to a third party, (the factor) who assumes the credit risk. The factor may be a factoring house or a department of a bank. The advantage to the exporter is the removal of contingent lia-bilities from its balance sheet, improved cash flow and elimination of bad debt risk.

Factoring is for short-term receivables (under 90 days) and is more related to receivables against commodity sales.


The exporter sells accounts receivables to a forfaiter on a “non-recourse discount” basis, and the exporter effectively passes all risks associated with the foreign debt to the forfaiter. The for-faiter may be a forfaiting house or a department of a bank. The benefits are same as factoring - maximize cash flow and eliminate the payment risk. It is a flexible finance tool that can be used in short, medium and long-term contracts.

Forfaiting can be for receivables against which payments are due over a longer term, over 90 days and even up to 5 years.

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The purpose of foreign credit insurance is to insure repayment of export credit against nonpay-ment due to political and/or commercial causes. It insures commercial risks of nonpayment by im-porters because of insolvency or other business factors and political risks of war, expropriation, confiscation, currency inconvertibility, civil commotion, or cancellation of import permits.


The Bankers Association for Foreign Trade (BAFT) is a collection of banking institutions, dedi-cated to promoting American exports, international trade, and finance and investment between U.S. firms and their trading partners. BAFT has set up a trade finance database with a grant from the U.S. Department of Commerce. The database serves as an essential resource for assisting exporters seeking trade finance and banks that provide financial services.


An Asian Importer wants to purchase machinery that he is unwilling or unable to pay for in cash until that machinery begins to generate income.

At the same time, the exporter wants immediate payment in full in order to meet his on-going business commitments

Forfaiting solution works as follows

1. Commercial contracts are negotiated subject to finance;

2. The importer arranges for an Irrevocable Letter of Credit to be issued or for a series of Promissory Notes or Bills of Exchange to be drawn in favour of the exporter which the importer arranges to have guaranteed by his local bank;

3. The exporter contacts the discounting bank (the forfaiter) for a rate of discount which is then agreed;

4. The goods are shipped;

5. The notes or bills are sent with shipping documentation and invoices to the discounting bank via the exporter (who endorses the notes or bills "without recourse" to the order of the discounting bank);

6. The discounting bank purchases the guaranteed notes or bills from the exporter at the agreed rate.

Result: the exporter receives payment in full immediately after shipping (against presentation of satisfactory documentation to the forfaiter); the importer gets his goods and can pay for them in installments over time; and the forfaiter has title to an asset which he may retain as an investment.

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*** The above “International Payments Comparison Chart” is reproduced from US Department of Agriculture website - Pub.

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The U.S. payments industry has undergone a significant shift in recent years. Check usage is de-clining while the adoption of electronic payment forms is growing. During calendar year 2003, 44.5 billion electronic payments were originated in the United States with a value of $27.4 trillion. This represents a CAGR of 3.8% since 2000, which is twice the real GDP growth (1.9%).

Non-cash Payment instruments in the US can be classified as follows:

Check-based Payments

Until recently, checks were the most used payment instrument in the US. Towards the end of 2004, Cards-based payment instruments have overtaken them. Their popularity has been due to their ease of use at the point of sale, for bill payments, and for person-to-person payments. The latest development in this payment instrument is the introduction of Check 21 Act, which is re-lated to the truncation of checks to electronic form. A recent study by Federal Reserve indicates that while checks paid decreased by over 5 billion from 2000 to 2003, the number of electronic payment transactions increased by over 13 billion. It is estimated that before the end of the decade credit cards and debit cards will individually exceed the number of paid checks.

Cards-based Payments


Debit cards enable the holder to make purchases and to charge those purchases directly to a cur-rent account at the bank issuing the payment card. Debit cards are either on-line (PIN-based) or off-line (Signature-based). On-line debit cards have been available for several decades and have seen tremendous growth since the early 1990’s. Off-line debit cards are a more recent innovation and consumers are increasingly using them at merchant locations that accept bankcards. Of all cards-based payments, debit has seen the highest growth.


Financial institutions issue ATM cards to consumers to provide on-line access to account informa-tion and to allow consumers to make withdrawals and deposits at ATMs. Many financial institu-tions now offer ATM cards that can also be used as debit cards for POS transactions at participat-ing retailers.


These include general-purpose credit cards and private-label credit cards (discussed later). Com-pared to other electronic payment instruments, credit cards have shown a relatively moderate growth since 2000.

Chip Cards

These cards have the capability to store funds electronically in an embedded chip, which updates the funds available data as transactions are made. While Prepaid cards are best known for their use as a gift card, they are increasingly used for payroll, incentives, insurance, refunds and other purposes. Some stored value cards may also be smart cards if they contain an integrated mi-crochip. The integrated chip can store value and perform other functions, such as consumer au-thentication, health care programs, government-funded benefits programs, transportation ser-vices, etc. The chip might also contain consumer preferences and loyalty program information for marketing purposes.

Automated Clearing House (ACH)

An ACH transaction is a batch-processed, value-dated electronic funds transfer between originat-ing and receiving financial institutions. ACH payments are used in a variety of payment environ-

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ments. Originally, consumers primarily used the ACH for paycheck direct deposit. Now, they in-creasingly use the ACH for bill payments (often referred to as direct payments), corporate pay-ments (business-to-business), and government payments (e.g., tax refunds), and electronic check presentment. There are two national ACH operators – Electronic Payment Networks, a pri-vate processor with a 30% market share while the rest of the market is served by the Federal Re-serve Banks.

Emerging Payments

Online Bill Pay (EBPP, EIPP)

Online services that enable customers to receive, review, and execute payment of their bills over the Internet.

Person-to-Person Payments (P2P)

On-line P2P payments, or e-mail payments, use existing retail payment networks to provide an electronically initiated transfer of value from one individual to another.

Internet Currencies / Digital Cash / e-Wallets

Similar to P2P payments, individuals can transfer electronic cash value to other individuals or businesses. Most electronic cash applications exist on the Internet. Consumers can use the cash payment instruments for purchases at retailers’ Web sites or they can transfer cash to other indi-viduals through e-mail. Individuals use a credit card or signature-based debit card number to pre-fund the Web certificate or electronic account, and recipients redeem the value with the Issuer.

Electronic Benefits Transfer (EBT)

Electronic system that allows a recipient to authorize transfer of his/her government benefits from a Federal account to a retailer account to pay for products received. EBT is currently used to is-sue food stamps and other benefits in the US.

Generic Framework for Payment Instruments

The diagram below depicts the common model on which most payment systems are based..

While the flow of funds, information, and data are different, in most cases, the set of participants are similar. The initiator of the payment (payer) is typically a consumer and the recipient of the payment (payee), typically a merchant. The payer and the payee are shown to have a relation-ship with their respective financial institutions. The payment network routes the transactions be-tween the financial institutions

Credit Card Market Overview

Financial Institution or Third party


Financial Institution or Third party

Payer Payee

Four Corner Payment System Model

Goods / Services

Present Non-cash Payment instrument

Solid line indicates flow of information

Financial Institution or Third party

Financial Institution or Third party


Financial Institution or Third party

Financial Institution or Third party

Payer Payee

Four Corner Payment System Model

Goods / Services

Present Non-cash Payment instrument

Solid line indicates flow of information

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Credit card activities in the US represent more than 25 billion individual transactions purchasing $1.7 trillion dollars in products and services equaling more than 10% of GDP. There are 1.2 billion credit cards (including store and gas credit cards) in circulation in the US held by over 160 million individuals. The average household possesses 14.27 credit cards with an average household credit balance of $9,450 in 2003†††. Credit card fees paid by consumers exceed $15 billion.

A Credit card is a type of a payment card product. A payment card product is a set of entitle-ments. It allows the client to access the features the provider (e.g., financial institution) attaches to the card.

A sample of possible payment card entitlements is shown below:

Access Convenience AffordabilityCredit Worldwide acceptance Interest rate

Deposits 24 hour availability FeesMerchants Portability BenefitsATMs Monthly statements Payment terms

To create an actual payment card product, these entitlements are grouped together to appeal to a target segment – consumer or business. A card is issued to a cardholder and usually displays cardholder name, account number, expiration date, location acceptance logos (e.g., Visa/Master-Card) and issuing organization. Most cards are plastic with a magnetic stripe. Some of the new cards contain chips that store information such as additional customer information and stored value. A card usually is linked to some type of financial account (e.g., credit card to a credit line and a debit card to a checking/savings account).

Credit Cards

A credit card indicates that the holder has been granted a line of credit enabling the cardholder to make purchases and/or draw cash up to a pre-arranged amount. Interest is charged on the amount of the unpaid credit balance and cardholders are often charged an annual user fee.

The dominant payment card types that are in use at this time in developed banking environments are those employing the use of “magnetic stripe” technology. Part of the reason for this is the rel-atively lower cost of Points-of-Sale (POS) terminals and the formation of well-established specifi-cations that allows these magnetic-stripe cards to be used in virtually any card-based POS device worldwide. The production costs of the stripe card are also low. Additionally, administrative sup-port requirements are well developed.

However, smart cards, introduced a decade ago, are making significant inroads in some countries where, in addition to, regulated pilots being undertaken some significant schemes are already in place. These plastic cards, which are embedded with a computer chip, offer a number of signifi-cant benefits to financial institutions, retailers, and cardholders—ranging from improved security to a host of innovative new features.

But while smart card usage has been rapidly increasing thanks to a diverse set of applications from wireless telephones to loyalty programs, the predicted mass migration of payment applica-tions from conventional magnetic-stripe cards to smart cards has not yet materialized. One of the biggest hurdles, until now, has been the lack of universally accepted specifications for smart card based payments; however, consensus on EMV (Europay / MasterCard / Visa) specifications for smart cards is now set to change this situation and smart cards are poised to challenge the 2+ billion magnetic-stripe cards in circulation around the globe.

Credit Card Market – Major Business Entities and their Activities

††† Source: Nilson Report

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Issuer: Holds contractual agreements with and issues cards to cardholders. The key

activities of an issuer can be represented in the following manner –

Acquirer: Does business with merchants enabling them to accept credit cards. Acquirers buy

(acquire) the merchant's sales slips and credit the tickets' value to the merchant's account.

Acquirer’s key activities can be summarized as –

Due to high factors such as high volumes and low profit margins, most US banks have sold

their acquirer businesses to non-banking entities that specialize in this field. Following are the

Income and Expense sources in an Acquirer business –


Merchant discount (1–4% of transaction value)

Processing fees ($ 0.20 – $ 0.40 per transaction)

Monthly minimum fees

Customer service fees

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POS Equipment sales/service


Interchange fees paid to Issuer

ISO/MSP fees

Data processing & Communications expenses

Risk Management

Losses on Merchant Chargebacks & Fraud

Processor (Third Party Entities): Provides credit card processing, billing, reporting and

settlement, and operational services to the Issuer/Acquirer. The Card Processing market is a

highly concentrated market with players like First Data and TSYS processing more than half

of all US card transactions. The two main services that the Third Party Processors offer are

Issuing Services and Acquiring Services -

Issuing services

Functions: Most activities of card Issuers

Income = Transaction Processing fees + Software Licensing & Maintenance

Expense = Data processing & Communications expense

Acquiring services

Functions: Most activities of card Acquirers

Income = Merchant fees + Processing fees + ISO/MSP fees

Expense = Data processing & Communications expense + Losses on Chargebacks + Depreciation

Independent Sales Organization (ISO): An outside company (not MasterCard/VISA

member, non-bank) that offers merchant accounts and may process credit card transactions

for a transaction fee. ISOs enter into a contract with Acquiring banks to offer bankcard

acquiring services, through registered or unregistered sales agents or employees

Association: An organization owned by members, which services and obtains processing

services for members. Members include commercial/retail banks, credit unions etc. Following

are few main characteristics of Association -

License members (Issuers, Acquirers) to issue & accept payment cards

However, associations themselves do NOT issue cards / set card fees / set credit limits / set interest rates, or solicit merchants / set discount rates

Serve as the nerve center connecting the issuing & acquiring sides

Provide the interchange systems to transfer data and funds between members (transaction processing – VisaNet, BankNet)

Offer a variety of product programs and services to improve member profitability and minimize member risk

E.g. ‘Verified by Visa’, SET

Implement rules and regulations that govern the interchange of transactions between members

Undertake brand advertising and promotional campaigns

A card Association -

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Provide These Functions Do Not Provide These Functions

Recommend, monitor & provide support services

o Bylaws

o Operating rules & regulations

Brand advertising & promotional campaigns

Authorization & settlement systems

Security/Risk management

Assessment & fee based services

Develop new products & services

Issue cards

Set credit limits

Set card fees

Set interest rates

Solicit merchants

Set discount rates

Merchant: A retailer, or any other person, firm, or corporation that, according to a Merchant

Agreement, agrees to accept credit cards, debit cards, or both, when properly presented.

Cardholder: The person to whom a financial transaction card is issued or an additional

person authorized to use the card

The following diagram depicts typical activities in transaction processing using a card

involving all the entities described above -

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The following table shows lists the description of the various entities involved in a Credit card pro-cessing

Entity Description

Issuing BankThis is a bank / financial institution that issues a credit product

Cardholder Account

Cardholder portfolio account is created when a credit application is ap-proved.

Business Portfolio Account

This defines the processing rules for all the accounts under a business venture of the same card offering type. This entity may hold billing rules, auth limits, collection strategies, and other properties that can be defined at this level. Examples of Business portfolio account may include Chase Visa Classic, Chase Visa Gold, etc

Card ProductIdentifies the different card types that the Credit system supports. Exam-ples may be proprietary cards, Visa, MasterCard

Authorization Engine

Authorization engines are used to authorize credit transactions. The autho-rization engine uses the account information, merchant information, and other related information to approve / decline / refer an authorization trans-action. There can be more than one authorization engines for a business portfolio.

Credit BureauProvides credit scores that are used by Issuers to process card applica-tions

Collection AgencyThird party to whom Issuer outsources the cardholder collection activities

Issuer ProcessorAn outside company with which the Issuer contracts to provide cardholder transaction processing activities.

Issuer Clearing Bank

Bank designated by the Issuer to receive the Issuer’s daily net settlement advisement. The clearing bank (may be the Issuer itself) will also conduct funds transfer activities with the net settlement bank and maintain the Is-suer’s clearing account.

AcquirerThis is a bank / financial institution that acquires merchant transactions

Acquirer Clearing Bank

Bank designated by Acquirer to receive the Acquirer’s daily net settlement advisement. The clearing bank (may be the Acquirer itself) will also con-duct funds transfer activities with the net settlement bank and maintain the Acquirer’s clearing account.

Acquirer ProcessorAn outside company with whom the Acquirer contracts to provide mer-chant processing services

Merchant AccountA merchant account is created when a merchant application is approved. A merchant account is necessary for a merchant to accept payment by credit card

Clearing fileContains presentments and other financial messages that need to be matched with corresponding authorizations

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Funding fileThis file is for enabling member settlement

Transaction Types

Entity Transaction Type Remarks

Cardholder transactions

Purchase Authorization/Verification Preauthorization Merchandise return

Triggered by the cardholder. Authorization/Verification is the default transaction type. If no type is indicated when submitting transactions to the

gateway, the gateway will assume that the transaction is of the type

System Generated Transactions

ReversalThis transaction is an action on a previous transaction and is used to cancel the previous transaction and ensure it does not get sent for settlement.

Exception Transactions

Adjustment Chargeback & Charge-

back Reversal Representment

Used to correct errors that occur at point of transaction or in a participant’s system

Others Administrative Network Reconciliation File Maintenance Fee transactions

These are routine transactional activities to ensure completion of the various activities involved in a transaction processing cycle

Chargeback & Chargeback Reversals –

At any time (currently limited to 60 days after statement date), cardholder may contact the Issuer to question whether a transaction is legitimate and request a copy of the transaction from the merchant. If the cardholder does not receive a copy of transaction, she may request a charge-back – a financial reversal of the transaction. Even if the retrieval request is fulfilled, cardholder still may request the Issuer to initiate a chargeback. However, if the merchant disputes the chargeback, the disputed transaction is dealt with through a defined dispute process. Following diagram depicts the process of chargeback and chargeback reversal

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Major Players

The following table shows some of the leading US card organizations and their respective roles in the Credit card industry:

Leading US Market Card Organizations

Banks Non-Banks Association / Organization

Citigroup (Issuer)

MBNA America (Issuer)

JPMorgan Chase / Bank One (Acquirer & Issuer)

Bank of America (Ac-quirer & Issuer)

Capital One (Issuer)

Wells Fargo (Acquirer & Issuer)

Wachovia (Issuer)

First Data Corp (Processor)

TSYS (Processor)

Vital (Acquirer & Processor)

American Express (Acquirer, Card Or-ganization & Issuer)

Discover (Acquirer, Card Organization & Issuer)

Diners Club (Card Organization & Is-suer)

Equifax (Processor)

Sears ( Acquirer, Card Organization & Issuer)

GE Card Services (Processor)

US Government (Acquirer & Issuer)

Visa (Card Associa-tion, Proces-sor)

MasterCard (Card Associa-tion, Proces-sor)

JCB (Card As-sociation)

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Cards are one of the most widely used mechanisms for transactions world wide. There are several types of cards used –

o Debit cards

o ATM cards

o Credit cards

o Chip cards

o Smart cards

ACH enables batch-processed, value-dated electronic funds transfer between originating and receiving financial institutions.

Emerging payments systems are –

o Online Bill Payment (EBPP, EIPP)

o Person to Person Payments (P2P)

o Internet currencies, digital cash, e-Wallet

o Electronic Benefit Transfer (EBT)

There are various entities involved in the credit card transaction pro-cessing cycle -

o Issuer

o Acquirer

o Third party Processor

o Independent Sales organization

o Association

o Merchant

o Card holder

Chargeback and Chargeback reversals are legitimate ways to cancel the credit card transactions within a limited time frame

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Private Banking covers banking services, including lending and investment management, Private banking primarily is a credit service, and is less dependent on accepting deposits than retail banking.

The Federal Reserve Supervisory Letter defines private banking as personalized services such as money management, financial advice, and investment services for high net worth clients.

Although high net worth is not defined, it is generally taken at a household income of at least $100,000 or net worth greater than $500,000. Larger private banks often require even higher thresholds - Several now require their new clients to have at least $1 million of investable assets. As per the World Wealth Report 2001 by Merrill Lynch / Cap Gemini, there are currently over 7.2 million millionaires in the world with a combined asset base exceeding US$ 27 trillion which is projected to grow to over US$ 45 trillion by the end of 2005.


A typical private banking division of a large bank would offer the following financial services to its Private clients:

Investment Management and Advice

A client relationship Manager understands the client’s liquidity, capital and investment needs. He strives to develop an integrated approach to manage client investments and capital markets trad-ing. Access to specialist advice and extensive research is a key feature of private banking.

Self-directed or non-discretionary: This is largely investment advisory in which the bank offers investment recommendations based on the Client’s approval. The client may choose to ignore this.

Discretionary: In this case, the bank’s portfolio managers make investment decisions on behalf of the customer.

Risk Management

Strives to reduce exposures for its clients across the world through a variety of hedging tools, tak-ing positions in derivative markets etc


Management of a Client’s liquidity (cash etc) needs through short-tem credit facilities, flexible cash management services etc. An exclusive cash management service with "sweep" facility is a Private Banking feature. The sweep automatically transfers excess funds over a pre-determined limit out of your current account into a higher yielding reserve account, optimizing your return on short-term cash. Funds are on call so they remain easy to access.

Structured Lending

Provides tailored lending to provide long-term liquidity to clients, or investment capital

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Enhanced banking facilities

Private clients enjoy a variety of exclusive banking services such as:


Foreign exchange transactions

Automatic credit entitlements etc

Issuer Capital formation

Providing clients with access to investment banking and other institutional services

Private Bankers are high-end relationship managers, as well as money managers and advisors. Private clients trade in larger volumes, the fees and commissions are larger.

Changes in the regulatory environment have redefined the competitive landscape of wealth man-agement by allowing involvement of banks in insurance activities. A successful wealth manager must harness and deploy not just the standard activities of equity and fixed income investment management, but a plethora of other products and services: tax and estate planning, insurance products, 401(k) rollovers, and more.

Most private banks segregate their clients based on net worth, investible assets, age etc. For ex-ample, one classification could be between young affluent and retired affluent.

Private banking clients typically demand higher returns on their investment, and as a result banks offering these services are heavily dependent on efficient Portfolio Analysis and Asset Allocation techniques to achieve this. The consequent investment in technology is also very high.

Private banking is a fee-driven business. Banks offering these services charge anything between 1-4 % for their service, depending on the nature of the service rendered. Return on equity for banks offering these services could be as high as 25%.


Personal Investment Companies (PICs)

A PIC is a shell company set up by a Private Bank’s offshore division (e.g. trust division) for a client, usually in a tax haven like the Cayman Islands. The PIC has its own legal entity and the investor enjoys confidentiality as well as tax benefits. There is substantial startup fee involved for these, and banks charge annual administration fees.

Payable Through Account (PTA)

PTAs are transaction deposit accounts that allow banks in one country to offer their foreign clients of a foreign bank, such services as check-writing. The foreign bank in this case plays the role of a correspondent bank. These accounts usually have a high transaction volume and attract dollar deposits from the foreign customers.

(Video) How This 31 Year Old Woman Scammed JP Morgan

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Hedge Funds

This is a private investment partnership, and is usually run by Private Banks. Hedge funds are highly speculative and they use a variety of techniques such as leverage, short-selling, and use of derivatives. Several hedge funds also utilize some form of arbitrage, such as those where they can take advantage of movements expected to occur in the stock price of two companies under-going a merger or other similar event. In most cases, investors in a hedge fund need to be duly accredited.


Most Banks have separate divisions offering dedicated private banking services. There may be Edge Corporations or Foreign subsidiaries of large national banks as well, which offer these ser-vices.

The large European banks like UBS, Credit Suisse are industry leaders. There are a number of standalone Private Banks as well. In banks such as Mellon and Bank One, Private Banking takes place in the Trust or Investment Management division. Many banks offer Private Client Ser-vices (PCS) to clients in other countries as well, through foreign subsidiaries, or even affiliated banks.


Most private banks target return on equity of at least 25% which is considerably higher than that of the average commercial bank.

Opportunities for off-balance sheet income are an additional incen-tive. Unlike depository accounts, securities and other instruments held in the clients’ investment accounts are not reflected on the bal-ance sheet of the institution because they belong to the client.

However, the institution can earn substantial fees for managing client assets or performing other cash management and custodial services.

How have average hedge fund returns performed vis-a-vis market levels?

“Multibillion dollar Quantum Fund managed by the legendary George Soros, for instance, boasted compound annual returns exceeding 30% for more than a decade.”

“Off Shore Hedge Funds: Survival and Performance: 1989-1995," a study by Yale and NYU Stern economists, indicates that, during that six-year period, the average annual return for offshore hedge funds was 13.6%, whereas the average annual gain for the S&P 500 was 16.5%. Even worse, the rate of closure for funds rose to over 20% per year, so choosing a long-term hedge fund is trickier even than choosing a stock investment.

Are hedge funds not immune to risk?

Led by Wall Street trader John Meriwether and a team of finance wizards and Ph.Ds, Long Term Capital Management imploded in the late 1990s. It nearly sank the global financial system and had to be bailed out by Wall Street's biggest banks. In 2000 George Soros shut down his Quantum Fund after sustaining stupendous losses.

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To grow, private banks need to lure new wealthy investors away from direct investing or from investing with major mutual funds such as Fidelity or Merrill Lynch.


Sales and Marketing / Client Prospecting

Client Management, Servicing and delivery

Financial Planning

Portfolio Analysis and Optimization

Market Activities


Compliance controls.


The high-level process flow for private banking is shown below. The roles and responsibilities of the various players are outlined below:

Client Representative:

Servicing specialist

Middle office

Back office

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The diagram below shows the various departments in the Private Banking division of a bank.

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Investment Management can be defined as the process of managing money, which includes in-vestments such as real estate, financial instruments such as stock, mutual fund, bonds or equip-ment that has monetary value that could be realized if sold. Very often, terms such as money management, asset management etc. are used interchangeably.


Investment Management aims at the following goals:

Manage investors money efficiently and cost effectively

Generate superior investment returns

Investing Goal Ultimate objective is to deliver equity type returns with lesser volatility risk and achieve capital preservation

In achieving the above goals, an Investment Manager uses the following approaches/principles:

Asset Mix is the primary determinant of portfolio return, optimum portfolios are designed using asset allocation tools

International Diversification - Investment in world wide stocks re-duces risk and improves returns

Screens/Filters - Variety of quantitative and qualitative screens to identify candidate investments, interviews with fund managers prior to investing and continuous due diligence.

Capital preservation - Preserve the wealth of investors and ensure erosion free investment

Alternative Investments - Investing in hedge fund and futures to have strong returns. These assets generally earn returns consistent with those of equities. By combining alternative investments with eq-uities, the asset manager can generate superior returns while reduc-ing the ups and downs of the portfolio.

Investment management services are usually offered by firms that specialize in managing an in-vestor’s money. These firms employ individuals known as portfolio managers who are responsi-ble for taking the decision on which type of assets to invest it to best suit the investors needs.


Making investment decisions is not an easy task and requires specialized skills and services and involves a number of business processes.

The diagram below depicts some of the key steps/process involved in the investment manage-ment life-cycle.

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Research is one of the primary inputs towards deciding what kind of asset or financial instrument to invest in. It involves performing a variety of qualitative and quantitative analysis to determine the ideal portfolio mix. His includes an in depth analysis about the institution issuing the instru-ment, estimating future growth, industry analysis, trend analysis of historical prices etc. Some of the pre-requisites for performing meaningful research to aid investment decision making are as follows:

Research team

The first step is to put together a dedicated research team. It is critical that the team members not only understand the financial market dynamics but also have knowledge on Model building and Econometrics. The success of the research team is usually evaluated relative to a benchmark re-turn.


The research team must have easy access to a variety of data. The collection and maintenance of the database is very important. Tactical decisions need to be made quickly as new data keeps pouring in. It is best to invest in a database system that takes the new data and automatically runs the quantitative analyses.


While most top-down data management exercises can be handled within Excel, the bottom up projects are not feasible within a spreadsheet. The bottom-up projects may include up to 10,000 securities along with vectors of attributes for each security.


Passive Approach

The portfolio manager has to decide on the mix of assets that maximizes the after-tax returns subject to the risk and cash flow constraints. Thus the investor’s characteristics determine the right mix for the portfolio. In coming up with the mix, the asset manager uses diversification strategies; asset classes tend to be influenced differently by macro economic events such as re-cessions or inflation. Diversifying across asset classes will yield better trade offs between risk and return than investing in any one risk class. The same observation can be made about expanding portfolios to include both domestic and foreign assets.

Active Approach

Portfolio managers often deviate from the passive mix by using “Market timing”. To the extent that portfolio managers believe that they can determine which markets are likely to go up more than expected and which less than expected, they will alter the active-passive mix accordingly. Thus, a portfolio manager who believes that the stock market is over valued and is ripe for a correction, while real estate is under valued, may reduce the proportion of the portfolio that is allocated to eq-uities and increase the proportion allocated to real estate. Market strategists at all of the major in-vestment firms influence the asset allocation decision.

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There have been fewer successful market timers than successful stock pickers. This can be at-tributed to the fact that it is far more difficult to gain a differential advantage at market timing than it is at stock selection. For instance, it is unlikely that one can acquire an informational advantage over other investors at timing markets. But it is still possible, with sufficient research and private information, to get an informational advantage at picking stocks. Market timers contend that they can take existing information and use it more creatively or in better models to arrive at predictions for markets, but such approaches can be easily imitated.


Fund managers generally adopt an individual investment management style. The following are the two quantitative approaches to tactical global asset management:

Top Down Approach

The "top down" investor begins by looking at the “big picture” - economy or broad trends in soci-ety to identify individual countries and then sectors that will benefit from the prevailing conditions. For example, a "top down" investor might say that since the huge baby-boomer generation is ag-ing and moving toward retirement, companies that provide products and services to older people should benefit from that trend. This might lead to buying pharmaceutical stocks or health care shares or, stocks of insurers that provide retirement annuities.

A "top down" investor may also make investments based on what he or she thinks lies ahead for the economy. So, for example, if a "top down" investor believed that a resurgent economy might re-ignite inflation fears, then he or she might consider buying gold or natural resource stocks, or jettisoning long-term bonds in favor of Treasury bills. So a "top down" investor starts with a con-cept and then looks for stocks that are compatible with it.

Then they work systematically down from this very broad perspective translating these top-down views into more specific economic and market forecasts. This is an analytical process; trying to identify those profound structural changes in global economies and societies, seeing what effects are likely to filter down and in time affect the value of ordinary investments.

An illustrative model of “top down” approach will look as follows:

Build country-by-country forecasting models based on benchmark re-turn

Validation of models

Forecast out of sample returns

Sort country returns

Invest in portfolio of highest expected return countries

Information in both the volatility and correlation is used in determin-ing optimal portfolio weights

"Hedge" strategies are also possible. This involves taking long positions in the highest expected returns countries and short positions in the lowest expected returns countries.

Bottom Up Approach

The idea is to select individual securities. From a variety of methods, forecasted winners are pur-chased and forecasted losers are sold. “Bottom up" investor would try to find investments that are

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attractive because of something particular to them -- i.e., their terrific growth potential, say, or the fact that their assets are selling for less than their intrinsic worth. So an investor who practices the "bottom up" approach might screen through a long list of stocks to find ones that look like a buy on the basis of their fundamentals.


There are many individual strategies that may show promise in terms of beating the market. How-ever, very few portfolio managers actually accomplish the same objective. One very important reason is the failure on the part of most studies to factor in both the difficulties and the costs as-sociated with executing strategies.

There are three dimensions to portfolio execution:

Cost of execution

There are three components to this cost.

Bid-ask spread, which leads investors to buy at a high price and sell at a lower price. For low-priced stocks, this cost can be as high as 20% of the price of the stock.

Price impact that investors have when they trade, pushing the price up as they buy and down as they sell. In illiquid markets, this cost can be significant especially for large trades.

Tax impact associated with trading, which becomes a factor when we consider the objective in portfolio management is maximizing after-tax returns.

When considered in aggregate, the trading costs will work out to be high. The trading costs will vary widely across different investment strategies, depending upon the trading frequency and ur-gency associated with each strategy.

Trading speed

The need to trade fast and the desire to keep transactions costs low will come into conflict. In-vestors who are willing to accept trades spread out over longer periods will generally be able to have much lower trading costs than investors who need to trade quickly. Long term value in-vestors will be less affected by trading costs than short term investors trading on information.

Portfolio Risk Management

Portfolio risk characteristics change over time and it is the portfolio manager’s job to keep the portfolio risk at desired levels at minimum costs. The derivatives markets provide portfolio man-agers with additional tools that can be used to hedge risk and add to returns over time.


Portfolio Managers follow different investment philosophies. Some examples are:

Passive Diversification

Some Portfolio Managers believe that markets are efficient; even if they are inefficient, the cost of exploiting the inefficiency is more the returns that can be earned. Hence, they are willing to ac-

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cept market returns. They try to construct portfolios that resemble the market index, often index-ing to broadest possible indices.

Passive Value Investing

Markets systematically undervalue certain companies. Portfolio Managers identify such compa-nies with parameters like low PE, High dividend yield, low Price to Book Value, low Price/Re-placement Value etc. The leading examples are the likes of Peter Lynch and Warren Buffet. Such Portfolio Managers have long time horizons, low turnover (i.e.) buying and selling, and transac-tions costs

Momentum Investing

Markets tend to stay in trends: if prices have gone up (down) quickly, they will tend to keep going up (down). Portfolio Managers who subscribe to this school, use price momentum indicators, rela-tive strength indicators and charts. They have short time horizons and speedy execution styles.

Market Timing

It is possible to forecast the direction of markets (i.e. to time markets) using identified variables like market timing models/indicators. Such Portfolio Managers usually take large bets on the mar-ket (in either direction), attempt tactical Asset Allocation in sectors, and use Hedge funds (selling overvalued and buying undervalued asset classes). An example would be George Soros and his Quantum Fund.

Contrarian Investing

Markets tend to correct themselves; if prices have gone up (down) quickly, they will tend to go down (up). If investors are too bullish (bearish), stocks are more likely to go down (up). Such Portfolio Managers have usually short time horizons, are willing to hold unpopular investments and use specialist short sales.


Example: In the middle of March this year, the war with Iraq was just starting. The SARS epi-demic was raging across Asia. Travellers, whether for business or pleasure, were staying at home in fear of terrorism – whether in the guise of chemical or biological warfare, or old fash-ioned high explosives. The airline, tourism, and hotel industries were warning of the worst conditions in living memory. The FTSE 100 index fell to an eight-year low of 3,300.

The contrarians, meanwhile, were rubbing their hands with glee.

Guess what? If you had invested then, at the pit of misery you would have made 27 per cent in around three months to the middle of June.

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Although we have seen the generic definition and a typical investment management process flow there are a number of variants in investment management that have evolved over the years to address specific needs of Investors. This section focuses on some of the investment options that are available to investors.


Institutional money managers are independent financial advisory firms organized and licensed under the Security and Exchange Commission or Banking Laws' oversight agency of the country. Institutional Asset Management service can be both Advisory or Fund handling and investing on behalf of the customer.

Institutional money managers are distinguished by the fact that:

They are under greater regulatory scrutiny from both state and fed-eral authorities

They provide exclusive service to their clientele who are typically in-stitutions having portfolios in excess of several million dollars.

They are very selective in the clientele they service and first do an in-dependent analysis of that client's financial needs, goals, objectives, and risk tolerance.

They charge competitive fees due to the fact that their clients entrust millions of dollars to them for investing. Accordingly they are under greater scrutiny to provide attractive performance returns.

All major international banks offer asset management services. Some key players include:

Morgan Stanley

Bankers Trust

Boston Partners

Pacific Investment Management Co. (PIMCO)


A mutual fund is a fund that pools together money from many investors and invests it on behalf of the group, in accordance with a stated set of objectives. Mutual funds raise the money by selling shares of the fund to investors that includes individuals and institutions, much like any other com-pany can sell stock in itself to the public. These funds take the proceeds of the money from the sale of the shares and invest it in other instruments like bonds, stocks etc. In return for the money they give to the fund when purchasing shares, shareholders receive an equity position in the fund and, in effect, in each of its underlying securities. For most mutual funds, shareholders are free to sell their shares at any time, although the price of a share in a mutual fund will fluctuate daily, de-pending upon the performance of the securities held by the fund.

Now you must be wondering that why do people buy mutual funds when they can directly buy the instruments that these mutual funds invest in. after all what is the need of having a middleman? There are numerous reasons for investing in the mutual fund. They are:

Diversification: With a mutual fund one can diversify the investment both across companies and across asset classes. When some assets are falling in price, others are likely to be rising, so diversification results in less risk than if you purchased just one or two investments.

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Liquidity: Most mutual funds are liquid and it is easy to sell the share of a mutual fund.

Low Investment Minimums: One doesn’t need to be wealthy to invest in mutual funds. Most mutual funds will allow you to buy into the fund with as little $1,000 or $2,000.

Convenience: When you own a mutual fund, you don't need to worry about tracking the dozens of different securities in which the fund invests; rather, all you need to do is to keep track of the fund's performance.

Low Transaction Costs: Mutual funds are able to keep transaction costs low because they benefit from reduced brokerage commissions for buying and selling large quantities of invest-ments at a single time.

Regulation: Mutual funds are regulated stringently by the government. Thus this reduces the risk for the end investor.

Professional Management: Mutual funds are managed by a team of professionals, which usu-ally includes one mutual fund manager and several analysts.

So mutual funds are full of benefits. Now you must be wondering if the mutual fund what the dis-advantages of mutual funds are. There are plenty of disadvantages:

Fees and Expenses: Most mutual funds charge management and operating fees that pay for the fund's management expenses (usually around 1.0% to 1.5% per year). Moreover a few mutual funds charge high sales commissions.

Poor Performance: Mutual funds do not guarantee a fixed or high return. On an average more than half of the mutual funds fail to do better than the market returns.

Loss of Control: The mutual fund managers are the people who decide upon the strategy to invest. Thus the investor loses the control of his money to the fund manager.

Inefficiency of Cash Reserves: Normally a Mutual fund maintains a large cash reserve to pro-vide protection against simultaneous withdrawals. This provides investors with liquidity, but due to the large cash reserve the mutual funds do not invest all cash in asset and thus pro-vide investor with lowered returns.

Types of mutual funds

Mutual funds come in many varieties. For example, there are index funds, stock funds, bond funds, money market funds.

Index funds

"Index fund" describes a type of mutual fund or Unit Investment Trust (UIT) whose investment ob-jective typically is to achieve the same return as a particular market index, such as the S&P 500 Composite Stock Price Index, the Russell 2000 Index, or the Wilshire 5000 Total Market Index.

Stock funds

"Stock fund" and "equity fund" describe a type of investment company (mutual fund, closed-end fund, Unit Investment Trust (UIT)) that invests primarily in stocks or "equities". The types of stocks in which a stock fund will invest will depend upon the fund’s investment objectives, poli-cies, and strategies. For example, one stock fund may invest in mostly established, "blue chip" companies that pay regular dividends whereas another stock fund may invest in newer, technol-ogy companies that pay no dividends but that may have more potential for growth.

Bond funds

"Bond fund" and "income fund" are terms used to describe a type of investment company (mutual fund, closed-end fund, or Unit Investment Trust (UIT)) that invests primarily in bonds or other

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types of debt securities. The securities that bond funds hold will vary in terms of risk, return, dura-tion, volatility, and other features.

Money market funds

A money market fund is a type of mutual fund that is required by law to invest in low-risk securi-ties. These funds have relatively low risks compared to other mutual funds and pay dividends that generally reflect short-term interest rates. Unlike a "money market deposit account" at a bank, money market funds are not federally insured.

Money market funds typically invest in government securities, certificates of deposits, commercial paper of companies, and other highly liquid and low-risk securities. While investor losses in money market funds have been rare, they are possible.

Net Asset Value

Net asset value," or "NAV," of an investment company or a mutual fund is the company/fund’s to-tal assets minus its total liabilities. For example, if an investment company has securities and other assets worth $100 million and has liabilities of $10 million, the investment company’s NAV will be $90 million. Because an investment company’s assets and liabilities change daily, NAV will also change daily. NAV might be $90 million one day, $100 million the next, and $80 million the day after.

The investment company/fund calculates the NAV of a single share (or the "per share NAV") by dividing its NAV by the number of shares that are outstanding.

Some of the leading companies that offer mutual funds are:

Fidelity Investments


ING Direct



A separately managed account is a portfolio of securities owned directly by the investor and man-aged by professional money manager in lieu of an asset-based fee. SMA or the separately man-aged accounts provides the individual investors the same quality of service as offered to institu-tional investors.

Separately managed accounts help investors build and manage their wealth by focusing on the investor's individual investment goals, time horizon, and risk tolerance. To determine these, a risk profile questionnaire is used. Clients receive a personalized Investment Policy Statement that outlines goals and the investment vehicles necessary to help achieve them. From there, the fi-nancial consultant chooses an asset allocation strategy that is used as a road map to achieve ob-jectives. The financial consultant then recommends the investment managers best suited to man-age the overall portfolio. Lastly, ongoing monitoring and review of the portfolio takes place at both the financial consultant and investment manager level.

Key Features

The key features of SMA are -:

Direct ownership: The portfolio is held in a personal account rather than held as a part of fund, thereby giving direct control to the investors.

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Exclusivity: The arrangement gives exclusivity to the investor as investment preference, ob-jectives and tax liability are not necessarily shared across a pool of investors

Customization: The security to be held and the investment pattern can be customized to indi-vidual needs. e.g. a customer may not want to invest in those companies that are in tobacco business. The portfolio can be customized to cater to his individual needs and preferences.

Tax advantages: In the case of traditional mutual funds, individual taxes are not an issue. However, in case of SMA tax advantages to investor results from tax loss harvesting strategy

Advantages and Disadvantages

Separately managed accounts provide the client with the following benefits:

The investors get access to top Investment managers at an affordable rate that they would have been difficult otherwise.

The fee structure is asset based and not commission based which offer a significant value to the customer.

The client is relieved of portfolio management functionality and he can concentrate on other matters.

The client gets better tax planning because of the tax-harvesting element in SMA.

The transactions and the operations are more transparent to the customer as compared to traditional mutual fund.

The client gets customized reports about his portfolio.DisadvantagesThere is no requirement for the reporting of the holding and there is no specific governing regulation unlike the mutual funds

There is no board in case of SMA, one hires the manager to manage the asset and there is no board to sue if something goes wrong

Closing an SMA would require moving the individual’s security to another manager, which is a complicated and time consuming exercise.

It is difficult to find an appropriate comparable to benchmark the performance of SMA.

Difference between SMA and Mutual Funds

The key difference between a mutual fund and an SMA is that an SMA offers investors a custom-ized approach to investing, rather than a generic product. Usually, the process begins with an as-sessment by an adviser of the individual’s financial needs and goals. The adviser can then rec-ommend a variety of portfolio strategy options, which are customized to meet each investor’s needs. Once the strategy has been agreed, a professional portfolio manager buys and sells stocks and bonds in the portfolio on the investor’s behalf. The financial adviser then keeps a close eye on the portfolio’s performance.

As the portfolio is tailored to meet both long- and short-term cash needs, an SMA, unlike a mutual fund, can take into account personal investment preferences, such as not investing in particular stocks for personal, social or environmental reasons. For e.g. an investor may specify that his/her portfolio should not contain any stock belonging to TOBACCO companies.

Also unlike mutual funds, the investor has direct ownership of the stocks and bonds within the portfolio. This can facilitate tax management strategies.

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Some of the leading investment managers offering SMA services are:

Merrill Lynch Investment Management

Brandes Investment Partners

Nuveen Investments

Alliance Capital

Morgan Stanley Investment Management


Hedge funds are very similar to mutual funds except that they are targeted at High Networth indi-viduals as explained in the previous chapter. Hedge funds are exempt from many of the rules and regulations governing other mutual fund which allows them to accomplish aggressive invest-ing goals. They are restricted by law to no more than 100 investors per fund, and as a result most hedge funds set extremely high minimum investment amounts, ranging anywhere from $250,000 to over $1 million. As with traditional mutual funds, investors in hedge funds pay a management fee; however, hedge funds also collect a percentage of the profits (usually 20%).


Pension funds are the funds launched to meet retirement savings of individuals so as to provide a steady income to them after retirement. Since conservation of income is of utmost importance for a pension fund their investment strategy focuses on long term, safer instruments. Investment in pension funds also offers tax benefits.

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Private Banking covers personalized services such as money man-agement, financial advice, and investment services for high net worth clients. High net worth is generally taken at a household income of at least $100,000 or net worth greater than $500,000. Larger private banks often require even higher thresholds of at least $1 million of in-vestable assets

A typical private banking division of a large bank would offer financial services like:

o Investment Management and Advice

o Risk Management

o Liquidity Management

o Structured Lending

o Enhanced banking facilities

o Issuer Capital formation

Core functions in private banking include the following:

o Sales and Marketing / Client Prospecting

o Client Management, Servicing and delivery

o Financial Planning

o Portfolio Analysis and Optimization

o Market Activities

o Research

o Compliance controls

Private Banking Front Office covers functions like Sales & Client prospecting, Contact Management, Account Aggregation and Finan-cial Advisory services.

Private Banking Middle/Back Office covers functions like Asset Allo-cation, Research, Portfolio Analysis, Risk Management, Trade Pro-cessing, Compliance and Documentation

Investment Management aims at managing investors’ money effi-

ciently and cost effectively to generate superior investment returns. The ultimate objective is to deliver equity type returns with lesser volatility risk and achieve capital preservation

An Asset Manager uses the following approaches/principles:

o Asset Mix

o International Diversification

o Screens/Filters

o Capital preservation

o Alternative Investments

Asset Allocation can be done passively or actively.

o Passive Approach - The portfolio manager has to decide on the mix of assets that maximizes the after-tax returns subject to the risk and cash flow constraints. Thus the investor’s characteristics determine the right mix for the portfolio.

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o Active Approach - Portfolio managers often deviate from the passive mix by using “Market timing”. To the extent that portfolio managers believe that they can determine which markets are likely to go up more than expected and which less than expected, they will alter the active-passive mix accordingly.

Fund managers generally adopt an individual "investment philoso-phy" whichoverlays their investment management style. The following are the two quantitative approaches to tactical global asset management.

The "top down" investor begins by looking at the “big picture” - econ-omy or broad trends in society to identify individual countries and then sectors that will benefit from the prevailing conditions.

The “bottom up” investor selects individual securities. From a variety of methods, forecasted winners are purchased and forecasted losers are sold. “Bottom up" investor would try to find investments that are attractive because of something special to the security.

Portfolio Managers follow different investment philosophies. Some examples are:

o Passive Diversification

o Passive Value Investing

o Momentum Investing

o Market Timing

o Contrarian Investing

There are several variants of investment management that have manifested in terms of firms offering products to suit specific needs of investors. Some of them are

o Institutional Asset Management

o Mutual Funds

o Separately Managed Accounts

o Hedge Funds

o Pension Funds

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Investment Banks assist clients in raising money in order to grow and expand their businesses. Their activities include:

Originating and managing issues of securities


Market Making

Principal buying or selling securities on a spread basis

The top-tier investment banks are:

Goldman Sachs

Merrill Lynch

Morgan Stanley Dean Witter

Credit Suisse First Boston


Salomon Smith Barney

J.P. Morgan

Lehman Brothers

Generally, the breakdown of an investment bank includes the following areas:


The bread and butter of a traditional investment bank, corporate finance generally performs two different functions:

Mergers and acquisitions advisory - Banks assist in negotiating and structuring a merger between two companies. If, for example, a com-pany wants to buy another firm, then an investment bank will help fi-nalize the purchase price, structure the deal, and generally ensure a smooth transaction.

Underwriting - The process by which investment bankers raise in-vestment capital from investors on behalf of corporations and gov-ernments that are issuing securities (both equity and debt).An Under-writer guarantees that the capital issue will be subscribed to the ex-tent of his underwritten amount. He will make good of any shortfall.


Salespeople take the form of: 1) the classic retail broker, 2) the institutional salesperson, or 3) the private client service representative. Brokers develop relationships with individual investors and sell stocks and stock advice.

Institutional salespeople develop business relationships with large institutional investors. Institu-tional investors are those who manage large groups of assets, for example pension funds or mu-tual funds.

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Private Client Service (PCS) representatives lie somewhere between retail brokers and institu-tional salespeople, providing brokerage and money management services for high net worth indi-viduals.

Salespeople make money through commissions on trades made through their firms.


Traders facilitate the buying and selling of stock, bonds, or other securities such as currencies, ei-ther by carrying an inventory of securities for sale or by executing a given trade for a client. Traders deal with transactions large and small and provide liquidity (the ability to buy and sell se-curities) for the market. (This is often called making a market.) Traders make money by purchas-ing securities and selling them at a slightly higher price. This price differential is called the "bid ask spread."


Research analysts follow stocks and bonds and make recommendations on whether to buy, sell, or hold those securities. Stock analysts typically focus on one industry and will cover up to 20 companies' stocks at any given time. Some research analysts work on the fixed income side and will cover a particular segment, such as high yield bonds or U.S. Treasury bonds.

Corporate finance bankers rely on research analysts to be experts in the industry in which they are working. Salespeople within the I-bank utilize research published by analysts to convince their clients to buy or sell securities through their firm.

Reputed research analysts can generate substantial corporate finance business as well as sub-stantial trading activity, and thus are an integral part of any investment bank.


The hub of the investment banking wheel, syndicate provides a vital link between salespeople and corporate finance. Syndicate exists to facilitate the placing of securities in a public offering, a knock-down drag-out affair between and among buyers of offerings and the investment banks managing the process. In a corporate or municipal debt deal, syndicate also determines the allo-cation of bonds.


An initial public offering (IPO) is the process by which a private company transforms itself into a public company. The company offers, for the first time, shares of its equity (ownership) to the in-vesting public. These shares subsequently trade on a public stock exchange like the New York Stock Exchange (NYSE) or the Nasdaq. The primary reason for going through the rigors of an IPO is to raise cash to fund the growth of a company. Often, the owners of a company may sim-ply wish to cash out either partially or entirely by selling their ownership in the firm in the offering. Thus, the owners will sell shares in the IPO and get cash for their equity in the firm.

The IPO process consists of these three major phases:

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Hiring the Managers

This choosing of an investment bank is often referred to as a "beauty contest." Typically, this process involves meeting and interviewing investment bankers from different firms, discussing the firm's reasons for going public, and ultimately nailing down a valuation. In making a valuation, I-bankers, pitch to the company wishing to go public what they believe the firm is worth, and there-fore how much stock it can realistically sell. Perhaps understandably, companies often choose the bank that provides the highest valuation during this beauty contest phase instead of the best-qualified manager. Almost all IPO candidates select two or more investment banks to manage the IPO process.

Due Diligence and Drafting

This phase involves understanding the company's business as well as possible scenarios (called due diligence), and then filing the legal documents as required by the SEC. The SEC legal form used by a company issuing new public securities is called the S-1 (or prospectus) and Lawyers, accountants, I-bankers, and of course company management must all toil to complete the S-1 in a timely manner.


Once the SEC has approved the prospectus, the company embarks on a road show to sell the deal. A road show involves flying the company's management coast to coast (and often to Eu-rope) to visit institutional investors potentially interested in buying shares in the offering. Typical road shows last from two to three weeks, and involve meeting literally hundreds of investors, who listen to the company's presentations, and then ask scrutinizing questions. Often, money man-agers decide whether or not to invest thousands of dollars in a company within just a few minutes of a presentation. The marketing phase ends abruptly with the placement of the stock, which re-sults in a new security trading in the market.

Successful IPOs trade up on their first day (increase in share price), and tend to succeed over the course of the next few quarters.


Between corporate finance and research, firms build what is known as a Chinese Wall separating research analysts from both bankers and Sales & Trading. Often, bankers are privy to inside in-formation at a company because of ongoing or potential M&A business, or because they know that a public company is in registration to file a follow-on offering. Either transaction is considered material non-public information and research analysts, privy to such information cannot change ratings or mention it, as doing so would effectively enable clients to benefit from inside informa-tion at the expense of existing shareholders. When it comes to certain information, a Chinese Wall also separates salespeople and traders from research analysts. The reason should be obvi-ous. Analyst reports often move stock prices - sometimes dramatically.

Thus, a salesperson with access to research information prior to it being published would give clients an unfair advantage over other investors. Research analysts even disguise the name of the company on a report until immediately before it is published. This way, if the report falls into the wrong hands, the information remains somewhat confidential.

Insiders of the company cannot sell any shares for a specified period of time, this is known as the _______? (Holding Period, Lockup Period, Buy & Hold Period)

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An Underwriter is a broker/dealer or an investment bank. He guarantees that the capital issue will be subscribed to the extent of his underwritten amount. He will make good of any shortfall. The contract between the issuer and the Lead or Managing Underwriter is the Underwriting Agreement. The agreement states the terms and conditions of the offering, such as, the Underwriting Spread (the amount the underwriters make on sales), the Public Offering Price (POP), and the amount of proceeds from the offering that will go to the issuer.

Three different levels of broker/dealers handle the underwriting process:

Managing Underwriters - The Manager (lead underwriter) is the broker/dealer awarded the is-sue, who generally handles the relationship with the issuer and oversees the underwriting process.

Syndicate - To share the risk, and more efficiently distribute the offering to the public, broker/dealers will join together in a Joint Trading Account. The syndicate profits by selling the securities and earning a Spread (i.e., the POP less the amount paid to the issuer). Syndicate members share the risk and are responsible for any unsold securities.

Selling Group - comprises of broker/dealers chosen to assist the syndicate in marketing the is-sue in a broker (agency) capacity. Selling Group firms are not members of the syndicate, and are not at risk for the securities. All broker/dealers involved in the underwriting of non-exempt securi-ties must be NASD member firms.

Underwriters earn 3 types of Underwriting Spread:

Manager's fee - The lead underwriter receives this fee on all securi-ties sold.

Underwriter's Allowance is the total spread minus the Manager's fee. This fee is shared by syndicate members based on the type of syndicate account.

Concession - It is typically the largest part of the spread and is paid to the broker/dealer that actually took the client’s order.

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Types of Underwriting

There are two basic types of commitments made by underwriters to issuers:

1. Firm commitment - The issue is purchased from the issuer, marked-up and sold to the pub-lic. The underwriter here is acting as a dealer and is at risk for the unsold securities; whatever securities are not sold will remain in the underwriter’s inventory. Standby Underwriting is al-ways used in a subsequent primary offering of stock that is preceded by a subscription or pre-emptive rights offering. During the rights offering, the underwriter “stands by”. After the rights offering period has ended and all rights have been either exercised or expired, the underwrit-ers must take any unsubscribed securities on a firm commitment basis.

2. Best-efforts underwriting - The underwriters act as agents or brokers for the issuer, and at-tempt to sell all the securities in the market. The best efforts underwriter is not at risk, and any unsold securities remain with the issuer. Two sub-types of best efforts are All-or-None and Mini-max. An all-or-none underwriting may be canceled by the issuer if the entire issue is not sold in a given time period. A mini-max underwriting requires a minimum amount to be sold. If the underwriter sells the minimum, they may then attempt to sell the maximum (usually being the entire issue). However, if the minimum is not sold, the issuer may cancel the underwriting.


The trading of outstanding issues takes place in the Secondary Markets. The secondary markets are broken down into four market types:

1. Listed Market – Exchanges where an Auction method is used at a physical location. Special-ists provide liquidity on the floor of an exchange. (Eg) The New York Stock Exchange (NYSE)

2. Over-the-Counter Market (OTC, Second Market, Unlisted) – A negotiated market without a physical location where transactions are done via telecommunications. Broker/dealers acting as Market Makers provide the liquidity.

3. Third Market – Where listed securities are traded OTC (over-the-counter), and broker/deal-ers acting as market markers offer an alternative to trading on the exchange itself. An exam-ple would be a broker/dealer that maintained an inventory of IBM stock (which trades on the NYSE), and buys and sells that stock to other brokers and customers using a negotiated, over-the-counter method of trading.

What is an agreement in which the underwriter is legally bound only to attempt to sell the securities in a public offering for the firm?

When the investment banker bears the risk of not being able to sell a new security at the established price, what is this is known as?

On the day that a lock-up period expires, the market value of the stock will most likely ________. (Increase/decrease/remain same.)

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4. Fourth Market – The Instinet, a system for direct over-the-counter institutional trading that bypasses broker/dealers and thus reduces the cost of large institutional Block Trades.

All the stock exchanges are registered with the SEC, and they have a “self regulation” mecha-nism. The Maloney Act of1938 enabled the NASD to be the SRO for the second, third and fourth markets.


NYSE (partially) and London are the only major exchanges which still use a trading floor. When an investor customer calls their broker to place a trade, the following sequence of activities hap-pen:

Brokerage Firm checks the customer's account for cash balance, re-strictions etc

Enter the order in its Order Match System. The rep notifies the bro-ker/dealer’s Order or Wire Room to execute the trade.

The Order room then wires the order to the Commission House Broker (CHB), an employee of the broker/dealer who trades on the floor of the exchange for that broker/dealer.

The CHB makes their way over to the respective Trading Post.

At the post, the CHB encounters other folks who want to trade IBM stock.

Transaction Report Is sent to the originating brokerage firms (buy-ing and selling). A market order through SuperDot to the specialist takes an average 15 seconds to complete.

Reports are also sent to Consolidated Tape Displays world-wide, and to the Clearing operations.

Post Trade Processing Matching of buyers and sellers -- the Com-parison process -- takes place almost immediately.

This is followed by a 3-day Clearing and Settlement cycle at which time transfer of ownership (shares for dollars or vice versa) is com-pleted via electronic record keeping in the Depository.

Brokerage Firm The transaction is processed electronically, credit-ing or debiting the customer's account for the number of shares bought or sold.

Investor Receives a trade confirmation from his/her firm. If shares were purchased, the investor submits payment. If shares were sold, the investor's account is credited with the proceeds.


Specialists conduct the auction as a broker or dealer and maintain a fair and orderly market by matching up buyers and sellers. The specialist is not an employee of the exchange and may trade for their own account, as well as trading as an agent for CHB orders.

Broker Dealer Executes orders for others Executes orders for themselves

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Acts as an Agent Acts as a Principal (i.e., a market maker)Charges Commission Charges Mark-up and Mark-down

An individual firm could act as a broker on one trade and a dealer on another. When acting as a broker, the firm is taking customer orders and acting as their agent to buy or sell the security. For this service, the broker charges a commission. A firm acting as a dealer is the actual buyer or seller, taking the other side of a trade. The price at which market makers will buy or sell a particu-lar security is known as the Bid or Ask Price.

Market Maker

Provide continuous bid and offer prices within a prescribed percent-age spread for shares designated to them

4 to 40 (or more) market makers for a particular stock depending on the average daily volume.

Play an important role in the secondary market as catalysts, particu-larly for enhancing stock liquidity

Registered Representatives

An individual who has passed the NASD's registration process and is licensed to work in the securities industry

Usually a brokerage firm employee acting as an account executive for clients

Sell to the public; they do not work on exchange floors

Order Types (Based on Price)

There are four basic order types.

1. Market Orders is executed at once, "at the market." A market order guarantees execution, but does not guarantee a price. The final price is determined by supply and demand.

2. Limit Orders - Some investors may want to buy or sell, but only at a specific price. A Limit or-der is executed at a set price or better and will not be executed if that price is not met. For ex-ample, a customer owns XYZ stock, which is currently trading at $50/share. They would like to sell the stock, but only if they can get a price of $55 or more. The investors would place a Sell Limit at $55/share, an order that will be executed only if a price of $55 or better is avail-able. Similarly an investor who seeks to buy, but only at a certain price or better, might enter a Buy Limit at $45/share.

3. Stop order - If the market price hits or passes through the stop price (Trigger), a market or-der is Elected. For example, an investor bought stock at $50/share. The investor wants the price of the stock to go up, but wishes to limit the losses if the stock price falls. Such an in-vestor might place a Sell Stop order at $45, and now if the market price falls to $45 or below, the stop is triggered and a market order is elected. Another example might be a Technical Trader who believes that if the stock goes up to a certain price, it is signaling the beginning of a Bullish run. This investor might enter a Buy Stop at $51, for example. Now, if the stock rises

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to $51 or above, a market order is triggered to buy the stock. A potential problem with a stop order is that it triggers a market order, which does not guarantee a purchase or sale price. A stop order must be triggered (activated or elected) before execution as a market order.

4. Stop Limit order - If the investors placed an order for $51 Stop, $52 Limit, the order would be elected at $51, but would not be filled (executed) unless a price of $52 or better was avail-able. Now, the investor has eliminated the risk of buying the stock without guaranteeing the price. A stop limit order, once triggered, becomes a limit order.

5. Do-not-reduce Order - Indicates that the order price should not be adjusted in the case of a stock split or a dividend payout.

Order Types (Based on Time)

Day Order – The order is valid till end of day and if it is unfilled at days end, it gets cancelled.

Open Order or Good Till Cancelled (GTC) – The order can remain open for up to six months. It is the responsibility of the registered representative to cancel at the customer’s direction. In addi-tion, at the end of April and the end of October, all GTC orders must be reconfirmed or elimi-nated.

Order Types (Based on Volume)

Fill or Kill (FOK) – The order must be immediately filled in one trade or canceled completely.

All or None (AON) - The entire order must be filled or canceled completely, but unlike FOK, AON can remain good till cancelled.

Immediate or Cancel (IOC) must immediately be filled for as much of the order as possible in one trade, with the remainder being cancelled.

Market Not Held order – The floor broker has the discretion concerning time and price. A key point is that Market Not Held orders are never on the Specialist's Book.


Unlike listed securities that trade on an exchange, unlisted securities trade Over the Counter (OTC). Most securities actually trade OTC, since U.S. government, Municipal and most corporate securities trade OTC. Since there is no specialist book and no post to record transactions, OTC price information is either published periodically in paper form, disseminated over telephone lines, or displayed real-time electronically.

A sell limit order can be filled at a lower price than your limit e.g. your sell limit is at 21.07 & you can be filled at 21.06? True/False

If you want to limit your risk on a long position you can place a sell stop order? True/false

If the market is currently bid 15.00 & offered at 15.01 you are guaranteed of buying at 15.01 if you place a market order? True/False

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Liquidity in the OTC market is provided by Market Makers (i.e., broker/dealers who maintain an inventory of a particular stock, and buy and sell the stock from and to customers).

The largest system for displaying OTC market quotes is Nasdaq (The NASD’s Automated Quota-tion system). Broker/Dealers subscribe to various levels of the Nasdaq system depending on their functional needs. Level 1 service (i.e., the Inside Quote or Representative Quote) is the highest bid and lowest ask prices of all market makers, and is used by registered reps. Level 2 service is for traders, and lists all market makers' firm quotes on price and size. Level 3 service also displays all quotes, and is used by market makers to enter quotes.

The quotes look like the following:

Bid Ask Dealer A 9 9.5

Dealer B 8.75 9.25

Dealer C 9.1 9.8

Dealer D 9 9.5

If you were selling stock, to whom would you sell? Dealer C has the highest bid of 9.1, while a buyer would go to Dealer B who has the lowest ask of 9.25. The inside quote, therefore, would be 9.1 – 9.25, the highest bid and the lowest ask.


A brokerage firm has the following departments:


New Accounts

Order Room

Purchase and Sales



Corporate Actions




Sales team is responsible for canvassing business. They are staffed with Account Executives/Ac-count Managers who solicit business from retail and wholesale customers.

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New Accounts

New Account department is responsible for receiving customer account opening applications and documenting the customer data. They are the custodians for various documents like New account form, Signature cards, Margin Agreements, Lending Agreements and Option Trading Agree-ments. Only when the required documents are received, the account can legally operate.

New accounts can be of one of the following types:

Individual Cash Account – Only cash transactions are permitted. No margin trading is permitted.

Margin Account

Joint Account

Power of Attorney Accounts

Order Room

Orders are taken by dealers in order room and they are executed in the best possible manner. Every order has detailed instructions like:




Security details etc.

We have covered the different order types in the earlier pages.

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The relationships among the various departments can be pictorially represented as below:


• Proxy voting • Information flow to customers


Transfer Agent

Stock Record

• Account numbering & coding • Audits • Security Movements


• Cash Dividends • Stock splits • Due bills • Bond Interest


• Bookkeeping • Daily cash record • Adjusted trail balance • Trail Balance • P & L Statement

Order Room

• Execution recording • Confirming GTC orders • Pending Orders


Account executive (Home or Branch office


• Account Maintenance • Sales support • Issue checks • Items due • Extensions • Close – Outs • Delivery of securities


• Receive & Deliver • Vaulting • Bank Loan • Stock Loan/borrow • Transfer • Reorganization

Clearing Corp (CNS)

Purchase & Sales (P&S)

• Recording • Figuration (including accrued interest) • Comparison (reconcilement) • Booking

Contra Brokers


Exchanges OTC Market

Execution Reports


Name Accounts (Name & Address)

• Open Accounts • Executing Changes

Reports Order Tickets



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Purchase and Sales

This department is responsible for the following activities:

Recording the trade with a unique number using codes and tickets.

Figuration to calculate the monetary value of the transaction

Reconciliation of customer trades with counter-party transactions

Customer Confirmation in a legally binding form.


Margin or Credit Department monitors the status of the customer accounts. As explained in the previous pages, they are also responsible for margin calls. The typical activities of this depart-ment are:

Account Maintenance

Sales Support

Clearing Checks

Items pending (Money due, stocks due)

Closing out


They are responsible for movement of securities and funds within the brokerage firm. They take care of the following functions:

Receiving and delivering



Security Transfers

Stock Lending

Corporate Action

Corporate Action refers to dividend declarations, stock splits etc. The Corporate Action depart-ment makes sure that the rightful owners (as on the Record Date) receive the dividends, Splits etc.


The Accounting department records, processes and balances the movement of money in the bro-kerage firm. They produce the Daily Cash Records and Trial Balance, Balance Sheet and Profit & Loss statements on a periodic basis.

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The Brokerage firms are regulated by SEC, by state regulatory agencies and industry wide Self Regulatory Organizations. The compliance department is responsible for ensuring that all the rules and regulations are complied with and reported on time.

They also make sure that the newer regulations like Anti Money Laundering Act are implemented inside the firm.


1. All of these are different types of brokerage accounts except?

a) Margin Account b) Cash Account c) IRA Account d) Nostro Account

2. A market order that executes after a specified price level has been reached is called?

a) Market Order b) Stop Order c) Fill or Kill Order d) Day Order

3. A brokerage or analyst report will contain all of the following except?

a) a detailed description of the company, and its industry.

b) an opinionated thesis on why the analyst believes the company will succeed or fail.

c) a recommendation to buy, sell, or hold the company.

d) a target price or performance prediction for the stock in a year.

e) a track record of the analyst writing the report.

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Index of market prices of a particular group of stocks.

Index Types

Value Weighted Index is a stock index in which each stock affects the index in proportion to its market value. Examples include Nasdaq Composite Index, S&P 500, Hang Seng Index, and EAFE Index. They are also called capitalization weighted index.

Price Weighted Index is a stock index in which each stock affects the index in proportion to its price per share. (Eg) Dow Jones Industrial Average

Key Market Indices

The important markets and the indices used are presented below:

US Diversified market Dow Jones Industrial Average (Dow)US Technology NASDAQ 100UK (London) Financial Times Stock Exchange Index (FTSE)Germany (Frankfurt) DAXFrance (Paris) CACSwitzerland (Zurich) SMIJapan (Tokyo) NikkeiHong Kong Hang SengSingapore Strait Times Index (STI)

Dow Jones Industrial Average (DJIA)

The Dow is made up of 30 large companies from various industries. The stocks in the following chart comprise the index.

3M Alcoa

AlliedSignal American Express

AT&T Boeing

Caterpillar Chevron

Citigroup Coca-Cola

DuPont Eastman Kodak

Exxon General Electric

General Motors Goodyear

Hewlett-Packard IBM

International Paper J.P. Morgan

Johnson & Johnson McDonald

Merck Philip Morris

Procter & Gamble Sears

Union Carbide United Technology

Wal-Mart Walt Disney

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Risk is any element of the operating environment that can cause loss or failure. Risks are difficult to define and they keep changing constantly. For example, if we ask two derivative traders to identify the biggest risks faced by them, we may get different answers.

Let us look at an example of an Export Oriented Unit. Most or all of their revenue is earned in for-eign exchange where as costs are in domestic currency. Expenses like cost of raw material, salaries, are paid out in Indian Rupees. If rupee appreciates significantly, the exporter’s profits may be significantly affected. This is summarized with a numerical example in the following table:

Scenario 1 Scenario 2INR/USD 50 45Revenues in USD 100 million 100 millionRevenues in INR 5000 million 4500 millionCosts 4000 million 4000 millionNet Profit 1000 million 500 million

A 10% appreciation in rupee resulted in a 50% drop in profits. This is a case of exchange rate risk. Of course, in times of dollar appreciation, the firm will end up making pots of money!


The higher the risk you take, the higher is the potential reward and the lower the risk, the lower is the potential reward. The lower the credit rating of the borrower, the higher is the risk of lending money but higher also is the interest rate that can be charged! Note that the word used here is “potential reward”. There is no set formula to say how much reward will justify a certain amount of risk. Also, sometimes the reward may depend upon the person’s or the organization’s ability to take advantage. However, the risk-reward principle should be the guiding principle while deciding on a risk management strategy.

A ship is safe in the harbor…But that is not what ships are built for!

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The following are some of the possible risk types.

Credit risk is the possibility of loss as a result of default, such as when a customer defaults on a loan, or more generally, any type of financial contract.


What are the risks?


How to estimate the risk?


Set tolerance limits and act

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Liquidity risk is the possibility that a firm will be unable to generate funds to meet contractual obligations as they fall due.

Operational risk is the possibility of loss resulting from errors in instructing payments or settling transactions.

Legal risk is the possibility of loss when a contract cannot be enforced -- for example, because the customer had no authority to enter into the contract or the contract turns out to be unenforce-able in a bankruptcy.

Market risk is the possibility of loss over a given period of time related to uncertain movements in market factors, such as interest rates, currencies, equities, and commodities.


Once the risks have been identified, the next step is to choose the quantitative and qualitative measures of those risks. Risk is essentially measured in terms of the following factors:

a. The probability of an unfavorable event occurring (expressed as a number between 0 and 1)

b. The estimated monetary impact on organization because of the event

The unfavorable events differ for different types of risk. For example, in case of market risk, future events refer to market scenarios. These scenarios impact each portfolio prices differently depend-ing on its composition.

Risk measurement is a combination of management, quantitative analysis and information tech-nology. Serious technology investment is required for accurate measurement and reporting.

One of the commonly used methodologies for market risk is “Value At Risk”

Value at Risk (VaR)

Value at Risk is an estimate of the worst expected loss on a portfolio under normal market condi-tions over a specific time interval at a given confidence level. It is also a forecast of a given per-centile, usually in the lower tail, of the distribution of returns on a portfolio over some period. VaR answers the question: how much one can lose.

Another way of expressing this is that VaR is the lowest quantile of the potential losses that can occur within a given portfolio during a specified time period. For an internal risk management model, the typical number is around 5%. Suppose that a portfolio manager has a daily VaR equal to $1 million at 1%. This means that there is only one chance in 100 that a daily loss bigger than $1 million occurs under normal market conditions.

Suppose portfolio manager manages a portfolio which consists of a single asset. The return of the asset is normally distributed with annual mean return 10% and annual standard deviation 30%. The value of the portfolio today is $100 million. We want to answer various simple questions about the end-of-year distribution of portfolio value:

1. What is the distribution of the end-of-year portfolio value?

2. What is the probability of a loss of more than $20 million dollars by year end?

3. With 1% probability what is the maximum loss at the end of the year? This is the VaR at 1%.

Value-at-Risk (VaR) is an integrated way to deal with different markets and different risks and to combine all of the factors into a single number which is a good indicator of the overall risk level.

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VaR Calculation

A generic step-wise approach to calculate would be:

Get price data for you portfolio holdings.

Convert price data in to log return data. (Log Return: u i = ln (Si / Si-1) where Si is the price of the asset on day i)

Calculate standard deviations of each instrument or each proxy.

Calculate preferred confidence level. 99% = 2.33 * standard devia-tion.

Multiply position holdings by their respective Standard Deviation at a 99% confidence level. This results in a position VaR at a 99% confi-dence level.

A. Monte-Carlo Simulation

It is a simulation technique. First, some assumptions about the distribution of changes in market prices and rates (for example, by assuming they are normally distributed) are made, followed by data collection to estimate the parameters of the distribution. The Monte Carlo then uses those assumptions to give successive sets of possible future realizations of changes in those rates. For each set, the portfolio is revalued. When done, you've got a set of portfolio revaluations corre-sponding to the set of possible realizations of rates. From that distribution you take the 99th per-centile loss as the VaR.

Example VaR Calculation

Assume that you have a holding in IBM Stock worth $10 million. You have calculated the standard deviation (SD) of change over one day in IBM is $ 0.20.

Therefore for the entire position, SD of change over 1 day = $200,000The SD of change over 10 days = $200,000 * √(10) = $632,456

The 99% VaR over 10 days = 2.33 * 632,456 = $1,473,621

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Example Monte-Carlo SimulationMonte-Carlo simulation is a computation process that utilizes random numbers to derive an outcome. So instead of having fixed inputs, probability distributions are assigned to some or all of the inputs. This will generate a probability distribution for the output after the simulation is ran. Here is an example.

A firm that sells product X under a pure/perfect competition market* wants to know the probability distribution for the profit of this product and the probability that the firm will loss money when marketing it. The equation for the profit is: TP = TR - TC = (Q*P) - (Q*VC+FC)


The Quantity Demanded (Q) fluctuates between 8,000 and 12,000 units All other similar Output factors are also simulated to reflect the change.

A simple simulation worksheet is prepared to with 50000 iterations for Q. It shows the profit number (with frequency) under various scenarios of quantity sold. This translates into a near Normal Curve with a Mean and Standard Deviation.

Using the required confidence interval from the normal curve and the standard deviation, a VaR limit is generated from this distribution.

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B. Historical Simulation

Like Monte Carlo, it is a simulation technique, but it skips the step of making assumptions about the distribution of changes in market prices and rates. Instead, it assumes that whatever the real-izations of those changes in prices and rates were in the past is the best indicator for the future.

It takes those actual changes, applies them to the current set of rates and then uses those to revalue the portfolio. When done, you've got a set of portfolio revaluations corresponding to the set of possible realizations of rates. From that distribution, we can calculate the standard devia-tion and take the 99th percentile loss as the VaR.

C. Variance-Covariance method

This is a very simplified and speedy approach to VaR computation. It is so, because it assumes a particular distribution for both the changes in market prices and rates and the changes in portfolio value. It incorporates the covariance matrix (correlation effects between each asset classes) pri-marily developed by JP Morgan Risk Management Advisory Group in 1996. It is often called Risk Metrics Methodology. It is reasonably good method for portfolio with no option type products. Thus far, it is the computationally fastest method known today. But this method is not suited for portfolio with major option type financial products.


There are multiple strategies to manage risks. Some of the commonly followed ones are:

1. Diversification

2. Hedging or Insurance

3. Setting Risk Limits

4. Ignore the risk!

All the above strategies will reduce the risk – but may not eliminate them. The top management will determine its risk policy (i.e.) its appetite for risk. The Risk Manager in a bank will be respon-sible for identifying the risks, setting up tolerance limits, measuring the risk on a day to day basis and take action whenever the limits are breached.

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Risk, defined as the deviation from expectation, is an extremely im-portant concept for financial services industry.

The nature of banking business gives rise to many different risks in this business. Credit risk, Liquidity risk, Operational risk, Legal risk, Market risk are some examples.

Risk management is a 3-step process: Defining, Measuring and Managing risks. Risk is measured in terms of the probability and the potential monetary impact should the adverse event occur.

Risk measurement is a combination of management, quantitative analysis and information technology. Serious technology investment is required for accurate measurement and reporting. One of the com-monly used methodologies for market risk is “Value at Risk”

There are multiple ways of managing risks. Rejecting credit if the credit rating is bad is one operational measure to avoid high risk. Di-versification spreads the total risk to the business over multiple mar-kets, thus reducing the impact of risk from any one market on the overall business. Another way to reduce risk is to transfer or trade the risk, for example by buying insurance.

However, any risk reduction measure has its own cost. Therefore, one has to achieve a balance between the cost of risk management and the benefit of those risk reduction measures.

Risk managers aim to reduce the risk to a manageable and known level through various risk reduction measures. They use risk man-agement systems to track and analyze the risks.

A good risk management system not only calculates the risk based on a set of parameters, but also allows the risk managers to drill down the risk to lowest components, carry out sensitivity, what-if analyses, generates customizable reports and sends alerts automati-cally when the risk crosses a defined tolerance limit.

The Risk Manager in a bank will be responsible for identifying the risks, setting up tolerance limits, measuring the risk on a day to day basis and take action whenever the limits are breached.

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Custody Services


The custody service business evolved from safekeeping and settlement services provided by banks to its customers for a fee. Banks, as a custodian originally provided only basic safekeeping services to their customers. The banks routinely settled trades and processed income for their own investments. Their customers kept and took their securities out of safekeeping to settle trades or for bond maturities. As time evolved, the banks realized that their expertise in securities processing and their image as a safe repository would be valuable to their customers and they began to promote their securities processing ability as an enhanced value-added service.

Services offered by Custodians

Services provided by a bank custodian are typically the settlement, safekeeping, and reporting of customers’ marketable securities and cash. A custody relationship is contractual, and services performed for a customer may vary.

Users of Custody Services

Institutional investors, money managers and broker/dealers are the primary customers for custo-dians and other market participants for the efficient handling of their worldwide securities portfo-lios.

Assets held Under Custody

Custodians hold a range of assets on behalf of their customers. These include equities, govern-ment bonds, corporate bonds, other debt instruments, mutual fund investments, warrants and de-rivatives.

Business Drivers of Custody Services

The following are the key drivers in the growth of custody services:

The wide range of financial instruments and the emerging markets spreading across geographies resulted in growing interest of in-vestors. The potential benefits associated with the investments re-sulted in growth of custody services.

The increasing use of global custodians to replace their own net-works of local custodians by Investment managers and banks.

The state withdrawing from its role of primary pension provider, causing citizens to invest in defined contribution pensions and mu-tual funds in record numbers - with custody banks serving the pen-sion funds and mutual funds, their money managers and the banks acting for high net worth individuals.

The introduction of floating exchange rates and lifting of exchange controls in many major economies resulted in rapid development of the market for international debt instruments.

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The specialist fund managers running dedicated portfolios of foreign equities have increased in recent time.

The gradual increase in equities and cross-border investments.

Securities Marketplace

Securities marketplace is a mechanism for bringing together those seeking investment and those seeking capital. These entities can be individual or institutional .The securities market can be classified as primary market and secondary market. For the purpose of the discussion we would concentrate on secondary market and its working mechanism.

(Video) Princes of the Yen | Documentary Film

1.1.1 Market Constituents


An investor is an entity that owns a financial asset. In general there are two types of investor, the individual and the institutional investor.

Individual Investor

Institutional Investor

o Mutual Fund Managers

o Pension Funds

o Insurance companies

o Hedge Funds


Broker is an intermediary who executes customer orders for a pre-defined commission. A "bro-ker" who specializes in stocks, bonds, commodities act as an agent and must be registered with the exchange where the securities are traded. The brokers can be classified based on the types of the services offered.


Dealer is an entity who is ready and willing to buy a security for its own account (at its bid price) or sell from its own account (at its ask price). They are individual or firms acting as a principal in a securities transaction.


A custodian is responsible for safekeeping the documentary evidence of the title to property like share certificates etc. The title to the custodian’s property remains vested with the original holder, or in their nominee(s), or custodian trustee, as the case may be. Based on confirmation from cus-tomers, clearing corporation assigns the obligation of settlement upon the custodian. In general the services provided by the custodians are classified in two main areas:

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Holding of Securities and Cash

Movement of securities and/or cash

Clearing Corporation

Clearing Corporation is responsible for post-trade activities of a stock exchange. Its responsible for clearing and settlement and risk management of trades. The list of activities performed by a clearinghouse is:

Clearing of trades

Determining obligations of members,

Arranging for pay-in of funds/securities,

Receiving funds/securities,

Processing for shortages in funds/securities,

Arranging for pay-out of funds/securities to members,

Guaranteeing settlement.

Examples of important clearing corporations across the globe are National Stock Clearing Corpo-ration in USA (NSCC), Sega Intersettle in Switzerland, Clearstream & Euroclear of European Union and so on.


The depository can be either domestic or international securities and depending upon that they are known as either National Central Securities Depository or International Central Securities De-positories (ICSDs).

Country Depository ab-breviation

Depository Full Name

India NSDL National Securities Deposi-tory Ltd

USA DTC Depository Trust Company


Japan JASDEC Japan Securities Depository Center

Hong Kong CCASS Central Clearing and settle-ment system

Clearing Banks

Clearing banks are a key link between the custodians and Clearing Corporation for funds settle-ment. Every custodian maintains a dedicated settlement account with one of the clearing banks. Based on his obligation as determined through Clearing Corporation, the clearing member makes

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funds available in the clearing account for the pay-in and receives funds in case of a payout. In most of the cases the custodians act as a clearing bank also.

1.1.2 Securities Market

Primary Market: It is a market for new security issue. In this market the securities are directly purchased from the issuer. For e.g. an investor directly buying security issued by IBM.

Secondary Market: A market in which an investor purchases a security from another investor rather than the issuer. We can divide the secondary market into wholesale and retail parts. The wholesale market is the market in which professionals, including institutional investors, trade with one another. Transactions are usually large. The retail market is the market in which the individual investor buys and sells securities.The principal OTC market is the National Association of Securities Dealers Automated Quotations (NASDAQ). The wholesale market for corporate equities is conducted on a number of exchanges as well as over the counter (OTC). The New York Stock Exchange (NYSE) dominates. Other U.S. exchanges include the American Stock Exchange (AMEX), also in New York City, and five regional exchanges – the Midwest, Pacific, Philadelphia-Baltimore-Washington,

Some other Markets are:-

Dealer Markets

Auction Markets

Hybrid Markets


A bank is responsible for maintaining the safety of custody assets held in physical form at one of the custodian’s premises, a sub-custodian facility, or an outside depository. The banks may hold assets either off-premises or on –premises


The banks hold the securities/assets in physical form in its vault. The securities (e.g., jewelry, art, coins) are kept in physical form by the bank .The banks also holds the securities, which are not maintained in the book entry form.

The banks providing the safekeeping services needs to follow certain norms related to the secu-rity and movement of securities. The bank provides security devices consistent with applicable law and sound custodial management. The bank ensures appropriate lighting, alarms, and other physical security controls. The banks ensure that assets are out of the only vault when it receives or delivers the assets following purchases, sales, deposits, distributions, corporate actions or ma-turities.

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The evolution of depository has resulted in vast majority of custodial assets being held in book entry form. Custodians reconcile changes in the depository’s position each day as a change in the position occurs, as well as completing a full-position reconcilement at least monthly. Deposi-tory position changes are generally the results of trade settlements, free deliveries (assets trans-ferred off the depository position when no cash is received), and free receipts (assets being de-posited or transferred to the depository position for new accounts when no cash is paid out).


1.1.3 Trade Initiation

The trade process is initiated in a variety of ways in which a customer decides either to buy or sell securities. The customer goes to either a Broker/ Dealer or a bank’s trading desk through its in-vestment manager. The bank in turn would coordinate with a broker who has access to the ex-change. The client sends across his order details through communication network. The client or-der contains standard features like:

Buy or Sell

Specific Quantity

Specific Security

The brokers typically record the order if the order has been placed through a broker or otherwise the trader directly maintains the details of the order.

1.1.4 Order Management

The order is placed by the client usually through a telecommunication network and is normally passed to either the exchange floor or to over the counter-trading desk. The order management process consists of Entering orders, order modification, order cancellation. The order capture process is done through appropriate trade entry applications. The process is to capture the order details i.e. identification of the security to be traded, the quantity, limit price, order duration and exchanges. The client places the order and specify the Operation i.e. either buy/sell, Quantity, Security Name and the Price. The order condition can be attached to the timing; price and quan-tity of the order, which is considered when the broker executes/match the trade .The client’s also modify/ cancel the order if the order has not been processed.

Order Types

There are two basic types of order: market orders and limit orders.

Market orders are instructions to buy or sell stock at the best avail-able price. They are the most common types of orders.

Limit orders tell your broker to buy or sell stock at the limit price or better. The limit price is a price you set when placing the order. For a given purchase, it is the most you will pay; for a given sale, it is the

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minimum you will accept. You can also place a limit order to buy along with one to sell. For example, if XYZ Corporation is currently trading at $42 per share, you can place a limit order to buy 100 shares of XYZ at 40 or better (less) and to sell 100 shares XYZ at 45 or better (more).

Order Conditions

A buyer/seller can specify order conditions with which the trade is to be executed. These are the conditions that are typically an upper limit in buy price, a lower limit in sell price, stop loss trade orders, quantity conditions and time criteria.

Time Conditions

Quantity Conditions

Price Conditions


Stop orders

Order Books

An order book is a placeholder for every order entered into the system. As and when valid orders are entered or received by the trading system, they are first numbered, time stamped and then scanned for a potential match. If a match is not found, then the orders are stored in the books as per the price/time priority. Price priority means that if two orders are entered into the system, the order having the best price gets the higher priority. Time priority means if two orders having the same price is entered, the order that is entered first gets the higher priority. Best price for a sell order is the lowest price and for a buy order, it is the highest price

Order Matching

The buy and sell orders are matched based on the matching priority. The best sell order is the order with the lowest price and a best buy order is the order with the highest price. The un-matched orders are queued in the system by the following priority:


All stop loss orders entered are stored in the stop loss book. These orders can contain two prices.

Trigger Price. It is the price at which the order gets triggered from the stop loss book.

Limit Price. It is the price for orders after the orders get triggered from the stop loss book. If the limit price is not specified, the trigger price is taken as the limit price for the order. The stop loss orders are prioritised in the stop loss book with the most likely order to trigger first and the least likely to trigger last. The priority is same as that of the regular lot book.

The stop loss condition is met under the following circumstances:

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Sell Order - A sell order in the stop loss book gets triggered when the last traded price in the nor-mal market reaches or falls below the trigger price of the order.

Buy Order - A buy order in the stop loss book gets triggered when the last traded price in the nor-mal market reaches or exceeds the trigger price of the order. When a stop loss order with IOC condition is there, the order is released in the market after it is triggered. Once triggered, the or-der scans the counter order book for a suitable match to result in a trade or else is cancelled by the system.

1.1.5 Trade Execution

The trade execution is carried out on a stock exchange after an order is placed. Order modifica-tion and/or order cancellation is required to handle any abnormality. An order in entered into the trading system by the brokers and they specify the information regarding the trade details. The trade details typically contain information like security Name, Quantity, Price, Order Duration etc. The order is entered into the order book and gets executed as per the time and price condition as specified in the order. The order matching for the execution takes place in the stock exchange. The order modification and order cancellation takes place before the order gets executed i.e. if the order is there in the order books of the exchange and is waiting to be executed the request for order modification is entertained by the stock exchange. The stock exchange prepares a NOE (Note of Execution) with the trade details and sends it across to the Broker/ Dealer and to the clearing corporation giving details of the trade. The date the trade is executed is known as the Trade Date, and is referred as ”T“ or T+0.

The order execution process for a customer sell order (individual investor placing order through a broker) goes through the following cycle:

Customer places a sell order through the Internet or to the account executive of the brokerage group.

The account executive sends the order to its corresponding floor bro-ker or to its trading desk.

The order execution takes place on the floor of the exchange such as on NYSE, AMEX etc.

The exchange sends a Notification of sell to the Firm’s representa-tive on the exchange as well as the trading desk of the brokerage group..

The Firm’s representative on the exchange floor send a notification of the sell to the floor broker which is then matched with the counter party broker.

The trade execution results in identifying the following trade components:

Trade Date

Trade Time

Value Date





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1.1.6 Trade Enrichment

The process of trade enrichment involves the selection, calculation and attachment to a trade of relevant information necessary for efficiently servicing the clients. The trade components, which require enrichment, are:

Calculation of cash value: The cash value calculation is done keep-ing the trade components in consideration.

Counter party Trade confirmation requirement: The trade details needs to be enriched to determine if the counter party needs the trade confirmation and if at all it needs the trade confirmation, the for-mat in which the confirmation would be send across to them.

Selection of custodian details: The client might have multiple ac-counts with multiple or single custodian. The investor would send the custodian details at which the settlement would take place. The trade details are enriched with the account number of the custodian, which will handle the cash/ securities settlement.

Method of Transaction reporting: The transaction reporting depends upon the security group as well as the country in which the transac-tion has occurred. For e.g. the UK equities may require one method of reporting whereas the international bonds would require another method.

1.1.7 Trade Validation

Trade validation is a process of checking the data contained in the fully enriched trade, in order to reduce the possibility of erroneous information being sent to the client (in case of institutional client) also the wrong trade related information can lead to delay in the settlement or even in set-tlement failure. The basic trade related information that are validated are following:

Trade Date

Trade Time

Value Date





Trade Cash Value

Methods of Trade Validation: The validation of trade can be effected manually or automatically according to the availability of the system.

Manual Trade Validation

Automatic Trade Validation

1.1.8 Trade Clearing

Clearing process signifies the execution of individual obligations with respect to a buyer and seller. Once the terms of a securities transaction have been confirmed, the respective obligations

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of the buyer and seller are established and agreed. This process is known as clearance and de-termines exactly what the counter parties to the trade expect to receive. Clearance is a service normally provided by a Clearing Corporation (CC).

Clearance can be carried out on a gross or net basis. When clearance is carried out on a gross basis, the respective obligations of the buyer and seller are calculated individually on a trade-by-trade basis. When clearance is carried out on a net basis, the mutual obligations of the buyer and seller are offset yielding a single obligation between the two counter parties. Accordingly, clear-ance on a net basis reduces substantially the number of securities/payment transfers that require to be made between the buyer and seller and limits the credit-risk exposure of both counter par-ties.


The Settlement process for the securities is expensive as moving securities and money involves costs. Since a given trader may engage in dozens or even hundreds of trades each day, these costs soon add up. One way to reduce these costs is through netting.

For example, suppose you sold the shares to Smith because you expected the price of GE to fall Say an hour later the price does fall to 75 and you buy the shares back at that price. By coinci-dence, you buy them from Smith. You and Smith could save a lot of transaction costs if you net-ted the two transactions – your earlier sale and your later repurchase. Net, Smith owes you 10,000 x ($80 - $75) = $50,000. if Smith just pays you this amount, no securities and a lot less money need change hands.

You could extend this idea beyond just netting pairs of specific transactions to a general bilateral netting arrangement with Smith. You could keep a running tab of your trading in GE shares over a period of time, and just settle your net position at the end of the period. You could save even more if you engaged in multi-issue netting – netting your trade in all securities.

Continuous Net Settlement

The Continuous Net Settlement (CNS) System is an automated book-entry accounting system that centralizes the settlement of compared security transactions and maintains an orderly flow of security and money balances. Throughout the CNS processing cycles, the system generates re-ports that provide participants with a complete record of security and money movements and re-lated information. CNS provides clearance for equities, corporate bonds, Unit Investment Trusts and municipal bonds that are eligible at The Depository Trust Company (DTC). DTC is an insti-tution that provides depository services in US.

Clearing Process

The process of clearing is explained in the following example:

A deal is struck between with Smith and you on Monday. That night your back-office people and Smith’s each send electronic notification of the trade to the computer of the National Securities Clearing Corporation (NSCC).

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The NSCC computer checks the two “confirms” against each other. If they match, the trade is “compared”. NSCC confirms to each of you on Tuesday morning, with instructions for settlement the same Thursday. If the trade does not compare, you are both notified and you can sort things out and resubmit the trade before the settlement date.

On Wednesday, the day before the settlement, NSCC interposes itself between the two parties to the transaction. That is, instead of the original deal between you and Smith, there are now two deals – one between you and NSCC and the other between NSCC and Smith. You now have a deal to sell 10,000 shares of GE to NSCC at 80, and Smith has a del to buy them from NSCC at the same price. You receive a notice to deliver the shares to NSCC; Smith receives a notice to make payment. By interposing itself in this way, NSCC is guaranteeing settlement to both of you. Whether or not Smith pays up, you will get your money on time. Whether or not you deliver the shares, Smith will get 10,000 shares of GE on Thursday.

The automated comparison is an important function of the clearing corporation because it en-ables the participant to ensure that the trade details agree with those of counter party prior to set-tlement.

1.1.9 Trade Affirmation/Confirmation

The trade affirmation/confirmation process occurs when a depository forwards the selling broker’s confirmation of the transaction to the buyer’s custodian. The custodian reviews the trade instruc-tions from the depository and matches the information to instructions for the trade received from its customer. If the instructions match, the custodian affirms the trade. If the instructions do not match, then the custodian will ”DK” (don’t know, or reject) the trade or will instruct the selling bro-ker how to handle the mismatch. The affirmation/confirmation process is generally completed by T+1 in a normal T+3 settlement cycle. On day T+2, depositories send settlement instructions to the custodian bank after affirmation and prior to settlement date. The instructions contain the de-tails of the trade that has been affirmed and agreed to by the parties in the trade. Custodians will match the settlement instructions to their records and prepare instructions to send funds or ex-pect funds from the depository on T+3 of the settlement cycle.

The following media is used for the transmission of trade confirmation/affirmation






1.1.10 Trade Settlement Failure

Trade settlement is the act of buyer and seller exchanging securities and cash on or after the value date in accordance to the contractual agreement. Settlement is successful when the seller is able to deliver the securities and buyer is able to pay the cash it owns to the seller. In some

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cases the settlement fails primarily because the seller was awaiting the delivery of securities from its purchase and therefore could not deliver the securities to the buyer.

It is mandatory now days to settle trade on the value date and whenever there is a settlement fail-ure the authority imposes penalties to the party concerned.

Causes of Settlement Failure

Non–Matching settlement instruction

Insufficient Securities

Insufficient Cash

1.1.11 Trade Settlement

Trade settlement is the act of buyer and seller exchanging securities and cash on or after the value date in accordance to the contractual agreement. Settlement is successful when the seller is able to deliver the securities and buyer is able to pay the cash it owns to the seller. There are different settlement methods depending upon the payment mechanism, security types etc.

In most of the markets the settlement is done on a rolling basis. In a Rolling Settlement, all trades outstanding at end of the day have to be settled, which means that the buyer has to make pay-ments for securities purchased and seller has to deliver the securities sold. For instance, USA and UK follow a T+3 system which means that a transaction entered into on Day 1 has to be set-tled on the Day 1 + 3 working days, when funds pay in or securities pay out takes place.


The settlement process has evolved over the period. Traditionally the settlement used to take place with the physical delivery of the shares, but with advent of Certificate Immobilization the Book Entry settlement system has evolved.

Physical Settlement

Book Entry Settlement


The settlement period is the time between the execution of the trade and the settlement of trade. It is time allowed before the securities sold must be delivered to the buyer. The settlement peri-ods depend upon the type of the securities traded. Appendix C has the list of the settlement pe-riod for different types of security.


Trade settlement occurs when securities and money are exchanged to complete the trade. Settle-ment occurs on T+3 in a T+3 settlement cycle. Settlement of a securities transaction involves the delivery of the securities and the payment of funds between the buyer and seller. The payment of funds is effected in the settlement system via a banking/payments system. A depository typically carries out the delivery of securities. A trade is not declared settled until both (funds and securi-ties) transfers are final.

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1.1.12 Trade Accounting & Reconciliation

Trade accounting and Reconciliation is the internal control process used by custodians to man-age trade transactions. In this process, the custodian determines that the customer’s account has the necessary securities on hand to deliver for sales, that the customer’s account has adequate cash or forecasted cash for purchases. It maintains the records of trades internally and tries to match it with outside world. It tries to match the positions by comparing positions of trades (Open and settled both).

1.1.13 Risks associated with Trading & Settlement

There are multiple risk associated with the trade execution process .The following example dis-cusses the risk associated with the trading process from the point of view of a broker associated with a exchange.

As a broker on the floor of the Stock Exchange and you have just agreed with Smith, another bro-ker, to sell him 10,000 shares of GE at 80. To execute this transaction, you need to transfer own-ership of the shares to Smith, and Smith needs to transfer the cash to you. In reality, once you and Smith agree on the terms, execution is handed over to others in the “back office”. The length of the process varies from market to market.

Principal Risk

Replacement Risk

Liquidity Risk

Operational Risk

Systemic Risk

1.1.14 Work Flows Of Trading and Settlement

The following example discusses how a typical equity trade takes place:

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Trade Date (T):

Step 1: The transaction begins with the investor wishing to invest in equity. He contacts his broker (buy side) with an order to buy and similarly an investor contacts his broker (sell side) to sell the securities.

Step 2: The brokers place trade request on the exchange.

Step 3: The trade execution takes place in the exchange as per the conditions specified in the or-der. The exchange prepares a NOE (Notice of Execution) and sends out to the Brokers and the clearing corporation.

Step 4: The clearing corporation receives the matched instruction i.e. the trade details (quantity, price etc) from the exchange. The trade details are entered into the Continuous net settlement system to obtain the net positions for a broker at the end of the day. The clearing corporation pre-pares a contract sheet with end of day positions for broker and sends it across to the depository.

Step 5: The Brokers sends a confirmation to the client about the trade details and the clients in turn inform their custodians about the receipt/delivery of shares.

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Trade Date +1/2 (T+1/2)

Step 1: The broker receives trade details from the clearing corporation and it enriches it with the fees, commission and other tax related details and send across the confirmation to the client.

Step 2: The client prepares an Affirmation order and sends it across to the custodians about the possible pay in/out of securities and funds.

Step 3: The clearing corporation prepares a final pay in/pay out details based on the affirmation received from the client and send it across to the depository.

Step 4: The custodians also confirm with the depository about the pay in/ pay out details about the funds and securities.

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Trade date + 3(T+3)

Step 1: Pay In of securities: Clearing corporation advises depository to debit account of sell side custodian and credit its account and the depository does it

Step 2:Pay in of funds (Clearing corporation advises clearing banks to debit account of buy side custodian and credit its account and the clearing bank does it)

Step 3:Pay Out of securities (Clearing corporation advises depository to credit account of buy side custodian and debit its account and depository does it)

Step 4: Pay Out of funds (Clearing corporation advises clearing banks to credit account of sell side custodian and debit its account and clearing banks does it)

Step 5: The custodian 1 confirms the receipt of shares to the buying client.

Step 6: The custodian 2 confirms the delivery of shares to the selling client.


Asset servicing is a ”core“ ongoing service provided by custodians. This service includes collect-ing dividends and interest payments, processing corporate actions and applying for tax relief from foreign governments on behalf of customers.

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1.1.15 Corporate Actions

A corporate action is an event related to capital reorganization or restructure affecting a share-holder. Custodians are responsible for monitoring corporate actions for the securities they hold under custody. Once the Custodian gets notified of a corporate action, it identifies the accounts that hold the security. If the account holder has a specified time to decide whether to accept the corporate action, the customer should be promptly contacted. The custodians have a process to monitor the corporate action to ensure that the customer has given a complete response by the due date. When a customer’s instructions are received, the custodian sends the instructions to the company for execution. The custodian monitors the status of the action to ensures timely set-tlement. The custodian’s procedures for corporate actions also include documentation of all cus-tomer directions. Business Process of Corporate Action Processing

Receiving Corporate Action: The information regarding the corporate action is received from a number of external sources. As the same corporate action data is supplied by many different sources, a hierarchy of sources is maintained to prioritize the obtained data.

Maintaining Corporate Action: The Corporate actions are classified as either mandatory or volun-tary

Mandatory Actions

It is a type of corporate action wherewith the shareholders are not given the option to conditional-ize their tender. e.g. stock splits, mergers and acquisitions, liquidations, bankruptcies, reorganiza-tions, redemption’s, bonus issues etc

Voluntary action

It is a type of corporate action wherewith the shareholders are given the option to conditionalize their tender. They include rights offers, tender offer, purchase order, exchange order etc.

Notification of Corporate Action: The notification is generated for the client of Voluntary and Mandatory Corporate Actions. The notification process ensures that the client receives the infor-mation of the corporate action. Maintaining Response of Corporate Action: The corporate action response is maintained for voluntary corporate action responses against expiration dates on a daily basis until the client responds with instructions.

Processing of Corporate Action :In this stage the Processing of corporate action is done to update the records of the banks. As per the feedback received from the client in case of voluntary ac-tions, the records for the client are updated in the records of the banks. A similar method is fol-lowed for the mandatory types of corporate action.

1.1.16 Income Processing

Custodians are responsible for collecting income payments received from the assets held under custody. The income payments typically take the form of dividends on equity securities and inter-est on bonds and cash equivalents. Custodians calculate the projected payments and inform the customers accordingly in advance. This enables the customers to plan investment decisions and

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use the proceeds effectively. The bank’s internal controls for income collection also include an in-come map procedure that details each client’s expected income from a particular security.

Contractual income payments are posted to the customer’s account on the date they are due rather than the date they are received by the custodian whereas the actual income payments are posted to the customer’s account on the date they are received by the custodian Business process of Income Processing

Receiving Corporate Announcement: The custodians are dependent on external vendors to re-ceive corporate action information. These vendors are specialized in providing information across the globe. Some of the common vendor feeds used are from JJ Kenny, DTC, Telekurs, and Reuters etc. The information collected is announcements regarding interest (coupon) payments for registered bonds, dividend payment for equities, income payment for ADR securities, mutual funds, private placement securities etc.

Generating Payment Obligation: A payment obligation is liability owned by a client. The payment obligation for a client is generated from the data regarding the corporate announcement. The pay-ment obligation is generated for the pending payments that are due to the client. Also the cash projection for the client depending upon corporate announcements is calculated.

Account Maintenance: Details regarding the trade are tracked and the corresponding account is updated. The trade details are maintained and the details regarding the transaction are captured and recorded.

Payment Settlement: The payment settlement stage encompasses entire process of Payment re-ceipt, payment reconciliation, and payment reversal

1.1.17 Proxy Voting

Custodians provide proxy-voting service to clients who want to exercise their rights as sharehold-ers of a company during the general meetings. If personal attendance is not possible, the share-holder may appoint a representative to attend the meeting and vote by proxy. A custodian helps investor to exercise their votes by providing a proxy voting service for all manner of general meet-ings wherever this service is available. Business Process Involved in Proxy Services

Receiving Corporate Announcement: The corporate announcement regarding the agenda of Gen-eral Body Meeting or Extraordinary General Body Meeting is captured from external vendors.

Notification to Client: The custodians notify the clients about the proxy services by providing the details of the corporate announcement.

Maintaining Response of Client: The client’s response to the corporate announcement is main-tained on a daily basis until the client responds with instructions. The client response is typically obtained from either email, fax etc. The response is typically like receiving client authorization to represent him at the meeting and vote on his behalf.

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1.1.18 Tax Processing

Custodians provide services to minimize foreign withholding taxes or reclaim taxes withheld for their customers. The tax treaties between countries often reduce withholding taxes and exempt capital gains from taxes. The purpose of tax treaties is to reduce the possibility of double taxation on income earned in foreign countries. In addition, some countries provide reduced tax withhold-ing rates for certain types of investments (government bonds, for example) or for certain types of investors (investors exempt from taxation in their home country, for example). Tax treaty benefits may provide for reduced withholding tax at the time the interest or dividend is paid (“relief at source”), while other treaties may require the investor to file for a refund after the fact (“reclaim”). Custodian files a form or statement on behalf of the client, certifying the investor’s tax status and country of residence for tax purposes. A custodian keeps track of the tax rates for each of the countries in which it provides custody. Dividends, interest, and capital gains may all be taxed at different rates. The custodian also maintains information about the tax treaties within its custody network, and whether its customers qualify for relief under the treaty. Business Process of Tax Handling

Maintaining Tax Information: The tax related information like standard tax rates, exemptions and reductions available under local law are maintained. The details specifying the reduced rates available by virtue of double taxation treaties are made available to the client. The market tax re-ports, summarizing local taxes for each market are provided to the client.

Tax Calculation: The tax calculation process captures trade details and applies the corresponding tax rates for computation of the tax.

Tax Reclamation: The tax reclamation process is used to reclaim the extra tax paid by the client. It can be of two types:

Contractual Tax Reclaims: In this kind of reclamation the client's cash account is credited with en-titlements to tax relief according to a pre-determined schedule of time-frames, in place of when the tax refund monies are received. The contractual time frame may be ‘n’ months after the in-come pay date (where the value of n varies according to the market concerned) or payment may be made, less a discount, with income payment. This can greatly assist clients in managing avail-able funds.

Non-contractual Tax Reclaims: In this type where tax relief is not obtained at source, the excess tax withholding is reclaimed. The bank prepares the required reclaim form and completes the as-sociated reclaim process, pursuing items as appropriate and reporting their status to clients.

Cash Sweep

Cash sweep is a value added service provided by custodian banks to its customers. This service ensures that the surplus cash in customers’ accounts are effectively invested in short-term invest-ment funds i.e. STIF (may be as short as an overnight fund) to generate additional returns. The sweep can be done intra-day based on projected earnings of the particular account or end-of-day based on actual surplus cash in the account. The STIFs invest money in money market or euro dollar Deposit.

Risks Associated with Custody Services

Many banks currently offer custodian services. The primary risks associated with custody ser-vices are: transaction, compliance, credit strategic and reputation.

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Transaction Risk

Compliance Risk

Credit Risk

Strategic Risk

Reputation Risk

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Employee benefit plans are established or maintained by an employer or by an employee organi-zation (such as a union), or both, that provides retirement income or defers income until termina-tion of covered employment or beyond. There are a number of types of retirement plans, includ-ing the 401(k) plan and the traditional pension plan, known as a defined benefit plan.

The Employee Retirement Income Security Act (ERISA) covers most private sector pension plans. Among other things, ERISA provides protections for participants and beneficiaries in em-ployee benefit plans, including providing access to plan information. Also, those individuals who manage plans (and other fiduciaries) must meet certain standards of conduct under the fiduciary responsibilities specified in the law.

The Employee Benefits Security Administration (EBSA) of the Department of Labor is responsible for Administering and enforcing these provisions of ERISA. As part of carrying out its responsibili-ties, the agency provides consumer information on pension plans, as well as compliance assis-tance for employers; plan service providers, and others to help them comply with ERISA.

The primary employee benefits are

Defined Benefits

Defined Contribution

Health and Welfare


Defined Benefit plans are the oldest retirement plans that exist in the Pension Industry. They promise to pay a specified benefit at retirement age. They define the amount of retirement income to be paid. The actual monthly (or annual) benefit is calculated using a specific formula stated in the plan document. The benefit is usually paid at a specified time such as attainment of age 65.

A Defined Benefit Plan is an employer-sponsored retirement plan in which retirement benefits are based on a formula indicating the exact benefit that one can expect upon retiring. Investment risk is borne by the employer and portfolio management is entirely under the control of the company. There are restrictions on when and how participant can withdraw these funds without penalties.

A private defined benefit plan is typically not contributory i.e. there are usually no employees con-tributions, no individual accounts are maintained for each employee. The employer makes regular contributions to the entire plan to fund the future benefits of the entire cohort of participants. The employer, rather than the participant, bears the investment risk. Usually, the promised benefit is tied to the employee's earnings, length of service, or both.

A Defined Benefit plan provides a guaranteed level of benefits on retirement and the cost is un-known for the employer. If the plan assets earn less than expected, the employer must make larger contributions to ensure that the plan will have sufficient funds to pay promised benefits. If the plan assets earn more than expected, the employer's contributions will decrease.

Defined Contribution

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A Defined Contribution Plan is a type of retirement plan that sets aside a certain amount of money each year for an employee. The amount to be contributed to each participant's account under the plan each year is defined (by either a fixed formula or by giving the employer the dis-cretion to decide how much to contribute each year). The size of a participant's benefit will de-pend on:

The amounts of money contributed to the individual's account by the employer and, perhaps, by the employee as well;

The rate of investment growth on the principal;

How long the money remains in the plan (in most cases, the em-ployee, upon retirement, has the option of either receiving the pay-ment in a lump sum or by taking partial payments on a regular basis while the balance continues to earn interest); and

Whether the forfeitures of participants who leave before they are fully vested can be shared among the remaining participants as a reward to long-term employees.

Since benefits accumulate on an individual basis, these plans are sometimes referred to as "indi-vidual account plans." In these plans, unlike in defined benefit plans, the risk (and reward) of in-vestment experience is borne by the participant. Defined contribution plans can permit, and sometimes require, that employees make contributions to the plan on either a pre-tax basis (as in a 401(k) plan) or an after-tax basis (as in a thrift plan). They may also, but are not required to, permit employees to decide how the monies contributed into their accounts will be invested.

Defined contribution plans have gained popularity as employers have begun to ask their employ-ees to share responsibility for their retirement. The main purpose of a defined contribution plan is to provide an investment vehicle for employees to accumulate retirement income.

Defined Benefit Plan Defined Contribution Plan

The employer funds it. Employee and employer contributions are allocated to individual participants

The employer bears the investment risk (the potential for investment gain or loss).

The participant bears the investment risk.

It is generally difficult to communicate. It is easier to communicate.

The final benefit is defined as it is formula driven taking definite parameters (like salary, number of years of service etc.) as input data

The final retirement benefit is unknown as it is decided by the performance of participant selected investment funds.

The benefit is expressed as an annuity (a specified annual or monthly payment to a pensioner over a specified period of time or based on life expectancy) payable at normal retirement age, usually age 65.

The benefit is expressed as an account balance.

The following plans are designated as defined contribution plans:

Profit Sharing Plans

Cash Or Deferred Arrangements Or 401(k) Plans

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Stock Bonus Plans And Employee Stock Ownership Plans

Simplified employee pensions (SEP)

Tax Sheltered Annuities Or 403(b) Arrangements

Business entities involved in the Defined Contribution Pension Administration process have strong interdependency in-terms of flow of information, fund and assets (stocks).

The diagram below depicts the main entities in the plan administration business and their relations with each other.

Fig 2.1

Sponsor delegates responsibilities to plan administrator

Participant contributes for the plan to the sponsor.

Trust owns the funds of the plan contributed by the sponsor and the participants and delegates management of the same to Investment Manager

Trust and plan administrator submit compliance reports to Federal Agencies which in turn would qualify the plan.

Participants direct the Investment manager on their investment pref-erences.

Record Keepers provide information on Participant, plan and account information to Plan Administrators, trustee, Sponsor and Participant.

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Following diagram explains the basic processes involved in benefits administration

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In the early days when the Social Security was adopted, Health insurance was taken care by private sectors. Later the escalating health costs and wage freezes of the post WW II era, prompted many companies to offer non-cash rewards in the form of Health care benefits. The challenges due to competitive benefits for maintaining the fiscal responsibility and changes in tax code made the employers to offer greater benefit choices with certain tax incentives.

Health and Welfare benefit plans can be either Defined-Benefit or Defined Contribution plans.

Defined Benefit health and welfare plans specify a determinable benefit, which may be in the form of reimbursement to the covered plan participant or a direct payment to providers or third party insurers for the cost of specified services. Even when a plan is funded pursuant to agreements that specify a fixed rate of employer contribution, it cannot be a Defined benefit health and welfare plan.

Defined Contribution health and welfare plans on the other hand maintain an individual account for each plan participant. The benefits a plan participant will receive are limited to the amount contributed to the participant’s account, experience, expenses etc. Health and Welfare plans generally are subject to certain fiduciary, reporting and other requirements of the ERISA (Employee Retirement Income Security Act, 1974).

Categories of health and welfare plans

Health Care

o Medical

o Prescription drug

o Behavioral health

o Dental

o Vision

o Long-term care

Disability Income

o Sick leave

o Short-term disability

o Long term disability

Survivor Benefitso Term life

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US Government passed the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism (USA PATRIOT Act) in response to the terrorists’ attacks of September 11, 2001. The key features are:

The Act gives federal officials greater authority to track and intercept communications, both for law enforcement and foreign intelligence gathering.

It vests the Secretary of the Treasury with regulatory powers to com-bat corruption of U.S. financial institutions for foreign money launder-ing purposes.

It seeks to further close our borders to foreign terrorists and to detain and remove those within US borders.

It creates new crimes, new penalties, and new procedural efficien-cies for use against domestic and international terrorists.

The anti money laundering rules are very important from a banking point of view. They are de-scribed in greater detail later in the chapter.

Criminal Investigations: Tracking and Gathering Communications

Federal communications privacy law currently features a three tiered system, erected for the dual purpose of protecting the confidentiality of communications while enabling authorities to identify and intercept criminal communications. The first level prohibits electronic eavesdropping on tele-phone conversations, face-to-face conversations, or computer and other forms of electronic com-munications in most instances. However, in serious criminal cases, law enforcement officers may seek a court order authorizing them to secretly capture conversations on a statutory list of of-fenses for the permitted duration.

The next tier of privacy protection covers telephone records, e-mail held in third party storage, and the like. The law permits law enforcement access, ordinarily pursuant to a warrant or court order or under a subpoena in some cases. There is also a procedure that governs court orders approving the government’s use of trap and trace devices and pen registers, a secret “caller id”, which identify the source and destination of calls made to and from a particular telephone.

Foreign Intelligence Investigations

The Act eases some of the restrictions on foreign intelligence gathering within the United States, and affords the U.S. intelligence community greater access to information unearthed during a criminal investigation, but it also establishes and expands safeguards against official abuse. It permits “roving” surveillance (court orders omitting the identification of the particular instrument, facilities, or place where the surveillance is to occur when the court finds the target is likely to thwart identification).

Money Laundering

‡‡‡ Extracted from Congressional Research Service, US and Federation of American Scientists -

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In federal law, money laundering is the flow of cash or other valuables derived from, or intended to facilitate, the commission of a criminal offence. Federal authorities attack money laundering through regulations, criminal sanctions, and forfeiture. The Act bolsters federal efforts in each area.

The Act expands the authority of the Secretary of the Treasury to regulate the activities of U.S. financial institutions, particularly their relations with foreign individuals and entities. Regulations have been promulgated covering the following areas:

Securities brokers and dealers as well as commodity merchants, ad-visors and pool operators must file suspicious activity reports (SARs);

Requiring businesses, which were only to report cash transactions involving more than $10,000 to the IRS, to file SARs as well;

Imposing additional “special measures” and “due diligence” require-ments to combat foreign money laundering;

Prohibiting U.S. financial institutions from maintaining correspondent accounts for foreign shell banks;

Preventing financial institutions from allowing their customers to con-ceal their financial activities by taking advantage of the institutions’ concentration account practices;

Establishing minimum new customer identification standards and re-cord-keeping and recommending an effective means to verify the identity of foreign customers;

Encouraging financial institutions and law enforcement agencies to share information concerning suspected money laundering and ter-rorist activities; and

Requiring financial institutions to maintain anti-money laundering programs which must include at least a compliance officer; an em-ployee training program; the development of internal policies, pro-cedures and controls; and an independent audit feature.

Crimes: The Act contains a number of new money laundering crimes, as well as amendments and increased penalties for earlier crimes.

Outlaws laundering the proceeds from foreign crimes of violence or political corruption;

Prohibits laundering the proceeds from cybercrime or supporting a terrorist organization;

Increases the penalties for counterfeiting; Seeks to overcome a Supreme Court decision finding that the confis-

cation of over $300,000 for attempt to leave the country without re-porting it to customs

Provides explicit authority to prosecute overseas fraud involving American credit cards; and

Permit prosecution of money laundering in the place where the pre-dicate offence occurs.

Forfeiture: The act allows confiscation of all of the property of participants in or plans an act of domestic or international terrorism; it also permits confiscation of any property derived from or used to facilitate domestic or international terrorism. Procedurally, the Act:

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Allows confiscation of property located in this country for a wider range of crimes committed in violation of foreign law;

Permits U.S. enforcement of foreign forfeiture orders;

Calls for the seizure of correspondent accounts held in U.S. financial institutions for foreign banks who are in turn holding forfeitable as-sets overseas; and

Denies corporate entities the right to contest if their principal share-holder is a fugitive.

Alien Terrorists and Victims

The Act contains provisions designed to prevent alien terrorists from entering the US, to enable authorities to detain and deport alien terrorists and those who support them; and to provide hu-manitarian immigration relief for foreign victims of the September 11.

Other Crimes, Penalties, & Procedures

New crimes: The Act creates new federal crimes, for terrorist attacks on mass transportation fa-cilities, for biological weapons offenses, for harboring terrorists, for affording terrorists material support, for money laundering, and for fraudulent charitable solicitation.

New Penalties: The Act increases the penalties for acts of terrorism and for crimes which terror-ists might commit.

Other Procedural Adjustments: The Act increases the rewards for information in terrorism cases, authorizes “sneak and peek” search warrants etc

Anti Money Laundering GUIDELINES

Treasury expects all financial institutions covered by the customer identification regulations to have their customer identification program drafted and approved by October 1, 2003 as sched-uled.

Foreign issued identification documents:

An effective program for identifying new customers must allow finan-cial institutions the flexibility to use methods of identifying and verify-ing the identity of their customers appropriate to their individual cir-cumstances. For example, some financial institutions open accounts via the Internet, never meeting customers face-to-face.

Rather than dictating which forms of identification documents finan-cial institutions may accept, the final rule employs a risk-based ap-proach that allows financial institutions flexibility, within certain pa-rameters, to determine which forms of identification they will accept and under what circumstances.

However, with this flexibility comes responsibility. When an institu-tion decides to accept a particular form of identification, they must assess risks associated with that document and take whatever rea-sonable steps may be required to minimize that risk.

Federal regulators will hold financial institutions accountable for the effectiveness of their customer identification programs.

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Additionally, federal regulators have the ability to notify financial insti-tutions of problems with specific identification documents allowing fi-nancial institutions to take appropriate steps to address those prob-lems.

Customer Identification Program

The rule requires that financial institutions develop a Customer Identification Program (CIP) that implements reasonable procedures to:

1. Collect identifying information about customers opening an account

2. Verify that the customers are who they say they are

3. Maintain records of the information used to verify their identity

4. Determine whether the customer appears on any list of suspected terrorists or terrorist orga-nizations

Collecting information:

As part of a Customer Identification Program (CIP), financial institutions will be required to de-velop procedures to collect relevant identifying information including a customer’s name, address, date of birth, and a taxpayer identification number – for individuals, this will likely be a Social Se-curity number. Foreign nationals without a U.S. taxpayer identification number could provide a similar government-issued identification number, such as a passport number.

Verifying identity:

A CIP is also required to include procedures to verify the identity of customers opening accounts. Most financial institutions will use traditional documentation such as a driver’s license or passport. However, the final rule recognizes that in some instances institutions cannot readily verify identity through more traditional means, and allows them the flexibility to utilize alternate methods to ef-fectively verify the identity of customers.

Maintaining records:

As part of a CIP, financial institutions must maintain records including customer information and methods taken to verify the customer’s identity.

Checking terrorist lists:

Institutions must also implement procedures to check customers against lists of suspected terror-ists and terrorist organizations when such lists are identified by Treasury in consultation with the federal functional regulators.

Reliance on other financial institutions:

The final rule also contains a provision that permits a financial institution to rely on another regu-lated U.S. financial institution to perform any part of the financial institution’s CIP. For example, in the securities industry it is common to have an introducing broker – who has opened an account for a customer – conduct securities trades on behalf of the customer through a clearing broker.

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Under this regulation, the introducing broker is required to identify and verify the identity of their customers and the clearing broker can rely on that information without having to conduct a sec-ond redundant verification provided certain criteria are met.

The following financial institutions are covered under the rule:

Banks and trust companies

Savings associations

Credit unions

Securities brokers and dealers

Mutual funds

Futures commission merchants and futures introducing brokers

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The Sarbanes-Oxley Act was signed into law on 30th July 2002, and introduced significant leg-islative changes to financial practice and corporate governance regulation. The act is named after its main architects, Senator Paul Sarbanes and Representative Michael Oxley, and of course fol-lowed a series of very high profile scandals, such as Enron. It is also intended to "deter and pun-ish corporate and accounting fraud and corruption, ensure justice for wrongdoers, and protect the interests of workers and shareholders"

It introduced stringent new rules with the stated objective: "to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws". It also in-troduced a number of deadlines, the prime ones being: - Most public companies must meet the financial reporting and certification mandates for any end of year financial statements filed after June 15th 2004 - smaller companies and foreign companies must meet these mandates for any statements filed after 15th April 2005.

The Sarbanes-Oxley Act itself is organized into eleven titles, although sections 302, 404, 401, 409, 802 and 906 are the most significant with respect to compliance. In addition, the Act also created a public company accounting board, to oversee the audit of public companies that are subject to the securities laws, and related matters, in order to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports for companies the securities of which are sold to, and held by and for, public investors.

Section 201 prohibits non audit services like bookkeeping, financial information systems design and implementation, actuarial services, management services etc from the scope of practice of auditors. They can however be taken up with the pre approval of the audit committee on a case by case basis.

Section 401 specifies enhanced financial disclosures specifically:

Accuracy of financial reports

Off-balance sheet transactions

Commission rules on pro forma figures

Section 501 seeks to improve objectivity of research by recommending rules designed to address conflicts of interest that can arise when securities analysts recommend equity securities in re-search reports. These rules are designed to foster greater public confidence in securities re-search, and to protect the objectivity and independence of securities analysts.

§§§ Extracted from Sarbanes-Oxley forum

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Bank for International Settlements (BIS), headquartered in Basel, Switzerland represents the Central Banks of 55 member countries.. The first Basel Capital Accord was instituted in 1988 to coordinate global regulatory efforts and institute minimum capital requirements to eliminate the threat posed by undercapitalized banks.

The 1988 Capital Accord prescribed a single, standard measure of risk to determine minimal cap-ital requirements. The accord aimed, primarily to reverse the steady erosion of bank capital ratios. As a basis for determining aggregate capital requirements, it has performed reasonably well. However, this led to offsetting of over and under assessed assets across a bank’s portfolio. The classification of obligors into sovereigns, banks and others (further divided between OECD and non-OECD) bears only a tenuous connection to comparative credit risk.

Post 1988, to address growing complexity, volatility, and interdependence among international fi-nancial markets, and heightened institutional and systemic threats, a new Capital Accord was proposed by the Basel Committee on Banking Supervision. The new Accord was aimed at estab-lishing a more sophisticated framework for banks to measure risk and ensure sufficient capital to cover losses from market, credit, and operational risk. The aim of Basel II is to promote safety and soundness in the financial system by allocating capital in organizations to reflect risk more accurately.

Basel II will apply to all financial services providers in the 110 countries that have signed the new Capital Accord, including security firms and asset managers with operations in banking and Capi-tal markets. EU member states will require all domestic and foreign financial services providers to comply, and the G-10 countries are including it into their regulatory environments in order to meet the Basel II implementation deadline of December 2006. Many of the over 25,000 banks around the world are expected to adopt Basel II as well, in order to maintain their competitive-ness.

The coverage of Basel II is likely to be as wide as the Y2K effort. Analysts’ estimate that IT spend would be around $22.5 billion to address Basel II requirements. A significant portion of this cost would comprise of the new technological developments and enhancements to the existing sys-tems.

Three Pillars

The underlying principle for the Accord is that Safety and soundness in today’s dynamic and com-plex financial system can be attained only by the combination of effective bank-level manage-ment, market discipline, and supervision.

The New Accord proposal is based on three mutually reinforcing pillars that allow banks and su-pervisors to evaluate the various risks that banks face.

**** Extracted from Bank of International Settlements’ documents –

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Pillar 1: Minimum Capital Requirements

The first pillar sets out minimum capital requirements. The New Accord has focused on improve-ments in the measurement of risks. The credit risk measurement methods are more elaborate than those in the current Accord. The new framework proposes for the first time a measure for operational risk, while the market risk measure remains unchanged.

Credit Risk: There is a choice between three increasingly sophisticated methods: the Standard-ized, the Foundation Internal Ratings Based (‘IRB’) and the Advanced IRB Approaches.

The Standardized Approach

The bank allocates a risk-weight to each of its assets and off-balance-sheet positions and pro-duces a sum of risk-weighted asset values.

Individual risk weights currently depend on the broad category of borrower (i.e. sovereigns, banks or corporates). The risk weights are to be refined by reference to a rating provided by an external credit assessment institution.

The Internal Ratings based Approach (IRB)

Under the IRB approach, banks will be allowed to use their internal estimates of borrower credit-worthiness to assess credit risk in their portfolios, subject to strict methodological and disclosure standards. Distinct analytical frameworks will be provided for different types of loan exposures, for example corporate and retail lending, whose loss characteristics are different.

Pillar 1


Pillar 2


Pillar 3

“Market Forces”

Supervisory Review

Market Discipline

Supervisory Review

Market Discipline

Minimum Capital Requirements

Supervisory Review

Market Discipline

• Disclosure re-quirements

• Capital struc-ture

• Risk expos-ures

• Capital ad-equacy

• Overview of supervisory re-view

• Key principles• Capital man-

agement pro-cesses

• Interest rate risk in the banking book

• Calculation of capital require-ments

• Credit risk• Operational

risk• Trading book

changes (mar-ket risk)

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Under both the foundation and advanced IRB approaches, the range of risk weights will be far more diverse than those in the standardized approach, resulting in greater risk sensitivity. A more complex approach (and therefore a more sophisticated risk management process) should lead to a lower capital charge.

Operational Risk: Broadly, Operational Risk (OR) is defined as the risk of monetary losses re-sulting from inadequate or failed internal processes, people, and systems or from external events. The events characterize the inherent risks in doing business and are mostly managed by putting in place controls. Some times controls may be ineffective or also fail because of weakness in people, processes, systems or external events. Some times inherent risks themselves may change because of the events in the external environment. Thus,

Operational risks = Inherent risks for which controls are not in place + Control risks

There is again a choice of approach: between a standardized and a more sophisticated Internal Measurement Approach (‘IMA’).

Basic Indicator Approach

This approach links the capital charge for operational risk to a single risk indicator for the whole bank. Gross income is proposed as the indicator, with each bank holding capital for operational risk equal to the amount of a fixed percentage, alpha. The Basic Indicator Approach can be ap-plied for any bank regardless of its complexity or sophistication.

The Standardized Approach

In this Approach, a bank’s activities are divided into a number of standardized business units and business lines. Within each business line, the capital charge is calculated by multiplying a bank’s broad financial indicator by a ‘beta’ factor. The capital charge would continue to be standardized by the supervisor. Now, for each business line gross income is taken to calculate the capital charge.

The Internal Measurement Approach

This approach strives to incorporate an individual bank’s internal loss data into the calculation of its required capital. Under the Internal Measurement Approach, a capital charge for the opera-tional risk of a bank would be determined using an Exposure Indicator (EI) within each business line / loss type combination, Probability of loss Event (PE), based on the banks’ internal loss data and Loss Given that Event (LGE) within each business line / loss type combination.

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The Check Clearing for the 21st Century Act (Check Truncation Act, Check 21) promotes check imaging through the introduction of a new payment instrument known as the substitute check (also referred to as the Image Replacement Document or IRD). The substitute check, which con-tains an image of the check, will be the legal equivalent of the original. Check 21 also abolishes the paying bank's right to demand presentment of the original paper check as a condition of pay-ment, which allows the bank of first deposit to truncate the check upon image capture. The Act is expected to speed the transition from traditional processing to imaged processing and encourage the use of electronic check clearing.

Check 21 will reduce paper flow resulting from 45- 50 billion paper checks processed each year, and, in many cases, will eliminate labor- and cost-intensive paper check handling, transportation, and storage issues. Banks that convert to check imaging will realize many other benefits, includ-ing:

Savings associated with lower transit costs and courier charges

Lower risk of lost items and/or transit delays

Lower check processing errors resulting from reduced handling and automated data capture from check images

Fully automated Day 2 (return) processing enabled by image excep-tion item processing

Compressed processing windows to enable later branch cutoff times

Improved collection float due to faster clearing processes

Check 21 will lead to additional payment system efficiency industry-wide. It will allow financial in-stitutions to further leverage their investment in check imaging technologies.

Check 21 – Technology challenges for banks

Banks would require substantial technology investments in migrating to a Check 21 environment. Analyzing from a process flow perspective, the following are the main systems required:

Check image capture (with verification and receipt generation if re-quired)

Check image storage, archival & exchange

Check image processing, pattern matching & signature verification

CRM integration – check research and adjustment

Some of the investments can be avoided by going in for an ASP-based solution whereby all pro-cesses like check image storage & archival, image exchange and processing workflow can be managed by a third party service provider on a subscription basis. However, the decision on out-sourcing these activities have to be taken by banks after considerable research on as-is process flow and technology analysis, capacity planning, security analysis and benchmarking.

Investments for check capture and image processing would be incremental, whereas there would be significant investment required for storage, archival and exchange of check images in a secure environment. This would be a major hurdle for most of the banks. Banks will also have to cope with multiple technology vendors and architectural solutions while ensuring that they stick to im-plementation time lines.

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Agency bonds: Agencies represent all bonds issued by the federal government, except for those issued by the Treasury (i.e. bonds issued by other agencies of the federal government). Exam-ples include the Federal National Mortgage Association (FNMA), and the Guaranteed National Mortgage Association (GNMA).

Arbitrage: The trading of securities to profit from a temporary difference between the price of se-curity in one market and the price in another. This temporary difference is often called market in-efficiency.

Annualized Percentage or Return: The periodic rate times the number of periods in a year. For example, a 5% quarterly return has an A.P.R. of 20%. It depends on the following:

How much repayment

How frequently

Which component of loan – interest or principal

Authorization (Credit Cards): The act of ensuring that the cardholder has adequate funds avail-able against their line of credit. A positive authorization results in an authorization code being generated, and a hold being placed on those funds. A "hold" means that the cardholder's avail-able credit limit is reduced by the authorized amount.

Beauty contest: The informal term for the process by which clients choose an investment bank. Some of the typical selling points when competing with other investment banks for deals are: "Look how strong our research department is in this industry. Our analyst in the industry is a real market mover, so if you go public with us, you'll be sure to get a lot of attention from her."

Bloomberg: Computer terminals providing real time quotes, news, and analytical tools, often used by traders and investment bankers.

Bond spreads: The difference between the yield of a corporate bond and a U.S. Treasury secu-rity of similar time to maturity.

Bulge bracket: The largest and most prestigious firms on Wall Street like Goldman Sachs, Mor-gan Stanley Dean Witter, Merrill Lynch, Salomon Smith Barney, Lehman Brothers, Credit Suisse First Boston.

Buy-side: The clients of investment banks (mutual funds, pension funds) that buy the stocks, bonds and securities sold by the investment banks. (The investment banks that sell these prod-ucts to investors are known as the sell-side.)

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Capitalized Loan: A loan in which the interest due and not paid is added to the principal balance of the loan. Capitalized interest becomes part of the principle of the loans; therefore, it increases the total cost of repaying the loan because interest will accumulate on the new, higher principle.

Capture (Credit Cards): Converting the authorization amount into a billable transaction record. Transactions cannot be captured unless previously authorized.

Commercial bank: A bank that lends, rather than raises money. For example, if a company wants $30 million to open a new production plant, it can approach a commercial bank for a loan.

Commercial paper: Short-term corporate debt, typically maturing in nine months or less.

Commodities: Assets (usually agricultural products or metals) that are generally interchangeable with one another and therefore share a common price. For example, corn, wheat, and rubber generally trade at one price on commodity markets worldwide.

Comparable company analysis (Comps): The primary tool of the corporate finance analyst. Comps include a list of financial data, valuation data and ratio data on a set of companies in an industry. Comps are used to value private companies or better understand a how the market val-ues and industry or particular player in the industry.

Consumer Price Index: The CPI measure the percentage increase in a standard basket of goods and services. CPI is a measure of inflation for consumers.

Coupon rate: The fixed interest paid on a bond as a percentage of its face value, each year, until maturity. In Thailand the coupon is usually paid semi-annually or annually.

Discount rate: The rate at which federal banks lend money to each other on overnight loans. A widely followed interest rate set by the Federal Reserve to cause market interest rates to rise or fall, thereby causing the U.S. economy to grow more quickly or less quickly.

Discount Rate for Credit Cards: A small percentage of each transaction that is withheld by the Acquiring Bank or ISO. This fee is basically what the merchant pays to be able to accept credit cards. The fee goes to the ISO (if applicable), the Acquiring Bank, and the Associations.

Dividend: A payment by a company to shareholders of its stock, usually as a way to distribute profits to shareholders.

Fed: The Federal Reserve, which manages the country's economy by setting interest rates.

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Federal funds rate: The rate domestic banks charge one another on overnight loans to meet Federal Reserve requirements. This rate tracks very closely to the discount rate, but is usually slightly higher.

Fixed income: Bonds and other securities that earn a fixed rate of return. Bonds are typically is-sued by governments, corporations and municipalities.

Float: The number of shares available for trade in the market. Generally speaking, the bigger the float, the greater the stock's liquidity.

Floating rate: An interest rate that is benchmarked to other rates (such as the rate paid on U.S. Treasuries), allowing the interest rate to change as market conditions change.

Glass-Steagall Act: Passed in 1933 during the “Depression” to help prevent future bank failures. The Glass-Steagall Act split America's investment banking (issuing and trading securities) opera-tions from commercial banking (lending). For example, J.P. Morgan was forced to spin off its se-curities unit as Morgan Stanley. Since the late 1980s, the Federal Reserve has steadily weak-ened the act, allowing commercial banks such as NationsBank and Bank of America to buy in-vestment banks like Montgomery Securities and Robertson Stephens. In 1999, Glass-Steagall was effectively repealed by the Graham-Leach-Bliley Act.

Graham-Leach-Biley Act: Also known as the Financial Services Modernization Act of 1999. Es-sentially repealed many of the restrictions of the Glass-Steagall Act and made possible the cur-rent trend of consolidation in the financial services industry. Allows commercial banks, investment banks, and insurance companies to affiliate under a holding company structure.

Gross Domestic Product: GDP measures the total domestic output of goods and services in the United States. For reference, the GDP grew at a 4.2 percent rate in 1999. Generally, when the GDP grows at a rate of less than 2 percent, the economy is considered to be in recession.

Hedge: To balance a position in the market in order to reduce risk. Hedges work like insurance: a small position pays off large amounts with a slight move in the market.

High grade corporate bond: A corporate bond with a rating above BB. Also called investment grade debt.

High yield debt (a.k.a. Junk bonds): Corporate bonds that pay high interest rates to compen-sate investors for high risk of default. Credit rating agencies such as Standard & Poor's rate a company's (or a municipality's) bonds based on default risk. Junk bonds rate below BB.

Institutional clients or investors: Large investors, such as pension funds or municipalities (as opposed to retail investors or individual investors).

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Lead manager: The primary investment bank managing a securities offering. An investment bank may share this responsibility with one or more co-managers.

League tables: Tables that rank investment banks based on underwriting volume in numerous categories, such as stocks, bonds, high yield debt, convertible debt, etc. High rankings in league tables are key selling points used by investment banks when trying to land a client engagement.

Leveraged Buyout (LBO): The buyout of a company with borrowed money, often using that company's own assets as collateral. LBOs were common in 1980s, when successful LBO firms such as Kohlberg Kravis Roberts made a practice of buying up companies, restructuring them, and reselling them or taking them public at a significant profit

LIBOR: London Inter-bank Offered Rate. A widely used short-term interest rate. LIBOR repre-sents the rate banks in England charge one another on overnight loans or loans up to five years. LIBOR is often used by banks to quote floating rate loan interest rates. Typically the benchmark LIBOR is the three-month rate.

Liquidity: The amount of a particular stock or bond available for trading in the market. For com-monly traded securities, such as big cap stocks and U.S. government bonds, they are said to be highly liquid instruments. Small cap stocks and smaller fixed income issues often are called illiq-uid (as they are not actively traded) and suffer a liquidity discount, i.e. they trade at lower valua-tions to similar, but more liquid, securities.

Long Bond: The 30-year U.S. Treasury bond. Treasury bonds are used as the starting point for pricing many other bonds, because Treasury bonds are assumed to have zero credit risk taking into account factors such as inflation. For example, a company will issue a bond that trades "40 over Treasuries." The 40 refers to 40 basis points (100 basis points = 1 percentage point).

Making markets: A function performed by investment banks to provide liquidity for their clients in a particular security, often for a security that the investment bank has underwritten. The invest-ment bank stands willing to buy the security, if necessary, when the investor later decides to sell it.

Market Capitalization: The total value of a company in the stock market (total shares outstand-ing x price per share).

Merchant Account: A special business account set up to process credit card transactions. A merchant account is not a bank account (even though a bank may issue it). Rather, it is designed to 1) process credit card payments and 2) deposit the funds into your (business) checking ac-count (minus transaction fees).

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Money market securities: This term is generally used to represent the market for securities ma-turing within one year. These include short-term CDs, repurchase agreements, commercial paper (low-risk corporate issues), among others. These are low risk, short-term securities that have yields similar to Treasuries.

Mortgage-backed bonds: Bonds collateralized by a pool of mortgages. Interest and principal payments are based on the individual homeowners making their mortgage payments. The more diverse the pool of mortgages backing the bond, the less risky they are.

Municipal bonds ("Munis"): Bonds issued by local and state governments, a.k.a. municipalities. Municipal bonds are structured as tax-free for the investor, which means investors in muni's earn interest payments without having to pay federal taxes. Sometimes investors are exempt from state and local taxes, too. Consequently, municipalities can pay lower interest rates on muni bonds than other bonds of similar risk.

Payment Gateway Fees (Credit Cards): The fees that payment gateways charge for their ser-vices. This generally includes a monthly fee and a small flat fee per transaction. These fees may be consolidated into a single bill by the acquiring bank or ISO, along with their fees.

Pitchbook: The book of exhibits, graphs, and initial recommendations presented by bankers to a prospective client when trying to land an engagement.

Pit traders: Traders who are positioned on the floor of stock and commodity exchanges (as op-posed to floor traders, situated in investment bank offices).

P/E ratio: The price to earnings ratio. This is the ratio of a company's stock price to its earnings-per-share. The higher the P/E ratio, the more expensive a stock is (and also the faster investors believe the company will grow). Stocks in fast-growing industries tend to have higher P/E ratios.

Prime rate: The average rate U.S. banks charge to companies for loans.

Producer Price Index: The PPI measure the percentage increase in a standard basket of goods and services. PPI is a measure of inflation for producers and manufacturers.

Proprietary trading: Trading of the firm's own assets (as opposed to trading client assets).

Prospectus: A report issued by a company (filed with and approved by the SEC) that wishes to sell securities to investors. Distributed to prospective investors, the prospectus discloses the com-pany's financial position, business description, and risk factors.

Red herring: Also known as a preliminary prospectus. A financial report printed by the issuer of a security that can be used to generate interest from prospective investors before the securities are

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legally available to be sold. Based on final SEC comments, the information reported in a red her-ring may change slightly by the time the securities are actually issued.

Retail clients: Individual investors (as opposed to institutional clients).

Return on equity: The ratio of a firm's profits to the value of its equity. Return on equity, or ROE, is a commonly used measure of how well an investment bank is doing, because it measures how efficiently and profitably the firm is using its capital.

Risk arbitrage: When an investment bank invests in the stock of a company it believes will be purchased in a merger or acquisition. (Distinguish from risk-free arbitrage.)

Road-show: The series of presentations to investors that a company undergoing an IPO usually gives in the weeks preceding the offering. Here's how it works: Several weeks before the IPO is issued, the company and its investment bank will travel to major cities throughout the country. In each city, the company's top executives make a presentation to analysts, mutual fund managers, and others attendees and also answer questions.

Sales memo: Short reports written by the corporate finance bankers and distributed to the bank's salespeople. The sales memo provides salespeople with points to emphasize when hawking the stocks and bonds the firm is underwriting.

Securities and Exchange Commission (SEC): A federal agency that, like the Glass-Steagall Act, was established as a result of the stock market crash of 1929 and the ensuing depression. The SEC monitors disclosure of financial information to stockholders, and protects against fraud. Publicly traded securities must first be approved by the SEC prior to trading.

Securitize: To convert an asset into a security that can then be sold to investors. Nearly any in-come generating asset can be turned into a security. For example, a 20-year mortgage on a home can be packaged with other mortgages just like it, and shares in this pool of mortgages can then be sold to investors.

Short-term debt: A bond that matures in nine months or less. Also called commercial paper.

Syndicate: A group of investment banks that will together underwrite a particular stock or debt of-fering. Usually the lead manager will underwrite the bulk of a deal, while other members of the syndicate will each underwrite a small portion.

Transaction Fee (Credit Cards): A small flat fee that is paid on each transaction. This fee is col-lected by the acquiring bank or ISO and pays for the toll-free dial out number and the processing network.

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T-Bill Yields: The yield or internal rate of return an investor would receive at any given moment on a 90-120 government treasury bill.

Tombstone: The advertisements that appear in publications like Financial Times or The Wall Street Journal announcing the issuance of a new security. The tombstone ad is placed by the in-vestment bank as information that it has completed a major deal.

Yield: The annual return on investment. A high yield bond, for example, pays a high rate of inter-est.

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The Bank Credit Card Business – American Bankers Association

Value At Risk – Phillipe Jorions

Principles of Corporate Finance – Brearley Myers

Securities Operations – Michael T Reddy – New York Institute of Fi-nance

After the Trade is Made – David M Weiss – New York Institute of Fi-nance

Investment Analysis & Portfolio Management - Frank K. Reilly &

Keith C. Brown

The Warren Buffet Way – Robert Hagstrom Jr

One Up on the Wall Street – Peter Lynch

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