A1] Credit Rating:
Capital and Money Market
Credit rating is essentially giving an expert opinion by a rating agency on the relative willingness and ability of the issuer of a debt instrument to meet the debt servicing obligation in time and full. Generally equities are not rated as there is not measurable and they being the owners of the companies have to take the residual risk.
But when companies issue bonds or debentures or any debt instruments, they are to be rated because investors had no way to know the credit quality of the companies whether they were strong financially, weak in some aspects, whether they are frauds.
In U.S.A. John Moody has issued his first rating in 1909. He published Manual of Information on U.S. Railroad companies. His ratings became popular with investors. He began to rate all companies issuing bonds and even bonds of foreign Govts. issued in the U.S.A.
During 1920’s Standard and Poor ratings became equally popular. After the depression of thirties, rating became more important, these agencies have become global rating agencies in 1980’s and 90’s.
Factors considered in evaluating the instruments:
They take into account the various risks involved in servicing of instruments. They undertake:
· Business Analysis: Legal position in terms of prospectus, memorandum and articles of association etc. Industry risk, demand and supply position for the company’s products, market share of the company, operational efficiency etc.
· Financial Analysis: Accounting quality of the company, inventory norms, depreciation policy, accounting and auditing methods, capital structure, methods of raising funds, adequacy of working capital funds, cash flows and earnings protection etc.
· Management Evaluation: Track record of the management, planning and control system, managerial expertise, tax planning, expansion plans, sales and assets growth, capacity to overcome adverse economic and market conditions etc.
· Fundamental Analysis: Evaluation is carried out for earnings per share, book value, capital and sales turnover management, debt-equity ratio, liquidity ratios, interest and sensitivity of the company, its profitability position etc.
A2] A CRISIL rating reflects CRISIL's current opinion on the relative likelihood of timely payment of interest and principal on the rated obligation. It is an unbiased, objective, and independent opinion as to the issuer's capacity to meet its financial obligations.
So far, CRISIL has rated 30,000 debt instruments, covering the entire debt market.
The debt obligations rated by CRISIL include:
- Non-convertible debentures/bonds/preference shares
- Commercial papers/certificates of deposits/short-term debt
- Fixed deposits
- Loans
- Structured debt
CRISIL Ratings' clientele includes all the industry majors - 23 of the BSE Sensex constituent companies and 39 of the NSE Nifty constituent companies, accounting for 80 per cent of the equity market capitalization, are CRISIL's clients.
CRISIL's credit ratings are
- An opinion on probability of default on the rated obligation
- Forward looking
- Specific to the obligation being rated
But they are not
- A comment on the issuer's general performance
- An indication of the potential price of the issuers' bonds or equity shares
- Indicative of the suitability of the issue to the investor
- A recommendation to buy/sell/hold a particular security
- A statutory or non-statutory audit of the issuer
- An opinion on the associates, affiliates, or group companies, or the promoters, directors, or officers of the issuer
CRISIL ratings are based on a robust and clearly articulated analytical framework, which ensures comprehensiveness, standardization, comparability, and effective communication of the ratings assigned and of every timely rating action. The assessment is based on the highest standards of independence and analytical rigor.
Facilities may include:
Bond/Long-term ratings: CRISIL's long-term ratings reflect CRISIL's current opinion on the relative safety of timely payment of interest and principal on the rated financial obligations which have an originally contracted maturity of more than one year.
The long-term debt obligations typically rated by CRISIL include:
- Non-convertible debentures/Bonds/Preference shares
- Fixed deposits
- Loans
- Structured debt
Commercial paper/Short-term instruments: CRISIL's short-term ratings reflect CRISIL's current opinion as to the relative safety of timely payment of interest and principal on the rated financial obligations, which have an originally contracted maturity of less than one year.
The short-term debt obligations typically rated by CRISIL include:
- Non-convertible debentures
- Inter corporate deposits
- Commercial papers/certificates of deposits/short-term debt
- Fixed deposits
- Loans
- Structured debt
Structured finance/PTCs: Ratings on pass through certificates (PTCs) indicate the relative degree of risk associated with timely payment of financial obligations on the PTCs as per the terms of the securitization transaction. The ratings reflect the degree of credit protection provided by the cash flows from the pool of securitized loans, together with the credit enhancements (if any), for making timely repayments on the PTCs as per the schedule indicated in the transaction documents. The ratings on PTCs carry the suffix '(so)' to indicate that the instruments have a structured obligation.
CRISIL rates a wide range of entities, including:
[Available for all]
- Urban local bodies
- Banks
- Non-banking financial companies (NBFCs)
- Infrastructure entities
- Microfinance institutions
[Available for the first two only]
- Insurance companies
- Mutual funds
- State governments
- Industrial companies
A3]
Forward Contract:
A forward contract is a contract to buy or sell an asset on a specified date, for a specified price. The terms of the contract like price, quantity, quality, delivery date etc. are negotiated bilaterally by the parties to the contract.
Futures Contract:
A futures contract is an agreement between a seller and a buyer that calls for the seller to deliver to the buyer a specified quantity and grade of an identified commodity or some asset, at a fixed time in the future, and at a price agreed to when the contract is first entered into.
Distinctions between Futures and Forward Contract:
1. In a futures contract, the contract terms are standardized whereas it is not standardized in case of forward contract.
2. In case of futures contract, the clearing house of exchange becomes counter-party for each contract and therefore, there is no counter-party risk. In case of forward contract there is counter-party risk.
3. In case of futures contract, both the buyer and seller must deposit margin money with the exchange which is around 10-20% of contract value. In case of forward contract, there is no margin money required.
4. There is secondary market for futures contract where as there is no secondary market for forward market.
5. A futures contract is settled in different ways such as Actual delivery, Reversing of trade, Cash settlement etc. whereas a forward contract is settled mostly by delivery of the asset.
6. A futures contract can be closed very easily whereas forward contracts are difficult to close before maturity.
7. There is marking to market in case of futures contract. Gain or loss on open positions are calculated daily and are debited or credited to the investors account. There is no such process in a forward contract.
8. A futures contract is entered into through the member of exchange. Whereas a forward contract is entered into without the broker/member.
A4] Options Contract:
An option is type of contract between two parties when one person grants the other person the right to buy or sell a specific asset at a specific price, on or before a specified time period
There are two types of options: Calls and Puts.
A call gives the holder (buyer) of the options contract the right, but not the obligation to buy the underlying futures contract. People who buy calls are forecasting that the price of the underlying futures is going to go up, so they can buy low and sell high. Conversely, a put gives the holder the right but not the obligation to sell the underlying futures contract.
The price at which the underlying futures contract may be bought or sold is the exercise price, also called the strike price. Several puts or calls at different strike prices will be available for a particular underlying futures contract. For example, there may be September CME S&P 500 call options at 1410, 1420, 1430, and so on.
An options contract affords the right to buy or sell for only a limited period of time. The expiration date of an option is the last day the option can be exercised or offset.
The writer of a call incurs an obligation to sell a futures contract and the writer of a put has an obligation to buy a futures contract. In return for the rights they are granted, options buyers pay options sellers a premium.
CALL
Option Buyer
- Purchased the right to buy the underlying futures contract at the specified price on
or before the defined date. - Call option buyer anticipates prices to rise in the underlying futures contract.
Option Seller (writer)
- Grants the right to the buyer, therefore has the obligation to sell the futures contract at
a predetermined price if the buyer chooses to exercise the call. - The expectation of the call option seller is that prices will remain neutral or decline.
PUT
Option Buyer
- Purchased the right to sell the underlying futures contract at the specified on
or before the defined date. - Call option buyer anticipates prices to decline in the underlying futures contract.
Option Seller (writer)
- Grants the right to the buyer, therefore has the obligation to buy the futures contract at
a predetermined price if the buyer chooses to exercise the call. - The expectation of the call option seller is that prices will remain neutral or rise.
An options contract is a depreciating asset. It has an initial value that declines, or wastes away, as time passes. Depending upon the movement of an options price, the buyer will choose one of three alternatives for terminating an options position:
- Exercise the options contract.
- Liquidate it by selling it back on the Exchange.
- Let it expire.
While liquidation is the most common choice, a small percentage of buyers choose to exercise their options, particularly if their strategy calls for acquiring a long or short futures position at the strike price. The ability to trade in and out of positions is the great advantage of standardized options contracts.
If the futures price does not move far enough for an exercise to be worthwhile, or moves in the opposite direction, buyers can simply let their options contract expire worthless.
Because trading on the Exchange is conducted among anonymous counterparties, when an options contract is exercised, the Exchange randomly assigns an options writer to fulfill the obligation.
As in the futures market, options trading takes place in a primarily open outcry auction market on the Exchange. While the value of futures is tied to the underlying cash commodity through the delivery process, the value of an options contract is related to the underlying futures contract through the ability to exercise the option.
A5] Instruments Dealt in a Money Market:
A money market deals with near-money or short-term credit instruments. The chief short-term credit instruments that are dealt with in a money market are:
1. Trade Bills.
2. Bankers’ Acceptance.
3. Commercial Papers.
4. Treasury Bills.
5. Short-term Government Bonds.
6. Hundis.
Trade Bills: Trade bills are bills of exchange arising out of inland or foreign trade. They are drawn for short-term periods of 1 month, 2 months, 3 months or 6 months. They are drawn by the sellers of goods on the buyers, directing them (i.e. the buyers) to pay the sum specified therein to certain persons on their due dates. They are accepted either by the purchasers of goods or by banks or acceptance houses on their behalf. They are discountable in money market and are also rediscountable with the central bank. They are popular in the London Money Market. In other money markets also they are used.
Bankers’ Acceptance: Bankers’ acceptances are bills of exchange drawn by business concerns on specified banks, and accepted by those banks on behalf of their customers, who are indebted to the drawers. They arise either out of international trade or out of inland trade. They are discountable in money market and are also rediscountable with the central bank. They are very popular in the New York Money Market. In other money markets also they are common.
Commercial Papers: Commercial papers are promissory notes given by certain well-known business houses (which seek short-term finance) to specified commercial paper houses (which are prepared to provide finance against those papers) promising to pay them the sum specified therein on specified dates. They are issued for periods of 3 to 6 months. They can be discounted in money market. They are also rediscountable with the central bank. They are the unique feature of the New York Money Market.
Treasury Bills: Treasury bills are promissory notes of 90 days maturity issued by the Government treasury for the purpose of raising short-term funds for the Government. They do not carry interest. But they are issued at a discount. The commercial banks and others purchase them at weekly auction of bidding. They are discountable in money market and are also rediscountable with the central bank. In recent years, they have become very important in almost all the money markets of the world.
Short-term Government Bonds: Short- term Government bonds are securities issued by the Government for short periods. They also include long-term Government securities approaching maturity. Commercial banks and other institutions in the money market purchase them. Of late, these securities have become very popular in all the money markets of the world.
Hundis: Hundis are the unique feature of the indigenous sector of the Indian Money Market. They are inland bills of exchange drawn in vernacular (i.e. local) languages. They can be used either for making payments or for transferring funds from one place to another. Hundis of some of the well-known indigenous bankers are discounted in the money market.
A6] The monetary mechanism works through CRR and SLR. The two are used to control money supply in following way; banks require keeping a certain percentage of total deposits in form of cash. CRR:
Cash Reserve Ratio (CRR) is the amount which scheduled commercial banks have to keep with RBI (Reserve Bank of
SLR:
SLR (Statutory Liquidity Ratio) is a portion of banks Net Demand and Time liabilities (NDTL) that Scheduled Commercial Banks are required to maintain with themselves in form of Cash, Gold, Government Bonds or unencumbered approved securities at closing of any business day. It regulates credit growth in country. RBI can increase it up to 40% of NDTL .this monetary tool is used by the RBI to ensure sufficient liquidity with banks. an increase in SLR will restrict banks lending capacity.
Difference between SLR and CRR:
1. SLR restricts the bank’s leverage of pumping money into the economy. CRR, or Cash Reserve Ratio, is the portion of deposits that the banks have to maintain with the RBI.
2. The other difference is that for SLR, banks can use cash, gold or unencumbered approved securities whereas with CRR it has to be only cash.
3. CRR is maintained in cash form with RBI, whereas SLR is maintained in liquid form with banks themselves.
Effects on money supply
CRR:
The reserve requirement can affect monetary policy, because the higher the reserve requirement is set, the less money banks will have to loan out, leading to lower money creation, and maintaining the purchasing power of the currency previously in use. The effect is exponential, because money that is loaned out can be re-deposited; a portion of that money may again be re-loaned, and so on. The effect on the monetary supply is governed by the following formula:
MS = Money Supply
Mb = Monetary base
mm = money multiplier
c = rate at which people hold cash (as opposed to depositing it), equal to one minus marginal propensity to consume
R = the reserve requirement (the percent of deposits that banks are not allowed to lend)
SLR:
The quantum is specified as some percentage of the total demand and time liabilities (i.e. the liabilities of the bank which are payable on demand anytime, and those liabilities which are accruing in one months time due to maturity) of a bank.
SLR Rate = Total Demand/Time Liabilities x 100%
This percentage is fixed by the Reserve Bank of India
