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Topic: What is derivative market? Explain the risks covered through this

market.

Derivative market:

A derivative instrument is a financial asset whose value derives from the value

of some other asset, index, or interest rate. A future transaction is contracts that exchange an asset or

commodity at a fixed price in a future. In an option, owner has a right but not the obligation to buy or sell

an asset at a specified price. In a swap, parties exchange one form of cash flows for another, typically a fixed

cash flow for a variable one.

Following are the risk covered through this market:

Foreign Exchange Risk:

One of the more common corporate uses of derivatives is for hedging foreign-

currency risk, or foreign-exchange risk, which is the risk that a change in currency exchange rates will

adversely impact business results.

Hedging Interest Rate Risk:

Companies can hedge interest-rate risk in various ways. Consider a company

that expects to sell a division in one year and at that time to receive a cash windfall that it wants to "park"

in a good risk-free investment. If the company strongly believes that interest rates will drop between now

and then, it could purchase (or 'take a long position on') a Treasury futures contract The company is

effectively locking in the future interest rate.

Commodity or Product Input Hedge:

Companies that depend heavily on raw-material inputs or commodities are

sensitive, sometimes significantly, to the price change of the inputs. Airlines, for example, consume lots of

jet fuel. Historically, most airlines have given a great deal of consideration to hedging against crude-oil price

increases - although at the start of 2004 one major airline mistakenly settled (eliminating) all of its crude-oil

hedges: a costly decision ahead of the surge in oil prices.

Topic: What is insurance business? Explain the types of insurance services in us.

Insurance: An arrangement by which a company or the state undertakes to provide a guarantee of

compensation for specified loss, damage, illness, or death in return for payment of a specified premium

Life Insurance:

The Life Insurance Company pays the beneficiary of the life insurance policy in the

event of the death of insured person.

Health Insurance:

A type of insurance coverage that pays for medical and surgical expenses that are

incurred by the insured Health insurance can either reimburse the insured for expenses incurred from

illness or injury or pay the care provider directly. Health insurance is often included in employer benefit

packages as a means of enticing quality employees.

Disability Insurance:

Disability insurance policies provide financial support in the event of the

policyholder becoming unable to work because of disabling illness or injury. It provides monthly support to

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help pay such obligations as mortgage loans and credit cards. Short-term and long-term disability policies

are available to individuals, but considering the expense, long-term policies are generally obtained only by

those with at least six-figure incomes, such as doctors, lawyers, etc. Short-term disability insurance covers

a person for a period typically up to six months, paying a net each month to cover medical bills and other

necessities

Define Primary market:

Who can issue securities in the primary market of US?

Describe the functions of Investment Bank.

Primary Market: The primary market is the part of the capital market that deals with issuing of new

securities. Companies, governments or public sector institutions can obtain funds through the sale of a new

stock or bond issues through primary market.

Securities Issuance in US: The United States government is the largest issuer of debt securities, and its bonds are

considered the safest fixed-income investments available to your customer. There are two primary types of

U.S. government debt securities:

Issues with direct government backing, as is the case with Treasury and federal agency issues, and

Issues with “moral" backing or guarantee, as is the case with government-sponsored

enterprise (GSE) issues. Examples of Treasury issues include Treasury bills (T-bills), Treasury notes (T-notes) and Treasury bonds (T-

bonds).

Functions of Investment Banks: Following are the functions of IB:

Mergers and Acquisitions

The major work of investment banks includes a lot of consulting. For

instance, they offer advices on mergers and acquisitions to companies. The other area where they give

advice are tracking the market and determining when should a company come out with a public offering

and what is the best possible way to manage the public assets of businesses. The role that an investment

bank plays sometimes gets overlapped with that of a private brokerage house. The usual advice of buying

and selling is also given by investment banks.

Corporate financing

At the macro level, investment banking is related with the primary

function of assisting the capital market in its function of capital intermediation, i.e., the movement of

financial resources from those who have them (the investors), to those who need to make use of them for

producing GDP (the issuers). Over the decades, investment banks have always suited the needs of the

finance community and thus become one of the most vibrant and exciting segment of financial services.

Underwriting

Investment bank is a financial institution and investment banking plays a

very important role in the economy. Investment banking helps the corporations in raising capital. It

facilitates the trading of securities thereby, increasing the liquidity of the securities.

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Topic: Role of Financial Intermediaries: Intermediaries obtain funds from customers and invest these funds. Such a role is called direct

intermediaries. Customers who give their funds to the intermediaries and who thereby hold claims on these

institutions are making indirect investments. A commercial bank accepts deposits and uses the proceeds to

lend funds. Financial intermediaries, such as investment companies, play a basic role of transforming

financial assets which are less desirable for a large part of the public into other financial assets which are

broadly preferred by the public. By doing so they provide at least one of the following four economic

functions;

i. Providing Maturity intermediation

ii. Reducing risk via diversification

iii. Reducing costs of contracting and

information process

iv. Provide a payment mechanism

Maturity Intermediation: The customer (depositor) often wants only a short term claim,

which the intermediary can turn into a claim on long term assets. In other words, the intermediary is willing

and able to handle the liquidity risk more readily than customer. This is called maturity intermediation.

Risk Reduction Via Diversification: By pooling funds from many customers the financial intermediary

can better achieve diversification of its portfolio than its customer.

Reduced costs of contracting and information processing:

Financial institutions provide expert analysis, better data access,

and loan enforcement. Costs of writing loan contracts are referred to as contracting costs. Also there are

information processing costs. They also benefit from economies of scale.

Providing a Payment Mechanism: Financial depositaries provide a payment mechanism, e.g. checking

accounts, credit cards, certainty debt cards and electronic transfers of funds.

Topic: Globalization of financial markets: The existence of foreign financial markets permits raising and investing funds outside of the domestic

market. There is a trend towards integration of financial markets throughout much of the world. The factors

that have led to integration are:

1. Deregulation or liberalization of markets to encourage competition;

2. Technological advances permit more information flows and rapid execution of orders;

3. Increased participation of financial institutions in global markets relative to individuals. Such firms

are more willing and able to transfer funds to diversify their portfolios and to take advantage of

possible mis-pricing in markets.

CLASSIFICATION OF GLOBAL FINANCIAL MARKETS:

Financial markets can be classified as either internal or external.

Internal: Internal Securities issued in the domestic or foreign markets. Foreigners can issue

securities in other country markets, subject to national regulations, e.g. Japanese firms can issue dollar

denominated securities in the United States, but they must follows U.S. regulations, which apply to

nationals and foreigners alike.

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External:

External securities issued outside jurisdiction of any country, e.g. offshore or Eurodollar

offerings can be dollar denominated. They thereby fall outside of foreign rules, which are designed to deal

with domestic financial concerns. The external market is sometimes called the offshore market or Euro

market.

Motivation for foreign and Eurodollar markets: Some funds needs cannot be met in a small country market, e.g. giant firm Philips cannot

raise all funds it needs if it is restricted to the Dutch capital market. Also, many underdeveloped nations

simply do not have a sizable capital market to meet their funds needs.

Lower funding costs when imperfections exist among capital markets, e.g. regulations as would be the case

in the U.S. market.

Topic: Basel Committee:

Basel Committee: Commercial banks are typically highly leveraged, i.e. equity constitutes a

small fraction (about 8%) of the bank’s assets. The organization that plays the primary role in establishing

risk and management guidelines for banks throughout the worlds is the Basel Committee on Banking

Supervision. The capital requirements that resulted from other Guidelines published by the Basel

committee are called risk based capital requirements. In July 1988, the Basel committee released its first

guidelines, the Capital Accord of 1988, commonly called Basel I Framework. In June 2004, comprehensive

amendments, Basel II framework, were published to improve on the rules as set forth in the Basel I

Framework by bringing risk based capital requirements more in line with the underlying risks to which banks

are exposed.

Credit risk and risk based capital requirements: The risk based capital guidelines attempt to recognize credit risk by segmenting

and weighting requirements. First, capital is categorized as tier 1 and Tier 2 capital. Tier 1 is the core capital.

Tier 2 is the supplementary capital. Second, the guidelines establish a credit risk weight for all assets.

Topic: Instruments of monetary policy: How the fed influence the supply of

money: The FED has three instruments as its disposal to affect the level of reserves:

Reserve Requirements:

Under our fractional reserve banking system have to maintain

specified fractional amounts of reserves against their deposits. The FED can raise or lower these required

reserve ratios, thereby permitting banks to decrease or increase their lending and investment portfolios. A

bank’s total reserves equal its required reserves plus any excess reserves.

Open market Operations: The fed most powerful instruments is its authority to conduct open

market operation. It buys and sells in open debt markets governments securities for its own accounts. The

fed prefers to use treasury bills because it can make its substantial transactions without seriously disrupting

the prices or yields of bills.

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The federal open market committee, or FOMC, is the unit that decides on the general issues of changing

the rate of growth in the money supply, by open market sales or purchases of securities. The

implementation of policy through open market operations is the responsibility of the trading desk of the

federal reserve bank of New York.

Open market purchase agreements: The fed often employs variants of simple open market purchases and

sales; these are called the repurchased agreements (or repo). In a repo the fed buys a particular amount of

securities from a seller that agrees to repurchase the same number of securities for a higher price at some

future time. In a reverse repo, the fed sells securities and makes a commitment to buy them back at a

higher price later.

Discount Rate: A bank borrowing from the fed is said to use the discount window. The discount rate is the rate charged to

banks borrowing directly from the fed. Raising the rate is designed to discourage such borrowing, while

lowering should have the opposite effect.

Topic: Liquidity Concern & Bank Services in US Liquidity Concern:

Liquidity concern is the possibility of withdrawal of funds by depositors or

insufficient funds available to meet lending needs. It can be handled by (1) attracting more deposits (2)

borrowing from federal agency or other institution (Federal Funds market) (3) raising short term funds in

the money market (4) selling or liquidating securities and other assets. Securities held for the purpose of

satisfying net withdrawals and customer’s loan demands are something referred to as secondary reserves.

Services provided by banks in US:

Banks provide numerous services and are broadly defined as follows

o Individual Banking

o Intuitional Banking

o Global Banking

Individual banking includes consumer lending mortgage lending (mortgage banking), credit card financing,

and brokerage services, student loans, and individual oriented financial investment services.

Institutional banking: It includes commercial real estate financing, leasing activities and factoring.

Global banking: It includes corporate financing, capital market and foreign exchange products and

services.

At one time some of these activities were restricted by the Glass Steagall Act. But this act was replaced by

the Gramm Leach Bliley Act in November 1999.

Comment on the nature of liabilities of depository institutions with one product covered

in each liability

All intermediaries face asset / liability management problems. The nature of the liabilities dictates the

investment strategy a financial institution will reward.

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Nature Of Liabilities:

The liabilities of a financial institution mean the amount and time of cash outlays that

must be made to satisfy the contractual terms of the obligations issued. These liabilities can be categorized

into four types:

o Type I Liabilities: Both amounts of cash outflows and timing are known, e.g. fixed rate certificates of deposit and

guaranteed investment contracts. The former are among liabilities of financial depositories. Life

Insurance Company offer the later.

o Type II Liabilities: Cash outflows are known, but timing is not, e.g. life insurance policies.

o Type III Liabilities: Cash outflows are not known, but timing is known, e.g. floating rate certificates of deposit.

o Type IV Liabilities: Neither cash outflows nor timing are known, e.g. auto or home insurance policies.

What is Insurance? Explain any two changes made by US government There have been three major types of changes in the insurance industry in the last two decades:

Deregulation of the Financial System: In 1933, Congress passed the Glass-Steagall Act, which separated commercial banking, investment banking,

and insurance. This act resulted in the breakup of the House of Morgan into separate investment banking

and commercial banking entities. . On November 12, 1999 the Gramm-Leach-Bliley Act (GLB), called the

Financial Modernization Act of 1999, was signed into law. This act removed the 50 year old "anti-affiliation

restrictions" among commercial banks, investments banks and insurance companies. The passage of this act

has eliminated the barriers between insurance companies, commercial banks, and investment banks and

various combinations of these types of companies will continue to evolve. Since then, however, Citigroup

sold its insurance business (Travelers) to MetLife, and no other major combinations between banking and

insurance have taken place.

Internationalization of the Insurance Industry: Globalization has occurred in many industries, including insurance industry. With respect to the U.S.

globalization operates in two directions. First, U.S. insurance companies have both acquired and entered

into agreements with international insurance companies and begun operations in other countries. Second,

international insurance companies, mainly European, have become even more active in acquiring U.S.

insurance and investment companies. The reasons are: (1) more rapid growth of the US financial business,

(2) attractive demographics and income potential of the US market, and (3) less regulations.

Demutualization: Since the mid-1990s, several insurance companies have changed from mutual to stock companies. Many

industry observers believe that the recent demutualized insurance companies will either acquire other

financial companies or will be acquired by other financial companies.

Explain the Followings:

Open End Mutual Funds:

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A type of mutual fund that does not have restrictions on the amount of shares the fund

will issue. If demand is high enough, the fund will continue to issue shares no matter how many investors

there are. Open-end funds also buy back shares when investors wish to sell.

The majority of mutual funds are open-end. By continuously selling and buying back fund shares, these

funds provide investors with a very useful and convenient investing vehicle.

It should be noted that when a fund's investment manager(s) determine that a fund's total assets have

become too large to effectively execute its stated objective, the fund will be closed to new investors and in

extreme cases, be closed to new investment by existing fund investors.

Close End Mutual Funds: A closed-end fund is a publicly traded investment company that raises a fixed amount of

capital through an initial public offering (IPO). The fund is then structured, listed and traded like a stock on a

stock exchange.

Also known as a "closed-end investment" or "closed-end mutual fund"

Despite the name similarities, a closed-end fund has little in common with a conventional mutual fund,

which is technically known as an open-end fund.

The former raises a prescribed amount of capital only once through an IPO by issuing a fixed number of

shares, which are purchased by investors in the closed-end fund as stock. Unlike regular stocks, closed-end

fund stock represents an interest in a specialized portfolio of securities that is actively managed by an

investment advisor and which typically concentrates on a specific industry, geographic market, or sector.

The stock prices of a closed-end fund fluctuate according to market forces (supply and demand) as well as

the changing values of the securities in the fund's holdings.

Benefit Pension Plans: An employer-sponsored retirement plan where employee benefits are sorted out based on a

formula using factors such as salary history and duration of employment. Investment risk and portfolio

management are entirely under the control of the company. There are also restrictions on when and how

you can withdraw these funds without penalties. Also known as "qualified benefit plan" or "non-qualified

benefit plan"

Explanation:

This fund is different from many pension funds where payouts are somewhat dependent on

the return of the invested funds. Therefore, employers will need to dip into the company’s earnings in the

event that the returns from the investments devoted to funding the employee's retirement result in a

funding shortfall. The payouts made to retiring employees participating in defined-benefit plans are

determined by more personalized factors, like length of employment.

A tax-qualified benefit plan, shares the same characteristics of a defined-benefit plan, but also provides the

beneficiary of the plan with added tax incentives. These tax incentives are not realized under non-qualified

plans.

Growth Of Mutual Funds: A diversified portfolio of stocks that has capital appreciation as its primary goal, with

little or no dividend payouts Portfolio companies would mainly consist of companies with above-average

growth in earnings that reinvest their earnings into expansion, acquisitions, and/or research and

development.

Explanation:

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Most growth funds offer higher potential capital appreciation but usually at above-average risk. Growth

funds are more volatile than funds in the value and blend categories. The companies in a growth fund

portfolio are in an expansion phase and they are not expected to pay dividends. Investing in growth funds

requires a tolerance for risk and a holding period with a time horizon of five to 10 years.

Unit Trust: An unincorporated mutual fund structure that allows funds to hold assets and pass

profits through to the individual owners, rather than reinvesting them back into the fund, the investment

fund is set up under a trust deed. The investor is effectively the beneficiary under the trust.

Explanation: The success of a unit trust depends on the expertise and experience of the management company. Common

types of investments undertaken by unit trusts are property, securities, mortgages and cash equivalents.

In the U.K. the term "unit trust" is synonymous with "mutual fund" as it is used in North America.

Development of TOKOYO and London Stock Exchange:

The Tokyo Stock Exchange:

The Tokyo Stock Exchange (TSE) is a stock exchange located in Tokyo,

Japan. It is the third largest stock exchange in the world by aggregate market capitalization of its listed

companies. It had 2,292 listed companies with a combined market capitalization of US$4.5 trillion as of

November 2013.

The main indices tracking the TSE are the Nikkei 225 index of companies selected by the Nihon Keizai Shim

bun(Japan's largest business newspaper), the TOPIX index based on the share prices of First Section

companies, and the J30 index of large industrial companies maintained by Japan's major broadsheet

newspapers.

The London Stock Exchange (LSE) and the TSE are developing jointly traded products and share technology,

marking the latest cross-border deal among bourses as international competition heats up. The TSE is also

looking for some partners in Asia, and more specifically is seeking an alliance with the Singapore Exchange

(SGX), which is considered as becoming a leading financial hub in the Asia-Pacific region

The London Stock Exchange: The London Stock Exchange is a stock exchange located in the City

of London in the United Kingdom. As of December 2011, the Exchange had a market capitalization of

US$3.266 trillion (short scale), making it the fourth-largest stock exchange in the world by this

measurement (and the largest in Europe).[2] The Exchange was founded in 1801 and its current premises

are situated in Paternoster Square close to St Paul's Cathedral in the City of London.

There are currently 2,938 companies from over 60 countries listed on the London Stock Exchange, of which

1151 are on AIM, 44 on the Professional Securities Market and 10 on the Specialist Funds Market.

By June 2011, the AIM had 56 companies as per country of operations from Africa, 41 from China, 26 from

Latin America, 23 from Central & Eastern Europe and 29 from India & Bangladesh, making it one of the

world's leading growth markets. Since its launch in 1995 More than £67 billion have been raised on AIM.

The total market value of these companies is £3.9 trillion.

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The FTSE 100 Index also called FTSE 100, FTSE, or, informally, the "footsie" /'fotsi: /, is a share index of the

100 companies listed on the London Stock Exchange with the highest market capitalization. It is one of the

most widely used stock indices and is seen as a gauge of business prosperity for business regulated by UK

company law.

Depository Institutions are exposed to different risk. Give yours views on

the basis of recommendations of Basel Committee These institutions seek to earn spread income, which is a positive spread or margin between the returns on

their assets and the costs of their liabilities. In generating spread income, a depository institution faces

several risks. These include credit risk, regulatory risk, and interest rate risk.

The risks of a financial institution are: credit, settlement, market, liquidity, operational, and legal.

Credit Risk: Credit risk is the risk that the obligor of a financial instrument held by a financial institution will

fail to fulfill its obligation. Settlement risk is the risk that when there is a settlement of a trade or obligation,

the transfer fails to take place. Counterparty risk is the risk that a counterparty fails to satisfy its obligation.

Liquidity Risk: Liquidity risk in the context of settlement risk means that the counterparty can eventually meet

its obligations, but not at the due date Liquidity risk has two forms. Market liquidity risk is the risk that a

financial institution is unable to transact in a financial instrument at a price near its market value. Funding

liquidity risk is the risk that the financial institution will be unable to obtain funding to obtain cash flow

necessary to satisfy its obligations.

Market Risk: Market risk is the risk of a financial institution's economic well being that results from an adverse

movement in the market price of the asset it owns or the level or the volatility of market prices. There are

measures that can be used to gauge this risk. One such measure endorsed by bank regulators is value-at-

risk.

Operational Risk: Operational risk is the risk of loss resulting from inadequate or failed internal processes, people

and systems, or from external events. The definition of operational risk includes legal risk. This is the risk of

loss resulting from failure to comply with laws as well as prudent ethical standards and contractual

obligations. Sources of operation risk include: employees, business process, relationships, technology, and

external factors. (Remaining Question Is Basel Committee)

Discuss the features of trading securities in the secondary market: Secondary market for Treasury securities is OTC, on a continuous bid-asked basis. The most recent issue is

called on the run. Dealers profit from: (1) bid-ask spreads, (2) inventory profits from price appreciation, and

(3) earning more income from Treasury securities than cost of funding them (cost of carry). Dealers will

trade with each other via brokers or with clients should the dealers make markets in the requested

securities. Spreads are lower among dealers (inside prices) than to other customers (retail).

Treasury securities are traded before the time they are issued by the Treasury. This part of the secondary

market is called when-issued market.

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Any firm can deal in government securities, but the Fed will deal only with designated dealers in carrying

out its open market operations. Primary dealers include commercial banks and investment houses,

including few foreign security dealers. When government dealers trade with each other, it is through

intermediaries known as government brokers.

T-bill values are quoted on a bank discount basis, not on a price basis. The yield on a bank discount basis is:

Yd =D/F x 360/t

Regulation of the Secondary Market In the Treasury securities market there is no display of bid-asked prices at which the public can transact.

Neither is spread disclosure required. Prospective Treasury security investors must rely mainly upon

primary market pricing and Fed disclosure.

How the Primary markets are regulated in US:

Primary Markets Regulation: Underwriting activities are regulated by the Securities and Exchange Commission (SEC) under the SEC Act of

1933. With some exemptions, issuers and underwriters must file with the SEC a registration statement. This

is divided into two parts: a prospectus, and supplemental information. They are responsible for maintaining

due diligence on providing information. They can be fined and underwriters sued in the case of misleading

information. The SEC approves an issue only on the basis of accuracy of information, not investment merit.

A "red herring" prospectus is often issued by the underwriter during the waiting period (it sets out required

information "pending approval by SEC."

Liquidity Concerns Due to different degrees of certainty about timing and outlay, some institutions must have deposits more

cash on hand or accessible in order to satisfy their obligations, e.g. the offering of demand means

customers can obtain whatever amount of their funds whenever they wish plays. The greater the concern

over liquidity, the fewer less-liquid investments an intermediary can hold.

Interest Rate Risk is one of the risks faced by depository institutions. Describe

with examples:

Interest Rate Risk: Interest rate risk or funding risk is the mismatching of assets and liabilities in

terms of their maturities. For example, this can arise because the deposits are short-term and assets long

term. An increase in expected interest rates will reduce the spread between the return on assets and the

deposit costs. Floating rate long-term assets can reduce this problem since they make long-term assets

behave like short-term funds that match deposit terms to maturity.

Example: Let's assume you purchase a bond from Company XYZ. Because bond prices typically fall when

interest rates rise, an unexpected increase in interest rates means that your investment could suddenly lose

value. If you expect to sell the bond before it matures, this could mean you end up selling the bond for less

than you paid for it (a capital loss). Of course, the magnitude of change in the bond price is also affected by

the maturity, coupon rate, its ability to be called, and other characteristics of the bond.

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Describe the types of treasury securities. Explain the idea of TIPS with an

example: There are three types of securities issued by the U.S. Treasury. These are distinguished by the amount of

time from the initial sale of the bond to maturity.

Treasury bonds These securities have the longest maturity of any bond issued by the U.S. Treasury, from 10 to 30 years. The

30-year bond is also called the "long bond." Denominations range from $1000 to $1 million. T-bonds pay

interest every 6 months at a fixed coupon rate. As mentioned above, these bonds are not callable, but some

older T-bonds available on the secondary market are callable within five years of the maturity date.

Treasury notes T-notes have maturities between 1 and 10 years. Denominations range from

$1000 to $5000 and are determined by the amount of time to maturity. Like T-bonds, these securities pay

interest semi-annually at a fixed coupon rate.

Treasury Bills T-bills are available with maturities of 13 weeks, 26 weeks and 52 weeks. They are

purchased at a discount to their $10,000 face value, and the full amount is received at maturity (making

them zero-coupon). The bills are sold at auction where the price of sale is determined by how much the bill

is worth on the date of issue, which depends mainly on interest rates.

TIPS TIPS are inflation-indexed securities issued by the U.S. Treasury in an effort to widen the selection

of government securities available to investors. The notes have a 10 year maturity and pay interest at a

fixed rate. The principal increases with the inflation rate, which in turn increases future interest payments.

One danger associated with investing in TIPS is that taxes are due on the increased principal before maturity

when the investor gains access to the principal. In times of high inflation, tax payments could even exceed

the interest income earned by the note.

Example of Tips: Suppose an individual invests $1,000 on January 15 in a new inflation-protected 10-year note with a 3% real

rate of return.

If inflation was 1% during the first six months of that year, then by mid-year the inflation-adjusted principal

amount of the security would be $1,010. ($1,000 x 1.01 = $1,010).

A) Describe the features of Discount and Coupon Securities.

B) Explain the concepts of Tips with an example:

Discount Securities/ Bond:

Any security that is sold at a price below the face value, or a security that is

issued for a price below the face value, but pays out the face value at maturity. Discount securities of

the first type may be re-sold later at a higher price, resulting in gains for the investor, while securities of

the second type yield profit by paying out more than the purchase price.

Explanation:

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The "discount" in a discount bond doesn't necessarily mean that investors get a better yield

than the market is offering, just a price below par. Depending on the length of time until maturity, zero-

coupon bonds can be issued at very large discounts to par, sometimes 50% or more

Coupon Securities / Bond:

A debt obligation with coupons attached that represent semiannual interest

payments. Also known as a "bearer bond"

No record of the purchaser is kept by the issuer, and the purchaser's name is not printed on the certificate.

Explanation:

For example, a $1,000 bond with a coupon of 7% will pay $70 a year.

It is called a "coupon" because some bonds literally have coupons attached to them. Holders receive

interest by stripping off the coupons and redeeming them. This is less common today as more records are

kept electronically.

Part B):

TIPS TIPS are inflation-indexed securities issued by the U.S. Treasury in an effort to widen the selection

of government securities available to investors. The notes have a 10 year maturity and pay interest at a

fixed rate. The principal increases with the inflation rate, which in turn increases future interest payments.

One danger associated with investing in TIPS is that taxes are due on the increased principal before maturity

when the investor gains access to the principal. In times of high inflation, tax payments could even exceed

the interest income earned by the note.

Example of Tips: Suppose an individual invests $1,000 on January 15 in a new inflation-protected 10-year note with a 3% real

rate of return.

If inflation was 1% during the first six months of that year, then by mid-year the inflation-adjusted principal

amount of the security would be $1,010. ($1,000 x 1.01 = $1,010

What is mortgage Explain any three mortgage designs common in US.

Mortgage: A legal agreement by which a bank, building society, etc. lends money at interest in

exchange for taking title of the debtor's property, with the condition that the conveyance of title becomes

void upon the payment of the debt.

Mortgage designs common in US:

Lien Status: The lien status of a mortgage loan indicates the loan's seniority in the event of forced

liquidation due to default. For a first lien, the lender would have first call on the proceeds of the liquidation

of the property. A mortgage loan could also be a second lien or junior lien, whose liquidation preference is

subordinate to that of the first lien.

Credit Classification: A loan that is originated where the borrower is viewed to have a high credit quality is

classified as a prime loan. A lower credit quality loan is classified as a subprime loan. Between the prime and

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subprime sector is a somewhat nebulous category referred to as alternative-A loan (or alt-A loan).

Creditworthiness is determined by among other things the borrower's FWD scores.

When the loan amount requested exceeds the original loan amount, the transaction is referred to as a cash-

out refinancing. If the loan balance remains unchanged, the transaction is said to be a rate-and-term

refinancing or no-cash refinancing.

Lenders use income ratios to assess creditworthiness. The front ratio is computed by dividing the total

monthly payments by the applicant's pretax monthly income. The back ratio is computed in a similar

manner, but it adds other debt payments such as auto loan and credit card payments.

Fixed Rate Mortgage: In a fixed-rate mortgage, the interest rate is set at closing and remains unchanged.

In an adjustable-rate mortgage (ARM), the rate changes over the life of the loan. The rate is based on both

the movement of an underlying rate called the index or reference rate, and a spread over the index called

the margin.

The basic ARM is one that resets periodically. The mortgage rate is affected by: (1) periodic caps, and (2)

lifetime rate caps and floors. A popular form of an ARM is the hybrid ARM, where the rate is fixed for a

specified period, but then adjusts thereafter.

How the mortgage loan is sanctioned by M.O? Explain

Or

Describe the steps for issuance of mortgage loan in US The requirements specified by the originator to grant the loan are referred to as underwriting standards.

The two primary factors in determining the creditworthiness of the applicant are: (1) the payment-to-

income ratio (PTI); (2) the loan-to-value ratio (LTV). If the lender decides to lend the funds, it sends a

commitment letter.

The mortgage originator will give the applicant a choice among various types of mortgages. The choice is

between a fixed-rate mortgage or an adjustable-rate mortgage. In the case of fixed-rate mortgage, the

lender typically gives the applicant a choice as to when the interest rate on the mortgage will be

determined. The three choices may be: (1) at the time the loan application is submitted; (2) at the time a

commitment letter is issued to the borrower; or (3) at the closing date.

Mortgage originators can either: (1) hold the mortgage in their portfolio; (2) sell the mortgage to an

investor who wishes to hold the mortgage in his portfolio or who will place the mortgage in a pool of

mortgages that will be used as collateral for the issuance of a security; or, (3) use the mortgages themselves

as collateral for the issuance of a security.

When a mortgage is used as collateral for the issuance of a security, the mortgage is said to be securitized.

When a mortgage originator intends to sell the mortgage, it will obtain a commitment from the potential

investor. The intermediating entity is called the conduit. The mortgage rate that the originator will set on

the loan, referred to as the note rate, will depend on the mortgage rate required by the investor who plans

to purchase the mortgage.

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Define mortgage and also risk associated with it: Mortgage:

A legal agreement by which a bank, building society, etc. lends money at interest in

exchange for taking title of the debtor's property, with the condition that the conveyance of title becomes

void upon the payment of the debt.

Below are the risks associated with Mortgage loans

Credit Risk: Credit Risk is the risk to earnings from borrower’s failure to meet the bank’s contract

Interest Rate Risk: Interest rate risk to earnings from fluctuation of interest rates in market

Price Risk: Price risk is the risk to earning from changes in the values of foreign exchange, equity etc

Transaction Risk: Transaction risk is the risk to earnings from delay of services and product delivery.

Liquidity Risk: Liquidity Risk is the risk from bank’s inability to manage the unplanned decreases in funds

resources.

Compliance Risk: Compliance Risk is the risk to earnings from the violation of rules, laws and ethical

standards by the underwriter or broker.

Strategic Risk: Strategic Risk is the risk to earnings from the improper strategies applied in mortgage

lending business.

Describe the concept of Short Selling in US stock market with an

example:

Short Selling: Short selling involves the sale of securities not owned. They are borrowed from the

broker and the proceeds of the sale are kept with the broker. The customer eventually covers the short by

buying the stock in the open market (presumably at a lower price) giving the shares to the broker in return

for the sale proceeds the broker had kept on hand. Customer must pay commissions, a lending fee on the

stock and any dividends due during the period that the short sale is not covered. An "uptick" rule specifies

that a short sale may not take place unless the prior trade was an uptick in the price. This rule is designed to

foster price stabilization. Too many consecutive short sales could force a custodial substantial price decline.

Example:

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Mr. Johnson believes that the stock of ABC Corp. will fall in the future. He calls his broker and

asks him to find 100 shares of ABC that he (Mr. Johnson) can borrow for a short sale. ABC's current price is

$25 per share. Mr. Johnson receives a cash inflow of $2,500 after he sells the shares he has borrowed.

Two weeks later, the price has indeed dropped, and shares of ABC now trade for $20 each. Mr. Johnson

buys back the shares (known as covering his short position) for $20 each. He spends $2,000 to repurchase

the shares and returns the shares to the person he borrowed them from.

Mr. Johnson's profit on the trade is $500 ($2,500 received from the sale of the stock minus $2,000 paid to

repurchase the stock).

Describe the concept of Margin Transactions in US stock market with

an example:

Transaction Market: Investors can purchase securities by borrowing the money from a broker

and using the stocks themselves as collateral. The amount borrowed is known as margin and there are

limitations on the maximum margin that brokers can provide to their clients. The borrowed fund is the debit

balance. The call money rate or broker loan rate is the interest rate that banks charge brokers for funds for

this purpose. These limits are set by the Federal Reserve under the Securities Exchange Act of 1934.

Currently, the margin requirement is 40 percent (it was 50% as of March 2008). If the stock value changes,

the investor may need to contribute more cash. The minimum level of margin is known as the maintenance

margin, and this level is different for short-sellers and margin buyers.