STUDENT MENTORSHIP PROGRAM (MODULE 5-

FINANCE)

Module 1: Fundamentals of finance

By the end of this reading, you will understand

What the field of Financial is?

How Financial Markets work?

What different financial products are?

What is Finance? Finance is the study of how and under what terms money are allocated between lenders

and borrowers. The term finance may incorporate any of the following:

o The study of money and other assets

o The management and control of those assets

o Profiling and managing project risks

Finance is distinct from economics in that it addresses not only how resources

are allocated but also under what terms and through what channels Finance is based on economic principles

The field of finance deals with the concepts of time, money, risk and how they

are interrelated. It also deals with how money is spent and budgeted

Behavioural Finance studies how the psychology of investors or managers

affects financial decisions and markets.

Financial System

The financial system consists of institutions that help to match one person’s

saving with another person’s investment.

It moves the economy’s scarce resources from savers to borrowers.

The financial system is made up of institutions(Markets and Intermediaries)

The household is the primary provider of funds to businesses and government.

Households must accumulate financial resources throughout their working life times to

have enough savings (pension) to live on in their retirement years

Financial intermediaries transform the nature of the securities they issue and

invest in Banks, trust companies, credit unions, insurance firms, mutual funds

Market intermediaries simply help make markets work

Investment dealers

Brokers

(Investment Advisors)

Financial Markets

Capital markets which consist of:

o Stock markets, which provide financing through the issuance of shares

or common stock, and enable the subsequent trading thereof.

o Bond markets, which provide financing through the issuance of bonds,

and enable the subsequent trading thereof.

Commodity markets, which facilitate the trading of commodities.

Money markets, which provide short term debt financing and investment.

Derivatives markets, which provide instruments for the management of

financial risk.

Futures markets, which provide standardized forward contracts for trading

products at some future date; see also forward market.

Insurance markets, which facilitate the redistribution of various risks.

Foreign exchange markets, which facilitate the trading of foreign exchange. Financial Markets

1. Primary Markets: The primary market is that part of the capital markets that

deals with the issuance of new securities. Companies, governments or public

sector institutions can obtain funding through the sale of a new stock or bond

issue. Primary markets creates long term instruments through which corporate

entities borrow from capital market.

Methods of issuing securities in the primary market are:

o Initial public offering

o Follow-on Public Offer (for existing companies)

o Rights issue (for existing companies)

o Preferential issue

2. Secondary Markets: The secondary market, also called aftermarket, is the

financial market where previously issued securities and financial instruments

such as stock, bonds, options, and futures are bought and sold. Ex: Stock

Exchanges, OTC Markets.

The stock exchanges, under the supervision of the regulatory authority, like

SEC/SEBI, provide a trading platform, where buyers and sellers can meet to

transact in securities.

Initial Public Offering

An initial public offering, or IPO, is the first sale of a corporation's common

shares to investors on a public stock exchange.

The main purpose of an IPO is to raise capital for the corporation. It also gives

the company more exposure, prestige and public image

In an IPO the issuer obtains the assistance of an underwriting firm, which

helps determine what type of security to issue (common or preferred), best

offering price and time to bring it to market.

Underwriting is an agreement, entered into by a company with a financial

agency, in order to ensure that the public will subscribe for the entire issue of

shares or debentures made by the company. The financial agency is known as

the underwriter and it agrees to buy that part of the company issues which are

not subscribed to by the public in consideration of a specified underwriting

commission.

Book Runner is the primary underwriter Bonds

A bond is a certificate of indebtedness that specifies obligations of the borrower

to the holder of the bond. It is an IOU between the Issuer and the investors.

Bond Terminology:

o Issuer of Bonds: Borrower

o Bond Holder: Lender

o Par Value: Amount which issuer pays interest on and which is repaid on

maturity date

o Issue Price: Price at which bonds are offered to investors

o Maturity Date: Length of time (More than one year)

o Coupon: Rate of interest paid by the issuer on the par/face value of the

bond

o Coupon Date: The date on which interest is paid to investors

Yield: The interest rate which can be earned on an investment, currently quoted

by the market or implied by the current market price for the investment.

Yield to maturity: The internal rate of return of a bond. The yield necessary to

discount all the bond’s cash flows to an NPV equal to its current price.

Types of Bonds (based on coupon payments):

o Fixed rate bonds: Pay fixed coupon (does not change with market

conditions)

o Floating rate bonds: Pay floating Coupon (changes with market

conditions)

o Zero-coupon bonds: Do not pay any coupon at all during the life

o Inflation linked bonds: Principal amount and interest payments -

indexed to inflation.

Types of Bonds (based on credit risk):

o Investment Grade: have low probability of default, hence low yield

o Speculative: have high probability of default, hence high yield

Types of Bonds (based on issuer):

Government Securities: Issued by Governments

o Bills - debt securities maturing in less than one year.

o Notes - debt securities maturing in one to 10 years.

o Bonds - debt securities maturing in more than 10 years.

Corporate Bonds: Issued by Corporates

Stocks

A stock is a tradable security that a firm issues to certify that the stockholder

owns a share of the firm.

A stock market or equity market is an entity for the trading of company stock

(shares) and derivatives at an agreed price; these are securities listed on a stock

exchange as well as those only traded privately.

Stocks are ownership in a company and are made up of shares. Each share is a

portion of the company „

A company has a finite number of shares. As a company’s value changes, so

does the value of it’s shares

The sale of stock to raise money is called equity financing.

Compared to bonds, stocks offer both higher risk and potentially higher returns. How is Money Made by investors?

o Trading - Buy low, sell high!

o Dividends - Sharing profits

1. Common Stock: Common shares represent ownership in a company

and a claim (dividends) on a portion of profits. Investors get one vote per

share to elect the board members, who oversee the major decisions made by

management.

2. Preferred Stock: Represents some degree of ownership in a company but

usually doesn't come with the same voting rights. With preferred shares,

investors are usually guaranteed a fixed dividend forever.

A bull market is when everything in the economy is great, people are

finding jobs, gross domestic product (GDP) is growing, and stocks are

rising. If a person is optimistic and believes that stocks will go up, he/she is

called a ‘bull’ and is said to have ‘bullish outlook’

A bear market is when the economy is bad, recession is looming and stock

prices are falling. If a person is pessimistic, believing that stocks are going

to drop, he/she is called a ‘bear’ and said to have a ‘bearish outlook’.

Derivative Markets A financial contract of pre-determined duration, whose value is derived from the value

of an underlying asset. The underlying assets can be Securities, Commodities,

Bullion, Precious metals, Currency, Livestock, Index such as interest rates,

exchange rates.

Derivatives attempt either to

(i) Minimize the loss arising from adverse price movements of the

underlying asset (hedging) (ii) Maximize the profits arising out of favorable price fluctuation

(speculating). (iii) Price discovery (arbitraging) Since they derive their value from the underlying asset, hence they are called

derivatives. Based on the underlying assets derivatives are classified into.

o Financial Derivatives – Underlying: Financial Asset – Ex: Stocks

o Commodity Derivatives – Underlying: Commodity – Ex: Gold

o Index Derivative – Underlying: Index/Reference Rate – Ex: BSE Sensex Forward contracts: A one to one bipartite contract, which is to be performed in

future at the terms decided today. Eg: A and B enter into a contract to trade in one

stock on Infosys 3 months from today the date of the contract @ a price of Rs 3500/-.

Product, Price, Quantity & Time have been determined in advance by both the parties.

Futures: Future contracts are organized/standardized contracts in terms of quantity,

quality, delivery time and place for settlement on any date in future. These

contracts are traded on exchanges.

Options: An option is a contract giving the buyer the right, but not the obligation, to

buy or sell an underlying asset at a specific price on or before a certain date.

Put: Contract giving the buyer the right, but not the obligation, to sell an

underlying asset at a specific price on or before a certain date.

Call: Contract giving the buyer the right, but not the obligation, to buy an

underlying asset at a specific price on or before a certain date

Swaps: An agreement between two parties to exchange one set of cash flows for

another. These cash flows are most commonly the interest payments associated with

debt service.

Interest rate swap: Exchange fixed interest rate payments for the floating

interest rate payments.

Currency swap: Exchange currencies of debt service obligation (e.g. from

Euro loan to USD loan)

Time Value of Money

Which would you rather have -- $1,000 today or $1,000 in 5 years?

Obviously, $1,000 today.

Time Value of Money: The idea that money available at present time is worth more

than the same amount in the future due to its potential earning capacity.

For example, assuming a 5% interest rate, $100 invested today will be worth $105 in

one year ($1000 multiplied by 1.05). Conversely, $1000 received one year from now is

only worth $952.40 today ($1000 divided by 1.05), assuming a 5% interest rate. Present value: The current worth of a future sum of money or stream of cash flows

given a specified rate of return

Future value is the value of an asset or cash at a specified date in the future that is

equivalent in value to a specified sum today. Annuity: A series of equal payments or receipts that occur at evenly spaced intervals. Perpetuity: An infinite and constant stream of identical cash flows.

Capital Budgeting – Decision Making

NPV and IRR are used in capital budgeting to analyze the profitability of

projects.

Net present value (NPV): The difference between the present value of cash

inflows and the present value of cash outflows, discounted at cost of capital (r).

If NPV > 0, Accept the project

If NPV < 0, Reject the project The internal rate of return (IRR):

(1) the discount rate that equates the sum of the present values of all cash inflows to

the sum of the present values of all cash outflows

(2) the discount rate that sets the net present value equal to zero

If IRR > Cost of Capital, Accept the project

If IRR < Cost of Capital, Reject the project

Concept Checkers

How financial markets work?

How does a company raise money in public?

What is the difference between Bond and Stock?

What are Derivatives? How are they used?

What is the concept of time value of money?

MCQ Quiz:

1. The concept of compound interest refers to:

A) Earning interest on the original investment.

B) Payment of interest on previously earned interest.

C) Investing for a multi-year period of time.

D) Determining the APR of the investment.

2. When an investment pays only simple interest, this means:

A) The interest rate is lower than on comparable investments.

B) The future value of the investment will be low.

C) The earned interest is non taxable to the investor.

D) Interest is earned only on the original investment.

3. Assume the total expense for your current year in college equals $20,000.

Approximately how much would your parents have needed to invest 21 years

ago in an account paying 8% compounded annually to cover this amount?

A) $ 952

B) $1,600

C) $1,728

D) $3,973

4. How much will accumulate in an account with an initial deposit of $100, and

which earns 10% interest compounded quarterly for three years?

A) $107.69

B) $133.10

C) $134.49

D) $313.84

5. How much must be invested today in order to generate a five-year annuity of

$1,000 per year, with the first payment one year from today, at an interest rate

of 12%?

A) $3,604,78

B) $3,746.25

C) $4,037.35

D) $4,604.78

6. A stock's par value is represented by:

A) The maturity value of the stock.

B) The price at which each share is recorded.

C) The price at which an investor could sell the stock.

D) The price received by the firm when the stock was issued.

7. Additional paid-in capital refers to:

A) A firm's retained earnings.

B) A firm's treasury stock.

C) The difference between the issue price and the par value.

D) Funds borrowed from a bank or bondholders.

8. Which of the following equity concepts would you expect to be least important

to a financial analyst?

A) Par value per share

B) Additional paid-in capital

C) Retained earnings

D) Net common equity

9. An increase in a firm's financial leverage will:

A) Increase the variability in earnings per share.

B) Reduce the operating risk of the firm.

C) Increase the value of the firm in a non-MM world.

D) Increase the WACC.

10. Financial risk refers to the:

A) Risk of owning equity securities.

B) Risk faced by equity holders when debt is used.

C) General business risk of the firm.

D) Possibility that interest rates will increase.

11. Ignoring taxes, a firm's weighted-average cost of capital is equal to:

A) Its expected return on assets.

B) Its expected return on equity.

C) The sum of expected return on equity and expected return on debt.

D) Its expected return on assets times the debt-equity ratio.

12. What is the proportion of debt financing for a firm that expects a 24% return

on equity, a 16% return on assets, and a 12% return on debt? Ignore taxes.

A) 54.0%

B) 60.0%

C) 66.7%

D) 75.0%

13. A firm has an expected return on equity of 16% and an after-tax cost of debt

of 8%. What debt-equity ratio should be used in order to keep the WACC at

12%?

A) .50

B) .75

C) 1.00

D) 1.50

14. Which of the following is not found in John Lintner's "stylized facts" of

corporate dividend policies?

A) Firms have long-run target dividend payout ratios.

B) Managers focus more on dividend absolute levels than on its changes.

C) Dividend changes follow shifts in long-run, sustainable levels of earnings rather

than short-run changes in earnings.

D) Managers are reluctant to make dividend changes that might have to be

reversed.

15. An increase in dividends might not increase price and may actually decrease

stock price if:

A) The dividend increase cannot be sustained.

B) The firm does not maintain an exact dividend payout ratio.

C) The firm has too much retained earnings.

D) Markets are weak-form efficient.

16. A policy of dividend "smoothing" refers to:

A) Maintaining a constant dividend payout ratio.

B) Keeping the regular dividend at the same level indefinitely.

C) Maintaining a steady progression of dividend increases over time.

D) Alternating cash dividends with stock dividends.

17. What is the most likely prediction after a firm reduces its regular dividend

payment?

A) Earnings are expected to decline.

B) Investment is expected to increase.

C) Retained earnings are expected to decrease.

D) Share price is expected to increase.

18. What is the cash conversion cycle for a firm with a receivables period of 40

days, a payables period of 30 days, and an inventory period of 60 days?

A) 10 days

B) 50 days

C) 70 days

D) 130 days

19. Which of the following would not be included among the costs of carrying

inventory?

A) Obsolescence

B) Opportunity cost of capital

C) Raw material cost

D) Risk of pilferage

20. When financial managers take action to minimize the carrying costs of current

assets, they:

A) Are likely to maximize profits.

B) Also consider spoilage costs.

C) May increase costs due to shortages.

D) Engage in the matching of maturities.

21. Which of the following would act to reduce the carrying costs of inventory?

A) The inventory is capable of spoiling.

B) The inventory will rapidly go out of style.

C) General interest rates decrease in the economy.

D) General interest rates increase in the economy.

22. Which of the following statements about total capital requirement is least

likely to be correct for a profitable firm?

A) Requirements remain constant over time.

B) Seasonal variations are often experienced.

C) The trend is often upward-sloping.

D) A portion of working capital is permanent.

23. Which of the following would not be included as a source of short-term

financing?

A) Line of credit

B) Increase in the minimum operating cash balance

C) Sale of marketable securities

D) Stretching accounts payable

24. Bank lines of credit must be judiciously requested because the lines often:

A) Accrue interest regardless of whether funds are borrowed.

B) Require payment of a commitment fee to establish.

C) Appear as a liability on the firm's balance sheet.

D) Have a negative impact on the firm's credit history.

25. Although commercial paper is unsecured, the companies that issue this short-

term security are:

A) Typically known to repay all defaults.

B) Large firms of top credit quality.

C) Small firms of top credit quality.

D) Firms that have government-sponsored guarantees for the debt.

CASE STUDY:

MBA DECISION

Ben Bates Graduated from college six years ago with a finance undergraduate degree. Although

he is satisfied with his current job, his goal is to become an investment banker. He

feels that an MBA degree would allow him to achieve this goal. After examining schools,

he has narrowed his choice to either Wilton University or Mount Perry College. Although

internships are encouraged by both schools, to get class credit for the internships, no salary

can be paid, other than internships, neither school will allow its students to work while enroll in

its MBA program. Ben currently works at the money management firm of Dewy and Louis. His

annual salary at the firm is 50,000 $ per year, and his salary is expected to increase at 3%

per year until retirement. He is currently 28 years old and expects to work for 35

more years. His current job includes a fully paid health insurance plan, and his

current average tax rate is 26%. Ben has a saving account with enough money to

cover his entire cost for the MBA program. Rifter college of Business at Wilton University

is one of the top MBA program in the country. The MBA degree requires full time enrollment at

the university the annual tuition is 60,000 payable at the beginning of each school year. Books

and other supplies are estimated to cost 2500 per year. Ben expects that after graduation from

Wilton, he will receive a job offer for a job offer for about 95000 per year, with a 15000 signing

bonus. The Salary at this job will increase at 4% per year. Because of the higher salary, his

average income tax rate will increase to 31%.The Bradley school of Business at Mount Perry

College began its MBA program 16 years ago. The Bradley School is smaller and less well

known then the Ritter College. Bradley offers an accelerated one year program, with

a tuition cost of 7500 $ to be paid upon matriculation. Books and other supplies for the program

are expected to cost3500$. Ben thinks that he will receive an offer of 78000$ per year upon

graduation, with the 10000$ signing bonus, the salary at this job will increase at 3.5% per year.

His average tax rate at this level of income will be 29%.Both schools offer a health

insurance that will cost 3000% per year, payable at beginning of the year. Ben also

estimates that room and board expenses will cost 20,000$ per year at both schools. The

appropriate discount rate is 6.5%.

Questions:

1 . H o w d o e s B e n ’ s a g e a f f e c t h i s d e c i s i o n t o g e t a n M B A ? 2 . W h a t o t h e r , p e r h a p s n o n - q u a n t i f i a b l e , f a c t o r s a f f e c t B e n ’ s d e c i s i o n t o g e t a n M B A ? 3 . A s s u m i n g a l l s a l a r i e s a r e p a i d a t t h e e n d o f e a c h y e a r , w h a t i s t h e b e s t o p t i o n f o r B e n f r o m strictly financial standpoint?

ET in Classroom

1. ET in the classroom: Why GAAR caused panic

Finance Minister Pranab Mukherjee's clarification on General Anti-Avoidance Rules

(GAAR) fired up the markets on Monday, when global indices were deep in the red. A

look at why GAAR has caused panic among investors:

What are general anti-avoidance rules?

These rules, originally proposed in the Direct Taxes Code, are targeted at arrangements

or transactions made specifically to avoid taxes. The government had decided to

advance the introduction of GAAR and implement it from the current financial year

itself. More than 30 countries have introduced GAAR provisions in their respective tax

codes to check evasion.

What are the implications?

GAAR allows tax authorities to call a business arrangement or a transaction

'impermissible avoidance arrangement' if they feel it has been primarily entered into to

avoid taxes.

Once an arrangement is ruled 'impermissible' then the tax authorities can deny tax

benefits. Most aggressive tax avoidance arrangements would be under the risk of being

termed impermissible. The rule can apply on domestic as well as overseas transactions.

What were the key concerns?

GAAR is a very broadbased provision and can easily be applied to most tax-saving

arrangements. Many experts feel that the provision would give unbridled powers to tax

officers, allowing them to question any taxsaving deal.

Foreign institutional investors are worried that their investments routed through

Mauritius could be denied tax benefits enjoyed by them under the Indo-Mauritius tax

treaty. The proposal had spooked stock market as FII inflows dropped on concerns, and

the rupee hit a low of Rs 53.47 to the dollar.

What has the govt done now?

It has postponed GAAR to the next financial year. This will give a breather to tax

payers and also allow the government time to frame clear rules after consultations with

stakeholders.

He has also clarified that the onus to prove that an arrangement is 'impermissible' will

lie with the tax department. The GAAR panel, the final body that will decide on the

applicability of the law, will include an independent member.

2. ET in the classroom: Non-inflationary rate of

growth

In a recent interview to the Wall Street Journal, D Subbarao, governor of the Reserve

Bank of India, said India's Non-inflationary rate of growth had come down since

the global financial crisis and now probably stands at around 7%. ET looks at the

concept:

What is non-inflationary rate of growth (NIRG)?

Non inflationary rate of growth is the maximum rate of growth that the Indian economy

can achieve without fanning inflationary pressures. It is similar to the concept of

potential rate of growth and is crucial input in the monetary decisions.

How does this concept work?

If an economy is growing faster than its potential rate of growth, capacities tend to get

stretched and resources scarcity emerges. Both producers & workers are then able to

raise prices and wages because of the high demand for their products & services. These

rising prices across the board lead to generalized inflationary pressures. This implies

that there exists a rate of growth for an economy at which inflation will be within a

particular comfort zone.

What is the risk at the moment?

India grew by 6.9% in the second quarter that is almost equal to its potential rate of

growth estimated by the RBI. A level of growth higher than 7% could translate into

another bout of high inflation unless there is investment in capacity creation and easing

supply bottlenecks to increase resource flow. According to the RBI annual bulletin for

the year 2010-11, the threshold for inflation was in the range of 4-6%.

"Lower trend growth is the result of sharp falls in the investment and savings rates, a

higher fiscal deficit and a lack of policy reforms. Therefore, concerted efforts to address

supply-side bottlenecks are imperative to reverse the decline." says Sonal Varma

3. ET in the classroom: What is under recovery?

It is the gap between the local price of fuel and what would have been the price if the

fuel were imported.

Is under-recovery the same as loss?

It is a notional loss in revenue to the extent the international price of the fuel is higher.

It may or may not be a loss-making proposition to produce the fuel when there is an

under-recovery.

In case of kerosene, oil companies suffer an under-recovery as well as a loss because

the local retail price is much lower than the cost of crude oil. But sale of a product like

petrol can still be very profitable at times, even if oil companies are reporting under-

recovery of a few rupees a litre.

Does a rise in under recovery make an oil co's operation less profitable?

It may not. At times, international crude oil prices remain flat but petrol and diesel

prices rise. In such a situation, an Indian refinery's profitability will not change because

crude oil costs have not gone up. But under-recovery would have risen because the cost

of importing the fuel would have risen.

Has the concept of under recovery exaggerated the problems of oil firms?

This year it did. Prices of oil products in Asia rose earlier this year, when a fire shut

down a large refinery in Taiwan. This reduced the supply of refined oil products and

the change in the demand supply situation made petrol and diesel more costly.

The Tsunami in Japan and a recent fire at a refinery in Singapore had the same impact.

The refining margin for diesel, called "crack spread" has been $20 a barrel most of this

year. In April, diesel margins jumped to a three-year high of $24 per barrel. Last year, it

was $10-15.

So, under-recovery on diesel looks higher this year. In other words, oil companies want

a higher price for diesel partly because some refineries in other countries were shut

down. Apart from this, oil companies also charge a customs duty and a marketing

margin, in addition to marketing cost, to calculate under recovery. These are profits, not

costs.

Can oil companies be at a disadvantage by linking prices to under-recovery?

Yes. This may happen next year. In 2010, very little new refining capacity was added in

Asia, while demand was strong. Next year, China and the Middle East will add about 1

million barrels per day of refining capacity. This is expected to increase supply of

products and deflate refining margins. As a result under-recovery is expected to fall.

4. ET Classroom: Market dominance- Finding the

right level

The Telecom Regulatory Authority of India recently proposed that mergers should be

cleared if the combined entity held up to 60% market share. This has been opposed by a

panel of the department of telecom, which wanted the market share threshold to be

brought down to 35%.

The panel probably feared that holding 60% share could be detrimental to the market,

triggering a debate on what combination of parameters best define dominance.

WHAT IS DOMINANT POSITION?

It is a position of strength that allows a company to either operate independently of its

competitors, suppliers and consumers. This position can be attained through expansion,

mergers and acquisitions, invention of a new product or even consumer demand for a

particular brand of product. It gives a company pricing power.

For instance, Maruti Suzuki enjoys a dominant position in automobiles; Reliance

Industries in the polypropylene market; and Colgate-Palmolive in toothpastes. Yet a

dominant position cannot be quantified as strong competition can prevent abusive

behavior by the dominant player. In a market with multiple players, even a 25% market

share can be described as dominant.

DOES IT HURT COMPETITION?

A dominant position in itself is not bad. For instance, the merger

of Boeing and McDonald Douglas created an entity with more than 60% market share

in the US and elsewhere. Regulators allowed the merger to go through as it was felt that

amalgamation would not have any adverse impact on competition or hurt consumers.

Had the regulators felt that the merged entity would abuse its dominance, they could

have prevented it. Boeing faces stiff competition from Airbus Industries in the

commercial jet planes (100+ seaters) business and that keeps a check on the market

behaviour of the American aircraft maker.

Microsoft was not so lucky. Its practice of bundling Internet Explorer with Windows

operating system fell foul with competition regulators in the US and the EU. Likewise,

Intel invited strictures from regulators for abusing its dominance in the microprocessors

market by using coercion and conditional payments for PC makers. India's Competition

Act 2002 also does not prohibit dominant position, but disallows abuse of dominance.

HOW DO COMPANIES ABUSE THEIR POSITION OF STRENGTH?

By resorting to predatory pricing, or dropping prices below cost, to force out

competition, limiting supplies to influence prices and imposing restrictions that require

buyers to also buy other products and prohibiting dealers and small retailers from

dealing in competitors' products. For instance, if Hindustan Unilever were to prohibit

retail shops from selling products of its competitors, the practice would amount to an

abuse of dominant position.

5. ET in the Classroom

What are reserves?

Reserves are essentially foreign currency assets which are readily available to q11

monetary authorities of any economy for direct financing of external payment

imbalances. The reserves are also controlled by the monetary authorities. Reserves also

include gold at market prices.

Reserves are held for a variety of reasons. Most importantly, it is held for maintaining

liquidity and allowing time to absorb shocks in situations where access to borrowing is

curtailed or are very costly. Moreover, reserves also provide confidence that the

authorities are committed to the timely discharge of external obligations and to

supporting the value.

What are the various measures of adequacy of reserves?

Most popular measures are import-based indicators, which most central banks use to

assess reserves adequacy in their economies. According to this measures, adequacy is

assessed in terms of the number of months of a country’s imports that they can finance.

According to an IMF staff paper; this ratio is likely to remain relevant as a simple way

of scaling the level of reserves by the size and openness of the economy. This measure

is more relevant for countries which have limited access to capital market or those

economies which are vulnerable to capital inflows. Besides, there are money-based

indicators of reserves. These provide a measure of the potential for flight of capital

from a particular currency. An unstable demand for money or the presence of a weak

banking system indicates a greater probability of such capital flight. In these

circumstances, the ratio of reserves to broad money is thus a potentially useful

indicator.

These indicators have assumed importance over the past decade. Improved policies for

debt and liquidity management are increasingly seen as an important element to avert

crisis. Better guidance in this area would be useful to policymakers in managing

reserves and debt to the fund in the exercise of its surveillance responsibilities and to

market participants in assessing risks.

India's financial system is strong: RBI

A day after global credit rating agency S&P cut India's outlook to 'negative', RBI on

Thursday said the country's financial system is strong and sometimes these ratings are

discounted by markets.

It also said that the Reserve Bank will intervene in the forex market only if there is high

volatility in the currency market, not just because of the ratings.

RBI Deputy Governor KC Chakrabarty said the central bank will come out in June with

its next financial stability report, which showcases the country s financial strength, and

it will reflect the position of the economy.

"Indian financial system is strong. That is what our internal assessment. That our

financial stability report always gives. Again, RBI s financial stability report will come

in June. Then you can see what the position is," Chakrabarty told reporters on the

sidelines of an event.

"Sometimes rating discounts. That means what is coming in the rating is discounted by

market," he added, while replying to a query on the impact of S&P report.

Standard & Poor's yesterday downgraded India's credit outlook to 'negative' and warned

of a downgrade if there is no improvement in the fiscal situation and political climate.

Finance Minister Pranab Mukhejree had said the government was not feeling panicky

but it was concerned and will take note of the "timely warning".

Chakrabarty said RBI is examining the situation and cannot comment further on the

subject.

"Now without examination and diagnosis I cannot comment. Let me complete the

testing and diagnosis. After that let me understand what is happening," he said.

Replying to query on RBI s intervention in forex markets, he said, "Our currency

intervention depends on volatility in the market. Not based on the ratings. Because of

the rating if there is a volatility, if there is need to intervene, then RBI will intervene."