Financial System

ASSIGNMENT- A
Attempt these five analytical questions
Q1.

What do you understand by financial system of a country? Explain its

definition, significance and structure?

A financial system of a country is a system of financial institutions in

country that mobilize monetary resources, distribute the resources in the
process of financing and crediting, and exercise financial control.
Significance of Financial system:
It provides a link between savings and investments for the creation of
new wealth and to permit portfolio adjustment in the composition of
existing wealth..
It plays a vital role in the economic growth of a country, as its primary
function is the mobilization of savings, their distribution for industrial
investment and stimulating capital formation to accelerate the process
of economic growth.
One important function of financial system is to achieve optimum
allocation of risk bearing, it limits, pools and trade the risks involved
in mobilizing savings and allocating credit. It aims at containing risks
within acceptable limits and reducing the cost of gathering and
analyzing information to assist operators in decision making.
Structure:
Structure of the financial system per country by type of institution and their
components: Central banks, other monetary institutions, other financial
institutions and insurance institutions. Data relate to number of institutions,
number of branches, number of employees, total assets and liabilities and
total financial assets.

Q2.

Financial Markets are an important component of the financial

system, what are different types of financial markets ? Explain

Types of financial markets:

Capital Markets
A capital market is one which individuals and institutions trade
financial securities,i.e stock market; where investors buy and sell
shares in publicly traded companies,and bond market where investors
loans money to an entity which borrows the funds for a defined period
of time at a fixed interest rate.
Money Market
The money market is a segment of the financial market in which
financial instrument with high liquidity and very short maturities are
traded.
Forex Market
The Forex market deals with the multi currency requirement which
are met by the exchange of currencies depending on the exchange rate
that is applicable, the transfer of funds takes place in this market.
Credit Market
Credit market is a place where banks,financial institutions and Non
banking corporations lend short,medium and long term loans to
corporate and individuals

Q3.

What are characteristics and functions of financial markets?

Characteristics of Financial Markets

Financial markets are characterized by a large volume of transactions
and a speed with which financial resources move from one market to
another.

 There are various segments of financial markets such as stock

markets, bond markets primary and secondary segments, where
savers themselves decide when and where they should invest money.
There is scope of instant arbitrage among various markets and types
of instruments.
Financial markets are highly volatile and susceptible to panic and
distress selling as the behavior of a limited group of operators can get
generalized.
Markets are dominated by financial intermediaries who take
investment decisions as well as risks on behalf of their depositors.
Negative externalities are associated with financial markets. A failure
in any one segment of these markets may affect many other segments
of the market, including the non financial markets.
Domestic financial markets are getting integrated with worldwide
financial markets. The failure and vulnerability in a particular
domestic market can have international ramifications. Similarly,
problems in external markets can affect the functioning of domestic
markets.
Functions of Financial Market:

Enabling economic units to exercise their time preference;

Separation, distribution, diversification, and reduction of risk;
Efficient payment mechanism;
Providing information about companies. This spurs investors to make
inquiries themselves and keep track of the companies activities with a
view to trading in their stock efficiently;
Transmutation or transformation of financial claims to suit the
preferences of both savers and borrowers;
Enhancing liquidity of financial claims through trading in securities;
and
Portfolio management.

Q4.

What are money market instruments? Explain

Money market instruments are short term, low risk financial instruments
such as bankers, acceptance certificate of deposits, commercial paper
or treasury bills.

Q5.

What are bonds? Explain their features. How are they different from
debentures?

A bond is a debt security in which the authorized issuer owes the holders a
debt and is obliged to repay the principal and interest(the coupon) at a later
date, termed maturity.
Features:
Nominal, principal or face value-the amount at which the issuer
pays interest, and which has to be paid at the end.
Issue price-the price at which investors buys the bonds when they are
first issued.
Maturity date-The date at which the issuer has to repay the nominal
amount.
Coupon rate-The interest rate that issuer pays to the bond holders.
Coupon date-The dates at which the issuer pays the coupon to the
bond holders
Indentures and Covenants-An indenture is a formal debt agreement
that establishes the terms of a bond issue, while covenants are the
clauses of such an agreement. Covenants specify the rights of
bondholders and the duties of issuers.

Difference:
Bonds are more secure than debentures, and carry a lower interest
rate. In the case of bonds, the company provides collateral for the
loan, while debentures have no collateral.

Assignment B

Q1.

How are primary market and secondary market different from each
other? Explain

The primary market deals with the trading of newly issued securities,
the corporations, government and companies issue securities like
stocks and bonds when they need to raise capital, secondary market is
the part of the capital market that deals with the securities that are
already issued in the primary market.
When the company issue securities in the primary market they collect
funds directly from investors through security sales, but in the case of
secondary market the money earned from selling a security does not
go to the company, the money thus earned goes to the investor who
sells the security.

Q2.

What are mutual funds? Explain the benefit and risks involved in
investing in Mutual Funds.

Mutual Funds:
Mutual funds are financial intermediaries which collect the savings of
investors and invest them in a large and well diversified portfolio of
securities such as money market instruments, corporate and Government
bonds and equity shares of joint stock companies.
Benefits:
Small investments: Mutual funds help you to reap the benefit of returns by
a portfolio spread across a wide spectrum of companies with small
investments.
Professional Fund Management: Professionals having considerable
expertise, experience and resources manage the pool of money collected by
a mutual fund. They thoroughly analyse the markets and economy to pick
good investment opportunities.
Spreading Risk: An investor with limited funds might be able to invest in
only one or two stocks/bonds, thus increasing his or her risk. However, a
mutual fund will spread its risk by investing a number of sound stocks or
bonds. A fund normally invests in companies across a wide range of
industries, so the risk is diversified.

Transparency: Mutual Funds regularly provide investors with information

on the value of their investments. Mutual Funds also provide complete
portfolio disclosure of the investments made by various schemes and also
the proportion invested in each asset type.
Choice: The large amount of Mutual Funds offer the investor a wide variety
to choose from. An investor can pick up a scheme depending upon his risk/
return profile.
Regulations: All the mutual funds are registered with SEBI and they
function within the provisions of strict regulation designed to protect the
interests of the investor.

Risks:
Market risk
If the overall stock or bond markets fall on account of overall economic
factors, the value of stock or bond holdings in the fund's portfolio can drop,
thereby impacting the fund performance.
Non-market risk
Bad news about an individual company can pull down its stock price, which
can negatively affect fund holdings. This risk can be reduced by having a
diversified portfolio that consists of a wide variety of stocks drawn from
different industries.
Interest rate risk
Bond prices and interest rates move in opposite directions. When interest
rates rise, bond prices fall and this decline in underlying securities affects the
fund negatively.
Credit risk
Bonds are debt obligations. So when the funds invest in corporate bonds,
they run the risk of the corporate defaulting on their interest and principal
payment obligations and when that risk crystallizes, it leads to a fall in the
value of the bond causing the NAV of the fund to take a beating.

Q3.

Write Short notes on:

a) FDI
b) NBFC

FDI:
Foreign Direct Investment is viewed as a major stimulus to economic growth
in developing countries. It is also defined as a company from one country
making a physical investment into building a factory in another country. The
FDI relationship consists of a parent enterprise and a foreign affiliate which
together form a multinational corporation (MNC). In order to qualify as FDI
the investment must afford the parent enterprise control over its foreign
affiliate
NBFC:
Non banking financial company is a company carrying on all or any of the
following types of business, Hire purchase finance companies ,investment
company including primary dealers, loan company, mutual benefit financial
company,equipmet leasing companies, chit fund company, miscellaneous
non banking companies.NBFC operate in an unorganized sector and they do
not have a transparent, uniform or laid down accounting standards, strict
vigilance or audit systems or an effective supervisory system as opposed to
the those in the organized financial sector, and hence make it difficult to
supervise them.

CASE STUDY
The US-64 Controversy
They have cheated us. I am telling everyone to sell. If they are
stupid and offering Rs 14.25 for paper worth Rs 9, why should I
let go of the opportunity?
- An unhappy US-64 investor in 1998.
CAN OF WORMS
In 1998, investors of Unit Trust of India's (UTI) Unit Scheme1964 (US-64) were shaken by media reports claiming that
things were seriously wrong with the mutual fund major. For
the first time in its 32 years of existence, US-64 faced
depleting funds and redemptions exceeding the sales. Between
July 1995 and March 1996, funds declined by Rs 3,104 crore.
Analysts remarked that the depleting corpus coupled with the
redemptions could soon result in a liquidity crisis.
Soon, reports regarding the lack of proper fund management
and internal control systems at UTI added to the growing
investor frenzy. By October 1998, US-64's equity
component's market value had come down to Rs 4200 crore
from its acquisition price of Rs 8200 crore. The net asset
value (NAV) of US-64 also declined significantly during 19931996 due to turbulent stock market conditions. A Business
Today survey cited US-64's NAV at Rs 9.68. The US-64 units,
which were sold at Rs 14.55 and repurchased at Rs 14.25 in
October 1998, thus were around 50% and 47%, above their
estimated NAV.
Amidst growing concerns over the fate of US-64 investors, it
became necessary for UTI to take immediate steps to put rest
to the controversy.
CREATING TRUST
UTI was established through a Parliament Act in 1964, to
channelise the nation's savings via mutual fund schemes. This

was done as in the earlier days, raising the capital from

markets was very difficult for the companies due to the public
being very conservative and risk averse. By February 2001,
UTI was managing funds worth Rs 64,250 crore through over
92 saving schemes such as US-64, Unit Linked Insurance
Plan, Monthly Income Plan etc. UTI's distribution network was
well spread out with 54 branch offices, 295 district
representatives and about 75,000 agents across the country.
The first scheme introduced by UTI was the Unit Scheme1964, popularly known as US-64. The fund's initial capital of
Rs 5 crore was contributed by Reserve Bank of India (RBI),
Financial Institutions, Life Insurance Corporation (LIC), State
Bank of India (SBI) and other scheduled banks including few
foreign banks. It was an open-ended scheme , promising an
attractive income, ready liquidity and tax benefits. In the first
year of its launch, US-64 mobilized Rs 19 crore and offered a
6.1% dividend as compared to the prevailing bank deposit
interest rates of 3.75 - 6%. This impressed the average Indian
investor who until then considered bank deposits to be the
safest and best investment opportunity. By October 2000, US64 increased its capital base to Rs 15993 crore, spread over 2
crore unit holders all over the world.
However by the late 1990s, US-64 had emerged as an example
for portfolio mismanagement. In 1998, UTI chairman
P.S.Subramanyam revealed that the reserves of US-64 had
turned negative by Rs 1098 crore. Immediately after the
announcement, the Sensex fell by 224 points. A few days later,
the Sensex went down further by 40 points, reaching a 22month low under selling pressure by Foreign Institutional
Investors (FIIs). This was widely believed to have reflected the
adverse market sentiments about US-64. Nervous investors
soon redeemed US-64 units worth Rs 580 crore. There was
widespread panic across the country with intensive media
coverage adding fuel to the controversy.
DISTRUST IN TRUST
Unlike the usual practice for mutual funds, UTI never declared
the NAV of US-64 - only the purchase and sale prices for the

units were announced. Analysts remarked that the practise of

not declaring US-64's NAV in the initial years was justified as
the scheme was formulated to attract the small investors into
capital markets. The declaration of NAV at that time would not
have been advisable, as heavy stock market fluctuations
resulting in low NAV figures would have discouraged the
investors. This seemed to have led to a mistaken feeling that
the UTI and US-64 were somehow immune to the volatility of
the Sensex.
Following the heavy redemption wave, it soon became public
knowledge that the erosion of US-64's reserves was gradual.
Internal audit reports of SEBI regarding US-64 established
that there were serious flaws in the management of funds.
Till the 1980s, the equity component of US-64 never went
beyond 30%. UTI acquired public sector unit (PSU) stocks
under the 1992-97 disinvestment program of the union
government. Around Rs 6000-7000 crore was invested in
scripts such as MTNL, ONGC, IOC, HPCL & SAIL.
A former UTI executive said, Every chairman of the UTI
wanted to prove himself by collecting increasingly larger
amounts of money to US-64, and declaring high dividends.
This seemed to have resulted in US-64 forgetting its identity as
an income scheme, supposed to provide fixed, regular returns
by primarily investing in debt instruments.
Even a typical balanced fund (equal debt and equity) usually
did not put more than 30% of its corpus into equity. A
Business Today report claimed that eager to capitalise on the
1994 stock market boom, US-64 had recklessly increased its
equity holdings. By the late 1990s the fund's portfolio
comprised around 70% equity.
While the equity investments increased by 40%, UTI seemed to
have ignored the risk factor involved with it. Most of the above
investments fared very badly on the bourses, causing huge
losses to US-64. The management failed to offload the equities
when the market started declining. While the book value of
US-64's equity portfolio went up from Rs 7,943 crore (June
1994) to Rs 13,627 (June 1998), the market value had actually

declined in the same period from Rs 18,334 crore to Rs 10,029

crore. Analysts remarked that UTI had been pumping money
into scrips whose market value kept falling. Raising further
questions about the fund management practices was the fact
that there were hardly any growth scrips'from the IT and
pharma sectors in the equity portfolio.
In spite of all this, UTI was able to declare dividends as it was
paying them out of its yearly income, its reserves and by
selling the stocks that had appreciated. This kept the problem
under wraps till the reserves turned negative and UTI could no
longer afford to keep the sale and purchase prices artificially
inflated.
Following the public outrage against the whole issue, UTI in
collaboration with the government of India began the task of
controlling the damage to US-64's image.
RESTORING THE TRUST
UTI realised that it had become compulsory to restructure US64's portfolio and review its asset allocation policy. In October
1998, UTI constituted a committee under the chairmanship of
Deepak Parekh, chairman, HDFC bank, to review the working
of scheme and to recommend measures for bringing in more
transparency and accountability in working of the scheme.
US-64's portfolio restructuring however was not as easy as
market watchers deemed it to be. UTI could not freely offload
the poor performing PSU stocks bought under the GoI
disinvestment program, due to the fear of massive price
erosions after such offloading. After much deliberation, a new
scheme called SUS-99 was launched.
The scheme was formulated to help US-64 improve its NAV by
an amount, which was the difference between the book value
and the market value of those PSU holdings. The government
bought the units of SUS-99 at a face value of Rs 4810 crore.
For the other PSU stocks held prior to the disinvestment
acquisitions, UTI decided to sell them through negotiations to

the highest bidder. UTI also began working on the committee's

recommendation to strengthen the capital base of the scheme
by infusing fresh funds of Rs 500 crore. This was to be on a
proportionate basis linked to the promoter's holding pattern in
the fund.
The inclusion of the growth stocks in the portfolio was another
step towards restoring US-64's image. Sen, Executive Director,
UTI said, The US-64 equity portfolio has been revamped since
June. During the last nine months the new ones that have
come to occupy a place among the Top 20 stocks from the
(Satyam Computers, NIIT and Infosys) and FMCG (HLL,
SmithKline Beecham and Reckitt & Colman) sectors. US-64
has reduced its weightage in the commodity stocks (Indian
Rayon, GSFC, Tisco, ACC and Hindalco.)
To control the redemptions and to attract further investments,
the income distributed under US-64 was made tax-free for
three years from 1999. To strengthen the focus on small
investors and to reduce the tilt towards corporate investors,
UTI decided that retail investors should be concentrated upon
and their number should be increased in the scheme.
UTI also decided to have five additional trustees on its board.
To enable trustees to assume higher degree of responsibility
and exercise greater authority UTI decided to give emphasis on
a proper system of performance evaluation of all schemes,
marked-to-market valuation[5] of assets and evaluation of
performance benchmarked to a market index. The
management of US-64 was entrusted to an independent fund
management group headed by an Executive Director. UTI
made plans to ensure that full responsibility and
accountability was achieved with support of a strong research
team. Two independent sub-groups were formed to manage
the equity and debt portion of US-64. An independent equity
research cell was formed to provide market analysis and
research reports.

TABLE
HOW THINGS WERE SET RIGHT
PSU shares were transferred to a special unit
scheme (SUS'99) subscribed by the government in
1998-99.
Core promoters such as the Industrial Development
Bank of India added around Rs 450 crore to the unit
capital, thus helping to bridge the reserves deficit of
Rs 2,800 crore in 1998-99.
Portfolios were recast in the current quarter to
capitalise on the stock surge as the BSE Sensex rose
by 15%. Greater weightage was given to stocks such
as HLL, Infosys, Ranbaxy, M&M and NIIT.
In US-64's case exposure to IT, FMCG and Pharma
stocks rose from 20.45% to 22.09%. This was
replicated across funds. Between June 1999 September 1999, 21 out of UTI's 28 schemes have
outperformed the Sensex.
UTI has become more proactive in fund
management. For instance, it bought into Crest at
between
Rs 200 and Rs 210 in October 1999. The stock was
trading at Rs 340 in November 1999.
Stocks like Visual Software, Mastek and Gujarat
Ambuja have entered the top 50 equity holding list.
Scrips like Thermax, Thomas Cook and Carrier
Aircon are out.
Complete exit from illiquid stocks such as Esab
Industries. The divesture of around 83 stocks
released estimated Rs 300-500 crore of extra
investible cash.

Source: Business World, November 29, 1999.

UTI constituted an ad-hoc Asset Management Committee with
7 members comprising 5 outside professionals and 2 senior
UTI officials. The committee's role was clearly defined and its
scope covered the following areas:

 To ensure that US-64 complied with the regulations and

guidelines and the prudential investment norms laid down by
the
UTI
board
of
trustees from
time
to
time.
To review the scheme's performance regularly and guide fund
managers on the future course of action to be adopted.
To oversee the key issues such as product designing,
marketing
and
investor
servicing
along
with
the
recommendations to Board of Trustees.
One of the most important steps taken was the initiative to
make US-64 scheme NAV driven by February 2002 and to
increase gradually the spread between sale and repurchase
price. The gap between sale and repurchase price of US-64
was to be maintained within a SEBI specified range. UTI
announced that dividend policy of US-64 would be made more
realistic and it would reflect the performance of the fund in the
market. US-64 was to be fully SEBI regulated scheme with
appropriate amendment to the UTI Act.
The real estate investments made by UTI for the US-64
portfolio were also a part of the controversy as they were
against the SEBI guidelines for mutual funds. UTI had Rs 386
crore worth investments in real estate. UTI claimed that since
its investments were made in real estate, it was safe and it
could sell the assets whenever required. However, the value of
the real estate in US-64's portfolio had gone down
considerably over the years. The real estate investments were
hence revalued and later transferred to the Development
Reserve Fund of the trust according to the recommendations
of the Deepak Parekh committee.
By December 1999, the investible funds of US-64 had
increased by 60% to Rs 19,923 crore from Rs 12,433 crore in
December 1998. The NAV had recovered from Rs 9.57 to Rs 16
by February 2000 after the committee recommendations were
implemented
DEAD END SCHEME?

Though UTI started announcing the dividends according to the

market conditions, this was not received well by the investors.
They felt that though the dividend was tax-free, it was not
appealing as most of the investors were senior citizens and
they
did
not
come
under
the
tax
bracket.
The statement in media by UTI chairman that trust would try
to attract the corporate investors into the scheme was against
the recommendation by the committee, which had adviced the
trust to attract the retail investors into the scheme. This led to
doubts about UTI's commitment towards the revival of the
scheme.
However, led by improving NAV figures and image-building
exercises on UTI's part, by 2000, US-64 was again termed as
one of the best investment avenues by analysts and market
researchers. UTI had become more proactive in fund
management with its scrips rising in value, restoring the
confidence of the small investor in the scheme. The National
Council of Applied Economic Research (NCAER) and SEBI
surveys mentioned that US-64 was once again perceived as a
safe investment by the middle class income groups.
However, the euphoria seemed to be short lived as in 2001,
US-64 was involved in yet another scam due to its investments
in the K-10 stocks . Talks of a drastically low NAV, inflated
prices, increasing redemption and GoI bailouts appeared once
again in the media. An Economic Times report claimed that
there was a difference of over Rs 6000 crore between the NAV
and the sale prices. Doubts were raised as to US-64 being an
inherently
weak
scheme,
which
coupled
with
its
mismanagement, had led to its downfall once again.
This however, was yet another story.
Source:www.icmrindia.org
QUESTIONS FOR DISCUSSION:

1. Explain in detail the reasons behind the problems faced by

US-64 in the mid 1990s. Were these problems the sole
responsibility of UTI? Give reasons to support your answer.
The reasons behind the problems faced by US-64 include
Acquiring public sector unit stocks: UTI made a huge investment of
around 70billion in Public Sector Unit (PSU) stocks with the hope of distributing
higher dividends. But PSU stocks were the poor performing ones. While
making this investment, it forgot its identity as a scheme that had to provide
fixed regular returns to its investors by maintaining a balanced portfolio.
Lack of proper fund management and internal control systems. Media
reports came to be true that UTI lacked proper fund management and internal
control systems. This lead to a severe decline in market value of equity of UTI
from 82billion to 42 billion.
Portfolio of equity being greater than debts:
The equity holdings of UTI climbed from 30% to 70%. But a typically
balanced mutual fund doesnt hold more than 30%equity. The case of
UTI is just reverse. It is holding 70% of equity. This kind of equity holding was
an example of a reckless investment decision made by UTI.
Yes, I think the problems were the sole responsibility of UTI. Ambitious plans to
distribute higher dividends investing in equities (esp. PSUs), lack of proper
management and internal control systems, misbalancing the portfolio by
holding higher portion of equity were all the faults UTI made by itself. Hence,
UTI should be held responsible for these hasty decisions.

2. Analyse the steps taken by UTI to restore investor confidence

in US-64. Comment briefly on the efficacy of these steps.
Steps taken by UTI to restore investor confidence are:.
Selling PSU stocks through negotiations to the highest bidder.
Forming a committee to review and recommend members to increase
transparency and accountability under the chairmanship of Deepak
Parekh (chairman of HDFC)
Using fresh funds to strengthen the capital base (around Rs 5 billion)
Freeing tax in incomes for the next three years to attract more investors
Emphasizing on performance evaluation of all schemes.
Formation of two independent groups to manage equity and debt
portfolio
3. As a market analyst, would you term US-64 a safe mode of
investment? Justify your stand with reasons.
As a market analyst I would term US-64 a safe mode of investment
because we live in present forgetting the failure stories of UTI before.
And it shows that UTI had become proactive in fund management,
with its scripts rising in value, restoring the confidence of the small
investors in the scheme

ASSIGNMENT C
1A
2D
3C
4B
5B
6C
7B
8D
9A
10 D

11
12
13
14
15
16
17
18
19
20

D
B
D
A
C
B
C
C
A
B

21
22
23
24
25
26
27
28
29
30

C
B
A
A
B
C
C
B
C
D

31
32
33
34
35
36
37
38
39
40

B
B
A
A
A
C
A
B
A
B