funds
i.e capital, retained earnings, subsidies / grants etc External sources i.e Banks, Financial Institutions in the form of term loans, capital market, Debentures, Preference shares, Deferred Payment Guarantees etc Short Term or Working Capital: requirements of SME / Corporate are predominantly funded by Commercial Banks. Working capital will be in the form of credit facilities involving both funds and without providing funds also.
Transferable Credits: The beneficiary may ask for transferring the credit in full or part to one or more other beneficiaries (textile exports) Back to Back Credits: The beneficiary gets LC from a bank and requests his bank to open another LC/LCs in favour of his suppliers. One LC is backed by another LC Standby Credits: are security cover for beneficiaries and the issuing bank undertakes to pay only on default by the applicant (buyer). If any one transaction is not paid by the buyer, the standby LC will authorise the beneficiary to draw on the issuing bank, giving a certificate that the default has occurred.
Bank Guarantees:
Financial Guarantees (Bid bond/EMD, Mobilisation advance, retention money )-risk weightage 100% Performance Guarantee-Risk weightage 50%
Environmental, PCB clearances Demand Forecasting, demand supply gap Production capacity, product features etc Cost of the project, means of finance Time schedule Commercial viability of the project Security primary, collateral, margin etc Financial projections, sensitivity analysis, DSCR, BEP analysis Funds Flow Statement Rate of return etc Pay Back period, IRR, NPV etc.
The main sources of finance would be: Owned Funds - Share Capital ( public, promoters etc) Preference Shares Internal cash accruals (existing entities) Debt Funds Term Loans Debentures Leasing (Air Craft, Oil rigs) Deposits Unsecured Loans Central or State Govt Subsidies Interest Free Loans (ST def.) Deferred Payment Guarantees etc
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Banks and FIs seek audited financial statements, projections covering the period of credit facilities requested. The single most widely followed testing tool by Indian Bankers being Ratio Analysis, The analyst / appraiser reads and interprets the Balance Sheet and P&L account of the enterprise. Ratios are not end in themselves; rather on a selective basis, they help answer significant questions. As a part of credit appraisal, the following tools are used: Percentage analysis Ratio Analysis Funds Flow Statements Cash Flow Statements
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Percentage Analysis
Various figures appearing in the financial statements are reduced to percentage of total. This tool may be applied for big corporates and with history for studying the changes in components
Ratio analysis
The analyst / appraiser to determine relationships that are to be interpreted thru ratio analysis. Ratios should be computed in respect of figures which have significant relationships. For ex. Sundry Debtors to Sales etc. Comparison is to examine the ratio of one year to previous year and reasons for variances, and with similar business units in the industry for the same period.
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The ratios can be broadly classified into the following: Capitalization / Leverage Ratios ( Debt/Equity, TOL/TNW etc) Liquidity Ratios (Current Ratio, Quick Ratio, NWC etc) Profitability Ratios (OPBDIT/sales, PAT/Sales, RONW, ROI etc) Coverage ratios (Interest coverage, fixed assets coverage, DSCR) Turnover Ratios (raw material to consumption; stores/spares to consumption; SIP/Cost of Prod; Finished goods to Cost of Sales etc)
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Contingent Liabilities
A contingent liability is a liability which may or may not occur in the future, arising out of the existing situation. A contingent becomes an actual liability based on the occurrence or non-occurrence of one or more uncertain events in future Examples: Claims against the company not acknowledged as debts Arrears of fixed cumulative dividends Bills discounted with Banks Guarantees issued on behalf of the company and also on behalf of subsidiaries, group companies Letters of credit outstanding Estimated amount of contracts remaining to be executed on capital account not provided for
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Credit Risk
Credit risk =Risk that a party to a contractual agreement or transaction will be unable to meet their obligations or will default on commitments. Credit risk can be associated with almost any transaction or instrument such as swaps, repos, CDs, foreign exchange transactions, etc apart from FB, NFB facilities Specific types of credit risk include sovereign risk, country risk, legal or force majeure risk, marginal risk and settlement risk.
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Credit Ratings
In the Standard & Poor rating system, AAA is the best rating. After that comes AA, A, BBB, BB, B, CCC, CC, and C The corresponding Moodys ratings are Aaa, Aa, A, Baa, Ba, B,Caa, Ca, and C Bonds with ratings of BBB (or Baa) and above are considered to be investment grade Historical Data Historical data provided by rating agencies are also used to estimate the probability of default
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Impact of Basel II on Capital requirement of Banks -Loan of INR 1000 mio Basel-I Basel II
Rating Risk Wt Cap req Rs.mio 90.00 90.00 90.00 90.00 90.00 90.00 Risk Wt Cap req Rs.mio 18.00 27.00 45.00 90.00 135.00 135.00 Cap saved Rs. mio 72.00 63.00 45.00 nil (45.00) (45.00)
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For a company that starts with a good credit rating default probabilities tend to increase with time For a company that starts with a poor credit rating default probabilities tend to decrease with time
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2
0.000 0.019 0.095 0.506 3.219
3
0.000 0.042 0.220 0.930 5.568
4
0.026 0.106 0.344 1.434 7.958 22.054 46.904
5
0.099 0.177 0.472 1.938
7
0.251 0.343 0.759 2.959
10
0.521 0.522 1.287 4.637
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Interpretation The table shows the probability of default for companies starting with a particular credit rating A company with an initial credit rating of Baa has a probability of 0.181% of defaulting by the end of the first year, 0.506% by the end of the second year, and so on
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Operational Risk
Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputation risk. There are 3 methods of calculating Operational Risk; (i) the Basic Indicator Approach (BIA) (ii) the Standardised Approach (TSA)- Divided into 8 business lines; 12% for retail brokerage to 18% for corporate finance (iii) Advanced Measurement Approaches (AMA) Internal risk measurement both qualitative and quantitative subject to approval by RBI
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Operational Risk
Minimum capital required under the Basic Indicator Approach is 15% of average of previous three years annual gross income for operational risk some of the risks that the banks are generally exposed to but which are not captured or not fully captured would include: (a) Interest rate risk in the banking book; (b) Credit concentration risk; (c) Liquidity risk; (d) Settlement risk; (e) Reputation risk; (f) Strategic risk; The methodologies and techniques are still evolving w.r.t measurement of non-quantifiable risks, such as reputation and strategic risks.
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Market Risk
Market risk is defined as the risk of losses in onbalance sheet and off-balance sheet positions arising from movements in market prices. The market risk positions subject to capital charge requirement are: The risks pertaining to interest rate related instruments and equities in the trading book; and (ii) Foreign exchange risk (including open position in precious metals) throughout the bank (both banking and trading books). Trading book for the purpose of capital adequacy will include: (i) Securities included under Held for Trading
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Market Risk
(ii) Securities included under the Available for Sale (iii) Open gold position limits (iv) Open foreign exchange position limits (v) Trading positions in derivatives, and (vi) Derivatives entered into for hedging trading book exposures. The minimum capital requirement is expressed in: specific risk charge for each security, designed to protect against any adverse movement in the price of an individual security owing to factors related to the individual issuer general market risk charge towards interest rate risk
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Derivatives
In the last 25 years derivatives have become more popular in the world of finance. A derivative can be defined as a financial instrument whose value depends or derives from the values of other, more basic, underlying variables. Futures and Options are now traded actively on many exchanges throughout the world. Different types of forward contracts, swaps, options and other derivatives were regularly traded by Financial Institutions, Fund Managers, Corporate Treasurers either to hedge or speculate or to take advantage of arbitrage. Derivatives o/s US$ 680 trillion Forex derivatives are denominated in one leg US$-83%, Euro 41%, Yen 22%
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Forward Contracts
Forward contract is a simple derivative product. It is an agreement to buy or sell an asset at a certain future time for a certain price. This is in contrast to the Spot Contract. A forward contract is traded usually between two financial institutions or between a financial institution and one of its clients. Forward Contracts on foreign exchange are very popular and are being used predominantly by Exporters and importers or enterprises having FOREX commitments Futures Contract: is a standardised contract traded on an exchange. A range of delivery dates is usually specified. It is settled daily and usually closed prior to maturity.
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Options
Options are traded on exchanges and OTC. There are two basic types. A call option, put option A call option gives the holder the right to buy the underlying asset by a certain date for a certain price. A Put Option gives the holder the right to sell the underlying asset by a certain date for a certain price. Advantage-holder of options does not have to exercise the right. In case of forwards and futures, the holder is obliged to buy or sell the underlying asset. Forward contracts-designed to neutralize the risk by fixing the price that the hedger will pay/receive Options, by contrast, provide insurance. Costs nothing to enter into a forward or future contract whereas up-front fee is to paid for options
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Swaps
Swap is an agreement between two companies to exchange cash flows in the future. The agreement defines the dates when the cash flows are to be paid, the way in which they are to be calculated (interest rate, exchange rate and/or other market variable)
The most common type of swap is Plain Vanilla interest rate swap. A company agrees to pay cash flows equal to the interest at a predetermined fixed rate on a notional principal for a number of years. In return, it receives interest at a floating rate on the same notional principal for the same period of time. Floating rate in most interest rate swaps agreements is LIBOR, as LIBOR is quoted in all major currencies for 1 month, 3 m, 6 m and 12 month period.
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Mar.5, 2004
Sept. 5, 2004
4.2%
4.8%
Mar.5, 2005
Sept. 5, 2005 Mar.5, 2006
5.3%
5.5% 5.6%
+2.40
+2.65 +2.75
2.50
2.50 2.50
0.10
+0.15 +0.25
Sept. 5, 2006
Mar.5, 2007
5.9%
6.4%
+2.80
+2.95
2.50
2.50
+0.30
+0.45
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Converting a liability from fixed rate to floating rate floating rate to fixed rate
Converting an investment from fixed rate to floating rate floating rate to fixed rate
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An Example of a Currency Swap An agreement to pay 5% on a sterling principal of 10,000,000 & receive 6% on a US$ principal of $18,000,000 every year for 5 years
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The Cash Flows Dollars Pounds $ ------millions-----18.00 +10.00 +1.08 0.50 +1.08 0.50 +1.08 0.50 +1.08 0.50 +19.08 10.50
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Exchange of Principal
In an interest rate swap the principal is not exchanged In a currency swap the principal is usually exchanged at the beginning and the end of the swaps life Typical Uses of a currency Swap Conversion from a liability in one currency to a liability in another currency Conversion from an investment in one currency to an investment in another currency
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CDS Structure
Recovery rate, R, is the ratio of the value of the bond issued by reference entity immediately after default to the face value of the bond
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Possible Structure
Asset 1 Asset 2 Asset 3
Tranche 1 (equity) Principal=$5 million Yield = 30% Tranche 2 (mezzanine) Principal=$20 million Yield = 10% Tranche 3 (super senior) Principal=$75 million Yield = 6%
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SPV
Currency Swaps
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Questions..
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Thank you
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