FIIM CH-1-4 Best

FINANCIAL INSTITUTIONS
& INVESTMENT
MANAGEMENT
Dr Kishor Chandra Meher
Professor(Accounting & Finance)
Debre Berhan University
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1.1.Classification of Finance
• FINANCE- Definition
• “ The managing or the science of managing money
matters”.
• FINANCING-Definition
• “To supply or obtain money or credit”.
• “ That administrative area or set of administrative
functions in an organization which relates with the
arrangement of cash and credit, so that the
organization may have the means to carry out its
objectives as satisfactorily as possible.”
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1.1.Classification of Finance
• A) Public Finance
• B) Private Finance
• Public Finance studies the sources of funds of
public authorities such as states, local self
Govts. And Central Govts.
• It deals with the incomes, expenditures and
borrowings of public authorities.
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Public Finance
• The disciplines of public Finance
describes and analyses government
services, subsidies and welfare payments
and the methods by which the
expenditures to these are covered
through taxation, borrowing, foreign aid
and creation of new money”.
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Private Finance
• Personal Finance
• Business Finance
– External Finance a) Direct financing , b) Indirect

financing
– Internal finance
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Personal Finance
• Management of finance of an individual
household through rational consumption and
saving thereby developing the ecconomy of a
country.
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Business Finance
• It is that business activity which deals with the
acquisition and conservation of capital funds
in meeting the financial needs and over all
objectives of business enterprises.
• Requires for its capital expenditure and
working capital.
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External Finance
• Obtain necessary funds from outside sources.
– Direct financing through issuing securities through
stock exchanges,
– Indirect financing through middle men like
investment companies.
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Internal Finance
• Ploughing back of profits
• For financing working capital and or fixed
capital requirements
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CH-1.2
FINANCIAL SYSTEM
FINANCIAL MARKETS
FINANCIAL INSTRUMENTS
FINANCIAL SERVICES
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Meaning of Financial System
 Definition: Financial System is a set of
institutions, instruments and markets which
foster savings and channel them to their
efficient use.
 Financial system consists of many financial
institutions and the mechanism which
affects the generation, mobilization and
distribution of saving of the community
among all those who demand the funds for
investment purposes.
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Financial System Contd…
 Financial System consists of two groups:
 1. All Institutions that promote saving
among the public, collect and transfer the
same to the investors. These include
banking system, The insurance companies,
Mutual funds companies, investment
companies.
 2. The investors r borrowers of the Nation: It
comprises of individual investors, industrial,
trading companies, Governments.
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Functions of Financial
System
 Major role in economic development of the country.
 Stimulating capital accumulation and efficient
allocation of it.
 Amongst the savers and investors.
 Savers are those whose current incomes exceeds
current expenditure,
 Investors are those whose current income is less
than current expenditure,
 FS establishes linkage between savers and investors
to facilitate transformation of saving in to
investment.
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FINANCIAL SYSTEM
Financial System consists of four
parts:
1) Financial Institutions
2) Financial Markets
3) Financial Instruments
4) Financial Services
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 They mobilize the savings and
transfer it to deficit units. They deal
only in financial assets like deposits,
securities, etc. They collect fund
from those units having savings.
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Financial Institutions
Contd…
Financial Intermediaries
It is defined as all economic units whose main
function is holding of and trading in financial
assets. They issue indirect securities and use
the fund thus raised to purchase primary
securities.
That means they issue one kind of securities
and purchase another kind.
The savings of the surplus channels are
channeled in to deficit sectors.
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Types of Financial
Intermediaries
 Types of financial intermediaries:
 A) Bank or Monetary financial
intermediaries: Central bank, Commercial
Banks, Cooperative banks,
 B) Non-Monetary or non bank
Intermediaries: Saving & Loans
associations, Development banks, Unit
Trust, Investment companies, hire purchase
& leasing companies, Agricultural financial
institutions etc.
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Financial Intermediaries
 The financial assets created by bank in the
form of deposits are generally accepted as
means of payment which is money.
 Non-bank intermediaries create non
monetary claims by issuing indirect securities
such as saving deposits, shares and other
obligations. Hence, the assets which they
create are not acceptable as a means of
payment, and they have to be converted in
to money in order to make payments.
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FINANCIAL MARKETS
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TYPES OF FINANCIAL MARKET
Share Market.
Debt Market.
Money Market.
Derivative Market.
Foreign Exchange Market
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Capital Market Participants
 Banks
 Exchanges
 Clearing Corporations
 Brokers
 Custodians
 Depositories
 Investors
 Merchant Bankers
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FINANCIAL MARKET
ORGANISED UNORGANISED
CAPIATAL MONEY
MARKET MARKET
INDUSTRIAL GOVT LONG TERM

SECURITY SECURITY LOAN
Term loan Market Market

Primar Secondary For For
y Market mortgage Financial
Market
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22
FINANCIAL MARKETS
This is the place from where savings are transferred from surplus
units to deficit units. There are two segments of financial
market. They are money market and capital market.
Money market is concerned with short-term funds or claims.
Capital market deals with those financial assets, which have

maturity period of more than a year.
Another classification could be primary and secondary

markets.
Primary market deals with new issues. The secondary market
deals with outstanding securities.
Primary markets by issuing new securities mobilise the savings

directly. Secondary markets provide liquidity to the securities.
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Primary Market or
New Issue Market
 The new issue market deals with the
new securities which were not
previously available to the investing
public i.e. the securities that are
offered to the investing public for
the first time.
 In other words, new issue market

deals with raising of fresh capital by
companies either for cash or for
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Secondary market
 The market where existing
securities are traded is referred
to as the secondary market or
stock market.
 In this Market, purchases and

sales of securities whether of
Govt. or Semi-Govt. bodies or
other public bodies and also
shares and debentures issued
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Methods of Raising
Capital
I. Offer for sale
II. Placement
III. Right Issue
iv. Public Issues
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IMPORTANCE OF CAPITAL
MARKET
 It mobilizes the savings of the
people .
 It provides incentives to saving .
 It facilitates increase in production
and productivity in the economy .

 It give quantitative and qualitative
directions to the flow of funds .

 Consisting of expert intermediaries
promotes stability .
 It serves as an important source for
technological up gradation to
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DEBT MARKETS
A debt market is also known as a 'fixed income market' as debt
instruments pay fixed returns. The Bond Market is part of the
debt market. Debt markets are now considered an alternative
route to banking channels for finance. Some of the benefits to
the investors in debt instruments are:
 The investors benefit by investing in fixed income securities as
they preserve and increase their invested capital and also
ensure the receipt of regular interest income.
 The investors can even neutralize the default risk on their
investments by investing in Govt. securities, which are normally
referred to as risk-free investments due to the sovereign
guarantee on these instruments.
 The prices of Debt securities display a lower average volatility as
compared to the prices of other financial securities and ensure
the greater safety of accompanying investments.
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Impact of the Debt Market on the Economy
The Asian financial crisis in the 1990s stressed the importance
of a fully active debt market; the lack of which aggravated the
crisis. For a developing economy like India, debt markets are
crucial sources of capital funds. The debt market in India is
amongst the largest in Asia.
How do the debt markets impact
the economy?
 Opportunity for investors to diversify their investment portfolio.
 Higher liquidity and control over credit.
 Better corporate governance.
 Improved transparency because of stringent disclosure norms
and auditing requirements.
 Less risk compared to the equity markets, encouraging low-risk
investments. This leads to inflow of funds in the economy.
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Security Analysis and Portfolio Management 29
DEBT/BOND VALUATION
Debt instruments promise to pay a stipulated stream of cash
flows. This generally comprises periodic interest payments
over the life of the instrument and principal payment at the
time of Maturity. A vast menu of debt instruments exists. They
may be classified into two groups according to maturity, where
maturity is defined as the length of time between the issue
date and the redemption date. Debt instruments which have a
maturity of one year or less are called money market
instruments. Debt instruments which have a maturity of more
than one year are called bonds (or debentures).
Types and Features of Debt Instruments
 The variety of debt instruments may be classified as follows:
 Money market instruments
 Government securities and government-guaranteed bonds
 Corporate debentures
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MONEY MARKET
Debt instruments which have a maturity of less than 1 year at the time
of issue are called money market instruments. The important money
market instruments are: Treasury bills, certificates of deposits, and
commercial paper.
Treasury Bills
Treasury bills represent short-term obligations of the Government
which have maturities like 91 days, 182 days, and 364 days. They do
not carry an explicit interest rate (or coupon rate). They are instead
sold at a discount and redeemed at par value. Though the yield on
Treasury bills is somewhat low, they have an appeal for the following
reasons:
(i) They can be transacted readily as they are issued in bearer
form.
(ii) There is a very active secondary market for Treasury bills and
the Discount and Finance House of India is a major market
maker.
(iii) Treasury bills are virtually risk free.
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Certificates of Deposit
A certificate of deposit (CD) represents a negotiable receipt

of funds deposited in a bank for a fixed period. It may be in a
registered form or a bearer form. The latter is more popular
as it can be transacted more readily in the secondary market.
Like Treasury bills, CDs are sold at a discount and redeemed
at par value. CDs are a popular form of short-term investment
for companies for the following reasons:
(i) Banks are normally willing to tailor the denominations
and maturities to suit the needs of the investors.
(ii) CDs are fairly liquid.
(iii) CDs are generally risk-free.
(iv) CDs generally offer a higher rate of interest than
Treasury bills or term deposits.
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Commercial Paper
Commercial paper represents short-term unsecured promissory
notes issued by firms that are generally considered to be
financially strong. Commercial paper usually has a maturity
period of 90 days to 180 days. It is sold at a discount and
redeemed at par. Hence the implicit rate is a function of the size
of discount and the period of maturity. Commercial paper is either
directly placed with the investor or sold through dealers.
Commercial paper does not presently have a well developed
secondary market in India.
Government Securities and Government-
Guaranted Bonds
The largest borrowers in India are the central and state
governments. The Government of India periodically sells central
government securities. These are essentially medium to long-
term bonds issued by the Reserve Bank of India on behalf of the
Government of India.
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Corporate Debt or Corporate Bonds
Bonds (or debentures) are issued frequently by public sector
companies, financial institutions, and private sector companies. A
wide range of innovative debt securities have been created in
India, particularly from early 1990s. A brief description of various
types of corporate bonds is given below.
Straight Bonds
The straight bond (also called plain vanilla bond) is the most
annual coupon over its life and returns the principal on the
maturity date.
Zero Coupon Bonds
A zero coupon bond (or just zero) does not carry any regular
interest payment. It is issued at a steep discount over its face
value and redeemed at face value on maturity.
Floating Rate Bonds
Straight bonds pay a fixed rate of interest. Floating rate bonds, on
the other hand, pay an interest rate that is linked to a benchmark
rate such as the Treasury bill interest rate.
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Bonds with Embedded Options
Bonds may have options embedded in them. These options give certain
rights to investors and/or issuers. The more common types of bonds with
embedded options are: Convertible Bonds Convertible bonds give the bond
holder the right (option) to convert them into equity shares on certain terms.
Commodity-linked Bonds
The payoff from a commodity linked bond depends to a certain extent on the
price of a certain commodity
Bond Features
Bonds tend to be confusing because of complex provisions attached to them.
The financial contract between the issuer and the holder of bonds is called
the bond indenture which spells out the features of the bond in terms of
collateral, sinking fund, call provision, protective covenants, and so on.
Collateral
Collateral represents a pledge of assets in favor of the bond holders. If
serves as an insurance against any possible default by the borrower.
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DERIVATIVE MARKET
“A derivative instrument is an
instrument whose value depends upon or
derives from, among other things, the
value of another instrument. The latter is
known as the ‘underlying’
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HISTORY
 CHICAGO BOARD OF
TRADE(C.B.O.T)-1848
 CHICAGO MERCENTILE
EXCHANGE(C.M.E)
 India: N.S.E & B.S.E-1990
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PARTICIPANTS IN DERIVATIVE MARKET
The major players in the futures market are Hedgers,

Speculators and Arbitrageurs.
Hedgers: Hedgers wish to eliminate or reduce the price risk
to which they are already exposed. The hedging function
solely focuses on the role of transferring the risk of price
changes to other holders in the futures markets.
Speculators: Speculators are those class of investors who
willingly take price risks to profit from price changes in the
underlying.
Arbitrageurs: Arbitrageurs profit from price differential
existing in two markets by simultaneously operating in two
different markets.
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TYPES OF DERIVATIVES
They can be classified according to:
 Type of Contract
 Type of underlying asset
 Whether Exchange Traded or OTC(Over
the Counter)
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Types of Contract
 Forward- OTC
 Futures – Exchange Traded
 Options – Exchange Traded
 Swaps - OTC
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Type of Underlying Asset
 Foreign Exchange
 Equities
 Fixed Income
 Commodities
 Energy Products
 Live Cattle
 Precious Metals
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FOREIGN EXCHANGE
MARKET
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I. What is Foreign Exchange?
 Foreign exchange means foreign

currency.
 It is the money denominated in the
currency of another nation or group of
nations It also means deposits, credits,
and balance payable in foreign
exchange.
- Foreign Currency includes all
currency notes, postal notes, drafts,
postal orders, money orders, bills of
exchange, promissory notes, credit
cards. Notifies by Central Banks.
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- It can be in the form of
drafts/travelers cheques/LC/bills of
exchange drawn in foreign currency by
banks out side India.
- It means drafts/ TC/LC/ BOE
expressed in rupees but payable in
foreign exchange.
- It means drafts/TC/LC/BOE drawn
by banks, Institutions or persons
outside India, but payable in Indian
currency.
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II. What is an Exchange Rate ?
 Itis the price of a currency .
 It is the number of units of one
currency that buys units of another
currency and this number can
change daily.
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III. What is Foreign Exchange Market?
 - It is made of many players. Some
players buy and sell foreign exchange
because they are exporters and importers of
goods and services.
 - Other players buy and sell foreign

exchange because of FDI – both inviting
capital in to and pulling dividend out of a
country.
 - Others are portfolio investors- They buy
to sell them at a more profitable exchange
rate later.
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IV.CHARACTERISTICS OF FOREIGN EXCHANGE
 - SCARCITY CHARACTER
 - COMMODITY CHARACTER
 i) Buying transactions- when the
authorized dealer takes/ receives foreign
exchange and pays/ credits equivalent
amount in rupees , he is entering in to a
buying transactions.
 ii) Sale transactions – When he gives/
delivers foreign exchange and accepts/ takes
the amount in rupees, he is entering in to
selling transactions. The objectives of the
dealer are to earn profit.
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- PRICE OR RATE OF FOREIGN EXCHANGE-
 One buying rate and one selling rate prevail in
the market.
 SPREAD/ Margin of Profit
= Selling rate – Buying rate
- - MARKET FOR FOREIGN EXCHANGE
Three Players in the Market-
 i) Merchant Market (Authorised Person or dealer)
 a. Retail Market
 b. Transactions of an authorised dealer with public.
 c. Examples :
 Ø Issue/ payment of travelers cheques/ currency
notes to/ from public,
 Ø Purchase of export proceeds
 Ø Inward remittance/ outward remittance on
account of customers.
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 ii) Inter bank Market:
 v Transactions between Authorised dealers,

 v Inter bank rates- bigger amount and
wholesale in nature better than merchant
rate.
 v Benchmark or base rate for the Authorised
dealer to quote their merchant rates.
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iii) International Market
 Transactions between
Authorised dealer and
international bank,
 A Whole sale market ,
 Rates in the market are better
compared to the inter bank
market .
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I. CHARACTERISTIC FEATURES OF FOREIGN EXCHANGE MARKETS-
 - NO EXACT LOCATION
 - AN OTC MARKET- Without the intervention of an exchange /
clearing house the participants can directly deal with each other.
- TWENTY FOUR HOUR MARKET
 · The rate may change overnight.
- VERY VOLATILE – Rate fluctuates every second.
 - MAJOR PLAYERS
 v Multinational companies, International Banks.
 - AD AS MARKET MAKERS : Banks/ Ads offer two way quotes
( to buy/ sell foreign exchange.
 - FOREIGN EXCHANGE MARKET :
• Participants are :
 ü Corporate,
 ü Commercial Banks,
 ü Exchange Brokers,
 ü Central Banks.
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Classification of Financial Assets
Marketable Assets Non- Marketable Assets
Shares Gov Bonds MF UTI Bearer

Securities Units units Debentures
Bank PF LIC PO Cos

Deposits Scheme Certificates Deposits
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 The products, which are traded in a
financial market, are financial assets
or financial instruments. The
requirement of lenders and
borrowers are varied.
 Therefore, there is a variety of
securities in the financial markets.
Financial assets represent a claim on
the repayment of principal at a
future date.
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 SHARE MARKET –
Primary Market-IPO(Initial Public Offering),
FPO(Follow on Public Offering) ,
Secondary Market - Listed Stock in Stock exchange
 DEBT MARKET – Bond , Debentures, Corporate Bond.
 MONEY MARKET – Treasury Bills, Certificate of deposits,
Commercial papers, Govt. Bonds, Call money.
 DERIVATIVE MARKET – Forward, Future, Options,
Swap.
 FOREIGN EXCHANGE MARKET - Foreign Currency.
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SHARES Vs DERIVATIVES Vs INDEX
 The difference between a share and derivative is that

shares/securities is an asset while derivative instrument is a
contract.
 What is an Index?
 A stock index represents the change in value of a set of stocks,
which constitute the index. A market index is very important for
the market players as it acts as a barometer for market behavior
and as an underlying in derivative instruments such as index
futures.
 Example- Sensex of BSE and Nifty of NSE
 In India the most popular indices have been the BSE Sensex and
S&P CNX Nifty. The BSE Sensex has 30 stocks comprising the index
which are selected based on market capitalization, industry
representation, trading frequency etc. It represents 30 large well-
established and financially sound companies. The Sensex
represents a broad spectrum of companies in a variety of
industries. It represents 14 major industry groups. Then there is a
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BSE national index and BSE 200. 56
SHARES Vs DERIVATIVES Vs Index
 While the BSE Sensex was the first

stock market index in the country,
Nifty was launched by the National
Stock Exchange in April 1996
taking the base of November 3,
1995. The Nifty index consists of
shares of 50 companies with each
having a market capitalization of
more than Rs 500 crore.
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FORWARD CONTRACT
 Forward contract
 A forward contract is the simplest mode of a derivative
transaction. It is an agreement to buy or sell an asset (of a
specified quantity) at a certain future time for a certain price.
No cash is exchanged when the contract is entered into.
 Illustration 1:
 Birahanu wants to buy a TV, which costs $ 10,000 but he has
no cash to buy it outright. He can only buy it 3 months
hence. He, however, fears that prices of televisions will rise 3
months from now. So in order to protect himself from the rise
in prices Birahanu enters into a contract with the TV dealer
that 3 months from now he will buy the TV for $ 10,000.
What Birahanu is doing is that he is locking the current
price of a TV for a forward contract. The forward
contract is settled at maturity. The dealer will deliver the
asset to Birahanu at the end of three months and Birahanu
in turn will pay cash equivalent to the TV price on delivery.
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FORWARD CONTRACT
 Illustration 2:
 Joseph is an importer who has to make a payment
for his consignment in six months time. In order to
meet his payment obligation he has to buy dollars
six months from today. However, he is not sure
what the Re/$ rate will be then. In order to be sure
of his expenditure he will enter into a contract
with a bank to buy dollars six months from now at
a decided rate. As he is entering into a contract
on a future date it is a forward contract and the
underlying security is the foreign currency.
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FUTURES CONTRACT
 Obligation :agree to a future transaction as in a forward
contract
 Traded on organized exchanges
 Standardized contracts-amount of underlying,expiry dates,
 Daily settlement(marking to market)
-Reduces default risk:essentially, a series of one day
contracts
Margins(performance bonds)
-Initial margin,Variation margin
-Maintenance margin
-Margin call
 Exchange clearinghouse-counter party to all
transactions.
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OPTIONS
 Option to buy or sell the underlying asset,at a
stated price on or up to a certain date.
 The option buyer has the right but not the
obligation to go through with the contract.Option
seller must fulfill his commitment if option buyer
decides to enforce the right.
 Call option : right to buy the U/L asset
 Put option: right to sell the U/L ASSET
 Buyer=holder= long position (option to exercise)
 Seller= writer =short position: has the obligation
but not the right.
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PARAMETERS OF OPTIONS
 Exercise price =Strike price =price at
which the holder of the option (and thus
buy or sell the underlying asset)
 Expiration date
 Premium=amount paid by the option
buyer to the option seller for the
option,usually up-front
 American option: can exercise only on
expiration date.
 European option: Can exercise any time
before the expiration date
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Differences between Futures
and Forward contaracts
POINT OF FUTURE CONTRACT FORWARD CONTRACT
DIFFERENCE
Underlying This is specified by the This is specified by both the
asset concerned stock ex-change. parties mutually
Quantity Minimum quantity & multiples Quality is decided by both
are decided by the exchange the parties mutually.
in the form of lot size.
Duration & Stock exchange fixes the Parties decide these
value duration & value date. mutually.
Date
Exchange They are traded on the stock They are traded on otc
exchange. exchange.
Regulation Regulated according to the Regulated according to the
rule of stock exchange. rule of otc exchange.
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Similarity between Futures
and Forward Transaction
 Derivative product: both the futures and forward
transaction are derivative products. They generate a
value according to the movement of prices of the
underlying assets.
 Tools for hedging: hedging is a mechanism to counter
balance or minimize the risk arising from investment
in securities.
 Tools to speculate: both of these provide an
opportunity to speculate in the underlying asset. With
the help of long position in them, one can gain when
prices rise in the future, and when prices decline the 64
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Differences Between Option
& Future/Forward Contract
Point of Option Contract Future/Forward Contract
Difference
Right Only buyer of the option has Both the parties have right.
the right.
risk Only for seller of the option. For both the parties.
obligation Only for seller of the option. For both the parties.
premium Buyer of the option is None of the required to pay

required to pay it upfront. for it.
settlement It can simply expire without Here settlement is must , it
being exercised. never expires.
nature It is a pure hedging tool. It is not a pure hedging tool.
margin In this
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SWAP
It is a transaction whereby two parties
parties exchange either a currency, a
loan, or an interest obligation with regard
to certain loan.
Swap transactions are of following types:
 Foreign exchange swap
 Interest rate swap ( plain vanilla swap )
 Cross currency swap ( total loan swap )
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SWAP
 Foreign Exchange Swap:
In this kind of swap transaction, two parties agree
to exchange certain money value represented in
different currencies at present,
With the commitment to do the reverse of this in
the future. These are done to hedge the risk
arising out of fluctuation in the exchange rate of
the currencies.
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SWAP
 Interest rate SWAP:
In this kind of swap transaction, two
parties agree to exchange interest
obligation for a certain loan amount.
One party pays the interest
obligation for loan taken by another
Party and later pays it for the loan
taken by the former.
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SWAP
 Cross Currency Swap:
It is an agreement between two
parties, in which they exchange the
principal amount of the loan as well
as interest obligation. It is done to
gain from the comparative
advantage of each other.
The following mechanism is adopted
for this :
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SWAP
 Each party will raise a loan
according to the objective of another
party.
 Loan amounts are exchanged by
both the parties in the beginning of
swap.
 On respective interest due date,
both make the payment for interest
obligation of each other.
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SWAP
 On the maturity date of the loan
both exchange the principal amount
to be repaid by them.
 The benefit arising out of the swap
transaction is exchanged according
to the mutual agreement.
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INTERNATIONAL FINANCIAL INSTRUMENTS
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Part V: Managing Foreign Operations
Depository Receipts – Global Depository Receipts
C23 and American Depository Receipts
A company may issue DRs for a number of reasons:

 To raise capital in foreign markets.
 To increase consumer interest in their products by strengthening name
recognition in foreign markets.
 To potentially increase the liquidity of their shares by broadening
shareholder base (DRs facilitate cross border trading).
 To gain visibility through financial market presence which can generate
support for and interest in potential mergers and acquisitions.
 To allow employees outside the home market to participate in the parent
company.
Copyright © 2003, Madhu Vij

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23– 73 International Financial Management (2 nd Edition) Madhu Vij Excel Books
American Depository Receipt (ADR)

An ADR is a dollar denominated negotiable certificate that represents a non-US
company’s publicly traded equity. It falls within the regulatory framework of the
USA and requires registration of the ADRs and the underlying shares with the
Securities Exchange Commission (SEC). (In 1990, changes in Rule 144A
allowed companies to raise capital without having to register with SEC.) Non-US
companies have a choice of five types of ADR facilities: unsponsored, three
levels of sponsored ADRs, and one type of private (Rule 144A) ADR facility.
The US is the world’s largest and most liquid capital market. All issues listed on
the New York Stock Exchange (NYSE) can access the US retail market
network.
To set up a successful ADR programme, the issuing company must be a
significant player in the global arena.

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Benefits of ADRs
Benefits to the Issuing Company
 An ADR programme can stimulate investor interest, enhance a
company’s visibility, broaden its shareholder base, and increase liquidity.
 ADRs can provide enhanced communications with shareholders in the
United States.
 ADRs provide an easy way for US employees of non-US companies to
invest in their companies’ employee stock purchase plans.
 Features such as dividend reinvestment programmes can help ensure a
continual stream of investment into an issuer’s programme.
 ADR ratios can be adjusted to help ensure that an issuer’s ADRs trade is
in a comparable range with those of its peers in the US market.
 May increase local prices as a result of global demand / trading through a
more broadened and a more diversified investor exposure. Cont….
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Benefits to the Investors

 Depository Receipts are US securities
 Depository Receipts are easy to buy and sell
 Depository Receipts are liquid
 Depository Receipts are global
 Depository Receipts are convenient to own
 Depository Receipts are cost-effective0
Cont….

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Global Depository Receipt

GDRs vis-à-vis Direct Foreign Investment
1. A GDR is denominated in US dollars, while the shares held in the
domestic market by Foreign Institutional Investors (FIIs) are
denominated in Indian rupees.
2. GDR holders need not register with any Indian regulatory agency,
while FIIs need to register themselves with SEBI.
3. Shares of the FII are held by the custodian for an additional
charge. GDR holders need not pay this additional amount,
thereby making GDR a good 10-25 basis points cheaper than
ordinary shares.
4. GDRs are generally offered to investors at a discount at the
domestic price, while FIIs have to invest in a company’s shares
at par in the domestic market etc. Cont….

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History of GDRs in India

India entered the international arena in May 1992, with the first GDR issue by
Reliance Industries Limited, which collected US $150 million. This was followed
by Grasim Industries’ offer of US $90 million in November. Then, the GDR
markets witnessed a lull till 1993-end in the wake of the securities scam and the
consequent fall in the domestic markets, during which time the only Indian
offering came from HINDALCO in July 1993, which raised US $72 million.
The end of 1993 saw a flood of Indian paper hit the Euromarkets with Bombay
Dyeing, Mahindra and Mahindra, SPIC and Sterlite Industries raising funds. This
boom continued till mid-1995, after which a combination of factors – political
instability, falling markets, reduced profitability due to a liquidity crunch – pulled
down the GDR market again, till the end of 1996, during which time, the only
notable exception was the US $370 million offering by the State Bank of India.
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Benefits and Uses of a GDR

 Access to capital markets outside the home market to provide a
mechanism for raising capital or as a vehicle for an acquisition.
 Enhancement of company visibility by enhancement of image of the
company’s products, services or financial instruments in a marketplace
outside its home country.
 Expanded shareholder base which may increase or stabilise the share
price.
 May increase local share price as a result of global demand/trading
through a broadened and a more diversified investor exposure.
 Increase potential liquidity by enlarging the market for the company’s
shares.
 Adjust share price to trading market comparables through ratio.
 Enhance shareholder communications and enable employees to invest
easily in the parent company. Cont….

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Benefits to an Investor
 They facilitate diversification into foreign securities.
 Trade, clear and settle in accordance with requirements of the market in
which they trade.
 Eliminate custody charges.
 Can be easily compared to securities of similar companies.
 Permit prompt dividend payments and corporate action notifications.
 If DRs are exchange listed, investors also benefit from accessibility of
price and trading information and research.
Cont….

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FINANCIAL SERVICES
 Financial services include the
services offered by both types of
companies- Asset Management
Companies and Liability
Management Companies
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FUNCTIONS OF FINANCIAL SERVICES
Financial services firms not only help to raise the required funds
but also assure the efficient deployment of funds.
They assist in deciding the financing mix.
They extend their service up to the stage of servicing of lenders.
They provide services like bill discounting, factoring of debtors,

parking of short-term funds in the money market, e-commerce,
Securitization of debts, etc. in order to ensure an
efficient management of funds.
Financial services firms provide some specialised services like

credit rating, venture capital financing, lease financing, factoring,
mutual funds, merchant banking, stock lending, depository, credit
cards, housing finance, book building, etc.
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CH-1.3 EVOLUTION OF
BANKING INSTITUTIONS
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Origin of Bank
 The word bank was derived from
word ‘Banco’.
 Germans used the word ‘Banck’ for
joint stock funds, meaning a ‘heap’.
 Later italians converted in to ‘banca’
means accumulation of either stock
or money.
 Establishment of Banca di
Venezia(Bank of Venice) in
1157,Italy.
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View of another Group
 Bank was derived from the word ‘
bancus’ means bench.
 Jews carried out their money
changing business in Lombardy at
the market place sitting on benches.
 Banker unable to meet obligations,
the bench on which he was carrying
on business was broken in to pieces
and that led to the word ‘bankrupt’.
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Contd…
 As early as 2000 B.C. Babylonian
temples were lending gold and silver
which had been left with them for
safe keeping at high rate of interest.
 Greek temples were lending temple
funds at an interest.
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First bank in the Planet
 Bank of Barcelona in Spain(1401)
was the first institution could be
called a bank.
 Bank of Venice(Banca de Venezia)
though established in 1157 could
not be called a bank because it was
formed solely for the purpose of
taking over public debt created by
Venice to finance her many wars.
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Contd..
 Bank of Amsterdam one of the most
famous bank in 1609.
 Establishment of Bank of England in
1694.
 In 18th and 19th century, banks had
developed rapidly with the
expansion of industry and trade.
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Ancestors of Present Day banks
 The Merchant
 The Money lender
 The Goldsmith
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The Merchant
 The mechant was able to collect
deposits from the customers ecause
of his reputation.
 It was not for the business of
banking but to finance his trading
business.
 He issued Document which was
considered as title to money.
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The Money Lender
 Conducted business with his own
money.
 People entrusted money with him
because of his special skill at low
rate of interest .
 Then he lent the money at high rate
of interest.
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The Goldsmith
 Originated in England.
 When gold and silver were considered as
money.
 The London merchants deposited their
surplus gold and silver in the Towers of
London.
 The King Charles I in 1640 seized
merchants’ gold kept in the Tower.
 Then, they deposited their surplus gold
and silver with the Goldsmiths.
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The Goldsmith Contd…
 The goldsmith issued receipts in return of
deposits.
 Receipt was used for withdrawal of
deposits.
 Receipts began to be exchanged in
settlement of debts.
 The goldsmith made the deposits
transferable y the letters issued by the
depositors. This was the origin of modern
cheque .
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MODERN BANKERS
 Accepts deposits from customers
like merchant banker.
 Lends money to needy like money
lender.
 Accepts valuable and money for safe
custody like goldsmith.
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1.2. Functions of Commercial Bank
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Functions of Commercial Bank
• Accepts deposits from public but repayable on
demand and withdrawal by cheque.
• Lend money for shorter periods for genuine
commercial and industrial purposes.
• In Great Britain, Banks which accept demand
deposits should restrict their lending to highly
liquid loans for short term commercial
purposes.
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Functions of Commercial Bank
I. Primary functions
o Accepting deposits
o Lending Money
II. Secondary functions
o Agency services
o General utility services
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Accepting deposits
• (A)Current Deposits or Demand Deposits

– Account opened by business house
– Called Demand Deposits in USA
– Can be withdrawn by cheque
– Nature of account is Current Account
– No interest allowed
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Accepting deposits
• (B)Saving Deposits
– To pool small savings of low and middle income

groups.
– Banks restricts maximum amount that can be
deposited in or withdrawn from the saving
account.
– KYC(Know your Customer) Norms applied
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Accepting deposits
• (C) Fixed or Time Deposits

– Known as fixed Deposits in England and Time
Deposits in USA.
– Depositors earn higher rate of interest.
– Banker gets money for a fixed period.
– Bank renders many services like
o Protect the funds from theft or loss
o Convenient means of transferring funds through
cheque
o Depositors earn regular interest
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Lending Money
• Mobilize the idle capital of the Nation for

productive purposes.
• Lends money in different forms like
Overdrafts
Cash credits
Loans and Advances
Discounting of Bills of Exchange
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Secondary Functions
• AGENCY SERVICES
 Collection of cheques, drafts and bills for their
customer
 Execution of standing orders eg: payment of
commercial bills, collection of dividend warrants etc.
 Conduct stock exchange transactions such as buying
and selling of shares
 Acting as executors and Trustees
 Providing income tax services
 Conduct f foreign exchange business
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Secondary Functions
• General Utility Services
Safe keeping of valuables
Issue of commercial letter of credit and
traveler's cheque
Collecting trade information foreign countries
Arranging business tours
Providing suitable investment advisory services
Render services for a nominal fee
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Modern Services to customer
• Teller System
• Credit Card
• Debit Card
• ATM(Automated teller Machine) Card
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Teller System
• Reduces waiting time of customers

• A Counter called Teller opened in the bank
• Customer can transact within a fixed limit
amount
• Advantages of teller Counter
 For customers depositing or withdrawing small
amount
 Without verifying the balance or specimen
signature , Teller can pay cheque
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Credit Card
• Originated in USA in 1920.

• First credit card used at various establishment from
Diners Club in 1950
• Card made of plastic
• Specimen signature on card
• Designed to enhance the purchasing power of holder
• To avoid paying cash while purchasing goods
• Member of payment brand like Visa, Master, Maestro
linked to global payment system by their symbol.
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Debit Card Cum Atm Card
• Can be used if there is balance in your account

• Used in shops for purchase of goods
• POS(Point of Sale)Terminal at every place of
purchase
• PIN(Personal Identification Number) required
at purchase terminal
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Credit Card Vs Debit Card
• Pay later Vs Pay now
• 50 days credit Vs outright debit on purchase
• Interest leviable Vs no interest on withdrawal
• No bank account Vs opening and maintaining
minimum balance is mandatory
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Modern technology in banking
• Electronic Fund Transfer system
• Internet banking
• Anywhere Anytime banking
• Mobile banking
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Electronic Fund Transfer system
• Enables remittance of funds

• Available to retail and corporate customers
• Paperless banking
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Internet banking
• Pay utility bills, transfer funds

• Low transaction cost
• View and print your statements
• Make third party payments
• Pay credit card bills
• Send request for cheque books
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Anywhere Anytime banking
• Mobile banking
– Limitation of internet banking
– Enable any where banking
– Account balance enquiry
– Cheque status enquiry
– Minimum balance alerts
– Bill payment alerts
– Recent transaction history alerts
– Fund transfer between accounts
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Socioeconomic Development of
Commercial Banks
• Promote capital Formation
• Optimum utilization of resources
• Financing the priority sectors
• Promote balanced regional development
• Expansion of credit
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Ch-2.3 Credit Creation
by
Commercial Bank
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Money circulation of country
• Notes and coins issued by the Central Govt.
• Currency notes issued by the Central Bank.
• Credit money and deposit money created by the
banking system.
Anything which has got purchasing power can be

considered as money.
The bank creates some additional purchasing power by
allowing their deposits holders to draw cheques against
their deposit account.
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Types of Deposits
• Primary Deposits: A deposit arising from the
entrustment of currency or its equivalent is called a
primary deposit,
• Derivative deposits: The primary deposits enable
the banker to create additional deposit because
they are derived from the lending of the original or
primary deposits.
• When the banking system creates derivative
deposits, the total stock of the money with the
community is increased.
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CREDIT CREATION EXAMPLE
• There is only one bank called Commercial
Bank of Ethiopia and it receives a cash deposit
of $ 10,000/- from one of its customer.
BALANCE SHEET OF CBA
ASSETS LIABILITY
Cash in hand 10,000 Deposit 10,000
10,000 10,000
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Contd..
Though the deposits are repayable on demand,
from past experience the banks are sure that all
the depositors will not demand repayment of
their deposits at the same time. But it is true that
there are some irregularities in the average inflow
and outflow of cash due to payment habits and
unforeseen events. Owing to these irregularities,
a minimum average cash reserve against primary
deposits are required to be maintained.
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• Let us assume that the necessary cash
required to meet unforeseen contingencies is
20 % of the deposits. Then the bank is able to
lend the remaining 80% ,i.e. $8,000 after
keeping a reserve of $2,000 out of the total
primary deposit of $10,000 .
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• After paying out the loan, the position of the
balance sheet of the bank will be changed as
follows:
ASSETS LIABILITY
Cash in hand 2,000 Deposits 10,000
Loan & Advance 8,000
10,000 10,000
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• Whenever a loan involving a big amount is granted
to a customer, he will not withdraw the full
amount of loan in cash. He needs money for
making different business payments which he will
do by issue of cheques. Therefore, instead of
withdrawing full value of loan in cash, he will allow
the bank to credit his current account with the
loan amount. This will increase the bank’s deposits.
There will be no immediate outflow of cash from
the bank.
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• Then the position of bank’s balance sheet will
be as follows:
ASSETS LIABILITY
(2,000+ 8,000) (10,000+8,000)
18,000 18,000
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• The cash reserve needed, however it is only 20% of
$18,000 = $ 3,600.
• This bank has $10,000 cash reserve.
• Therefore, the bank can lend a further amount of
$6,400(10,000-3,600) in case the customer is also
willing to allow the bank to credit his current
account with the amount of the loan, the deposit of
the bank will further increase to the extent of the
new loan sanctioned while the cash position of the
bank remains unaffected.
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• The position of the Balance sheet of the bank
is as follows:
ASSETS LIABILITY
(18,000+6,400)
(8,000+6,400) 24,400 24,400
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• In this manner the bank can go on lending till
$10,000 becomes 20% of total deposits.
• Therefore, the bank can have total deposits of
$50,000 if it has received a primary deposits of
$10,000 provide the reserve requirement
remains at 20%.
• If the reserve ratio is changed, the bank’s
capacity to create deposits will also be
changed.
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• When the bank reaches the maximum level of creation
of credit with a primary deposit of $10,000 and with
reserve ratio of 20%, the balance sheet of the bank will
be as follows:
ASSETS LIABILITY

50,000 50,000
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Derivative Deposit
• It is clear that the bank has created a further deposit of
$40,000 with a primary deposit of $10,000.
• The additional deposit of $40,000 created by the bank is
known a derivative deposit i.e. the deposit derived from
the primary deposit.
• Since the depositors have right to draw cheques against
their deposits, the purchasing power of the depositors will
be increased to the same extent. Therefore, the bank is able
to provide additional purchasing power by creating new
deposits.
• Every loan creates a deposit or every deposit creates a loan
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• Bank deposit may also arise when the bank
discounts a bill of exchange or buys a govt.
security.
• When a bill is discounted or a govt. security is
purchased, instead of paying hard cash to the
seller, the banker credits his current account which
will increase the bank’s deposits.
• Credit creation will reverse when a borrower
repays the loan by issuing cheque or there is an
unexpected withdrawal of cash.
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Limitations of Credit Creation
1. Minimum cash reserve requirement sets the
limit to the capacity of the bank to create
credit,
2. Availability of primary deposits,
3. Availability of good securities given by the
borrower to get loan,
4. Economic conditions during the period of
prosperity and depression.
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CH-2.4. BALANCE SHEET
OF
COMMERCIAL BANK
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2.4.Balance Sheet of Commercial Bank
• The balance sheet of a bank reveals the
solvency of the bank.
• Bank is said to be solvent when the money
value of liabilities equals the rupee value of
assets.
• Bank can be said to be solvent when the
money value of assets falls below that of
liabilties.
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BANK BALANCE SHEET
Property & Assets Capital & Liabilities
1. Cash in hand & with Central Bank 1. Capital
2. Balance with other banks 2. Reserve Fund & Other
3. Money at call & short notice Reserve
4. Bills discounted 3. Deposits & other accounts
5. Investments
4. Borrowing from other banks
6. Advances
& agents
7. Bills for collection being bills
receivable(as per contra) 5. Bills for collection being bills
8. Acceptance, endorsements &
receivable(as per contra)
other obligations(as per Contra) 6. Acceptance, endorsements &
9. Fixed Assets other obligations(as per
Contra)
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LIABILITY SIDE
• SHARE CAPITAL
– Authorized Capital
– Issued Capital
– Subscribed Capital
– Called up Capital
– Paid-up Capital
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Authorized Capital
• Maximum amount of capital that can be

collected by the bank as permitted my
Memorandum of Associations
• Only a portion of the authorized capital will be
issued to the public for subscriptions.
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Other Capital
• Issued Capital
– Portion of capital offered to public for subscriptions
• Subscribed Capital
– Portion of capital public has applied/subscribed for.
• Called-up Capital
– Amount actually required to be paid by the
shareholders.
• Paid-up Capital
– Actual amount of money received from the
shareholders
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Reserve Fund & other Reserve
• Reserves are created to meet the demand
deposits.(As deposits are repayable on
demand)
• A portion of the profit is transferred to create
reserve every year(In India 20% of Profit)
• Reserve is invested in first class securities
• Any unexpected loss can be met by disposing
these securities
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Deposits
• Demand deposits form part of a total money
supply of the country as they can be used directly
as money.
• Forms major portion of bank’s funds, represents
90% of Banks's funds.
• Types of deposits- Current or demand deposits,
saving deposits, fixed deposits, recurring deposits.
• All these are shown separately in the balance
sheet.
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Borrowing from other banks
• To meet temporary shortfall in their cash
balance or to meet contingencies.
11/15/2024 138
Bills for Collection
• Bills accepted from customers for collection
will be held by the bank till the date of
maturity.
• It appears in the liability side since it creates a
liability to the customers.
• It appears in the asset side as a contra since it
is held by the bank till matuirity.
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Acceptance, Endorsements & Other
Obligations
• Accept or endorse bills of exchange on behalf of the
customers.
• The customers are expected to remit the money
before the due date of the bill.
• Bankers are undertaking this responsibility just to
help the customers who do not have a good
standing in the market or not known to the drawer.
• It also appear in the asset side as a contra since it is
held by the bank. It is an amount actually due from
the customers.
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ASSET SIDE
• Principle to follow to select assets for
investment of funds, viz: liquidity, profitability
& security.
• The assets side are arranged in the order of
liquidity.
11/15/2024 141
Cash in hand
• Represents the legal tender money held in the
tills(valuts) of the bank to meet the demands of the
customers.
• Some percentage of total deposits will be kept as
liquid cash.
• It also includes the money kept with the central
bank.
• Cash is an idle asset as it earns no income, so banks
keep a small portion of deposits in cash to maintain
confidence.
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Balance with other banks
• Maintain balance with other banks to meet
emergency of funds.
• Considered as first line of defense.
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Money at call and short notice
• Represents short term loan granted to
discount house(in case of England) or to other
banks(other countries) which are obtainable
at call or short notice.
• These loans carries low rate of interest.
• A large amount of money is invested in this to
ensure liquidity.
• It is also called second line of defense.
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Bills Discounted
• A portion of resources of banks is invested in bill of
exchange by discounting the bills of exchange.
• Following reasons:
– Date of maturity is certain ,so bank knows when he will get
money,
– This investment is a short term self liquidating productive loan
as the loans are repayable out of the price fetched by its sale,
– Called as liquid asset as it is rediscount able with central bank,
– Earns income in the form of discount when the bills are
discounted.
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Investments
• Invested in Govt. securities, bonds, shares and
debentures of companies.
• Securities are considered liquid as they are
readily shiftable to other banks who are
willing to supply cash,
• Easy conversion of securities in cash due ready
market in the stock exchange.
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Advances
• Represents advance given to customers
against approves collateral securities,
• Loans are granted for a fixed period,
• Generally loan granted are self liquidating one
as the customer will find funds for the
repayment of the loan from the sale of its
product , but these are considered as least
liquid because it is difficult for the bank to
convert them in cash when required.
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Acceptance & Endorsements
• It is a contra item,
• These are the amount due from the customers
on whose behalf the bankers has accepted or
endorsed bills of exchange,
• Banker will receive the amounts before the
due date of the bill which they have acceted
on their behalf.
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Fixed Assets
• Land, building , Furniture, Fixture etc. .
• Some amount of Bank’s funds are locked up in
these assets .
• These can not be realized to meet unforeseen
emergencies except on its liquidation.
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CH-3.1 EVOLUTION
OF
CENTRAL BANKING SYSTEM
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DEFINITION OF CENTRAL BANKING
• The central bank of a country as the name signifies is
the central monetary institution that regulates the
supply, availability and cost of money in the interest
of the general public.
• According to the statutes the bank for international
settlements, a central bank is the bank in any country
to which has been entrusted the duty of regulating
the volume of currency and credit in the country.
• According to KISCH and ELKIN a central bank is a
bank whose essential duty is to maintain stability of
monetary standard.
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DEFINITION OF CENTRAL BANKING
• It is the fiscal agent of the national government and
manages the monetary system of the countries.
• The central bank refers to a special group of powers
to control the total stock of money in the country.
• The essential difference between a commercial
bank and the central bank is that the commercial
banks thinks primarily of making a profit ,whereas
the central bank thinks of the effects of its
operations on the working of the economic system.
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EVOLUTION OF CENTRAL
•
BANKING
Today central bank is the central arch-pillar of the
monetary and fiscal framework in every country of the
world and its activities are essential for the proper
functioning of the economy and are indispensable for the
fiscal operation of the government.
• Although some central banks were established more than
two centuries ago, central banking is mostly a recent
development being essentially a product of the nineteenth
century.
• Among the existing central banks the Riks Bank of Sweden
is the oldest and was established in 1668, the bank of
England was established in 1694. It was the first to
function as the true central bank in 1844.
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•
BANKING
Central banking originated in England almost by chance as the
commercial banks found it convenient to settle their clearing
balances by cheques on the bank of England.
• The bank of France which was organized in 1800 was closely
connected with the state ever since its establishment.
• The Richs bank in Germany was established in 1876 after the
formation of the empire.
• The bank of Netherlands was founded in 1814 on the ruins of
the old bank of Amsterdam.
• The national bank of Austria, which was reorganized as the
bank of Austria in 1877, was established in 1817 to restore
order in the national monetary system which had
deteriorated due to the over issue of paper currency.
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• BANKING
The bank of Norway, the national bank of Denmark, the national
bank of Belgium and the bank of Spain were established in 1817,
1818 and 1856 respectively.
• The bank of Russia was established in 1860 to consolidate
money circulation and to float debt for the Russian empire.
• The bank of Japan was established in 1882 to restore order in
the currency system of the country.
• The United States of America established its central banking in
1914.
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BANKING
Thus the nineteenth century was the century
par excellence of the establishment of central
banks in many countries of the world,
particularly in Europe where almost every
country had established a central bank
empowered to issue note and vested with
special privileges and powers. In due course of
time those banks became the bankers and
advisers to their respective government.
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Evolution of the National Bank of Ethiopia
• The National Bank of Ethiopia was established
in 1963 by proclamation 206 of 1963 and
began operation in January 1964. Prior to this
proclamation, the bank used to carry out dual
activities, i.e. commercial banking and central
banking. The proclamation raised the Bank’s
capital to Ethiopia dollar (the then legal
tender money) 10 million and granted broad
administrative autonomy and juridical
personality.
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RESPONSIBILITIES
• To regulate the supply, availability and cost of
money and credit.
• To manage and administer the country’s
international reserves.
• To license and supervise banks and hold commercial
banks reserves and lend money to them.
• To supervise loans of commercial banks and
regulate interest rates.
• To issue paper money and coins, to act as agent of
the government.
• To fix and control the foreign exchange rates.
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• However, monetary and banking proclamation no. 99 of 1976
came into force on September 1976 to shape the Bank’s role
according to the socialist economic principle that the country
adopted.
• Hence the bank was allowed to participate actively in national
planning, specifically financial planning, in cooperation with
the concerned state organs.
• The Bank’s supervisory area was also increased to include
other financial institutions such as insurance institutions,
credit cooperatives and investment oriented banks.
• Moreover the proclamation introduced the new Ethiopian
currency called ‘Birr’ in place the former ‘Ethiopia dollar’ that
eased to be legal tender thereafter. The proclamation revised
the Bank’s relationship with the government.
11/15/2024 159
• It initially raised the legal limits of outstanding
government domestic borrowing to 25% of the
actual ordinary revenue of the government during
the preceding three budget years as against the
proclamation 206/1963, which was set it to be
15%.
• This proclamation was in force till the new
proclamation issued in 1994 to reorganize the bank
according to the market-based economic policy so
that it could foster monetary stability, a sound
financial system and such other credit and
exchange conditions as are conducive to the
balanced growth of the economy of the country. 160
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powers and duties vested in the bank by proclamation
83/1994.
• Regulate the supply and availability of money and credit
and applicable interest and other changes.
• Set limits on gold and foreign exchange assets which
banks and other financial institutions authorized to deal
in foreign exchange and hold in deposits.
• Set limits on the net foreign exchange position and on
the terms and amount of external indebtedness of banks
and other financial institutions.
• Make short and long term refinancing facilities available
to banks and other financial institutions.
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CH-3.2 FUNCTIONS OF
OF
CENTRAL BANKING
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FUNCTIONS OF CENTRAL BANK
The primary function of the central bank is to regulate the
monetary system of the country so as to promote the
stability of the national monetary unit.
The functions of central bank are different from those of
commercial banks.
• A central bank is established for public service than for private
profit. Unlike commercial banks, their operations are not
guided by profit motive.
• A central bank has a special relationship with the government
of the country. Since the central bank acts as banker to the
government, the later influences its activities.
• A central bank does not directly deal with the public; it deals
with the public indirectly through the commercial banks and
money market. It does not accept deposit from the public.
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FUNCTIONS OF CENTRAL BANK
• Bank of issue/note issue
• Banker, agent and financial advisor to
government
• Banker’s bank and Lender of last resort
• Custodian of nations foreign exchange reserve
• Bank of central settlement and transfer acting
as a clearing house
• Controller of credit
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Bank of issue/note issue
Main reasons for the exclusive monopoly of note issue to the
central bank.
• Uniformity-if all the notes are issued by single bank there will
be uniformity in the note circulation.
• State supervision-it is easier for the state to have effective
supervision over the note issue if it is concentrated in a single
institution on which the state is having some degree of
control.
• Credit control- it is easy to control the excessive credit
expansion by the commercial banks and some measures to
control over undue credit expansion
• Prestige-the right of note issue in one single bank, particularly
when the payment of notes is guaranteed by the government,
imparts the notes a distinctive prestige .
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Banker, agent and financial advisor to
government
• As a banker to the government the central bank performs all the
functions that an ordinary commercial bank performs to its customers.
• It keeps the banking accounts of government departments and
enterprises.
• It gives short term loans to government in anticipation of collection of
taxes/revenue or raising of loans from the public
• In addition, the central bank makes and receives payment on behalf of
the government and collects cheques and drafts drawn on other banks
• It conducts transactions on behalf of the government involving the
purchase or sale of foreign currencies
• Acts as the financial agent of the government/or generally acts as
financial advisor to government
• Since the central bank is in close touch with the money market of the
country, it is in position to advice the government in matters relating
to finance.
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Banker’s bank and Lender of last resort
• As bankers bank- it keeps the banking accounts of
commercial banks. Keep a part of their cash
balances as a deposit with the central bank of the
country either by custom or by legal compulsion.
• As lender of last resort- the central bank is
expected to help the commercial banks by
providing accommodation in times of difficulty
and crises. Generally the commercial banks go to
the central bank for accommodation only when
they lose al other possibilities of getting it. Hence
the name of lender of last resort.
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Custodian of nation’s foreign exchange
reserve
• Central bank is the meeting of adverseness at any time
in countries balance of payments and the maintenance
of foreign exchange stability.
• A central bank is required by law to maintain minimum
gold and foreign exchange reserves against both its note
and deposit liabilities, its holding of these reserves are
immobilized and are not available for maintaining
equilibrium in the international balance of payments.
• It buys and sells foreign exchange and regulates the
movement of gold and foreign exchange
11/15/2024 168
Bank of central settlement and transfer
acting as a clearing house
• The central bank of every country acts as clearing
house. Since all the commercial banks keep reserves
with the central bank, this function of clearing cheques
can very easily be done.
• Every day, the commercial banks receive a large
number of cheques drawn on different banks involving
large amounts. Presenting these cheques on the
counters of each bank on which they are drawn is a
different process. Therefore, effecting settlements
between banks on the books of the central bank have
been found to be more convenient by the banking
community.
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Credit control
• Controlling the credit creation activities of the
commercial banks is, perhaps, the most important
function of a central bank. The single most important
objective of credit control is maintenance of external
and internal stability.
• External stability refers to the stability of the rate of
exchanges whereas internal stability refers to the
stability of prices, income and employment.
• Inflation and deflation cause instability (both internal
and external) in the economy, and by controlling them
stability can be achieved. They are the result of
change in the total quantity of money in the country.
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FUNCTIONS OF NATIONAL BANK
OF ETHIOPIA
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As stipulated in the monetary and banking proclamation No. 83/1994, the
primary duties and responsibilities of the National Bank of Ethiopia
include
• Conducting and implementation of monetary policy and exchange rate
policy,
• Regulation and supervision of banks and other financial institutions,
• Issuance of currency,
• maintaining and managing of gold and foreign exchange reserves,
• Precision of refinancing facilities to banks and other financial institutions,
• banking services and financial advice to the government.
• Maintain monetary stability with the view of achieving macroeconomic
stability, and sustainable economic growth and development.
• Implements exchange rate policy with the objective of enhancing the
country’s competitiveness in the global economy, fostering macro-
economic stability and avoiding the detrimental effect of wide fluctuations
in the foreign exchange rates.
• Administers the country’s international reserves required for the
payments of imports and services as well as for meeting external debt
servicing and other payment obligations.
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Bank of Issue
• National Bank of Ethiopia has the sole right to

issue bank notes of all denominations coins,
prints and issues the legal tender currency,
and regulates the country’s money supply.
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Banker to Government
• Act as government banker, agent and advisor.
• Obligation to transact government business, via to
keep the cash balances as deposits free of interest,
to receive and to make payments on behalf of the
government and to carry out their exchange
remittance and other banking operations.
• Helps the government to float new loans and to
manage public debt.
• Makes loans and advances to the states and local
authorities.
• Acts as advisor to the government on all monetary
and banking matters.
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Bankers’ Bank and Lender of the Last
Resort
• As the Bankers’ bank: Every scheduled banks are required
to maintain with the National Bank a cash balance. The
minimum cash requirements can be changed by the
National Bank of Ethiopia.
• As lender of the last resort: The scheduled banks can
borrow from the National Bank of Ethiopia on the basis of
eligible securities or get financial accommodation in times
of need or stringency by rediscounting bills of exchange.
Since commercial banks can always expect the National
Bank of Ethiopia to come to their help in times of banking
crisis the National Bank becomes not only the Banker’s Bank
but also the lender of the last resort.
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Controller of credit
• The National Bank of Ethiopia is the controller of credit, i.e. it
has the power to influence the volume of credit created by
banks.
• It can do so through changing the bank rate or through open
market operations.
• It can ask any particular bank or the whole banking system
not to lend to particular groups or persons on the basis of
certain types of securities.
Power as supreme banking authority in the country:
• It holds the cash reserves of all the scheduled banks
• It controls the credit operations of banks through quantitative
and qualitative controls.
• It controls the banking system through the system of
licensing, inspection and calling for information.
• As Lender of the last resort by providing rediscount facilities .176
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Custodian of foreign reserves
• Responsibility to maintain the official rate of

exchange.
• Acts as the custodian of reserve of
international currencies.
• Represents the country in international
monetary institutions and acts consistently
with international monetary and banking
agreements to which Ethiopia is a party.
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Other functions
• Provides short and long term refinancing facilities to

banks and other financial institutions.
• Accepts deposit of any kind from foreign sources.
• Promotes and encourages the dissemination of
banking and insurance services throughout the
country.
• Prepares periodic economic studies, together with
forecasts of the balance of payments, money supply,
prices and other relevant statistical indicators of the
Ethiopian economy useful for analysis and for the
formulation and determination by the bank of
monetary, saving and exchange policies.
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Role of National Bank of Ethiopia
• Improve service delivery of the Bank.
• Strength IT service and enhance computerization process of
the Bank.
• Enhance the capacity of the Bank.
• Contain annual core inflation (non-food inflation) within a
single digit.
• Maintain the exchange rate of Birr close to the equilibrium
exchange rate.
• Contain the premium between the official and parallel market
exchange rate to the level below 1.5%.
• Maintain the premium of respective buying and selling rates
of the USD between the National Bank of Ethiopia and
commercial banks below 2%.
• Ensure that the international reserves of the country are not
11/15/2024 179
less than three and half month of imports of goods.
Role of National Bank of Ethiopia
• Manage the country’s foreign exchange reserve efficiently and
effectively.
• Ensure and manage the effective use of the country’s foreign
exchange.
• Ensure the average level of NPL (Non-Performing Loans) of
commercial banks is reduced to below 15%.
• Conduct effective onsite inspection.
• Ensure systematic risk management framework for each bank.
• Finalize the Ethiopian macroeconomic model and start its application.
• Strengthen the Bank’s research and policy advisory capabilities and
the dissemination of its finding in terms published research papers
and policy discussion forums.
• Create a national payment framework.
• Conduct structural reforms on the existing payment system.
• Ensure the availability and distribution of the Birr notes and coins.
• Ensure the automatic provision of Birr notes exchange services.
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INDIVIDUAL ASSIGNMENT-II
• WRITE CREDIT CONTROL BY CENTRAL BANK
WITH SPECIAL REFERENCE TO NATIONAL BANK
OF ETHIOPIA
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GUIDANCE NOTE ON ASSIGNMENT-II
• Quantitative (general) credit control method- This
method tries to regulate the total volume of credit
that is put into circulation by the commercial
banks.
• The general credit control affects the entire
banking and financial system. Included in this list
are:
– Bank Rate Policy
– Open-Market Operations
– Variable Reserve Ratio
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GUIDANCE NOTE ON ASSIGNMENT-II
• Qualitative (selective) credit control method: Selective credit
control strives to control the flow of aggregate band credit
into different productive activities in the economy.
• It aims at encouraging productive activities and at stiffing
speculative activities in the economy.
• This credit control method includes
• Regulation of margin requirement
• Consumer credit regulation
• Control of bank advances
• Rationing of credit
• Moral suasion
• Direct action
• Publicity
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CH-4.1. RISK & RETURN
11/15/2024 184
What is Risk ?
• Risk is usually used interchangeably with
uncertainty.
• Risk is the probability or likelihood that actual
results (rates of return) deviates from
expected returns.
• It is the variability of returns associated with a
given investment.
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RISK IN A TRADITIONAL SENSE
• Risk in holding securities is generally associated with possibility
that realized returns will be less than the returns that were
expected.
• The source of such disappointment is the failure of dividends
(interest) and/or the security's price to materialize as expected.
• Forces that contribute to variations in return price or
dividend( interest) constitute elements of risk.
• Some influences are external to the firm, cannot be controlled,
and affect large numbers of securities.
• Other influences are internal to the firm and are controllable to
a large degree.
11/15/2024 186
Risk profile of Investor
• Risk Seeking (Risk Lover): is the attitude towards risk in which a
decreased return would be accepted for an increase in risk.
Because, they enjoy risk, managers of this attitude are willing to
give up some returns to take more risk. Investors like investment
with higher risky irrespective of the rates of return.
• Risk Averse: They generally do not want to take risk but the
attitude in which an increased return would be required for an
increase in risk. Because managers with this attitude shy away
from risk, they require higher returns to compensate them for
taking greater risk.Investors chose investments which have equal
rates of return with the lowest risk.
• Risk Indifferent (Neutral): the attitude towards risk in which no
change is required for an increase in risk. The risk neutral
investor does not consider risk, and he would always prefer
investment with higher return.
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What is the attitude of a Manager ?
• In general, managers are assumed to be risk averse,
i.e. they accept additional risk only if coupled with an
appropriate increase in expected return.
• Managerial risk aversion provides two criteria that
can be used to ran%k risky projects:
– If two projects have the same expected return, the
manager will prefer the one with the lesser amount of
risk.
– If two projects have the same degree of risk, the manager
will prefer the one with the higher expected return.
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Classification of Risk
• Risk has been classified in to the following
types:
–Systematic Risk
–Unsystematic Risk
11/15/2024 189
SYSTEMATIC RISK
• Systematic risk refers to that portion of total variability in return
caused by factors affecting the prices of all securities.
• Economic, political, and sociological changes are sources of
systematic risk. Their effect is to cause prices of nearly all
individual common stocks and/or all individual bonds to move
together in the same manner.
• For example, if the economy is moving toward a recession and
corporate profits shift downward, stock prices may decline across
a broad front. Nearly all stocks listed on the National Stock
Exchange (NSE) move in the same direction as the NSE Index. On
an average, 50 percent of the variation in a stock's price can be
explained by variation in the market index. In other words, about
one-half the total risk in an average common stock is systematic
risk.
• Systematic risk can not be minimized by the firm .
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Types of Systematic Risk
• Systematic risk consists of the following risks:
–Market Risk
–Interest rate Risk
–Purchasing power Risk
11/15/2024 191
Market Risk
• Finding stock prices falling from time to time while a
company's earnings are rising, and vice– versa, is not
uncommon. The price of a stock may fluctuate widely within a
short span of time even though earnings remain unchanged.
• Variability in return on most common stocks that is due to
basic sweeping changes in investor expectations is referred to
as market risk.
• Market risk is caused by investor reaction to tangible as well
as intangible events. Expectations of lower corporate profits
in general may cause the larger body of common to fall in
price. Investors are expressing their judgment that too much
is being paid for earnings in the light of anticipated events.
• Tangible events are political, social, or economic.
• Intangible events are related to market psychology.
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Interest-rate Risk
• It refers to the uncertainty of future market values and of the

size of future income, caused by fluctuations in the general level
of interest rates.
• The root cause of interest-rate risk lies in the fact that, as the
rate of interest paid on Indian Government Securities (IGSs)
rises or falls, the rates of return demanded on alternative
investment vehicles such as stocks and bonds issued in the
private sector, rise or fall.
• In other words, as the cost of money changes for nearly risk-free
securities (IGSs), the cost of money to more risk-prone issuers
(Private sector) will also change.
• Investors normally regard IGSs as coming closest to being risk
free. The interest rates demanded on IGSs are thought to
approximate the "pure" rate of interest, or the cost of hiring
money at no risk.
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Purchasing Power Risk
• It can be defined in terms of uncertainties as to the

amount of current dollars to be received by an
investor. Purchasing–power risk is the uncertainty
the purchasing power of the amounts to be
received.
• In more everyday terms, purchasing power risk
refers to the impact of inflation or deflation on an
investment.
• If we think of investment as the postponement of
consumption, we can see that when a person
purchases a stock, he has foregone the opportunity
to buy some good or service for as long as he owns
the stock.
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UNSYSTEMATIC RISK
• Unsystematic risk is the portion of total risk that

is unique or peculiar to a firm or an industry,
above and beyond that affecting securities
markets in general.
• Factors such as management capability,
consumer preferences, and labor strikes can
cause unsystematic variability of returns for a
company's stock. Because these factors affect
one industry and/or one firm, they must be
examined separately for each company.
• Unsystematic risk can be minimized by the firm.
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Classification of Unsystematic Risk
The uncertainty surrounding the ability of the
issuer to make payments on securities stems
from two sources:
• Business Risk: The operating environment of
the business,
• Financing Risk :The financing of the firm.
11/15/2024 196
Business Risk
• Business risk is a function of the operating conditions faced by

a firm and the variability these conditions inject into operating
income and expected to increase 10 percent per year over the
foreseeable future,
• business risk would be higher if operating earnings could
grow as much as 14 percent or as little as 6 percent than if the
range were from a high of 11 percent to a low of 9 percent.
The degree of variation from the expected trend would
measure business risk.
• Business risk can be divided into two broad categories:
• Internal business risk is largely associated with the efficiency
with which a firm conducts its operations within the broader
operating environment imposed upon it. Each firm has its
own set of internal risks.
• External business risk is the result of operating conditions
imposed upon the firm by circumstances beyond its control.197
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Financial Risk
• Financial risk is associated with the way in which a

company finances its activities.
• Gauge financial risk by looking at the capital structure of a
firm. The presence of borrowed money of debt in the
capital structure creates fixed payment in the form of
interest that must be sustained by the firm. The presence
of these interest commitments fixed interest payments
due to debt of fixed–dividend payments on preferred stock
causes the amount of residual earnings available for
common stock dividends to be more variable than if no
interest payments were required.
• Financial risk is avoidable risk to the extent that
managements have the freedom to decide to borrow or
not to borrow funds.
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Assigning Risk Allowances (Premiums)
One way of quantifying risk and building a required rate of

return (R), would be to express the required rate as
comprising a riskless rate plus compensation for individual risk
factors previously enunciated, or as:
R=i+p+b+f+m+o
• Where:
• R= Required rate of return
• i = real interest rate (risk free rate)
• p = purchasing–power-risk allowance
• b = business–risk allowance
• f = financial–risk allowance
• m = market–risk allowance
• o = allowance for "other" risks
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CH-4.2. MEASURING EXPECTED
RISK & RETURN
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Return of a Single Asset
• This is the total gain or loss experienced on behalf of
the owner of an investment over a given period of time.
• Types of return namely:
• Current income from investments in the form of
dividends and interest income. Certain investments like
bank deposits, public deposits, debentures, bonds etc.
will carry a fixed rate of return payable periodically
• Capital appreciation: This return is the difference
between the selling price and purchase price of the
asset that has resulted in to capital gain or capital loss
due to change in the price of the asset.
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Measuring return of a Single Asset
• Measuring Historical Return
– Annual rate of return
– Average rate of return
• Measuring Expected Return
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Annual rate of Return
• The annual rate of return of a particular investment can be
dividend yield and capital gain of the asset which is calculated
as follows:
• R = D1/P0 + ( P1- P0)/P0 = D1(P1 - P0)/P0
• Where R = Annual rate of return of a share

• D1 = Dividend paid at the end of the year
• P0 = Market price of share at the
beginning of the year
• P1 = Market price of share at the end of
the year
• D1/ P0 = Dividend yield
•
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WORK OUT- 1
• Mr. Getachew has purchased 100 shares of
$ 10 each of Honda Ltd in 2012 at $ 78 per
share. The company has declared a dividend
@ 40% for the year 2013-14. The market price
of share as at 1-04-2013 was $ 110 and on 31-
03-2014 was $ 130. Calculate the annual rate
of return on the investment for the year 2013-
14
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Average rate of Return
• The rate of return can also be calculated for a period more
than one year.
• The average rate of return represents the average of
annual rates of return over a period of years. Which is as
follow s:
• R = 1/n ( R1 + R2 + R3 + …… Rn)
• Where R = Average rate of return
• N = Total number of periods
• R1 + R2 + R3 + …… Rn = Annual rate of return in
period 1,2,3 ….n
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WORK OUT-2
• The average market prices and dividend per
share of TATA Ltd for the past 6 years are given
below:
• Calculate the Average rate of Return of TATA
Ltd’s share for the past 6 years.
• Date are given below:
• The average market price for F.Y.1998-99 was
$ 32.
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WORK OUT -2
Year Average Market price($) Dividend Per share($)
20 04-05 68 3.0
20 03-04 61 2.3
20 02-03 50 2.0
20 01-02 53 2.5
20 00-01 45 2.0
19 99-00 38 1.8
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Measuring Expected Return(R)
• Expected rate of return is the return expected to be realized
from an investment.
• It is the mean value of the probability distribution of possible
returns.
• It is the sum of the probability distribution of each out come
(return) and its associated probability.
• Where, ri = possible return in year i.
• Pi = probability of occurrence of ri.
• R = p1r1 + p2r2……+ pnrn

• N = number of possible returns. Or,
where, p1,p2…. pn = is the probability of the ith out come.
• r1, r2..... rn = is the ith possible out come (return).
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WORK OUT- 3
• Mr. Dereje invested in equity shares of ICICI
Bank Ltd ,its anticipated returns and
associated probabilities are give below:
• You are required to calculate the expected
rate of return and risk in terms of standard
deviation.
Return
% -15 -10 5 10 15 20 30
Probabi
lity 0.05 0.10 0.15 0.25 0.30 0.10 0.05
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RISK OF A SINGLE ASSET
• The risk of a single asset is more difficult to quantify.
Statistically, we can express risk in terms of standard deviation
of return.
• For example, in case of gilt-edged security or government
bonds, the risk is nil since the return does not vary, it is fixed.
But strictly speaking, if we consider inflation and calculate the
real rate of return(inflation adjusted) we found that even
government bonds have some amount of risk since the rate of
inflation may vary.
• Return from unsecured fixed deposit appear to have zero
variability and zero risk. But there is a risk of default of
interest as well as principal. In such case, the rate of return
can be negative. Hence, this investment has high risk through
apparently it carries zero risk.
11/15/2024 210
•
Measuring Historical Risk
• For other investment like shares, business etc, where the
rate of return is not fixed, there may be a schedule of
return with associated probability for each rate of return.
The mean of probable returns gives the expected rate of
return and the standard deviation or variance, which is
square of standard deviation and hence higher risk.
• A risk averse investor will look for return where the
range is low because low standard deviation means low
risk.
• The objective in portfolio management is to minimize the
standard deviation without sacrificing expected rate of
return. This is possible by diversification. Risk is
measured in terms of variability of returns.
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What is Standard Deviation ?
• Standard deviation is the most common statistical
indicator of an asset’s risk (stand alone risk).
• It measures the dispersion of the probability
distribution around its expected value.
• It measures the variability of a set of observations.
• The larger standard deviation indicates a greater
variation of returns and thus a greater chance that
the expected return will not be realized.
• The larger the Standard deviation , the higher the
risk, and vice versa, because Standard deviation is a
measure of total risk.
11/15/2024 212
How to calculate Standard Deviation ?
• Variance = σ2 = ∑ ( R- Ṝ)2/N
• σ = Standard deviation
• R= Actual return
• Ṝ= Average return or Mean return
• N= Number of years
• σ =√v
11/15/2024 213
WORK OUT- 4
• The rate of return of equity shares of
Jp Morgan Ltd for the past 6 years are given
below . Calculate Average rate of return and
Standard deviation.
Year
2000 2001 2002 2003 2004 2005
Rate of
return 12 18 -6 20 22 24
%
11/15/2024 214
Co-efficient of Variation(CV)
• Coefficient of Variation (CV) is a measure of
relative dispersion that is useful in comparing
the risk of assets with deferring expected
returns.
• It shows the risk per unit of return and it
provides a more meaningful basis for
comparison when the expected returns on two
alternatives are not the same.
• CV = σ/Ṝ
11/15/2024 215
WORK OUT - 5
• The following information pertains to the two assets X & Y.
• Required:
• Determine Coefficient of Variation (CV) for each of the assets
• Find which Asset is having higher risk and why ?
Assets X Y
Expected Return(Ṝ) 12% 20%
Standard 9 10
Deviation(σ)
11/15/2024 216
CH-4.3. PORTFOLIO RISK & RETURN
11/15/2024 217
Return of Portfolio (Two Assets)
• The expected return from a portfolio of two or more securities is equal
to the weighted average of the expected returns from the individual
securities.
• ∑ (Rp) = WA (RA) + WB (RB)
Where
∑ (Rp) = Expected return from a portfolio of two securities
• WA = Proportion of funds invested in securities A

• WB = Proportion of funds invested in securities B
• RA = Expected return of security A
• RB = Expected return of security B
• WA + WB =1
11/15/2024 218
Work Out -1
• A Ltd’s share gives return of 20%

and B Ltd’s share gives return of
32%. Mr. Joseph invested 25% in
A Ltd’s share and 75% of B Ltd’s
share. Find out the expected
return of the portfolio.
11/15/2024 219
Work Out -2
• Mr. Getachew’s portfolio consists of 6 securities. The
individual returns of each of the security in the portfolio are
given below.
• Calculate the weighted average of return of the securities
consisting of the portfolio.
Security Proportion of Return(%)
investment in
Portfolio
A 10% 18%
B 25% 12%
C 8% 22%
X 30% 15%
Y 12% 6%
Z 15% 8%
11/15/2024 220
Risk of Portfolio (Two Assets)
• The risk of a security is measured in terms of

variance or standard deviation of its returns.
• The portfolio risk is not simply a measure of its
weighted average risk. The securities consisting
in a portfolio are associated with each other.
• The portfolio risk also considers the covariance
between the return of the investment,
covariance of two securities is a measure of
their co-movement, and it expresses the
degree to which the securities vary together.
11/15/2024 221
STANDARD DEVIATION OF PORTFOLIO
The standard deviation of two shares portfolio is
calculated by applying the formula given below.
σ 2p = WA2 x σA2 + WB2 x σB2 + 2 WA WB ρAB σA σB
Where,
• σp = Standard deviation of portfolio
consisting of securities A & B.
• WA , W B = Proportion of funds invested in
securities A & B.
• σA , σB = Standard deviation of returns of
security A & B.
• ρAB = Correlation coefficient between returns
of security A & B.
11/15/2024 222
• The correlation coefficient (ρAB) can be
computed as follows:
• ρAB = Go to word file
• The Covariance of security A and security B
(CovAB) can be presented as follows:
• CovAB = ρAB σA σB
11/15/2024 223
Diversification of Unsystematic Risk
• The diversification of unsystematic risk, using two security
portfolio, depends upon the correlation that exists between
the returns of those two securities. The quantification of
correlation is done through calculation of correlation
coefficient of two securities.
• (ρAB). The value of correlation ranges between -1 to 1, it can
be interpreted as follows:
• If ρAB = 1,Then no unsystematic risk can be diversified.
• If ρAB = -1, Then all unsystematic risk can be diversified.
• If ρAB = 0, Then no correlation exists between the return of

security A and security B .
11/15/2024 224
Work Out -3
• The returns of security A and security B for the

past 5 years are given below.
• The proportion of investment between
security A & B was 80:20.
Year Security A Return% Security B Return%
2001 9 10
2002 5 -6
2003 3 12
2004 12 9
2005 16 15
11/15/2024 225
Work Out -3
Contd…
Calculate the following:
1. Mean return and standard deviation of
security A
2. Mean return and standard deviation of
security B
3. Portfolio Return
4. Portfolio Risk
11/15/2024 226
Return and Risk of Portfolio (Three Assets)
• The portfolio risk can be calculated in the following way:
• σ 2p = Go to word file
Where,
σ 2p = Portfolio risk
• Wx , Wy , Wz = Proportion of amount invested in
securities X,Y,Z.
• σx , σy, σz = Standard deviation of securities X,Y,Z.
• ρxy = Correlation coefficient between security X & Y
• ρyz = Correlation coefficient between security Y & Z
• ρzx = Correlation coefficient between security Z & X
11/15/2024 227
Work Out -4
• A portfolio consists of three securities P,Q & R

with the following parameters.
P Q R Correlation
Coefficient
Expected 25 22 20
return(%)
Standard 30 26 24
Deviation(%)
Correlation
Coefficient (ρ)
ρ of P and Q 0.3
ρ of Q and R 0.4
ρ of R and P 0.6
11/15/2024 228
Work Out -4
Contd..
• The proportions of investment of securities
are 50:30:20.
Calculate the following;
a) Expected return of portfolio
b) Risk of portfolio
11/15/2024 229
CH-4.4.OPTIMUM RISKY
PORTFOLIO
11/15/2024 230
Optimal Portfolio consisting of Two Assets
• The investor can minimize the risk on the
portfolio. Risk avoidance and risk minimization
are the important objectives of portfolio
management.
• A portfolio contains different securities by
combining their weighted return; the
expected return of the portfolio can be
obtained.
• A risk averse investor always prefers to
minimize the portfolio risk by selecting the
optimal portfolio.
11/15/2024 231
• The minimum risk portfolio having two assets
can be ascertained as follows:
• WA = GO TO WORD FILE
11/15/2024 232
Work Out -1
• In continuation of Work out-3,

• Calculate the proportion of security A & B to
be invested to achieve optimal portfolio.
11/15/2024 233
Work Out -2
A portfolio of Mr. Girma consists of two securities X and

Y having the following data.
σ of Security X = 7.9
σ of Security Y = 15.6
Correlation coefficient (ρXY ) between returns of security
X & Y = 0.75
Calculate the following;
a) Covariance between security X & Y
b) proportion of security X & Y to be invested to achieve
optimal portfolio.
11/15/2024 234

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FINANCIAL INSTITUTIONS

– External Finance a) Direct financing , b) Indirect

INDUSTRIAL GOVT LONG TERM

Term loan Market Market

Capital market deals with those financial assets, which have

Another classification could be primary and secondary

Primary markets by issuing new securities mobilise the savings

 In other words, new issue market

 In this Market, purchases and

III. Right Issue

iv. Public Issues

and productivity in the economy .

directions to the flow of funds .

A certificate of deposit (CD) represents a negotiable receipt

 India: N.S.E & B.S.E-1990

The major players in the futures market are Hedgers,

 Whether Exchange Traded or OTC(Over

 Foreign exchange means foreign

 - Other players buy and sell foreign

 v Transactions between Authorised dealers,

Marketable Assets Non- Marketable Assets

Shares Gov Bonds MF UTI Bearer

Bank PF LIC PO Cos

 The difference between a share and derivative is that

 While the BSE Sensex was the first

premium Buyer of the option is None of the required to pay

A company may issue DRs for a number of reasons:

Copyright © 2003, Madhu Vij

American Depository Receipt (ADR)

Copyright © 2003, Madhu Vij

Benefits to the Investors

Copyright © 2003, Madhu Vij

Global Depository Receipt

Copyright © 2003, Madhu Vij

History of GDRs in India

Benefits and Uses of a GDR

Copyright © 2003, Madhu Vij

Copyright © 2003, Madhu Vij

They assist in deciding the financing mix.

They extend their service up to the stage of servicing of lenders.

They provide services like bill discounting, factoring of debtors,

Financial services firms provide some specialised services like

 The Money lender

• (A)Current Deposits or Demand Deposits

– To pool small savings of low and middle income

• (C) Fixed or Time Deposits

• Mobilize the idle capital of the Nation for

• Reduces waiting time of customers

• Originated in USA in 1920.

• Can be used if there is balance in your account

• Enables remittance of funds

• Pay utility bills, transfer funds

Anything which has got purchasing power can be

Loan & Advance 40,000

• Maximum amount of capital that can be

• National Bank of Ethiopia has the sole right to

• Responsibility to maintain the official rate of

• Provides short and long term refinancing facilities to

• It refers to the uncertainty of future market values and of the