Financial

Institutions and
Markets
Question No. 1
Mr Raman is one of the directors in XYZ ltd company. The company is engaged
in hotel sector, which has recently witnessed a steady downfall in its revenue
and value of its assets due to a downward trend persisting in the market. The
periodical financial result of the company was to be declared in the fortnight
time. Mr. Raman being an insider, had to access to unpublished price sensitive
information related to it. Consequently, he sells the major portion of his holding
in an anticipation of fall in the market price of the shares of the company
subsequent to announcement of periodical financial result of the company. On
conducting a probe, SEBI finds Mr. Raman guilty of insider is trading. In
context to the above case – State the importance of SEBI and its various
functions.
Answer:

(A) What is SEBI:

In the context of the case you mentioned, it's clear that Mr. Raman's actions
constitute insider trading, which is illegal and unethical.
The Securities and Exchange Board of India (SEBI) plays a crucial role in
regulating and overseeing the securities market in India.
SEBI stands for Securities and Exchange Board of India. It is a statutory
regulatory body that was established by the Government of India in 1992 for
protecting the interests of investors investing in securities along with regulating
the securities market. SEBI also regulates how the stock market and mutual
fund’s function.

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The Securities and Exchange Board of India (SEBI) plays a pivotal role in the
Indian financial market ecosystem. Established in 1988 and given statutory
powers in 1992, SEBI’s primary objective is to protect the interests of investors
in securities and promote the development and regulation of the securities
market. The case of Mr. Raman, a director at XYZ Ltd., underscores the
significance of SEBI’s role in ensuring a level playing field for all market
participants. Insider trading, as seen in this scenario, is a malpractice where
individuals with access to unpublished price-sensitive information exploit it for
personal gains.
(B) Objectives of SEBI
Following are some of the objectives of the SEBI:
1. Investor Protection: This is one of the most important objectives of setting up
SEBI. It involves protecting the interests of investors by providing guidance and
ensuring that the investment done is safe.
2. Preventing the fraudulent practices and malpractices which are related to
trading and regulation of the activities of the stock exchange
3. To develop a code of conduct for the financial intermediaries such as
underwriters, brokers, etc.
4. To maintain a balance between statutory regulations and self-regulation.

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(c) Functions of SEBI

SEBI has the following functions
1. Protective Function
2. Regulatory Function
3. Development Function
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The following functions will be discussed in detail

1. Protective Function:
The protective function implies the role that SEBI plays in protecting the
investor interest and also that of other financial participants. The protective
function includes the following activities.
a. Prohibits insider trading: Insider trading is the act of buying or selling of the
securities by the insiders of a company, which includes the directors, employees
and promoters. To prevent such trading SEBI has barred the companies to
purchase their own shares from the secondary market.
b. Check price rigging: Price rigging is the act of causing unnatural fluctuations
in the price of securities by either increasing or decreasing the market price of
the stocks that leads to unexpected losses for the investors. SEBI maintains
strict watch in order to prevent such malpractices.
c. Promoting fair practices: SEBI promotes fair trade practice and works
towards prohibiting fraudulent activities related to trading of securities.
d. Financial education provider: SEBI educates the investors by conducting
online and offline sessions that provide information related to market insights
and also on money management.
2. Regulatory Function:
Regulatory functions involve establishment of rules and regulations for the
financial intermediaries along with corporates that helps in efficient
management of the market.
The following are some of the regulatory functions.
a. SEBI has defined the rules and regulations and formed guidelines and code of
conduct that should be followed by the corporates as well as the financial
intermediaries.
b. Regulating the process of taking over of a company.
c. Conducting inquiries and audit of stock exchanges.
d. Regulates the working of stock brokers, merchant brokers.
3. Developmental Function:
Developmental function refers to the steps taken by SEBI in order to provide
the investors with a knowledge of the trading and market function. The
following activities are included as part of developmental function.
1. Training of intermediaries who are a part of the security market.
2. Introduction of trading through electronic means or through the internet by
the help of registered stock brokers.
3. By making the underwriting an optional system in order to reduce cost of
issue.

(D) Purpose of SEBI

The purpose for which SEBI was setup was to provide an environment that
paves the way for mobilsation and allocation of resources.It provides practices,
framework and infrastructure to meet the growing demand.
It meets the needs of the following groups:
1. Issuer: For issuers, SEBI provides a marketplace that can utilised for raising
funds.
2. Investors: It provides protection and supply of accurate information that is
maintained on a regular basis.
3. Intermediaries: It provides a competitive market for the intermediaries by
arranging for proper infrastructure.
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(E) Structure of SEBI

SEBI board comprises nine members. The Board consists of the following
members.
1. One Chairman of the board who is appointed by the Central Government of
India
2. One Board member who is appointed by the Central Bank, that is, the RBI
3. Two Board members who are hailing from the Union Ministry of Finance
4. Five Board members who are elected by the Central Government of India

(F) Conclusion:
In the case you described, SEBI's importance lies in its role as a regulatory
authority that investigates and takes action against insider trading, thus
safeguarding the interests of investors and maintaining the integrity and
trustworthiness of the Indian securities market.


Question No. 2
Rima buys a financial asset from the RBI. This financial asset is an instrument
of short-term borrowing. He has bought it because he doesn’t want to take risk
and wants an assured return. This instrument is a promissory note. It is highly
liquid. The instrument is also known as zero coupon bonds. On this instrument,
it is written T-91 Based on the above case study, Identify the financial asset
indicated in the above case. Elaborate why this instrument is called as zero-
coupon bonds and mention what are functions of these instruments and why this
is called as T-91?
Answer:

(A) Introduction:
Financial markets are replete with a variety of instruments that cater to the
diverse needs of investors. These instruments range from high-risk, high-return
equities to low-risk, fixed-return bonds. The case study introduces us to a
financial asset purchased by Rima from the RBI, which is a short-term
borrowing instrument. This asset is designed for investors who are risk-averse
and seek an assured return on their investment. The instrument, described as a
promissory note, is highly liquid and is known as a zero-coupon bond. The
nomenclature “T-91” is also associated with this asset.

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Treasury Bills, commonly referred to as T-Bills, are short-term debt instruments

issued by the central government to meet its short-term financing requirements.
It is crucial to note that the state government lacks authorization to issue
treasury bills, as this prerogative rests solely with the central government. These
instruments come with maturities ranging from 91 days, 182 days and 364 days.
T-Bills are essentially zero-coupon securities i.e. they are issued at a discount to
their face value and investors earn the difference between the issue price and
face value as income. The 91-days T-bill is issued weekly, while the 182-days
and 364-days T-bills are issued fortnightly

(B) Zero coupon Bonds/T-Bills

Zero coupon bonds are those bonds that do not pay any periodic interest during
their tenure. Instead, they are sold at a discount to their face value and provide a
return to the investor upon maturity, when the bondholder receives the face
value of the bond. Similarly, T-bills are issued at a discount to their face value,
allowing investors to purchase them at a lower price than what they will receive
upon maturity.
Zero-coupon bonds, also known as discount bonds, are debt securities that
investors obtain at steep discounts on the face value of the bond. This type of
bond does not pay any interest during its lifetime. Rather, zero-coupon bonds
release the returns at maturity in the form of a lump sum, which is the full-face
value of the bond. Continue reading to learn more about zero-coupon bonds and
how they work.

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(C) Functions of Treasury Bills

Treasury bills (T-bills) are short-term debt instruments issued by governments to
raise funds. They are typically issued by the national treasury or central bank
and are considered to be one of the safest forms of investment. These are
some features of treasury bills:
1. Purpose
2. Issuer
 3. Maturity
4. Finance Bills
5. Issuance and Auctions
6. Liquidity
7. Vital Resource
8. Monetary Management
9. Investment Purpose
10. Taxation

1. Purpose
Governments issue treasury bills to finance their short-term borrowing needs
and manage their cash flow. They are used to cover budget deficits or fund
government projects.
2. Issuer
Treasury bills are issued by the government for raising short-term funds from
institutions or the public for bridging temporary gaps between receipts (both
revenue and capital) and expenditure.
3. Maturity
Treasury bills have a maturity period of less than one year, typically ranging
from a few days to 52 weeks (1 year). They are categorized as “money market
instruments” due to their short-term nature.
4. Finance Bills
Treasury bills are in the nature of finance bills because they do not arise due to
any genuine commercial transactions in goods.
5. Issuance and Auctions
Treasury bills are typically issued through regular auctions conducted by the
government or central bank. Investors place bids specifying the discount rate at
which they are willing to purchase the bills. The highest bids are accepted until
the government’s funding target is reached.
6. Liquidity
Treasury bills are highly liquid investments. They can be bought and sold in the
secondary market before their maturity date, providing investors with the
flexibility to access their funds when needed. Treasury bills are not self-
liquidating like genuine trade bills, although they enjoy a higher degree of
liquidity.
 7. Vital Resource
Treasury bills are an important source of raising short-term funds for the
government.
8. Monetary Management
Treasury bills serve as an important tool of monetary management used by the
central bank of the country to infuse liquidity into the economy.
9. Investment Purpose
Treasury bills are commonly used by investors as a safe haven for parking
excess cash or as a short-term investment option. They are also popular among
institutional investors, banks, and money market funds.
10. Taxation
The interest earned from treasury bills is generally subject to income tax at the
federal level. However, it is exempt from state and local taxes.

(D) Types of Treasury Bills

Types of treasury bills can be categorized as follows:

T-Bill Maturity Period Auction Frequency Minimum Investment

14 days Every Wednesday ₹1 lakh
91 days Every week ₹ 25,000
182 days Every alternate week ₹ 25,000
364 days Every alternate week ₹ 25,000

 91 Days Treasury Bills

The 91-day Treasury bills, issued since July 1965, were tap-based and offered at
discount rates ranging from 2.5% to 4.6% per annum. The returns on these bills
were low, but the RBI provided a free rediscounting facility. Commercial banks
also invested surplus funds for short periods, typically 1 or 2 days.
To manage fluctuations in bill volume, the RBI introduced measures: bill
recycling from October 1986 and an additional early rediscounting fee from
November 1986. However, the bills market did not become an integral part of
the money market.
(D) Conclusion
Treasury bills are a cornerstone of the fixed-income asset class in the Indian
financial market. Issued by the Indian government, T-bills are short-term and
low-risk debt instruments. They serve as an excellent avenue for the
government to meet their short-term needs, while also providing investors with
safety, liquidity and reasonable returns. By understanding the benefits and risks
associated with T-Bills, investors can make informed decisions and potentially
include them in their investment portfolios to achieve their financial goals.


Question No.
3(a)
Explain different types of risks associated
with systematic risk
Answer:

(A) Introduction:
In the dynamic world of financial markets, risks are as inherent as returns. For
every potential gain, there exists an associated risk. Nishanth, with his
experience in portfolio management, understands the importance of not just
chasing returns but also managing and mitigating risks. To provide a
comprehensive understanding to the new recruits, he categorizes risks into two
categories.

(B) What is Systematic Risk?

Systematic risk is that part of the total risk that is caused by factors beyond the
control of a specific company or individual. Systematic risk is caused by factors
that are external to the organization. All investments or securities are subject to
systematic risk and, therefore, it is a non-diversifiable risk. Systematic risk
cannot be diversified away by holding a large number of securities.

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(C)Types of Systematic Risk

Systematic risk includes market risk, interest rate risk, purchasing power risk,
and exchange rate risk.

1. Market Risk
Market risk is caused by the herd mentality of investors, i.e. the tendency of
investors to follow the direction of the market. Hence, market risk is the
tendency of security prices to move together. If the market is declining, then
even the share prices of good-performing companies fall. Market risk
constitutes almost two-thirds of total systematic risk. Therefore, sometimes the
systematic risk is also referred to as market risk. Market price changes are the
most prominent source of risk in securities.

2. Interest Rate Risk

Interest rate risk arises due to changes in market interest rates. In the stock
market, this primarily affects fixed income securities because bond prices are
inversely related to the market interest rate. In fact, interest rate risks include
two opposite components: Price Risk and Reinvestment Risk. Both of these
risks work in opposite directions. Price risk is associated with changes in the
price of a security due to changes in interest rate. Reinvestment risk is
associated with reinvesting interest/ dividend income. If price risk is negative
(i.e., fall in price), reinvestment risk would be positive (i.e., increase in earnings
on reinvested money). Interest rate changes are the main source of risk for fixed
income securities such as bonds and debentures.

3. Purchasing Power Risk (or Inflation Risk)

Purchasing power risk arises due to inflation. Inflation is the persistent and
sustained increase in the general price level. Inflation erodes the purchasing
power of money, i.e., the same amount of money can buy fewer goods and
services due to an increase in prices. Therefore, if an investor’s income does not
increase in times of rising inflation, then the investor is actually getting lower
income in real terms. Fixed income securities are subject to a high level of
purchasing power risk because income from such securities is fixed in nominal
terms. It is often said that equity shares are good hedges against inflation and
hence subject to lower purchasing power risk.

4. Exchange Rate Risk

In a globalized economy, most companies have exposure to foreign currency.
Exchange rate risk is the uncertainty associated with changes in the value of
foreign currencies. Therefore, this type of risk affects only the securities of
companies with foreign exchange transactions or exposures such as export
companies, MNCs, or companies that use imported raw materials or products.

(D) Calculation of Systematic Risk (β)

Systematic risk is that part of the total risk that is caused by factors beyond the
control of a specific company, such as economic, political, and social factors. It
can be captured by the sensitivity of a security’s return with respect to the
overall market return. This sensitivity can be calculated by the β (beta)
coefficient. The β coefficient is calculated by regressing a security’s return on
market return. The estimated equation is given below:

RS is the return on a particular security while RM is the market return. It can be

observed that β is the regression coefficient of RS on RM. The intercept term α
shows a security’s return independent of market return.
The value of β can be calculated using the following formula:
When β = 0 it suggests the portfolio/stock is uncorrelated with the market
return.
When β < 0 it suggests the portfolio/stock has an inverse correlation with the
market return.
When 0 < β < 1 it suggests the portfolio/stock return is positively
correlated with the market return however with smaller volatility.
When β = 1 it suggests that the portfolio return has a perfect correlation with the
market portfolio return.
When β > 1 it suggests that the portfolio has a positive correlation with the
market, but would have price movements of greater magnitude.

(E) Conclusion:
The systematic risk estimates are then related to other properties of equity
returns and, importantly, to the size and the age of firms. Finally, Section 5
summarises the findings and ties them into the conclusion that systematic risk is
being manipulated by firms.


Question No.
3(b)
Explain different types of risks associated
with unsystematic risk
Answer:

(A) Introduction:
Unsystematic Risks are risk that are not shared with the wider market or
industry. Unsystematic risk are often specific to an individual company due to
their management, financial obligation or location. Unsystematic risk can be
reduced by diversifying one’s investments.
Unsystematic risk is unique and is caused due to internal factors. It cannot be
avoided and controlled. It can be minimized by diversification in the sense of an
investment portfolio.

(B) What Is Unsystematic Risk?

Unsystematic Risk can be defined as an uncertainty of an investment in a firm
or industry. Types of unsystematic risk comprise a new market competitor or
ability to take substantial market share from the company being invested in.

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Unsystematic risk is also known as diversifiable risk or specific risk or residual

risk. Investors in this case can generally gauge possibilities of unsystematic risk
but it is not possible to be totally aware regarding when and how it will happen.
For instance, a firm may generate high profits in case of which the stock prices
go up. On the other hand, some other firm may generate low profits which make
its stock prices go up or down.
(C) Types Of Unsystematic Risk
The following are the types of Unsystematic Risk

1. Business Risk
Business Risk includes internal factors that risks the revenue and performance
of the company. This includes not obtaining proper copyright for a new brand or
a patent for a new product. Thereby the competitor can have a freehand to
introduce the same product or use the same brand. Business risk can occur due
to external factors also known as government agencies that may prohibit a drug
that a company sells.

2. Finance Risk
Financial Risk means risk related to company’s capital structure. The capital
structure of all the companies usually has a mix of debt and equity. To derive
maximum benefits from the capital structure a company must maintain and
strive to achieve optimal mix of debt and equity. If the company fails to
maintain balance between the two, it could affect cash flows and earnings.
Therefore, the risk arises from the sub-optimal level of the debt equity mix.

3. Operational Risk
Operational Risk arises due to negligence or unforeseen events, such as supply
chain problems, breakdown of machinery, data breaches etc. Operational risk
includes risk from day-to-day operations and companies take up preventive
measures regularly to avoid equipment related issues.

4. Strategic Risk
The risk involves management’s failure to take right decision regarding its
product or services. An example of this is the company entering in to
partnership with a fraud entity. Another example is management could not
visualize in advance or not being able to change course when the product is not
performing well.
5. Legal and Regulatory Risk
The legal risks relate to changes in laws or regulations that go against the
company or industry. Usually, such changes increase cost or make operations
more difficult. These risks also include companies violating laws.

(D) Examples Of Unsystematic Risk

Most Unsystematic Risk are related to errors in entrepreneurial judgement.
Suppose a watch manufacturing company performs market research and finds
that consumers want small watches instead of big straps and the products are
altered accordingly. Later on, the company finds it that the consumer actually
needs large watches instead of small. Now the existing inventory goes unsold
or it has to be sold at a major loss. This can damage the stock price.

Another example of unsystematic Risk is the litigation risk which the company
faces due to legal action. Some companies face greater litigation risk. For
example, a company whose products are more likely to be defective will face
more litigation and action suits than the other companies

 Limitations
The Limitations of Unsystematic Risks include:
1. Unpredictable
Unsystematic Risks are affected by number of factors and therefore investors
may not be able to predict in advance which stock it will affect. This is a barrier
in taking decisions for the investors.

2. Not easily found out

This type of risk is caused mainly due to internal factors most of the time, and
what can cause them cannot always be known through the publicly available
information and therefore investors may not always be able to quantify.
Therefore, it is difficult for the investors to find out such problems.
(E) Conclusion
Thus, Unsystematic risk are diversifiable risks which means if you buy shares
across of different companies it can reduce risk. Unsystematic risk is often tied
to a specific company or industry and it can be avoided by building a well-
diversified portfolio.
It is dynamic because the problems that each company faces are unique and it
has no correlation with entire economy. As a result, the government
involvement is very less and private players need to handle the issues on their
own. Therefore, portfolio diversification is suggested to avoid deep shocks.