Real options

We have been almost entirely concerned with the valuation of derivative dependent on financial assets. Real assets include land, building, plant, and so on.Often there are embedded options.Valuation is difficult because market prices are not readily available.

We start by explaining the traditional approach to evaluating investments in real assets and their shortcomings.


The traditional approach to valuing a potential  capital investment project is known as the “net” present value” or NPV  approach. The NPV of a project is the present value of its expected future incremental cash inflows and outflows. The discount rate used to calculate the present value is a “risk-asjusted” discount rate, chosen to reflect the risk of the project. As the riskness of the project increases, the discount rate also increases.

As an example consider an investment that costs $100 million. If the risk-adjusted discount rate is 12%,the net present value of the investment is(in million of dollars)

-100+\frac{25}{1.12}+\frac{25}{1.12^{2}}+\frac{25}{1.12^{3}}+\frac{25}{1.12^{4}}+\frac{25}{1.12^{5}}= -9.88

A negative NPV, such as the one we have just calculated,indicates that the project will reduce the value of the company to its shareholder and should not be undertake. A positive NPV indicates that the project should be the undertaken because it will increase shareholder wealth.

The risk adjusted discount rate should be the return required by the company, or the company’s shareholder, on the investment. This can be calculated in a number of ways. One approach often recommended involves the capital asset pricing model. The steps are as follows.

1) Take a sample of companies whose main lines of business is the same as that of the project being contemplated.

2) Calculate the betas of the companies and average them to obtain a proxy beta for the project.

3) Set the requested rate of return equal to the risk-free rate plus the proxy beta times the excess return of the market portfolio over the risk-free rate.

One problem with the traditional NPV approach is that many projects contain embedded options. Consider, for example, a company that is considering building a plant to manufacture a new product.

Often the company has the option to abandon the project if things do not work out well. It may also have the option to expand the plant if demand for the output exceeds expectations. These options usually have quite different risk characteristics from the base project and require different discount rate.

This involved a stock whose current is $20. In three months ‘ time the price will be either $22 or $18. Risk neutral valuation shows that the value of a three-month call option on the stock with a strike price of 21 is 0.633.

The expected return required on the call option is 42.6%.In practice it would be very difficult to estimate these expected returns directly in order to value the option on real assets.

There is no easy way of estimating the risk-adjusted discount rates appropriate for cash flows when they arise from abandonment, expansion , and other options. This is the motivation for exploring whether the risk-neutral valuation principal can be applied to options on real assets as well as options on financial assets.

Another problem with the traditional NPV approach lies in the estimation of the appropriate risk-adjusted discount rate for the base project. The companies that are used to estimate a proxy beta for the project in the three-step procedure above have expansion options and abandonment options of their own. Their betas reflect these options and may not therefore be appropriate for estimating a beta for the base project.


Consider an asset whose price, f , depends on variable 0 and time t. Assume that the process followed by 0 is.

\frac{d\theta }{\theta }=m dt+s dz


Where dz is a Wiener process. The parameters m and s are the expected growth rate in \Theta and t. The variable \Theta need not be a financial variable. It could be something as far removed from financial markets as the temperature in the Centre of New Orleans.

The asset price f follows a process of the form

df= \mu f dt+\sigma fdz

Extension of Traditional Risk-Neutral valuation

Any solution to equation for s is a solution to equation for \theta, and vice versa , when the substitution

q= r-m+ \lambda s

Using risk- neutral valuation. This involves setting the expected growth rate of a equal to r-q and discounting expected payoffs at the risk-free interest rate. It follows that we can solve by setting the expected growth of \theta equal to

r= (r-m+ \lambda s)= m-\lambda s

and discounting expected payoffs at the risk-free interest rate.


Traditional methods of business valuation, such as applying a price earnings multiplier to current earnings, do not work well for new business. Typically a company ‘s earnings are negative during  it’s really years as it attempt to gain market share and establish relationship with customers. The company must be valued by estimating future earnings and cash flows under different scenarios.

The company ‘ future cash flows typically depend on a number of variables such as sales, variable costs as a percent of sales, fixed costs, and so on. Single estimates should be sufficient for outlined in the previous two sections. A Monte Carlo simulation can then be carried out to generate alternative scenario for the net cash flows per year in a risk-neutral world.  It is likely that under some of these scenarios the company does very well and under others it becomes bankrupt and ceases operations.

The simulation must have a built-in  rule for determining when bankruptcy happens. The value of the company is the present value of the expected cash flow in each year using the risk -free rate for discounting.











Cash management

Cash is the important current asset for the operations of the business. Cash is the basic input needed to keep the business running on a continuous basis.It is also the ultimate output expected to be realised by selling the service or product manufactured by the firm. The firm should keep sufficient cash neither more or less.

Cash shortage will disrupt the firm’s manufactured operation while excessive cash will simply remain idle, without contributing anything towards the firm’s manufacturing operation as while excessive cash will simply remain idle, without contributing anything towards the firm’s profitability.

Cash is the money which a firm can disburse immediately without any restriction. The term cash included coins, currency and cheques held by the firm, and balances in its bank accounts. Sometimes near-cash itmes,such as marketable securities or bank times deposits, are also included in cash.

The basic characteristic of near-cash asset is that they can readily be converted into cash. Generally, when a firm has excess cash, it invest it in marketable securities . This kind of investment contribute some profit to the firm.


Cash management is concerned with the manager of

i) Cash flows into and out of the firm.

ii) Cash flows within the firm.

iii) Cash balances held by the firm at a point of time by financing deficit or investing surplus cash.

It can be represented by a cash management cycle.Sales generate cash which has to be disbursed out. The surplus cash has to be invested while deficit has to be borrowed. Cash management seeks to accomplish this cycle at a minimum cost. At the same time, it also seeks to achieve liquidity and control.

Cash management assume more importance than other current assets because cash is the most significant and the least productive assets that a firm holds.

It is significant because it is used to pay the firm’s holds. It is significant because it is used to pay the firm’s obligations.However, cash is unproductive. Unlike fixed assets or inventories, it does not produce goods for sale. Therefore,  the aim of cash management is to maintain adequate control over cash position to keep the firm sufficiently liquid and to use excess cash in some profitable way.

Cash management is also important because it is difficult to  predict cash flows accurately, particular the inflows, and there is no perfect coincidence between the inflows and outflows of cash.The firm should evolve strategies regarding the following four facets of cash management.

1)Cash planning- Cash inflows and outflows should be planned to project cash surplus or deficit for each period of the planning period. Cash budget should be prepared for this purpose.

2)Managing the cash flows-The flow of cash should be properly managed. The cash inflows should be accelerated while,as far as possible, the cash outflows should be decelerated.

3) Optimum cash level- The firm should decide about the appropriate level of cash balances. The cost of excess cash and danger of cash deficiency should be matched to determine the optimum level of cash balances.

4) Investing surplus cash- The surplus cash balances should be properly invested to earn profits. The firm should decide about the division of such cash balance between alternative short-term investment opportunities such as bank deposits, marketable securities, or inter-corporate lending.


The firm’s need to hold cash may be attributed to the following three motives.

1) The transaction motive-The transactions motive requires a firm to hold cash to conduct its business in the ordinary course. The firm needs cash primarily to make payments for purchase, wages and salaries, other operating expenses, taxes, dividends etc. The need to hold cash would not arise if there were perfect synchronization between cash receipts and cash payments.

2) Precautionary Motive- The precautionary motive is the need to hold cash to meet contingencies in the future. It provides a cushion or buffer to withstand some unexpected emergency. The precautionary amount of cash depends upon the predictability of cash flows. If cash flows can be predicted with accuracy, less cash will be maintained for an emergency. The amount of precautionary cash is also influenced by the firm’s ability of the firm to borrow at short notice,less the need for precautionary balance.

Speculative Motive- The speculative motive relates to the holding of cash for investing in profit-making opportunities as and when they arise. The opportunity to make profit may arise when the security prices will hold cash, when it is expected that interest rates will rise and security prices will fall.

Securities can be purchased when the interest rate is expected to fall. The firm will benefit by the subsequent fall in interest rate is expected to fall; the firm will benefit by the subsequent fall in interest rates and increase in security prices.

Cash planning-Cash flows are inseparable parts of the business operations of firms. A firm needs cash to invest in inventory,receivable and fixed assets and to make payment for operating expenses in order to maintain growth in sales and earning.

Cash planning is a technique to plan and control the use of cash. It helps to anticipate the future cash flows and needs of the firm and reduces the possibility of idle cash balances.



Brokerage business

In under to transact business in the securities market, an investor has to route her order is through a brokerage firms as only member broker are allocated to enter the trading floor trading among the member of a recognized  stock exchange is carried on within  the framework of rules, bye laws and regulation of the exchange.

Function of brokerage firm

1) The business of broker consists of searching out buyer when their customer wish to sell and locating sellers when their customers wish to buy so as to executes transaction as per customer instruction.

2) The broker do not function as principals in the transaction, they are agents only.

3)The exercise of care and skill require that the broker follows instructions and places the order in the market. When the security is traded in the fastest possible time.¹

4) The brokerage firm may be hold liable for any losses resulting its mistake.

5)The brokerage firm can not act as  both broker and dealer in the same transaction because these could be  conflict of interest or double commission might result.

6) The broker makes his fee from the difference between the price at which he buys the shares for his own account and the price at which he sells their to customer.

Functional specialization  of members

Functional specialization of member at the stock exchange helps a lot in making it is free active and continuous market. In  India the stock exchange rules, by-laws and regulation do not prescribe any functional distinction between member.

1)Commission broker-Almost all members act as commission brokers. The commission broker executes buying and selling orders on the floor of the exchange. For that, he charges a commission not exceeding the official scale of brokerage.

2) Floor broker- The floor brokers are not officially attached to other members. The floor broker executes orders for any members and receives as his compensation a share of the brokerage charged by commission broker to his constituent.

3) Taravniwalla or jobber- The taraniwalla may be a jobber or specialist who specializes in stocks located at the same trading post.  He trades in and out of the market for small difference in price and as such is an important factor in.

4) Dealers in non-cleared securities- The dealer in non-cleared securities specializes in buying and selling on his own account shares which are not in the active list.

5) Odd-lot-dealer- The odd-lot dealer specializes in buying and selling in amount less than the prescribed trading units or lots. He buys odd lots and makes them up into marketable trading units.

6) Budliwala- The Budliwala or financier lends money to the market by taking up delivery on the due date at the end of the clearing for those who wish to carry over their purchase or loans securities to the market when it is short by giving delivery on the due date at the end of the clearing for those who wish to carry over their sales.

7) Arbitrageur-The arbitrageur specializes in making purchase and sales in different markets at the same time and profits by the differences in prices between the two centres.

8) Security dealer-The security dealer specialises in buying and selling gilt-edged securities that is securities issued by the central and state Governments and by statutory public bodies such as Municipal Corporation.

Types of transactions in a stock exchange

The member of recognized stock Exchanges are permitted to enter into transactions in securities as under.

a) For “spot delivery” i.e for delivery and payment on the same day as the date of the contract or on the next day.

b) For “hand delivery”, i.e, for delivery a d payment within the time or on the date stipulated when entering into bargain, which time or date shall not be more than 14 days following the date of the contract.

C) For “special delivery”,i.e. for delivery and payment within any time exceeding 14 days following the date of contract as may be stipulated when entering into the bargain and permitted by the Govering Board or the President

         Basic types of  transaction

Long purchase– The long purchase is a transaction in which investor buy securities in the hope that they will increase in value and can be sold at a later date or profit. The object, then, is to buy low and sell high. A long purchase is the most common type of transaction.

Each of the basic types of orders described above can be used with long transaction. Because investor generally expect the price of the security to rise over the period of time they plant to hold it, their returns comes from any dividend or interest received during the ownership period, plus the difference between the price of the security to rise over the period of time they plant to hold it.

Their returns comes from any dividend or interest received during the ownership period l,plus the difference between the price at which they sell the security and the price paid to purchase it. This return, of course, is reduced by the brokerage fees paid to purchase and sell the securities.

Margin trading– Most security purchase do not have to be made on a cash basis borrowed funds can be used instead. This activity is referred to as margin trading and it is used for one basic reason to magnify returns. This is possible because the use of borrowed funds reduce the amount of capital that must be put by the investor. As peculiar as it may sound, the term margin itself refers to the amount of equity in an investment, or the amount that is not borrowed.

Essential of margin trading-Margin trading can be used with most kinds of securities. It normally leads to increased returns, but there are also some substantial risks. One of the biggest is that the issue may not perform as expected. If this in fact occurs, no amount of margin trading can corrects matters. Margin trading can only magnify, not produce them. Because the security being margins is always the ultimate source of returns, the security selection process is critical to this trading strategy.


Volatility smiles

A plot of the implied volatility of an option as a function  of its strike price is known as a volatility smile.

Describe volatility smiles in different way.      

Put call parity


Put-call parity provides a good starting point for understanding volatility smiles. It is an important relationship between the price,c, of a European call and the price,p,of a European put .

P+Soe^{-qt} = C+k^{-rt}

The call and the put have the same strike price ,k, time to maturity,T,

So= The variable is the price of the underlying assets today

r= Risk free interest rate

q= the yield on the assets

A key feature of the put-call parity relationship is that it is based on a relatively simple no-arbitrage argument. It does not require any assumptions about the future probability distribution of the assets price. It is true the when the assets price distribution is log normal and when it is not log normal.

Suppose that for a particular value of the volatility, PBs and CBs are the value of European put and call option calculate using the Black-Schloes model suppose further that Pmkt and Cmkt are the market values of these option.Because put-call parity holds for the market value of these option.Because put-call parity holds for the Black-Schloes model, we must have.


Because it also holds  for the market prices we have

P^{_{mkt}}+Soe^{-qt} =C^{_{mkt}}+Ke^{-rt}

Substracting these two equation gives

P^{_{Bs}}P^{_{mkt}} = C^{_{Bs}}C^{_{mkt}}

Foreign currency option

The volatility smile used by traders to price foreign currency options. The volatility is relatively low for at-the-money options.It becomes progressively higher as an option moves either in the money or out of the money.

We show how to determine the risk-neutral probability distribution for an assets price at future time from the volatility smile given by options maturing at that time. We refer to this as the implied distribution.

A log normal distribution with the same mean and standard deviation as the implied distribution has heavier tails than the log normal distribution.

Consistent with each other consider first a drop-out of the money call option with a higher strike price of K2. This option pays off only if the exchange rate proves to be above K2.

The probability of this is higher for the implied probability distribution than for the implied probability distribution. We therefore expect the implied distributed to give a relatively high price for the option. A relatively high price leads to a relatively high implied volatility.

Equity options

The volatility smile used by traders to price equity options (both those an individual stocks indices) This is some times referred to as a volatility skew. The volatility decrease as the price increase. The volatility used to price increase.

The volatility use in  price a low strike price option.(deep-out-of the money put on a drop-in-the money call) is significantly higher strike price option (deep-in-the-money put on a deep-out- of -the money call.

The volatility smile for the equity option corresponds to the implied probability distribution given by the solid  line. A log normal distribution with same mean and standard rather than as the relationship between the implied volatility and K. The smile is then usually much less dependent on the time to maturity.

Non-banking financial company

Finance may be defined as the art and service of managing money. The two major areas of finance are.

1) Financial management managerial finance corporate finance.

II) Finance services.

Financial management is concerned with duties of the financial manager in the business firm who perform such varied tasks as budgeting financial forecasting,cash management credit administration investment analysis funds management and so on financial services is concerned with the design and delivery of advice and financial products to individuals and business within the areas of banking and related institution.

Personal financial planning investment real assets and so on. A wide variety of funds assets based and non- fund based advisory services are provided mainly by the non-banking finance compsnies(NBFCs).

Non-banking financial company(NBFC)

It means i) A financial institution that is a company.

ii) A non-banking institution that business is the receiving of deposits under any scheme arrangements in any other manner or lending in any manner.

iii) Such other non-banking institution class of institution as the RBI may specify with the prior approval of the government and by notification in the official Gazette

Scope of NBFC

The direction supply to a NBFC which is defined to include only non-banking institution that is any purchase  finance investment loan of mutual benefit financial company and an equipment leasing company but excludes an insurance company stock exchange .

Stockbroking company merchant banking company.The directions are ads not applicable to NBFCs that do not accept/hold public deposit.NBFCs have to pass a resolution in a meeting of the have neither accepted nor would accept any public deposit doing the year to the effect that they have neither accepted nor would accept any public deposit during the year.

Repayment of deposit by a non problem NBFC

A non-problem NBFC may

1)Permit premature repayment of a public deposit at its sole direction.

2)Grant a laon upto 75 percent of the deposit after 3 month from the date of deposit at a rate of interest percent points above the rate of interest payable on the deposits.

Repayment by a problem NBFC

A problem NBFC means a NBFC which

i) Has refused to meet within 5 days lawful demand for repayment of a matured deposit.

ii) Intermate the company law Board under section 58-AA of the companies act about its default to a depositor in repayment of any part of it’s any interest on it.

iii) approaches the RBI for withdrawal of liquid asset securities to meet deposit obligation, or for any relief relaxation from the provisions of the RBI public.

iv) It has been identified by the RBI to be ment of public deposits/dues. Such a company may, to enable a depositor to meet expenses of an emergent nature l, prematurely(a) repay a tiny deposit that is aggregate amount not exceeding Rs.10000 in the name of the sole/first named depositor in all the branches of the NBFC) in entirely upto rs.percentage points above the rate of interest payable on the deposit.

For the purpose of premature repayment, all deposit accounts standing to the credit of sole first a named depositor should be clubbed and treated as one account. Where an NBFC prematurely repays a public deposit for any of the reason. a) after 3 months but more than 6 months not interest b) after 6 months but before maturity 2 percent lower than the interest applicable to a deposit for the period for which the concerned deposit has run. If no rate has been specified for that period l, 3 percent lower than the minimum rate at which public deposit is are accepted by the NBFC.

Deposits Receipts- All NBFC have to furnish deposit joint deposits or their agents with a receipt of the deposit stating the date of deposit name of the depositors, the amount of deposit (in words and figure), rate of interest and date of maturity. It must be signed by an officer who can act on behalf of the company in this regard.

Register of deposits- All NBFCs have to keep register of deposit, containing cache depositor particular as detailed below .

a) Name and address,

b) Date and amount of each deposit

C) Duration and due date of each deposit.

d) Date and amount of accrued interest premium on each deposit.

e) Date of claim made by depositor,

f) Date and amount of each repayment of principal/ interest.

g) Reason for delay in repayment beyond five working days and

h) Any other particulars relating to the deposits.

Cost of debt

A company may raise debt in a variety of ways. It may borrow funds from financial institutions or public either in the form of public deposit or debentures (bonds) for a specified period of time at a certain rate of interest.

A debenture or bond may be issued at par or at a discount or premium as compared to its face value. The contractual rate of interest or the coupon rate from that basis for calculating the cost of debt.

Debt issued at par

The before-tax cost of debt is the rate of return required by lenders. It is easy to compute before-tax cost of debt issued and to be redeemed at par;  It is simply equal to the contractual or coupan rate of interest.

For example, a company decides to sell a new issue of 7  years 15 percent bonds of Rs. 100 bonds and will pay Rs. two each at par. If the company realises to bond holders at maturity, the before-tax cost of debt will simply be equal to the rate of interest of 15 percent.

Kd =i= \frac{INT}{Bo}


Kd= before-tax cost of debt

i= the coupan rate of interest

Bo= the issue price of the bond(debt)

INT= Amount of interest

The before tax cost of bond in the example

Kd = \frac{15}{100}= 0.15 or 15%

Debt issued at discount and premium

When debt is issued at par and redeemed at par. This equation can be rewritten as follows to compute the before-tax cost of debt.

Bo = \frac{\sum_{}^{n}}{t=1} \frac{INTt}{(1+kd)t}+\frac{Bn}{(1+kd)}n

Bn= The repayment of debt on maturity

If the discount or premium is adjusted for computing taxes, following short-cut method can also be used to calculate the before-tax cost debt.

Cost of the existing debt

Sometime a firm may like to compute the current cost of the existing debt. In such a case the cost of debt should be approximate by the current market yield of the debt.

Firm has 11 percent debenture of Rs. 100000(rs.100 face value l) out standing at 31 December.19×1 matured on December 31. 19×6 ). If a new issue of debentures could be sold at net reliable price Rs.80 in the beginning of 19×2.

Tax adjustment in debt

The interest paid on debt is tax deductible. The higher the interest charges the lower will be the amount of tax payable by the firm. This implies that the government indirectly pays a part of the lender’s required rate of return. As a result of the interest tax shield, the after tax cost of debt to the firm will be substantially less than the investor required rate of return.

The before-tax cost of debt kd should therefore, be adjusted for the tax effect as follows.

After tax cost of debt

Kd(I-T), where T= the corporate tax

Kd(1-T)=0.1650(1-0.35)=0.1073 or 10.73%

It should be noted that the tax benefit of interest deductibility would be available only  when the firm is profitable and is paying taxes.

An unprofitable firm is not required to pay any taxes. It would not gain any tax benefit associated with the payment of interest and it’s true  cost of debt is the before-tax cost.

It is important to remember that in the calculation of the average cost of capital. The after-tax cost of debt must be used, not the before-tax cost of debt.



Capital market

Capital markets are place where investor buy and sell company and government securities with their trading decision reflecting information on company performance insight provided by financial analyst, dividend announcement by companies expectation on the future levels of interest rate and inflation the investment decision of financial managers and so on.

At both levels, companies and investor will want the capital markets to assign fair prices to the financial securities being traded.

In the language of corporate finance. Companies and investor want the capital markets to be efficient. It is possible to describe the characteristics of an efficient capital market by considering the relationship between market prices and the information available to the market.

Whether capital market are infact efficient has been studied extensively for many years.

Capital markets bring investor lender and firms (borrowing) together. Hence the financial manager has to deal with capital markets. He or she should fully understand the operations of capital market and the way in which the market value securities. He or she should also know-how risk is measured and how to cope with it in investment and financing decision.

For example, if a firm uses excessive debt to finance its growth investor many perceive it as risky. The value of the firm’s share may therefore decline. Similarly investor may not like the decision of a highly profitable growing firm to distribute dividend.

They may like the firm to reinvest profits in attractive opportunities that would enhance their prospects for making high capital gains in the future.

Investments also involve risk and return. It is through their operations in capital markets that investor continuously evaluate the actions of the financial manager.

Investor financial managers and capital market obtain a great deal of information about companies from their financial statements from financial database from the financial press, and so on.Through the application of ratio analysis financial statements can be made to yield useful information concerning the profitability, solvency performance, efficiency of operation and risk of individual companies.

This information will be used for example by investor when reaching decision about whether, and at what price to offer finance to companies by financial manager in making decisions in the key area of investment financing and dividend and by share holders making decision on which securities to add or remove from their portfolio.

The capital markets are markets for trading in long-term financial instrument or securities , but the most important ones for companies are ordinary shares or ordinary equity preference share and debt securities such as debenture, unsecured loan stock and convertible loan stock.

For companies capital market have two main function.

1) They act as a means whereby long-term funds can be raise by companies from those with fund to invest such as financial institutions and private investment.

In the fulfilling this function they act as primary market for new issue of equity or debt.

2) Second function  capital provide a ready means for investor to sell their existing holdings of share and bonds or to increase their portfolios by buying additional ones.

Here, they act as secondary market for dealing in exciting securities. The secondary market plays an important role in corporate financial management, because by facilitating the ready buying and selling of securities it increase their liquidity and hence their value.

Investor would pay less for security that was difficult to dispose of.

The secondary market is also a source  of pricing information for the primary market, increasing the efficiency with which new funds are allocated.



LAF(Liquidity Adjustment Facility

The LAF has emerged as one of the most important instruments of monetary policy in recent years. The RBI, as the lender of the last resort, was providing various general and sector-specific refinance facilities to the banks.

In keeping with the recent policy objective of shifting from direct to indirect techniques of monetary control. It became a general refinance facility.

The LAF operates through repo auctions,that is, the sale of Government securities from the RBI portfolio for absorption of liquidity, and reserve repo auctions, that is,  buying of Government securities for injection of liquidity on a daily basis, thereby creating a  corridor for the call money rates and other short-term interest rates.

The funds under LAF are expected to be used by banks for their day-to-day mismatches in liquidity. The maturity of repos is form one day to fourteen days. All scheduled banks are eligible to participate in the repo and reverse repo auctions.

The minimum bid size for LAF is rs.5 crore and in multiples of Rs. 5 crore thereafter. All transferable Government of India dated securities/T-bills (expect 14-day T-bills) can be traded in the repo and reverse repo markets.

The DL is the sum of the RBI balance sheet flows that arise out of its money market operation.It represent a change in the total liquidity in the system which occurs due to monetary policy action. It comprise policy-induced flows from the RBI to banks. It is the sum of the following i) net repos and OMOs  of the RBI and ii) RBI credit to banks.

The LAF technique is based on the view that the RBI balance sheet can be partitioned into autonomous and discretionary components.The Autonomous liquudity(AL) and DL bear an inverse relationship with the change in the change in the inter-bank call money rate.

The AL is the sum of RBI’s net incremental claims on the following.

i) the Government adjusted for OMOs and repo operation.

ii) Banks(other than credit to schedule banks)

iii) Commercial sector.

iv) Foreign assets net of liabilities (Other than schedule bank deposit with RBI.

Under LAF  the RBI periodically daily if necessary, sets/rests its repos and reverse repo rate.It uses 3-day repos to siphon of liquidity from the market. The repos are used for absorbing liquidity at a given rate (floor) ,and for infusing liquidity through reverse repos, at a given rate( ceiling).

Merits of LAF

i) The LAF is a new short-term liquidity management technique.

ii)It is a flexible instrument in the hands of the RBI to modulate, even out, adjust or manage short-term market.

iii) Liquidity fluctuation on a daily basis and to help create stable or orderly conditions in the overnight/call money markets.

iv)It is meant to help monetary authorities to transmit short-term interest rate signals to other money markets, financial markets, and the long-end of the yield curve.

V) The repos operations also provide liquidity and breadth to the underlying treasury securities markets.

The LAF operations combined with OMOs and B/R changes, have become the major technique (operating procedure) of the monetary policy in INDIA.


Monetary policy

The monetary policy stance of the reserve bank continued to be the provision of adequate liquidity to meet credit growth. Support investment demand in the economy while continuing a vigil on movement in the price level.

Liquidity management in India is a subject that is not widely discounted  but is the bread and butter of daily monetary management.

Conduct of monetary policy and management in the context of large and volatile capital flows has proved to be difficult for many countries.

The evolving policy mix involved careful calibration that book into account diverse objective of central banking changes in the monetary policy framework and operating procedures and widening of the set of instrument for liquidity management.

Liquidity management and management of capital flows

While in the macroeconomics context, liquidity management refers to overall monetary, conditions, reflecting the extent of mismatch between demand and supply of overall monetary resources.

For central bank, the concept of liquidity management typically refers to the framework and set of instruments that the central bank follows insuring the amount policy.

What is the price of bank reserves?

The price of bank reserve is fixed in terms of short-term interest rate. This is set in terms of overnight inter-bank borrowing and lending rates either secured or unsecured which affect the reserves do not clear offer an their own the central bank itself steps in by influencing the short-term repurchase obligation with banks.

Supply of monetary base depends on.

1) The public demand for currency as determined by the size of monetary transactions and the opportunity cost of holding money.

2) The banking system ‘s need for reserve to settle or discharge payment obligation control banks also attempt to contract and varying the supply of bank reserve to settle meet its are therefore influenced through reserve requirements or open market operation.

Role of central bank

1) The importance of central bank liquidity management lies in its ability to exercise considerable influence and control over short-term interest rate by small money market operation.

2) Central bank typically aim at a target overnight interest rate which at as a powerful economy wide signal.

3) The liquidity management function of a central bank involves a larger economy-wide perspective.

4) Central bank liquidity management has short-term effects in financial market.

5) Central bank attempt to influence money market liquidity in order to exercise control over the short-term interest rate.

6) The central bank may directly set at one of the short term interest rate that acts as its policy rate.

Money market instrument

1)  Repo rate– Repo is a collateralized short term borrowing and lending through sale/purchase operation in debt instrument. It is a temporary sale of debt. Transfer of ownership of the securities that is the assignment of voting and financial rights. The term of the contract is in terms of a repo rate, representing the money market borrowing lending rate. Repos are usually of 1-14 days .

The collateral security in the form of SGL is transferred from  the seller to the buyer. Generally ,repos transaction take place in market lots of Rs. 5 core. Repo transaction have very low credit risk due to the SGL mechanism and the existence of collateral in the form of the underlying security.

2) Reverse repo rate– A reverse repo ready forward repurchase (buy back) is a transaction in which two parties agree to sell and repurchase the same security. The seller sells specified securities with an agreement to repurchase the same at a mutually decided future date and price.

Likewise, the buyer purchases the securities with an agreement to resell the same to the seller on an agreed date and at a predetermined price.

Reverse repo are used to

1) Meet a shortfall in the cash position

2)  Increase return on fund held

3) Borrow securities to meet regulatory (SLR) requirements

4) By the RBI adjust liquidity in the financial system under the LAF

3) Statutory Liquidity Ratio(SLR)– While the CRR enables the RBI to impose primary reserve requirements. The SLR enables it to impose secondary and supplementary reserve requirements on the banking system.

The  objective of the SLR are three-fold i) To restrict the expansion of bank credit.ii) To augment a bank’s investment in Government securities and iii) To ensure solvency of banks.

The SLR is the ratio of cash in hand (excluding CRR) balances in current account with banks and RBI gold and unencumbered approved securities to the total demand and time liabilities of the banks. The SLR defaults result in restrictions on the access of refinance.

An increase in the SLR does not, however, restrain total expenditure in the economy it would restrict only private sector expenditure but it would also help increase the government sector expenditure. A decrease in the SLR would have the opposite effect. SLR is not a technique of monetary control it only distributes bank reserve in favour of the Government public sector.

4) Bank rate– The bank rate is the standard rate at which the RBI buys rediscounts Bill’s of exchange other eligible commercial paper.It is also the rate that the RBI charges on advances on specified collaterals to banks. An increase in the B/R would decrease /increase in the lending rate of banks.Thus the B/R technique regulate the cost/availability of finance and to that extent, the volume of funds available to banks and financial institutions.

5) Cash Reserve Ratio– The CRR refers to the cash which banks have to maintain with the RBI as a percentage of their demand and time liabilities. The objective is to ensure the safety and liquidity of bank deposits.The RBI is empowered to impose penal interest on banks in respect of their shortfall in the prescribed CRR.

The penal interest is a specified percentage above the bank rate.RBI can disallow fresh access to its refinance facility to defaulting banks and charge additional interest over and above the basic refinance rate on any accommodation availed of and which is equal to the shortfall in the CRR.

The RBI pays interest equal to the bank rate on all eligible cash balances. The CRR, as an instrument of monetary policy has been very actively used by the RBI recently in the downward direction. It is at its lowest level now.

6) Open market operation(OMOs)– The OMOs refer to the sale and purchase of securities of the central and state Government and treasury-bills (T-bills). The multiple objective of OMOs, i) To control the amount of and changes in bank credit and money supply through controlling the reserve base of banks.(ii) To make the bank rate policy more effective (iii) To maintain stability in the Government securities T-bills market(iv) To support the Government’s borrowing programme (v)To smoothen the seasonal flow of funds in the bank credit market.

Through the OMOs, the RBI can affect the reserve position of banks,yields on Government securities T-bills the volume and cost of credit.

In spite of the wide power to the RBI,the OMOs is not a widely-used technique of monetary control in India. There is no restriction on the quantity maturity of the Government securities which the RBI can buy/sell/hold.


Swap are similar to future and forward contracts in providing hedge against financial risk. A swap is an agreement between two parties called counter parties to trade cash flows cash flows over a period of time. Swaps arrangements are quite flexible and are useful in many financial situation.

Two most popular swap and interest rate swap. These two swaps can be combined when interest on loan in two currencies are swapped. The interest rate and currency swap market enable firms to arbitrage the differences between capital markets.

Currency Swap

Currency swap involves an exchange of cash payments in one currency for cash payments in another currency. Most international companies require foreign currency for making investment abroad.

These firm find difficulties in entering new market and raising capital at convenient terms.Currency swap is an easy alternative for these companies to overcome this problem.

Use of currency swap to transform loan and assets.

A swap such as the one considered can be used to transform borrowing in one currency to borrowing in another.

For example IBM an issue $15 million of U.S. dollar denominated bonds at 8% interest. It has the effect of transforming this transaction into one where IBM has borrowed £10 million pounds at 11% interest.

It has the effect of transforming this transaction into one where IBM has borrowed £10 million  pounds at 11%.The initial exchange of principal converts the proceeds of the bond issue from U.S. dollar to sterling.

It can also be used to transform the nature of assets. Suppose that IBM can invest £10 million pounds in the UK to yield 11% per annum for the next the five years. But feels that the U.S. dollar will strengthen against sterling and prefers a U.S. dollar will strengthen against sterling and prefer a U.S. denominated investment.

Valuation of currency swaps

In the absence of default risk. A currency swap can be decomposed into a position in two bonds. As is the case with an interest rate swap.It is short GBP bonds that pays interest at 11% per annum and long a USD bond that pays interest at 8% per annum.

In general, if we define V{_{swap}} as the value in U.S.dollar of a swap where dollar are received and a foreign currency is paid them.



B{_{F}} = value

B{_{D}} = U.S. dollar

S{_{o}} = spot exchange

Interest rate swap

The interest rate swap allows a company to borrow capital at fixed (or floating rate) and exchange its interest payments at floating rate or fixed rate. This is the most common type of swap is a plain vanilla interest swap. In this a company agree to pay cash flows equal to interest at a predetermined fixed rate.

On a notional principal for a number of years. In return, it receives interest at a floating rate on the same notional principal for the same period  of time.

The floating rate in many interest rate swap agreement is the London interbank offer rate(LIBOR). LIBOR is the rate offered on one-month deposit.

LIBOR rates are determined by trading between bank and change frequently so that the supply of the reference rate of interest for floating rate loans in the domestic financial market. LIBOR rates are determined by trading between banks and change frequently so that the supply of the reference rate of the interest for loans in international financial markets.

To understand how it is used consider a five year loan with a rate of interest specified as six-month LIBOR  plus 0.5% per annum.

The life of the loan is divided into ten periods. Each six months in length. For each periods the rate of interest is set 0.5% per annum above the six month LIBOR rate at the beginning of the period interest is paid at the end of the period.

Valuation of interest rate swaps

An interest rate swap is worth zero or close to zero, when it is first initiated. After it has been in existence for sometime its value may become positive or negative.

To calculate the value we can regard the swap either as a long position in one bond combined with a short position in another bond or as a portfolio of forward rate agreements.

Valuation in terms of bond prices.

V_{swap} = B_{n}B_{fix}