CHAPTER 1: INTRODUCTION (Detailed with Examples)

🔶 1. What Are Financial Assets?

Definition:
A financial asset is a non-physical asset such as a bond or share, which gives the holder the right to
receive future payments (cash flows).

🔹 Tangible Assets = Physical (e.g., land, gold, machinery)

🔹 Intangible Assets = Non-physical (e.g., patents, trademarks)
🔹 Financial Assets = Claims to future income (e.g., stocks, bonds)

Example:
If you buy a bond from a company, you're lending them money. In return, they promise to pay you
interest (regularly) and repay the bond amount later.

🔶 2. Debt vs Equity

Feature Debt Instrument Equity Instrument

Ownership No ownership in company Ownership in company

Return Fixed interest payment Variable dividends + capital gains

Risk Lower risk (paid first in liquidation) Higher risk (paid after debt holders)

Example Bonds, Loans Stocks, Shares

Example:
Buying a company bond means you'll receive fixed interest and get your money back after a period.
Buying company stock means you become part-owner. Your return depends on company profit.

🔶 3. Valuing a Financial Asset

The value of any financial asset is the present value (PV) of all future expected cash flows from it.

Formula:

Value=CF1(1+r)1+CF2(1+r)2+⋯+CFn(1+r)n\text{Value} = \frac{CF_1}{(1+r)^1} + \frac{CF_2}{(1+r)^2} +

\dots + \frac{CF_n}{(1+r)^n}Value=(1+r)1CF1+(1+r)2CF2+⋯+(1+r)nCFn

Where:

 CFCFCF = Cash flows (interest, dividend, etc.)

 rrr = Discount rate (interest rate)

 nnn = Time period

Example:
If a bond pays ₹1,000 next year and interest rate is 10%, then:
PV=10001.10=₹909.09\text{PV} = \frac{1000}{1.10} = ₹909.09PV=1.101000=₹909.09

🔶 4. Risks in Financial Assets

📌 Main Types of Risk:

Type of Risk Description Example

Credit Risk Issuer may not pay back debt A company defaults on bond payments

Purchasing power of money reduces over

Inflation Risk ₹1,000 today buys less in 5 years
time

Euro-denominated bond loses value in

Currency Risk Exchange rate fluctuations affect value
INR

Example:
If you buy a US bond in dollars and the rupee weakens, your return may fall after conversion.

🔶 5. Discount Rate for Valuation

When estimating asset value, we use a discount rate:

1. Risk-Free Rate: Interest rate with no credit risk (e.g., U.S. Treasury bonds)

2. Risk Premium: Extra return expected for taking on risk

Example:
If U.S. Treasury bonds pay 3% (risk-free), and a company bond has 5% credit risk, the investor may
demand 8% return.

🔶 6. Properties of Financial Assets

Property Explanation Example

Moneyness How easily it can be used like money Treasury Bills (close to cash)

Divisibility Can it be split into smaller parts? Stocks (can buy 1 share or 1000 shares)

Cost of buying and selling (round-

Reversibility Stock with large bid-ask spread is less reversible
trip)

Maturity Time till asset pays back fully A 10-year bond matures in 10 years

Ease of converting to cash without Apple stock = highly liquid; Real estate = less
Liquidity
loss liquid

Can it be changed into another

Convertibility Convertible bond into shares
asset?

Currency Risk Foreign exchange impact Euro bond held by Indian investor
Property Explanation Example

Government bonds = more predictable than

Predictability How stable are future returns?
stocks

Involves combinations of other

Complexity Mortgage-backed securities
assets

Tax Status Returns may be taxed differently Municipal bonds in U.S. may be tax-free

🔶 7. Financial Markets

Definition:
A financial market is a place/system where financial assets are bought and sold.

🔑 Roles of Financial Markets:

1. Price Discovery – Finds the fair value of an asset

2. Liquidity – Lets investors sell assets quickly

3. Reduce Transaction Costs – Time, effort, and information cost are minimized

Example:
The NSE (National Stock Exchange) is a financial market where you can buy/sell shares.

🔶 8. Types of Financial Markets

Classification Types Example

By Claim Debt Market, Equity Market Bond market, Stock market

By Maturity Money Market (short-term), Capital Market T-bills vs. corporate bonds

By Issuance Type Primary (new issue), Secondary (resale) IPO vs. regular share trading

🔶 9. Globalization of Financial Markets

Meaning:
Integration of different countries' financial systems into one global market.

🔹 Why It Happened:

1. Deregulation: Fewer restrictions on investment

2. Technology: Faster trades, better info

3. Institutionalization: More activity by mutual funds, pension funds

Example:
Indian companies raising capital by issuing bonds in London or New York is part of globalization.
🔶 10. Global Financial Markets Classification

Type Definition Example

Internal Indian company listed on BSE =

Domestic + Foreign markets in a country
Market domestic market

External Issued outside any national jurisdiction

Eurobonds sold in multiple countries
Market (Euromarket)

🔶 11. Derivatives

Definition:
A derivative is a financial product whose value depends on another asset (called underlying).

Type Function Example

Option Right to buy/sell an asset Buy Apple stock at ₹1000 anytime before Dec 2025

Future Contract to buy/sell asset at future date Agreement to buy oil at fixed price next month

Swap Exchange of cash flows Fixed vs floating interest swap between two parties

🔶 12. Asset Classes

Definition:
Asset classes are groups of investments with similar characteristics.

Type Traditional Alternative

Examples Stocks, Bonds, Cash Equivalents Real Estate, Gold, Private Equity, Crypto

Example:
A mutual fund may invest 60% in equity, 30% in bonds, and 10% in gold, across asset classes.

🔶 13. Market Capitalization

Formula:

Market Cap=No. of Shares×Price per Share\text{Market Cap} = \text{No. of Shares} \times \text{Price
per Share}Market Cap=No. of Shares×Price per Share

Example:
100 million shares × ₹35 = ₹3,500 crore market cap

✅ Summary Table

Section Key Learning Example

Financial Assets Claims on future income Bonds, Stocks

Section Key Learning Example

Valuation PV of expected cash flows Bond value from future interest payments

Risks Credit, Inflation, Currency Currency risk on Euro bond

Properties Moneyness, Liquidity, Tax Status Gold = low liquidity, Bonds = taxable

Markets Price discovery, liquidity Stock Exchange

Globalization Cross-border investment Indian firm lists in U.S.

Derivatives Value from other assets Options, Swaps

Asset Classes Traditional & Alternative Equity, Real Estate, Crypto

📘 Chapter Summary 2 : Market Participants & Financial Innovation

🔹 1. Key Market Participants

Participant Role Example

Issue securities (like Treasury bonds), regulate

Governments U.S. Treasury, SEBI
markets, and invest funds

Nonfinancial Issue equity/debt to raise funds, may have financial Ford Motor Credit
Corporations subsidiaries (subsidiary)

Depository
Accept deposits and provide loans HDFC Bank, ICICI Bank
Institutions

Insurance Companies Collect premiums, invest funds, and pay out claims LIC, Bajaj Allianz

Asset Management SBI Mutual Fund,

Manage portfolios on behalf of clients
Firms BlackRock

Goldman Sachs, Morgan

Investment Banks Help companies raise capital, act as brokers/dealers
Stanley

Nonprofits & Bill & Melinda Gates

Use investments to support social missions
Endowments Foundation

Invest via individuals, central banks, or European Investment

Foreign Investors
supranational bodies Bank

🔹 2. Financial Institutions vs Intermediaries

 Financial Institutions are large companies that engage in financial transactions (banks,
insurance firms).

 Financial Intermediaries act as middlemen between savers and borrowers, e.g., banks
converting deposits into loans.

🔹 3. Role of Financial Intermediaries

Financial intermediaries perform 4 major economic functions:

✅ 1. Maturity Intermediation

 Meaning: Converting short-term liabilities (like savings deposits) into long-term assets (like
loans).

 Example: Bank gives a 10-year home loan funded by 1-year term deposits.

✅ 2. Risk Reduction via Diversification

 Meaning: Pool funds and invest in multiple assets to spread risk.

  Example: Mutual fund invests in 50 stocks, so even if 5 underperform, others can balance
the loss.

✅ 3. Lower Contracting and Info Costs

 Meaning: Reduces transaction costs using standardized contracts and expert analysis.

 Example: Banks assess credit risk and process paperwork faster due to scale and expertise.

✅ 4. Providing Payment Mechanisms

 Meaning: Facilitate cashless transactions via cards, cheques, UPI, etc.

 Example: Using debit cards or Paytm to pay instead of cash.

🔹 4. Asset-Liability Management (ALM)

🧾 Types of Liabilities:

Type Description Example

I Known amount and timing Fixed-rate FD

II Known amount, unknown timing Life insurance payout

III Unknown amount, known timing Floating rate CDs

IV Unknown amount and timing Health insurance, pensions

🔹 5. Regulation of Financial Markets

✅ Reasons for Regulation:

 To correct market failures, protect investors, ensure fairness.

 Triggered by events like the 1929 Crash and 1930s Depression.

✅ Four Types of Regulation:

Type Purpose Example

Disclosure Regulation Ensure transparency; address asymmetric info SEBI/SEC mandatory filings

Financial Activity
Monitor traders and exchanges Insider trading laws
Reg.

Oversee lending, borrowing, and capital

Institution Regulation RBI guidelines for NBFCs
requirements

Foreign Participant Limit/control foreign access to domestic FDI restrictions in

Reg. markets banks/insurance

🔹 6. Financial Innovation
📌 What is it?

 Development of new financial products, services, or processes.

 Can be product innovations (new instruments) or process innovations (improved methods).

✅ Motivations:

1. High volatility (interest rates, inflation, exchange rates)

2. Technological advances

3. Greater professional expertise

4. Competition among institutions

5. Regulatory arbitrage

6. Global financial expansion

🔹 7. Securitization: A Key Innovation

✅ Definition:

Turning illiquid assets (like loans) into tradable securities.

✅ Steps:

1. Pooling assets (e.g., mortgage loans)

2. Selling claims on future cash flows to a Special Purpose Vehicle (SPV)

3. SPV issues securities to investors.

✅ Example:

Bank sells home loans to SPV → SPV issues Mortgage-Backed Securities (MBS) to investors.

✅ Benefits:

 Frees up bank capital

 Transfers risk to investors

 Promotes liquidity in markets

✅ Catastrophe Bonds (Cat Bonds):

 Issued to cover rare, extreme risks (like earthquakes).

 Investors lose money only if the catastrophe occurs.

🧠 Key Examples to Remember

Concept Example

Maturity Intermediation Bank uses short-term deposits to offer long-term home loans
Concept Example

Diversification Mutual fund invests in multiple sectors to reduce portfolio risk

Securitization Credit card receivables bundled into tradable securities

Type I Liability 3-year fixed deposit in a bank

Type IV Liability Health insurance claims (unknown amount and time)

Regulation Example SEC mandates IPO disclosures to protect investors

Process vs Product Faster loan approval (process); Cat bonds (product)

📘 MCQs – Financial Market Participants & Innovation

1. Which of the following is an example of a government-sponsored enterprise (GSE)?

A) World Bank
B) Federal Reserve Bank
C) Fannie Mae
D) BlackRock

2. A depository institution performs which of the following functions?

A) Issues government bonds
B) Pools insurance premiums
C) Accepts deposits and makes loans
D) Regulates the stock exchange

3. Which of the following best describes maturity intermediation?

A) Converting long-term deposits into short-term loans
B) Converting short-term liabilities into long-term assets
C) Pooling risks to create insurance products
D) Trading foreign exchange for arbitrage

4. Which financial institution primarily earns through charging a premium and investing that
money until claims are paid?
A) Asset Management Firm
B) Insurance Company
C) Commercial Bank
D) Investment Bank

5. Which type of liability involves both unknown cash outflows and unknown timing?
A) Type I
B) Type II
C) Type III
D) Type IV

6. Which of the following is NOT a function of financial intermediaries?

A) Providing payment mechanisms
B) Offering government subsidies
 C) Reducing contracting costs
D) Risk reduction through diversification

7. Which regulation deals with reducing asymmetric information in the market?

A) Foreign participant regulation
B) Disclosure regulation
C) Activity regulation
D) Tax regulation

8. Which financial innovation allows illiquid assets like credit card receivables to be pooled
and sold to investors?
A) Diversification
B) Mutualization
C) Securitization
D) Cross-listing

9. Which type of organization invests to support missions such as education or religion and is
tax-exempt?
A) Investment bank
B) Hedge fund
C) Nonprofit organization
D) Credit union

10. The European Investment Bank is best classified as a:

A) Central Bank
B) Nonfinancial Corporation
C) Supranational Institution
D) Cooperative Bank

11. Which of the following is considered a product innovation?

A) Mobile banking app
B) Catastrophe bond
C) Risk management system
D) Loan underwriting software

12. Which statement is true regarding process innovation?

A) It always introduces a new product
B) It improves how an existing service/product is delivered
C) It only applies to insurance services
D) It cannot occur in financial markets

13. Which of the following liabilities has known cash outflows but unknown timing?
A) Fixed-rate deposit
B) Variable-rate deposit
C) Life insurance policy
D) Catastrophe bond

14. Investment banks perform all of the following EXCEPT:

A) Providing insurance against risks
B) Assisting in raising capital
 C) Trading securities
D) Acting as brokers

15. What is the primary goal of regulation of financial institutions?

A) Encourage more foreign investment
B) Prevent monopolies
C) Ensure stable lending and borrowing
D) Increase stock market prices

✅ Answer Key

1. C

2. C

3. B

4. B

5. D

6. B

7. B

8. C

9. C

10. C

11. B

12. B

13. C

14. A

15. C

Chapter 3 – Depository Institutions (Detailed Notes)

🏦 1. What Are Depository Institutions?

Depository institutions are financial intermediaries that accept public deposits and use those funds
to make loans and invest in securities.

🔹 Examples:
  Commercial Banks (e.g., HDFC Bank)

 Savings and Loan Associations (S&Ls)

 Savings Banks

 Credit Unions

💼 2. Asset/Liability Management Problem

🔄 Spread Income / Margin:

 The difference between the return on assets (e.g., loans) and the cost of funds (e.g.,
interest on deposits).

 Banks aim to earn a positive spread to cover costs and provide return to shareholders.

⚠️Risks Involved:

 Credit Risk: Risk of borrower default.

 Regulatory Risk: Adverse impact due to changes in rules.

 Funding Risk: Arises from mismatch between the maturity of liabilities (short-term) and
assets (long-term).

o Example: 5-year home loan funded by 1-year fixed deposit.

💧 3. Liquidity Risk and Reserve Management

 Banks must always have funds to:

o Meet withdrawal requests.

o Satisfy loan demands.

✅ Ways to Maintain Liquidity:

1. Attract more deposits.

2. Borrow from other banks/Federal Reserve.

3. Sell securities.

4. Hold secondary reserves (liquid, low-risk securities).

🔒 4. Key Regulatory Concerns

Risk Type Explanation

Credit Risk Borrower fails to repay.

Settlement Risk Transaction fails to settle.

Risk Type Explanation

Liquidity Risk Institution can’t meet short-term cash needs.

Market Risk Adverse asset price movements.

Operational Risk Internal system/process failure or fraud.

Legal Risk Violation of laws, leading to penalties.

🏢 5. Commercial Banks

🔹 Dual Chartering System:

 State-Chartered and National Banks

 Regulated by: Federal Reserve Board, OCC, FDIC

🔹 Key Services:

Type Description

Individual Loans (home, auto, credit cards), savings, trust services.

Institutional Loans to companies, leasing, factoring.

Global FX trading, international trade financing, investment services.

💰 6. Bank Funding Sources

1. Deposits (Primary source)

o Demand deposits: No interest, can be withdrawn anytime.

o Savings deposits: Interest paid, no maturity.

o Time deposits / CDs: Fixed term and rate.

o MMDAs: Hybrid savings/checking tied to market rates.

2. Non-deposit Borrowings

o Borrowing in money markets, repo, bond market.

o Money center banks use this more than regional banks.

3. Equity Financing

o Common stock and retained earnings.

📊 7. Reserve Requirements and Federal Funds Market

 Banks must maintain non-interest-bearing reserves with the Fed.

  Calculated on a 2-week average.

 Banks short on reserves can borrow from others in the federal funds market.

o Interest rate = Federal funds rate

🏦 8. Discount Window Borrowing

 Banks can borrow from the Fed directly at the discount rate.

 Requires collateral.

 Frequent borrowing is seen as a sign of weakness.

📉 9. Capital Requirements (Basel Norms)

Framework Introduced Focus Area

Basel I 1988 Credit risk

Basel II 2004 Broader risk, including ops risk

💡 Capital Categories:

 Tier 1 (Core): Equity, retained earnings.

 Tier 2 (Supplementary): Reserves, hybrid debt.

✅ Risk Weights (US Banks):

 Treasury securities: 0%

 Municipal bonds: 20%

 Mortgages: 50%

 Commercial loans: 100%

→ Required:

 Tier 1 Capital ≥ 4% of assets

 Total Capital ≥ 8% of risk-weighted assets

10. Federal Deposit Insurance (FDIC)

 Covers depositors up to $100,000 (as per 1996).

 Paid via premiums from banks.

❗ Moral Hazard:

 Encourages risk-taking by bank managers.

 Depositors don’t monitor bank soundness.

💡 Proposals:

 Risk-based insurance premiums.

 Lower coverage limits to promote depositor vigilance.

🏠 11. Savings and Loan Associations (S&Ls)

 Focus: Home mortgages.

 Ownership: Mutual (by depositors) or stockholder-owned.

 Regulated by: Office of Thrift Supervision (OTS)

💡 S&L Crisis:

 Caused by interest rate mismatch (borrowing short, lending long).

 Led to collapse and stricter regulation.

💼 12. Savings Banks

 Similar to S&Ls, mostly mutually owned.

 Typically larger, but have less total deposits than S&Ls.

 Very high deposit-to-assets ratio.

👥 13. Credit Unions

 Member-owned (common bond required).

 Regulated by NCUA (National Credit Union Admin.)

 Deposits called "shares" and insured via NCUSIF.

 Can invest in corporate credit unions for services like payment systems.

🧠 Key Examples & Terms

Term Example/Explanation

Spread Income Loan interest = 8%, deposit cost = 4% → spread = 4%

Moral Hazard Banks take more risks, relying on FDIC insurance

NOW Account Interest-paying checking account with withdrawal limits

Tier 1 Capital Common equity and retained earnings

Securitization Selling home loan pool as MBS to reduce capital requirement

Term Example/Explanation

Federal Funds Rate Interest charged by one bank lending reserves to another

📘 MCQs – Chapter 3: Depository Institutions

1. Which of the following is NOT a depository institution?

A) Commercial Bank
B) Mutual Fund
C) Savings and Loan Association
D) Credit Union

2. What is the main source of income for depository institutions?

A) Premiums
B) Donations
C) Spread between asset return and cost of funds
D) Tax benefits

3. Which risk arises when a bank borrows short-term and lends long-term?
A) Market Risk
B) Funding Risk
C) Operational Risk
D) Settlement Risk

4. Liquidity risk can be managed by all of the following EXCEPT:

A) Attracting more deposits
B) Borrowing in the money market
C) Defaulting on loans
D) Selling liquid securities

5. What is a secondary reserve?

A) Gold reserves held at the central bank
B) High-yield long-term corporate bonds
C) Liquid, low-risk securities for emergency use
D) Reserve held at foreign branches

6. Which of the following institutions insures commercial bank deposits in the U.S.?
A) NCUSIF
B) OTS
C) FDIC
D) OCC

7. The primary regulator of federally chartered savings and loan associations is:
A) Federal Reserve
B) FDIC
C) Office of Thrift Supervision
D) Comptroller of the Currency

8. Which act allowed S&Ls to expand their investment options in 1982?

A) Glass-Steagall Act
 B) Garn-St. Germain Act
C) Dodd-Frank Act
D) Sarbanes-Oxley Act

9. Which type of bank account pays interest and has no fixed maturity?
A) Time Deposit
B) Demand Deposit
C) Savings Deposit
D) Certificate of Deposit

10. The interest rate for borrowing in the federal funds market is called:
A) Repo rate
B) Discount rate
C) Prime rate
D) Federal funds rate

11. Borrowing from the Fed by pledging securities is done through the:
A) Repo market
B) Discount window
C) Interbank clearing system
D) Basel Committee

12. Tier 1 capital primarily includes:

A) Subordinated debt
B) Preferred stock and reserves
C) Common equity and retained earnings
D) Hybrid instruments and loans

13. Which capital adequacy standard is established under the Basel II framework?
A) Profit-based capital
B) Operational-based capital
C) Risk-based capital
D) Market-capital threshold

14. Which of the following has a 0% risk weight under capital adequacy rules?
A) Municipal Bonds
B) Commercial Loans
C) Residential Mortgages
D) U.S. Treasury Securities

15. Credit unions are insured by which of the following?

A) FDIC
B) CLF
C) NCUSIF
D) NCUA

16. Which institution acts as a lender of last resort to credit unions?

A) Federal Reserve
B) Central Liquidity Facility (CLF)
C) Office of Thrift Supervision
D) Basel Committee
 17. Which best describes a moral hazard in banking?
A) Borrower defaults on loan
B) Managers take excessive risk because deposits are insured
C) Bank fails to meet reserve ratio
D) Banks charge higher interest rates than inflation

18. What caused the S&L crisis in the 1980s?

A) Bank frauds
B) Overregulation
C) Interest rate mismatch from borrowing short and lending long
D) Basel capital violations

19. In a NOW account, a depositor:

A) Cannot withdraw early
B) Does not earn interest
C) Can write checks and earn interest
D) Gets dividend from profits

20. Credit unions require which of the following for membership?

A) Business registration
B) Large minimum deposit
C) Common bond among members
D) Government-issued license

✅ Answer Key

1. B

2. C

3. B

4. C

5. C

6. C

7. C

8. B

9. C

10. D

11. B

12. C

13. C

14. D

15. C
 16. B

17. B

18. C

19. C

20. C

Chapter 4 – Insurance Companies (Detailed Notes)

1. What Is an Insurance Company?

An insurance company is a risk bearer. It agrees to cover fortuitous risks (unexpected losses) in
return for a premium paid by the insured.

🔍 Underwriting:

The process of evaluating risk to decide:

 Whether to insure

 At what premium

💰 2. Sources of Income for Insurance Companies

1. Underwriting Profit:

o When premiums > (claims + operating expenses).

o Can also be a loss if expenses exceed premiums.

2. Investment Income:

o Collected before claims are paid, premiums are invested.

o Key source of profit, especially for long-term policies.

🏥 3. Types of Insurance Products

Type What It Covers Example

Death risk; pays lump sum or periodic

Life Insurance ₹50 lakh term insurance
income

Mediclaim for
Health Insurance Medical costs (partial/full)
hospitalization
Type What It Covers Example

Property & Casualty Physical loss/damage (auto, home) Car insurance

Legal liabilities and lawsuit-related

Liability Insurance Business liability cover
costs

Disability Insurance Income loss from illness or injury Income protection policy

Ongoing medical/nursing care in old

Long-Term Care Senior citizen care plans
age

Court-ordered periodic
Structured Settlements Spread lawsuit payments over time
payouts

GIC (Guaranteed Investment

Fixed return investment from insurer Like a zero-coupon bond
Contract)

Provides structured income post- Monthly pension-like

Annuities
retirement payments

🏦 4. Types of Insurance Companies

Type Description

Life & Health Specialize in life and medical coverage

P&C Insurers Focus on auto, home, casualty, and liability coverage

Multiline Offer both life/health and P&C products

Monoline Only offer financial guarantees, e.g., on municipal bonds or securities

📊 5. Fundamentals of Insurance Industry

 Uncertain Liabilities: Don’t know when or how much will be paid out (e.g., death,
hurricanes).

 Requires long-term portfolio management.

 Must hold sufficient reserves to cover unexpected future claims.

6. Regulation of Insurance Companies

 Governed by state laws under the McCarran-Ferguson Act (1945).

 Model laws proposed by NAIC (National Association of Insurance Commissioners).

 Surplus = Assets – Liabilities (statutory surplus)

→ Used as a cushion to protect policyholders.
7. Deregulation of the Insurance Industry

Law Impact

Glass-Steagall Act (1933) Separated banks, insurers, and investment firms

Gramm-Leach-Bliley Act (1999) Repealed separation → allowed financial holding companies

🏦 Example:

 Citigroup merged Citibank + Salomon Smith Barney + Travelers Insurance

💼 8. Structure of an Insurance Company

1. Home Office – Product design and guarantee issuer

2. Investment Unit – Manages premiums and investments

3. Distribution Network – Markets and sells policies

Today, bankassurance (banks selling insurance products) is common.

🔁 9. Reinsurance

 A way for insurers to transfer part of their risk to another insurance company.

 Helps spread risks and protect against large losses.

💡 10. Types of Life Insurance Policies

Type Description & Features

Term Insurance Pure protection, fixed term, no cash value

Whole Life (Permanent) Includes insurance + investment/cash value, tax-free buildup

Guaranteed Cash Value Guaranteed returns based on general account

Participating Receives dividends based on insurer’s profits

Variable Life Investment options chosen by policyholder, value varies with markets

Universal Life Flexible premiums, unbundled structure (term + investment)

Survivorship (Second-to-Die) Pays out after second person dies in joint policy

💸 11. Taxation of Life Insurance

 Inside buildup (growth of cash value) is not taxed.

 Death benefits are tax-free to beneficiary.

  Estate tax may apply depending on structure.

🧾 12. Investment Accounts

Type Description

General Account Managed by insurer, guaranteed returns, used for most products

Separate Account Linked to market performance, no guarantees, e.g., variable life

Participating policies benefit if the general account performs well.

💼 13. Insurance Investment Strategies

 Investments must match liabilities (payout timing and type).

 Focus on:

o Corporate bonds

o Commercial loans

o Private placements

 Avoid municipal bonds (already tax-exempt).

Life insurers are among the largest investors in corporate debt.

🧠 Key Terms Summary

Term Meaning

Underwriting Risk assessment and pricing of policies

Statutory Surplus Assets – Liabilities (used to meet future claims)

Demutualization Converting from mutual to stock insurance company

Bankassurance Distribution of insurance via banking channels

Reinsurance Insurers transfer risk to other insurers for a fee

GIC Insurer-issued investment with guaranteed return

Inside Buildup Tax-free investment growth within a life policy

📘 MCQs – Chapter 4: Insurance Companies

1. What is the primary function of an insurance company?
A) To manage mutual funds
B) To underwrite bonds
C) To bear fortuitous risk in exchange for premiums
D) To guarantee government securities

2. Which of the following is NOT a source of income for insurance companies?

A) Underwriting profit
B) Investment income
C) Policyholder loans
D) Premium payments

3. Which type of insurance protects against damage to physical assets like a house or car?
A) Health insurance
B) Property & Casualty insurance
C) Liability insurance
D) Disability insurance

4. Guaranteed Investment Contracts (GICs) are most similar to which financial instrument?
A) Equity shares
B) Mutual fund units
C) Zero-coupon bonds
D) Floating rate notes

5. Which of the following describes a variable life insurance policy?

A) Fixed benefit with guaranteed premium
B) Cash value grows with insurer’s general portfolio
C) Returns depend on investment accounts selected by policyholder
D) Pays only after both spouses die

6. Inside buildup in a life insurance policy refers to:

A) The accumulation of unpaid premiums
B) The untaxed investment growth within the policy
C) The increase in death benefits with age
D) Reinvested dividends

7. Which act repealed the separation of banking and insurance businesses in the U.S.?
A) Glass-Steagall Act
B) Dodd-Frank Act
C) McCarran-Ferguson Act
D) Gramm-Leach-Bliley Act

8. Reinsurance involves:
A) Selling policies directly to corporations
B) Insurance companies insuring other insurers' risk
C) Banks distributing insurance policies
D) Issuing structured settlements

9. What is demutualization in the insurance industry?

A) Splitting an insurance firm into subsidiaries
B) Converting from stock to mutual ownership
 C) Converting from mutual to stock ownership
D) Merging investment and banking services

10. Which of the following is a monoline insurance product?

A) Term insurance
B) Liability insurance
C) Municipal bond guarantee
D) Annuity with cash value

11. Which insurance company department is responsible for creating policies and guarantees?
A) Reinsurance division
B) Investment arm
C) Home office
D) Distribution network

12. Statutory surplus refers to:

A) Profits declared to shareholders
B) Total premium income minus losses
C) Excess of assets over liabilities, regulated by states
D) Unclaimed death benefits

13. Which insurance product provides periodic income payments after retirement?
A) Term life insurance
B) Structured settlement
C) Annuity
D) Long-term care insurance

14. Which of the following is NOT regulated primarily at the state level in the U.S.?
A) Insurance companies
B) Credit unions
C) Banks
D) Life insurance policies

15. Which of these life insurance policies allows flexible premiums and separates the insurance
and investment parts?
A) Whole life insurance
B) Term insurance
C) Universal life insurance
D) Variable life insurance

✅ Answer Key

1. C

2. C

3. B

4. C

5. C
 6. B

7. D

8. B

9. C

10. C

11. C

12. C

13. C

14. C

15. C

CHAPTER 5: ASSET MANAGEMENT FIRMS – Detailed Notes with Examples

🏢 1. What Are Asset Management Firms?

Definition:
Asset management firms (also called money management or fund management firms) manage
investment portfolios for:

 Individuals

 Businesses

 Endowments

 Governments

💼 2. Revenue Model

 Management Fees: Based on Assets Under Management (AUM).

 Performance-Based Fees: Becoming more common, especially in hedge funds.

🔸 Example: If AUM = ₹100 crore, and management fee is 1%, the firm earns ₹1 crore/year.

🏦 3. Types of Investment Companies

a. Mutual Funds (Open-End Funds)

 Sell shares directly and redeem shares on demand.

 Priced at Net Asset Value (NAV).

  NAV Formula:

NAV=Market Value of Portfolio – LiabilitiesNumber of Shares Outstanding\text{NAV} = \frac{\

text{Market Value of Portfolio – Liabilities}}{\text{Number of Shares
Outstanding}}NAV=Number of Shares OutstandingMarket Value of Portfolio – Liabilities

🔸 Example:
Total assets = ₹10,50,000
Liabilities = ₹50,000
Shares = 10,000
NAV = ₹100/share

b. Closed-End Funds

 Issue a fixed number of shares traded on exchanges.

 Market price ≠ NAV (can trade at a discount/premium).

🔸 Example: A fund with ₹100 NAV might trade at ₹90 or ₹110 depending on market demand.

c. Unit Trusts

 Fixed portfolio (usually bonds)

 No active management

 Has a fixed termination date

💰 4. Mutual Fund Costs

a. Sales Charges (Loads)

 Front-End Load: Charged at time of purchase.

 Back-End Load: Charged at time of redemption.

 Level Load: Ongoing fee every year.

 No-Load Funds: No sales charges.

🔸 Example: A 5% front-end load on ₹1 lakh investment means ₹95,000 is invested.

b. Annual Operating Expenses (Expense Ratio)

 Includes:

o Investment advisory fee

o 12b-1 fee (distribution)

o Custody & accounting fees

🎯 5. Economic Motivation – Why Investors Use Funds

Mutual funds offer:

1. Diversification

2. Low transaction costs

3. Professional management

4. Liquidity

5. Variety of strategies

6. Payment mechanism

🧭 6. Types of Funds by Investment Objective

Fund Type Focus

Stock Funds Equity investments

Bond Funds Fixed-income securities

Aggressive Growth High return, high risk

Income Funds Focus on regular dividend income

Fund of Funds Invests in other mutual funds

Index (Passive) Funds Replicate a market index (e.g. Nifty)

Active Funds Try to outperform a benchmark

7. Family of Funds

 A single company offers multiple mutual funds.

 Allows free or low-cost shifting between funds.

🔸 Example: HDFC Mutual Fund offers equity, hybrid, and debt funds under one umbrella.

💸 8. Taxation of Mutual Funds

 If a fund distributes ≥ 90% of income, it qualifies as a Regulated Investment Company (RIC).

 Shareholders pay tax on:

o Dividends

o Capital gains distributions

⚠️Investors may be taxed even if they buy just before a capital gains distribution.
📜 9. Fund Regulation

Act Purpose

Securities Act (1933) Requires disclosure to investors

Securities Exchange Act (1934) Governs secondary trading

Investment Company Act (1940) Regulates fund operations; mandates 90% income distribution

🔁 10. Exchange-Traded Funds (ETFs)

 Traded like stocks (intra-day trading possible)

 No need to sell portfolio for redemptions → tax efficiency

 Price set by supply-demand

🔸 Example: Nifty ETF trades during the day, unlike a mutual fund which settles once daily.

🧳 11. Separately Managed Accounts (SMAs)

 Customized portfolio for a high-net-worth individual

 Unlike mutual funds, SMAs are personalized.

🧠 12. Hedge Funds

✅ Key Traits:

1. Not necessarily hedging – can take high risk.

2. Use advanced strategies: short selling, leverage, arbitrage.

3. Seek absolute returns (not just beating benchmarks).

4. Fees: Fixed % AUM + % of profit.

🧩 Types of Hedge Funds:

Type Description

Market Directional Exposed to general market trends (systematic risk)

Corporate Restructuring Invest in M&As, bankruptcies (e.g., merger arbitrage)

Convergence Trading Profit from expected “price corrections” (risk arbitrage)

Opportunistic Broadest scope, bets across markets

⚠️13. Risks with Hedge Funds

 Can cause market instability.

 Example: Collapse of Long-Term Capital Management (1998) and Bear Stearns hedge funds
(2007).

👥 14. Pension Funds

Definition:

Plans to provide retirement income, typically set up by employers (plan sponsors).

✅ Types of Plans:

1. Defined Benefit Plan:

o Guarantees retirement payout based on salary & tenure.

o Risk borne by employer.

o May be insured by PBGC.

2. Defined Contribution Plan:

o Employer contributes a fixed amount (e.g., 401(k)).

o Retirement corpus = investment performance.

o Risk borne by employee.

3. Hybrid Plans:

o Combine features of both.

4. Cash Balance Plan:

o A DB plan with account balance features.

⚖️15. Regulation of Pension Funds

Law/Agency Purpose

ERISA (1974) Minimum funding & vesting rules; fiduciary responsibility

PBGC (Pension Benefit Guaranty Corp) Insures vested benefits under DB plans

📉 16. Pension Fund Crisis (2000s)

Causes:

 Poor asset-liability matching

 Falling interest rates → lower discount rate → increased liabilities

  Stock market declines → asset value fell

Solution: Pension Protection Act (2006) and Pension Funding Equity Act (2004)

📏 17. Important Concepts

Term Explanation

Funding Ratio Assets ÷ Liabilities (financial health)

"Prudent Man" Rule Fiduciaries must invest responsibly and knowledgeably

Arbitrage Risk-free profit strategy (though hedge funds often use risk arbitrage)

🧮 Example: NAV Calculation

 Total assets = ₹1,050,000

 Liabilities = ₹50,000

 Shares = 10,000

NAV=(10,50,000−50,000)10,000=₹100 per share\text{NAV} = \frac{(10,50,000 - 50,000)}{10,000} =

₹100 \text{ per share}NAV=10,000(10,50,000−50,000)=₹100 per share

CAR and NAV Calculations - Detailed Explanation

Capital Adequacy Ratio (CAR) Calculation

What is CAR?

Capital Adequacy Ratio (CAR) is a crucial financial metric that measures a bank's capital in relation to
its risk-weighted assets. It ensures banks have sufficient capital to absorb potential losses while
continuing operations.

Formula:

CAR = Capital / Risk Weighted Assets (RWA) = (Tier 1 + Tier 2) / RWA

Components:

 Tier 1 Capital: Core capital (common equity, retained earnings)

 Tier 2 Capital: Supplementary capital (subordinated debt, loan loss reserves)

 Risk Weighted Assets: Assets weighted according to their risk levels

Example from Document:

Bank's Portfolio:

 Equity: $1,200

 Debt: $2,500
  Government securities: $400

 Corporate bonds: $5,000

 Municipal revenue bonds: $5,000

 Municipal general bonds: $10,000

Step 1: Calculate Total Capital

 Total Capital = Tier 1 + Tier 2 = $1,200 + $1,200 = $2,400

 (Note: The document shows equity of $1,200, and we can infer Tier 2 is also $1,200 to reach
the total of $2,400)

Step 2: Calculate Risk Weighted Assets Different assets carry different risk weights:

 Government securities: 0% risk weight = $400 × 0% = $0

 Corporate bonds: 100% risk weight = $5,000 × 100% = $5,000

 Municipal revenue bonds: 50% risk weight = $5,000 × 50% = $2,500

 Municipal general bonds: 20% risk weight = $10,000 × 20% = $2,000

Total RWA = $0 + $5,000 + $2,500 + $2,000 = $9,500

Step 3: Calculate CAR CAR = $2,400 / $9,500 = 25.2%

Why CAR is Important:

 Measures bank's financial strength and stability

 Regulatory requirement (minimum CAR typically 8-12%)

 Higher CAR indicates better ability to absorb losses

 Most important ratio for financial service companies as it directly relates to solvency

Net Asset Value (NAV) Calculation

What is NAV?

Net Asset Value represents the per-unit market value of a mutual fund or investment company. It's
calculated daily at market close.

Formula:

NAV = [(Market value of portfolio) - (Liabilities)] / (Number of shares/units outstanding)

Example from Document:

Mutual Fund Details:

 Total units outstanding: 10 million

 Market value of portfolio: $215 million

 Total liabilities: $15 million

Step 1: Calculate Net Assets Net Assets = Market value of portfolio - Liabilities Net Assets = $215
million - $15 million = $200 million

Step 2: Calculate NAV per unit NAV = $200 million / 10 million units = $20 per unit

Key Points about NAV:

 Calculated daily at market close

 Represents the price at which investors can buy/sell mutual fund units

 Fluctuates based on underlying asset performance

 Used for both purchases and redemptions in open-end funds

NAV vs Market Price:

 Open-end funds: Trade at NAV

 Closed-end funds: Can trade at premium or discount to NAV

 ETFs: Market price may vary slightly from NAV during trading hours

Practical Applications

For Banks (CAR):

 Regulatory compliance monitoring

 Risk management assessment

 Capital planning decisions

 Investor confidence indicator

For Mutual Funds (NAV):

 Daily pricing mechanism

 Performance tracking

 Investment decision making

 Portfolio valuation

Regulatory Context:

 CAR: Governed by Basel Committee guidelines (Basel I, II, III)

 NAV: Regulated by securities commissions (SEC in US, SEBI in India)

Both ratios are fundamental to financial analysis and regulatory compliance in their respective
sectors.
Global Capital Markets - MCQ Questions (Chapters 1-7)
Instructions:

Choose the best answer for each question. Answers are provided at the end.

1. According to the fundamental principle of valuation, the value of any financial asset is: a) The
sum of all future cash flows b) The present value of expected cash flows c) The average of past cash
flows d) The nominal value of the asset

2. Which of the following is NOT a property of financial assets? a) Moneyness b) Divisibility c)

Physical durability d) Liquidity

3. Financial markets reduce which of the following costs? a) Search costs and information costs b)
Production costs only c) Marketing costs only d) Transportation costs only

4. Money market deals with financial assets having maturity: a) Less than 6 months b) Less than 1
year c) Between 1-5 years d) More than 5 years

5. Which Government-Sponsored Enterprise was established first? a) Fannie Mae (1938) b) Freddie
Mac (1970) c) Federal Farm Credit Banks (1916) d) Sallie Mae (1972)

6. The primary market is where: a) Old securities are traded b) Government bonds are exclusively
sold c) Newly issued financial assets are sold d) International currencies are exchanged

7. Type I Liabilities are characterized by: a) Unknown amount and timing b) Known amount and
timing c) Known amount, unknown timing d) Unknown amount, known timing

8. What does ALM stand for in banking? a) Asset Liability Management b) Advanced Liquidity
Mechanism c) Automated Loan Management d) Asset Leverage Management

9. The formula for Net Interest Margin (NIM) is: a) (Interest Income + Interest Expense) / Assets b)
(Interest Income - Interest Expense) / Assets c) Interest Income / Interest Expense d) Assets /
(Interest Income - Interest Expense)

10. Which factor does NOT influence globalization of financial markets? a) Technology b)
Liberalization c) Integration d) Domestic regulation

11. Intangible assets represent: a) Physical properties with inherent value b) Legal claims to future
benefits c) Current market valuations d) Historical cost basis

12. What is the current FDIC insurance coverage limit per depositor? a) $100,000 b) $150,000 c)
$200,000 d) $250,000

13. Emerging markets are characterized by all EXCEPT: a) Economies in transition b) Implementing
political and economic reforms c) Stable currency values d) Short operational period for financial
markets

14. Which of the following is NOT a component of Basel II Framework's three pillars? a) Minimum
capital requirements b) Supervisory review c) Market discipline d) Liquidity management
15. Financial intermediaries provide which type of intermediation? a) Maturity intermediation only
b) Risk reduction intermediation only c) All of the above: maturity, risk reduction, denomination, and
information d) Denomination intermediation only

16. Capital Adequacy Ratio (CAR) is calculated as: a) Tier 1 Capital / Total Assets b) (Tier 1 + Tier 2) /
Risk Weighted Assets c) Total Capital / Total Deposits d) Equity / Total Liabilities

17. Three reasons why cash flow of debt instruments is uncertain include all EXCEPT: a) Issuer
might default b) Call/Put provisions c) Floating rate features d) Market liquidity conditions

18. In the given example, if a bank has capital of $2,400 and RWA of $9,500, the CAR is: a) 24.2% b)
25.2% c) 26.2% d) 27.2%

19. Which is NOT a form of federal government regulation? a) Disclosure Regulation b) Financial
Activity Regulation c) Market Price Regulation d) Foreign Participant Regulation

20. IORB Rate refers to: a) Interest rate on retail banking b) International overnight borrowing rate c)
Interest rate banks get on reserves deposited with the FED d) Inter-bank offering rate benchmark

21. Risk-management instruments include: a) Forwards, Futures, Options b) Credit cards and loans
c) Savings accounts d) Government bonds only

22. Which act removed anti-affiliation restrictions between commercial banks, investment banks,
and insurance companies? a) Glass-Steagall Act 1933 b) Gramm-Leach-Bliley Act 1999 c) McCarran
Ferguson Act 1945 d) Garn-St. Germain Act 1982

23. Securitization primarily involves: a) Making investments more secure b) Converting illiquid
assets into liquid assets c) Government backing of all securities d) Eliminating all investment risks

24. The primary source of income for insurance companies is: a) Investment income only b)
Premiums only c) Both premiums and investment income d) Regulatory subsidies

25. Internal credit enhancement techniques include all EXCEPT: a) Trenching b) Over
Collateralization c) Insurance d) Excess Spread

26. What type of life insurance provides coverage for a specific period and has no cash value? a)
Universal Life b) Variable Life c) Term Life d) Whole Life

27. Investors go to secondary markets primarily for: a) Tax benefits only b) Meeting liquidity needs
and information c) Government subsidies d) Avoiding regulations

28. Net Asset Value (NAV) is calculated as: a) Total Assets / Number of Units b) (Market Value -
Liabilities) / Outstanding Units c) Market Value / Total Liabilities d) Total Income / Number of
Investors

29. Type IV Liabilities have: a) Known amount and timing b) Known amount, unknown timing c)
Unknown amount, known timing d) Unknown amount and timing

30. If a mutual fund has 10 million units, portfolio value of $215 million, and liabilities of $15
million, the NAV is: a) $18 b) $20 c) $21.5 d) $22

31. Market-broadening instruments include: a) Smaller contract size in derivatives b) Credit

derivatives only c) Government bonds only d) Insurance policies
32. Which type of fund seeks to mimic market indexes? a) Active Funds b) Passive (Index) Funds c)
Hedge Funds d) Money Market Funds

33. Which debt instrument characteristic refers to "residual claim"? a) Debt instrument b) Equity
claim c) Fixed income security d) Money market instrument

34. The main difference between open-end and closed-end funds is: a) Investment strategy b)
Management fees c) Number of shares and redemption policy d) Regulatory requirements

35. External credit enhancement does NOT include: a) Insurance b) Third party surety c) Cash
Reserve d) Guarantee from external agency

36. What is the typical underwriting fee range for investment banking services? a) 2.5% - 4% b)
4.5% - 7% c) 7% - 10% d) 10% - 15%

37. Which organization was established in 1999? a) Fannie Mae b) Freddie Mac c) National Veteran
Business Development Corporation d) Farmer Mac

38. Which is NOT a type of hedge fund strategy mentioned? a) Market Directional b) Corporate
Restructuring c) Convergence Trading d) Government Bond Trading

39. Financial innovation is motivated by all EXCEPT: a) Increased volatility of interest rates b)
Advances in technology c) Reduced competition d) Changing global patterns of wealth

40. In a defined benefit pension plan: a) Employee bears investment risk b) Employer guarantees
specific retirement payments c) Contributions are fixed but benefits vary d) No employer
contributions are required

Answer Key:

1. b) The present value of expected cash flows

2. c) Physical durability

3. a) Search costs and information costs

4. b) Less than 1 year

5. c) Federal Farm Credit Banks (1916)

6. c) Newly issued financial assets are sold

7. b) Known amount and timing

8. a) Asset Liability Management

9. b) (Interest Income - Interest Expense) / Assets

10. d) Domestic regulation

11. b) Legal claims to future benefits

12. d) $250,000

13. c) Stable currency values

14. d) Liquidity management

15. c) All of the above: maturity, risk reduction, denomination, and information

16. b) (Tier 1 + Tier 2) / Risk Weighted Assets

17. d) Market liquidity conditions

18. b) 25.2%

19. c) Market Price Regulation

20. c) Interest rate banks get on reserves deposited with the FED

21. a) Forwards, Futures, Options

22. b) Gramm-Leach-Bliley Act 1999

23. b) Converting illiquid assets into liquid assets

24. c) Both premiums and investment income

25. c) Insurance

26. c) Term Life

27. b) Meeting liquidity needs and information

28. b) (Market Value - Liabilities) / Outstanding Units

29. d) Unknown amount and timing

30. b) $20

31. a) Smaller contract size in derivatives

32. b) Passive (Index) Funds

33. b) Equity claim

34. c) Number of shares and redemption policy

35. c) Cash Reserve

36. b) 4.5% - 7%

37. c) National Veteran Business Development Corporation

38. d) Government Bond Trading

39. c) Reduced competition

40. b) Employer guarantees specific retirement payments