Macroeconomic Policy

Macroeconomic policy refers to the strategies and measures adopted by a government to

regulate and stabilize a country's overall economic performance. These policies aim to achieve
macroeconomic goals like economic growth, price stability, full employment, and a healthy
balance of payments.

Macroeconomic policy is broadly divided into two types:

Fiscal Policy
Fiscal policy involves the use of government spending and taxation to influence the economy. It
is managed by the government.
Example:
During a recession, the government may:
Increase spending on infrastructure projects like roads, schools, and hospitals to create jobs and
boost demand in the economy.
Reduce taxes to increase disposable income, encouraging individuals and businesses to spend
and invest more.

Monetary Policy
Monetary policy involves the regulation of money supply and interest rates by a country’s
central bank (E.g. RBI) to control inflation and stabilize the currency.
Example:
During high inflation, the central bank may:
Increase interest rates: Higher borrowing costs discourage businesses and consumers from
taking loans, reducing overall demand and slowing down inflation.
Reduce money supply: The central bank might sell government bonds to absorb excess cash
from the economy.

Monetary Policy
Tools to Control Money Supply
Central banks use various tools to directly control the supply of money in an economy. These are
discussed below:

1. Open Market Operations (OMO)

The central bank buys or sells government securities (e.g., bonds) in the open market to
influence the money supply.
Selling securities Reduces the money supply as the central bank absorbs funds
from the market.
Buying securities Expands the money supply as the central bank injects funds
into the economy by paying for the securities.
Example:
Suppose there is high inflation in the economy. The central bank decides to sell $1 billion worth
of government securities. Investors and banks purchase these securities, reducing the cash
available for spending and lending. This action slows down inflation by reducing overall demand.

2. Reserve Asset Requirements (Cash Reserve Ratio - CRR)

The central bank sets a minimum percentage of a bank's total deposits that must be held as
reserves and not loaned out. Increasing the CRR reduces the money supply, while decreasing it
increases the money supply.
Example:
If the CRR is raised from 4% to 6%, banks must keep more reserves and will have less money to
lend to businesses and individuals. This contractionary measure helps control inflation by
reducing liquidity in the market.

3. Special Deposits
The central bank may require commercial banks to make special deposits with the central bank
to reduce their lending capacity. This directly reduces the money banks can lend, thereby
contracting the money supply.
Example:
If the central bank asks commercial banks to deposit an additional $500 million as a special
deposit, the funds available for loans and investment decrease. This measure is often used
during times of excess liquidity to prevent overheating of the economy.

Problems of Monetary Policy

Time Lag in Monetary policies, such as interest rate adjustments by central banks, take
Implementation time to affect the economy.
Example:
If RBI lowers interest rates to boost investment and spending, it may take
months before businesses increase investments and consumers spend more.
Ineffectiveness of In a globalized economy, businesses and individuals can access credit from
Credit Control international sources, reducing the effectiveness of domestic credit policies.

Unstable The effect of interest rates on investment and spending is unpredictable due
Relationship to other influencing factors like market confidence and geopolitical events.
Between Interest
Rates and Example:
Economic Even if the European Central Bank reduces interest rates to encourage
Activities spending, individuals may still hesitate due to political instability .

Negative Effects of 1. Higher interest rates increase borrowing costs, discouraging businesses
Increasing Interest from expanding.
Rates
2. Higher interest rates make borrowing expensive, reducing corporate
profits and lowering stock prices.
3. Higher interest costs mean consumers spend less on housing, cars, and
other goods.

Fiscal Policy
The Keynesian approach to fiscal policy is based on the ideas of economist JM Keynes, who
argued that government intervention is necessary to stabilize the economy. According to
Keynesians, the government can use fiscal policy tools—public spending and taxation—to
regulate economic demand and prevent extreme fluctuations in growth, unemployment, and
inflation.

Keynesian Fiscal Policy in a Recession

When an economy is in a recession, there is low demand for goods and services, leading to high
unemployment and slow economic growth. Keynesians believe that the government should step
in to stimulate demand by increasing spending or reducing taxes.
Example:
The government decides to increase spending by launching a large road construction project.
This project creates jobs for thousands of workers who now have more money to spend on
goods and services.
As people spend more, businesses see increased demand, leading them to hire more workers
and produce more goods.
As a result, the economy recovers from the recession.

Challenges:
Budget Deficit More government spending means higher borrowing, leading to increased
national debt.
Inefficiency Government funds may be misallocated to inefficient industries, wasting
resources.

Keynesian Fiscal Policy in an Overheating Economy

If an economy is overheating, it means that demand is too high, leading to inflation. To control
inflation, the government can reduce spending or increase taxes to slow down demand.
Example:
The government decides to cut back on infrastructure projects, reducing public sector
employment and demand.
Additionally, the government raises income taxes, reducing people's disposable income.
With less money to spend, demand falls, and inflation slows down.

Challenges:
Cutting Reducing spending on sectors like healthcare and education is politically
Government challenging.
Spending is
Difficult

Higher Taxes May Increasing taxes discourages businesses from investing in expansion and
Reduce innovation.
Investment

Supply Side Policy

Supply-side policies are strategies aimed at increasing the productive capacity of an economy by
improving the efficiency and competitiveness of markets, enhancing labour productivity, and
fostering long-term economic growth. These policies focus on influencing the supply-side factors
of production—labour, capital, and technology—rather than directly targeting demand in the
economy.

Example:
Germany invests heavily in vocational training programs (the dual education system) to create a
highly skilled workforce, contributing to its manufacturing competitiveness.

Exchange Rate Policy

Exchange rate policy refers to how governments manage their currency concerning foreign
currencies. It is closely tied to monetary policy.
Reasons for controlling exchange rates
1. Rectify trade deficit
Lower exchange rates to make exports cheaper and more competitive. This can counter higher
inflation.
Example:
India imports more goods than it exports. This trade imbalance leads to a higher demand for
foreign currency (like the U.S. dollar). To address this, RBI might allow depreciation of the Indian
Rupee. This makes Indian goods cheaper in foreign markets, stimulating exports.
₹/$
4/1/2024 80
12/1/2024 85
TATA Car is priced at ₹ 5,00,000. A US customer will need
$
4/1/2024 6,250
12/1/2024 5,882
This will increase the demand of TATA Car among US customers, thereby increasing exports.

2. Prevent Trade Surplus

A trade surplus occurs when a country's exports exceed its imports.
While a trade surplus can initially seem positive (as it brings in more foreign currency), it can lead
to economic challenges:
Currency Appreciation: High demand for the country's goods means more foreigners
need its currency to pay for those exports. This pushes up the
currency's value.
Reduced Exports: As the currency appreciates, the country’s goods and services
become more expensive in international markets, potentially
reducing future exports.
Raise exchange rates moderately to make imports cheaper, thus reducing export surpluses.
Example:
India exports more goods than it imports. This trade imbalance leads to a higher demand for
home currency (i.e. Indian rupee). To address this, RBI might allow moderate appreciation of the
Indian Rupee. This makes foreign goods cheaper in Indian markets, stimulating imports.
₹/$
4/1/2024 80
12/1/2024 78
Ford Car is priced at $8,000. An Indian customer will need
₹
4/1/2024 640,000
12/1/2024 624,000
This will increase the demand of Ford Car among Indian customers, thereby increasing imports.

3. Stabilize exchange rate

Maintain stability to reduce risks, boost investor confidence, and facilitate trade.
Example:
Countries like Japan often intervene to stabilize the Yen to ensure steady trade relations and
reduce exchange rate volatility risks for businesses.

Types of Exchange Rates

1. Floating Exchange Rate
A floating exchange rate allows the value of the currency to be determined entirely by market
forces of supply and demand without government intervention.
Example:
USD operates under a floating exchange rate. If U.S. exports increase due to demand, the dollar
appreciates because foreign buyers need more USD to pay for goods.
USD operates under a floating exchange rate. If U.S. exports increase due to demand, the dollar
appreciates because foreign buyers need more USD to pay for goods.

2. Fixed Exchange Rate

A fixed exchange rate pegs the currency's value to another currency (e.g., USD). The central
bank intervenes to preserve the exchange rate by controlling supply and demand.
Example:
Saudi Arabia's Riyal is fixed to the USD at a rate of 3.75 SAR = 1 USD. The central bank maintains
this rate by holding significant reserves of USD and intervening when market forces threaten to
destabilize the peg.
Pegging local currencies to the USD simplifies transaction for oil-exporting countries (like Saudi
Arabia, Kuwait, Oman & Qatar), as oil is priced in USD globally.

3. Crawling Peg
A crawling peg allows the currency to fluctuate within a narrow band around a pre-determined
target rate.
Example:
Brazil’s central bank sets a crawling peg for the Real (BRL) to USD with slight periodic
adjustments to manage inflation.

Inflation
Inflation refers to increase in the general level of prices in the economy.
It is measured using the Consumer Price Index (CPI), which tracks the average price change of a
fixed basket of goods and services over time.

Note: How CPI works

1. A fixed set of goods and services (e.g., food, housing, transportation, healthcare) is selected.
2. Prices of these items are recorded periodically.
3. The percentage change in these prices over time represents the inflation rate.

Example:
Imagine a basic basket of goods containing:
$
Rice 10
Milk 5
Electricity Bill 20
Bus Fare 15
Total Cost Last Year 50
Total Cost This Year 55
CPI 110%
This means prices have increased by 10% over the year.

Causes of inflation
Demand-Pull This occurs when demand for goods and services exceeds the economy's
Inflation ability to produce them. This increased demand “pulls” prices upward.
Example:
Imagine a booming economy where people have more money to spend. If
everyone suddenly wants to buy new cars but the production capacity is
limited, car prices will rise due to high demand. This is demand-pull inflation.
Cost-Push Inflation This happens when the cost of production (e.g., raw materials, wages)
increases, leading businesses to pass these higher costs to consumers by
raising prices.
Example:
If the price of crude oil increases significantly, fuel prices will rise. Since
transportation costs increase, companies will raise the prices of goods to
compensate for higher delivery costs. This leads to cost-push inflation.

General Economic Consequences of Inflation

Redistribution of Inflation benefits those who own assets (e.g., landlords, businesses) but
Income harms those on fixed incomes (e.g., pensioners, low-wage workers).
Example:
A retired person receives a fixed pension of $1,000 per month. If inflation is
10%, their purchasing power decreases because their pension does not
increase.
Disincentive to High inflation erodes the real value of money, discouraging savings.
Save Example:
You save $10,000 in a bank at 3% interest, but inflation is 8%. Your real
return is -5%, meaning your savings lose value over time.
Money Loses Its If inflation is extreme (hyperinflation), money may become worthless.
Function Example:
In Zimbabwe (2008), inflation was so high that prices doubled every few
hours, making money useless.
https://www.youtube.com/watch?v=5Wq0yv73NpY
Exchange Rate High inflation reduces the value of a country’s currency compared to others.
Depreciation Example:
If US inflation is 10% while Japan’s is 2%, the US dollar may weaken against
the Japanese yen, making imports more expensive.
Higher Interest To control inflation, central banks raise interest rates, making borrowing
Rates more expensive.
Example:
If home loan rate rises from 4% to 7%, homeowners pay higher monthly
payments, reducing spending power.

Consequences of Inflation for Businesses

Reduced High inflation makes future costs unpredictable, discouraging new
Entrepreneurial businesses.
Example:
Activity
A startup plans to invest $100,000 in machinery, but inflation raises costs by
20%, making the investment unaffordable.
Loss of If domestic prices rise faster than foreign competitors, exports become
International expensive.
Competitiveness
Example:
If US-made cars increase in price by 15% due to inflation, but German cars
only rise 5%, global buyers may prefer German cars.
Reduced High interest rates make loans expensive, reducing investment in growth.
Investment Example:
A business wants to build a new factory, but loan rates increase from 5% to
9%, making expansion too costly.
Higher Operating Inflation forces businesses to constantly adjust prices and search for cheaper
Costs suppliers.
Example:
A restaurant must frequently change menu prices and find lower-cost
ingredients to maintain profits.
Problems with Inflation distorts financial statements, making assets appear undervalued and
Historical Cost profits overstated.
Accounting
Example:
A company bought land 10 years ago for $100,000, but due to inflation, its
real value is now $500,000. However, accounting records still show the old
cost, making the company's assets seem less valuable than they are.

Government Intervention
Governments intervene in the free market.
Reasons for Government Intervention
Controlling When a single company dominates an industry, it can charge high prices and
Monopolies and reduce choices for consumers.
Restrictive
Practices Example:
If one internet provider controls the entire market, it may increase prices
unfairly. Governments may intervene by breaking up monopolies or
regulating prices.
Protecting Some industries are crucial for a nation's security and economy.
National Strategic Example:
Industries
The government may subsidize agriculture to ensure food security.

Addressing Social The free market may lead to income inequality and poverty.
Injustice Example:
Without government intervention, some people might not afford basic
healthcare or education. Governments may introduce minimum wage laws,
social welfare programs, or free public education.
Managing Companies may create negative externalities, harming society.
Externalities Example:
A factory pollutes a river, affecting local residents. The government may
impose pollution taxes or environmental regulations.
Providing Public Some essential services (e.g., healthcare, education, police, roads) are not
Goods profitable for private businesses, so governments provide them.
Example:
Public schools ensure that all children get an education, even if they can't
afford private schooling.
Funding Large Some projects (bridges, highways, railways, tunnels) require huge
Infrastructure investments that private businesses cannot afford alone.
Projects
Example:
The government builds a high-speed rail system because it benefits the
entire economy, even though private companies wouldn’t invest due to high
costs.
Privatisation
Privatisation refers to the transfer of ownership, management, or control of government-owned
enterprises to the private sector.
Example:
Air India (2021) The Indian government sold its stake in Air India to Tata Group, citing heavy
financial losses.
Bharat Petroleum The government has planned disinvestment to encourage private
participation in the oil sector.
LIC (2022) The government launched an IPO to sell a part of Life Insurance Corporation
of India (LIC) to the public.

Pros of Privatisation
Increase in After the telecom sector was privatised, companies like Jio, Airtel, and
Competition Vodafone led to better services and lower prices for consumers.
Boost to The sale of Air India to Tata helped reduce government liabilities and
Government generated funds for other projects.
Revenues
Wider Share LIC IPO allowed common citizens to invest in the country's largest insurance
Ownership firm.

Cons of Privatisation
Creation of Private If Adani or Tata dominates sectors like airports or ports, they may control
Monopolies pricing unfairly.

Loss of Economies Splitting BSNL into smaller units may increase operational costs instead of
of Scale reducing them.

Decline in Service Some fear that privatising Indian Railways could lead to higher fares and
Quality reduced accessibility for lower-income passengers.

Green Policies
Governments are increasingly taking active steps to improve the environmental performance of
organisation. Measures include:
Carbon Credits & Governments set limits on greenhouse gas emissions for companies. If a
Trading: company reduces its emissions, it can sell excess carbon credits to others
exceeding their limits.
Example:
A steel factory adopting renewable energy and reducing emissions can sell
carbon credits to another factory struggling to meet its target.
Environmental Governments establish organizations like the UK Environment Agency to
Agencies: enforce sustainability regulations.
Example:
The US Environmental Protection Agency (EPA) regulates emissions and
penalizes companies violating pollution norms.

Sustainability
https://www.youtube.com/watch?v=7V8oFI4GYMY
https://www.youtube.com/watch?v=_5r4loXPyx8

Sustainability refers to the ability to meet present needs without compromising the ability of
future generations to meet their own needs. It focuses on a balance between economic growth,
environmental protection, and social well-being, ensuring that development is enduring and
inclusive.
Sustainability refers to the ability to meet present needs without compromising the ability of
future generations to meet their own needs. It focuses on a balance between economic growth,
environmental protection, and social well-being, ensuring that development is enduring and
inclusive.

Three Pillars of Sustainability

Environmental Protecting natural resources and ecosystems.
Sustainability Reducing pollution and waste.
Promoting renewable energy and sustainable materials.
Economic Ensuring financial viability without exploiting resources unsustainably.
Sustainability Creating jobs and fostering innovation while maintaining long-term
profitability.
Social Promoting equity, social justice, and fair labour practices.
Sustainability Improving living conditions and supporting community well-being.

Example:
A coffee company wants to grow its business while ensuring its operations are sustainable.
Environmental The company sources coffee beans from farms practicing organic farming.
Sustainability It introduces biodegradable coffee packaging to reduce plastic waste.
Implements water-saving techniques in its production processes.
Economic The company invests in its farmers by providing fair trade prices, ensuring
Sustainability farmers earn a sustainable livelihood.
It uses cost-efficient, renewable energy to power its manufacturing plants.
Social The company funds education and healthcare programs for farming
Sustainability communities.
It builds long-term relationships with suppliers, fostering trust and
collaboration.
It encourages diversity and inclusion in its hiring practices.

ESG Framework
ESG stands for Environmental, Social, and Governance, a framework used by organizations and
investors to evaluate a company’s commitment to sustainable and ethical practices. It goes
beyond traditional financial metrics and assesses how a company interacts with the
environment, society, and its internal governance structures. This evaluation helps stakeholders
make informed decisions about investments, partnerships, and operations.

Environmental (E) This dimension focuses on a company’s impact on the natural environment.
It evaluates efforts to reduce carbon footprints, conserve resources, and
manage environmental risks.
https://www.youtube.com/watch?v=0XNuj2wfnCk
Example:
A company like Tesla emphasizes electric vehicles to reduce reliance on fossil
fuels, contributing to lower carbon emissions and environmental
sustainability.
Social (S) This dimension examines how a company manages relationships with
employees, customers, communities, and other stakeholders.
Example:
Unilever has initiatives like improving employee well-being, promoting fair
trade, and sourcing sustainable ingredients for their products, impacting both
local communities and global stakeholders.
Governance (G) Governance addresses the internal systems and controls used to govern an
organization. It ensures transparency, accountability, and ethical decision-
making.
Example:
Microsoft emphasizes ethical AI development and strong corporate
governance policies, ensuring compliance and transparency in decision-
making.

Financial Intermediaries
Financial intermediaries are institutions that facilitate the flow of funds between savers and
borrowers. They play a crucial role in the economy by improving capital allocation, reducing risks,
and providing liquidity.
Commercial Banks These institutions accept deposits from individuals and businesses, and use
these deposits to provide loans.
Example:
State Bank of India (SBI)
Investment Banks They specialize in financial services for companies, such as underwriting
(helping companies issue shares), mergers & acquisitions, & advisory
services.
Example:
Goldman Sachs
Insurance They collect premium payments from policyholders and invest the funds in
Companies long-term assets to generate returns. These funds are later used to pay
claims.
Example:
Life Insurance Corporation of India (LIC)
Mutual Funds These institutions pool money from multiple investors and invest in
diversified portfolio like shares, bonds, and commodities to generate returns.
Example:
HDFC Mutual Fund
Pension Funds These funds collect retirement savings from employees and invest them in
secure, long-term assets to ensure financial security post-retirement.
Example:
Employees’ Provident Fund (EPF)
Finance These are non-banking financial companies (NBFCs) that provide loans,
Companies leasing, and factoring services but do not accept public deposits.
Example:
Bajaj Finance

Role of Financial Intermediaries

Aggregation Financial intermediaries collect small deposits from multiple individuals and
pool them together to provide larger loans.
Example:
A bank accepts savings deposits from thousands of individuals. Each
depositor might save only $500, but the bank can pool these deposits and
lend $1,000,000 to a business for expansion.
Maturity Financial intermediaries convert short-term deposits into long-term loans.
Transformation Example:
A bank might receive deposits from customers that can be withdrawn at any
time (e.g., savings accounts). However, the bank uses these funds to provide
a 10-year home loan.
Maturity
Transformation
A bank might receive deposits from customers that can be withdrawn at any
time (e.g., savings accounts). However, the bank uses these funds to provide
a 10-year home loan.
Risk Diversification By lending to multiple borrowers, financial intermediaries spread the risk of
default.
Example:
A mutual fund invests in a portfolio of stocks and bonds rather than putting
all the money in one company. If one company performs poorly, the losses
are offset by gains in other investments, reducing overall risk.
Liquidity Provision Financial intermediaries provide liquid markets, allowing investors to borrow
and invest easily.
Example:
Banks ensure liquidity by allowing depositors to withdraw money on demand
while still using those deposits to provide loans.
Hedging & Risk Financial intermediaries offer instruments such as options, futures, and
Management swaps to help businesses manage financial risks.

Financial Markets
The financial markets include:
Capital Markets for medium- and long-term capital
Money Markets for short-term capital

The following activities take place in these markets:

Primary Market selling new securities to raise new funds.
activity
Secondary Market trading existing securities.
activity

Money Market
The money market is not a physical market; it is the term used to describe trading between
banks & other financial institutions. Although the money markets principally involve borrowing
and lending by banks, some large companies and the government are engaged in money market
operations.

Money Market Instruments

Interest Bearing Instruments
Interest-bearing instruments provide a fixed interest over a specified period.
Certificate of A CD is a savings product issued by commercial banks. It has a fixed interest
Deposit (CD) rate and a fixed maturity period, which could range from 1 month to 5 years.
It is generally considered a low-risk investment.
Example:
A bank issues a 1-year CD with an interest rate of 4% p.a.
Mr. A invests $ 10,000 in this CD.
At the end of the year, Mr. A receives the principal amount along with:
Interest $ 400
Repurchase Repos are short-term borrowing instruments, often used for overnight loans.
Agreements A seller (borrower) sells securities (like government bonds) to an investor
(Repo) with an agreement to repurchase them at a higher price at a future date.
Example:
A bank needs funds for a short period (say 7 days) and sells government
securities worth $ 10,00,000 to an investor.
Agreements
(Repo)

A bank needs funds for a short period (say 7 days) and sells government
securities worth $ 10,00,000 to an investor.
The agreement states the bank will repurchase the securities for $ 10,01,000
after 7 days.
The investor earns the $ 1,000 as interest for lending the funds for a week.
Municipal Notes These are short-term debt instruments issued by municipalities (local
governments) to raise funds. They are issued in anticipation of future
revenues such as tax receipts.
Example:
A city issues Municipal Notes worth $500,000 to fund the construction of a
new public facility. The notes mature in 6 months, and the repayment is
funded through tax collection in the next tax cycle.

Discount Instruments
Discount instruments are sold at a discount to nominal value and pay no regular interest (zero-
coupon instruments). At maturity, the investor receives the full face value, and the difference
represents the return.
Bill of Exchange A Bill of Exchange acts as an order for the buyer to pay the seller a specified
(BoE) amount at a future date. Bills can be discounted by banks for early cash
conversion.
Example:
A seller ships goods worth $ 10,000 to a buyer.
The buyer accepts a (BoE) promising to pay in 60 days.
The seller needs cash immediately, so he discounts the bill at his bank at 5%.
Discount 82 $. So, amount paid to seller $ 9,918
The bank collects the full amount from the buyer at maturity.
Commercial Paper Commercial Paper is an unsecured short-term debt instrument issued by
companies with high credit ratings to meet short-term funding needs. It
matures in 1 to 270 days and is sold at a discount.
Example:
A large company issues a Commercial Paper with a face value of $1,000
maturing in 3 months.
It is sold to investors at a discounted price of $980.
At maturity, the investor receives the full $1,000, earning a return of $20.
Banker’s A Banker’s Acceptance is a short-term debt instrument guaranteed by a
Acceptance bank. It is commonly used in international trade to provide payment security.
Example:
An exporter ships goods worth $ 50,000 to an importer.
The importer’s bank issues a Banker’s Acceptance maturing in 90 days.
The exporter can hold the acceptance until maturity or discount it with a
bank for immediate cash.
The bank guarantees the payment, making it a low-risk instrument.
Treasury Bills (T- T-Bills are short-term government debt instruments with maturities ranging
Bills) from 3 to 12 months. They are issued at a discount and pay no interest. At
maturity, investors receive the full face value.
T-Bills are considered one of the safest investments because they are backed
by the government.
Example:
Mr. A purchases a Treasury Bill with a face value of $ 1,000 for $ 950
(discounted price).
 Mr. A purchases a Treasury Bill with a face value of $ 1,000 for $ 950
(discounted price).
At maturity (e.g. in 6 months), Mr. A receives the face value $ 1,000, earning
a return of $50.

International Money & Capital Markets

1. Eurocurrency Markets
Eurocurrency markets refer to international money markets where currencies are held and
deposited outside their country of origin. The term "Eurocurrency" does not imply only the Euro;
it includes any currency held in foreign banks outside its domestic market.
Example:
A U.S.-based multinational company holds $10 million in a UK-based bank. This amount is
referred to as Eurodollars because the funds are in U.S. dollars but held outside the U.S.
The bank can lend these funds to other companies for a short period, say 3 months, at a
competitive interest rate.
The Eurocurrency markets are beneficial for:
Borrowers Companies can secure loans at lower interest rates.
Lenders Banks can lend excess funds to earn interest.

2. Eurobond Markets
Eurobond markets refer to international capital markets where companies issue bonds to
borrow funds directly from investors across multiple countries. Eurobonds are denominated in a
currency other than the currency of the country where the bond is issued.
Example:
A Japanese company issues Eurobonds worth $100 million. The bonds are issued in the London
market and sold to investors in Europe, Asia, and the U.S. The company uses the proceeds to
fund its overseas expansion.
The Eurobond markets are beneficial for:
Borrowers Japanese company gains access to U.S. dollar funds.
Investors The investors earn regular interest payments.

Perspectives of Market Efficiency

Market efficiency can be assessed in several ways:
1. Allocative Allocative efficiency refers to how well financial markets direct capital to the
Efficiency most productive and efficient uses. It ensures that funds flow to the
companies with the highest potential returns.
Example:
A startup with a groundbreaking renewable energy solution secures venture
capital funding, while a declining coal-based company struggles to attract
investment. The market is efficient because it allocates resources to a
company contributing to a sustainable future.

2. Operational Operational efficiency focuses on minimizing transaction costs and ensuring

Efficiency seamless trading. It ensures that market participants can trade securities
quickly and at low costs, fostering liquidity and high trading volumes.
Example:
Stock exchanges like NSE & BSE have advanced trading systems that allow
millions of transactions to occur per second with minimal transaction fees.
This enhances operational efficiency by reducing the cost and time
associated with buying or selling stocks.
3. Informational Informational efficiency refers to the extent to which all relevant information
Efficiency (past information, public information or insider information) is reflected in
stock prices.
Example:
If a publicly traded company announces record profits, its stock price
immediately rises to reflect the new information. Investors cannot gain an
advantage by acting on this news later since the information is already
factored into the stock price.

4. Pricing Pricing efficiency examines whether market prices accurately reflect all
Efficiency known information about a stock. This ensures that prices provide a true
representation of a stock's intrinsic value.
Example:
Suppose there’s news that a pharmaceutical company has received approval
for a breakthrough drug. In a pricing-efficient market, the company's stock
price will increase to reflect the anticipated growth in future earnings.
Together, these efficiencies contribute to a well-functioning financial market that drives
economic growth.

Efficient Market Hypothesis (EMH)

EMH states that stock prices reflect all available information, making it impossible to consistently
achieve higher returns than the overall market without taking on excessive risk.
It classifies market efficiency into three levels:
1. Weak-Form In a weak-form efficient market, share prices reflect all historical price data.
Efficiency This means technical analysis, which involves studying past price trends,
cannot consistently lead to better returns.
Investors cannot use price charts or patterns to predict future stock prices.
Example:
Suppose you analyse the historical prices of Apple Inc. and notice a recurring
upward trend every December. In a weak-form efficient market, knowledge
of this trend won't help you earn above-average returns because past price
data is already reflected in the current stock price.

2. Semi-Strong In a semi-strong form efficient market, share prices incorporate all publicly
Form Efficiency available information, including financial statements, news reports, and
economic indicators.
Neither fundamental analysis (evaluating a company's financial health) nor
public news can give you an advantage because the market instantly adjusts
prices to new public information.
Example:
IndusInd discrepancy in derivatives portfolio
Consider Tesla announcing record-breaking quarterly earnings. In a semi-
strong market, Tesla’s stock price will immediately adjust to reflect this news.
By the time you try to buy the stock after reading the earnings report, the
price will already have risen, leaving no room for profit based on this
information.

3. Strong Form In a strong-form efficient market, share prices reflect all information,
Efficiency including insider information.
Even insiders with confidential company data cannot earn abnormal returns
because the market already prices in all relevant information.
3. Strong Form
Efficiency

Example:
Imagine an executive at Microsoft knows about a pending acquisition before
it’s made public. In a strong-form efficient market, he cannot profit from this
knowledge because the stock price already factors in even undisclosed
information. This is rarely the case in real-world markets.

Most markets exhibit semi-strong efficiency rather than strong-form. Participants with insider
information can make abnormal gains in such markets.

Paradox of Efficient Markets

For markets to remain efficient, investors must actively analyse information to identify and
exploit mispriced stocks. This research and trading activity help align stock prices with their true
value, thereby ensuring market efficiency.
However, if a market becomes perfectly efficient (where all stocks are always correctly priced),
there would be no mispriced stocks left to exploit. Consequently, investors would stop analysing
and trading actively, causing the market to become inefficient again.
This paradox suggests that a market can only remain efficient if investors believe it is inefficient
and continue to research and trade actively.
The paradox emphasizes the importance of active participation by investors in maintaining
market efficiency. Without this participation, markets cannot remain efficient.

Factors influencing Interest Rates

1. General Factors
Inflation Higher inflation often leads to higher interest rates as lenders need
compensation for the reduced purchasing power of money.
Example:
If inflation in India rises to 8%, RBI may increase interest rates to curb
inflation and stabilize the economy. When interest rates are high, it becomes
more expensive for individuals to borrow, thereby leading to lower spending.
Government Central banks adjust interest rates based on economic objectives, like
Monetary Policy controlling inflation or encouraging growth.
Example:
The RBI might lower rates during a recession to boost borrowing and
Demand for spending.
High demand for loans pushes interest rates higher.
Borrowing Example:
During a housing boom, increased demand for home loans can raise their
interest rates.
Investors’ When investors prefer liquidity, higher rates are required to attract them into
Preference for longer-term investments.
Cash
International Global interest rates and exchange rate fluctuations affect domestic rates.
Factors

2. Specific Factors
Level of Risk Higher risk leads to higher interest rates to compensate for the potential for
default.
Example:
A startup company seeking a loan might face an interest rate of 12%,
compared to a well-established business that pays 5%.
Duration of the Longer-term loans usually come with higher interest rates due to greater
Loan uncertainty over time.
Example:
A 30-year home loan may have an interest rate of 6%, while a 5-year car loan
might only charge 3.5%.
Profit Margin for Banks charge higher loan rates than what they pay on deposits to earn
Financial profits.
Example:
Intermediaries
A bank might offer a 4% interest rate on savings accounts but charge 8%
interest on personal loans.
Size Larger loans or deposits often attract lower interest rates because of reduced
administrative costs.
Example:
A $10 million corporate loan might be charged 4%, while a $10,000 personal
loan might be charged 6%.
Term Structure of Rates vary based on the time to maturity, often reflected in the yield curve.
Interest Rates Example:
A 1-year government bond may offer a 2% yield, whereas a 10-year bond
may offer a 4% yield due to expectations of rising interest rates.

Yield Curve

Yield Curve shows how the yield on government bonds i.e. treasury notes, vary according to the
term of the borrowing.
The curve shows the yield expected by the investor assuming that the bond pays all of the return
as a single payment on maturity i.e. no coupon payments.

Government bonds, or treasury bills, are risk-free securities.

Investors of corporate securities require a return, which is higher than the yield on government
securities.
The excess return is known "corporate credit spread".

Theories for Yield Curve

Expectations Investor's anticipation that interest rates will rise in the future leads to an
Theory upward-sloping yield curve.
Liquidity Investors seek higher return on long term maturity, as compensation for
Preference Theory deferred consumption.
Market Short term bonds tend to be more popular with banks, and long term bonds
Segmentation tend to be more popular with pension funds. This theory suggests that the
Theory slope of the yield curve will reflect conditions as per the market
segmentation.
Risk Higher the risk, higher the yield

Fintech
Fintech refers to technology-driven financial innovations that improve financial services by
making them more accessible, efficient, and cost-effective. It leverages big data, artificial
intelligence (AI), blockchain, and mobile apps to transform traditional financial services.
https://www.youtube.com/watch?v=-EoNrg_DR3s

Key areas of fintech innovation:

Maturity Maturity transformation is the process where short-term deposits (e.g.,
Transformation savings accounts) are used to fund long-term loans (e.g., home loans,
business loans).
Allocation of Allocation of funds refers to how investments are distributed across different
Funds asset classes to balance risk and return.
Example:
Groww allows users to invest in mutual funds and stocks with a simple
mobile app.
Payment Services Fintech has transformed payments by making transactions faster, cheaper,
and more secure.
Example:
Paytm and PhonePe enable users to make digital payments, pay bills, and
transfer money.
Information Fintech firms use big data and AI for fraud detection, risk assessment, and
Processing personalized services.
Example:
Flipkart uses AI algorithms to detect fraud in online shopping.

The impacts of FinTech on financial markets and institutions include:

Disintermediation Disintermediation removes middlemen (banks, brokers) from financial
transactions. This allows borrowers and investors to interact directly,
reducing fees and improving efficiency.
Example:
Zerodha eliminates the need for traditional brokers.
Availability of Fintech has improved credit accessibility, helping borrowers rejected by
Credit traditional banks secure financing through alternative platforms.
Example:
KreditBee offers instant loans to young professionals and small businesses.
Security Token STOs use blockchain technology to issue digital tokens that represent
Offerings (STOs) ownership in real-world assets (stocks, real estate, commodities, etc.).
Example:
A property worth $5 million can be divided into 10,000 tokens on a
blockchain.
Investors can buy and trade small fractions of the property.
Owners earn rental income and appreciation based on the tokens they hold.
Peer-to-Peer (P2P) P2P lending allows individuals and businesses to borrow money directly from
Lending investors through online platforms, bypassing banks.
Example:
Faircent is one of India's leading RBI-regulated P2P lending platforms. It
connects individual borrowers and lenders directly, eliminating banks as
intermediaries.
Lending

Faircent is one of India's leading RBI-regulated P2P lending platforms. It

connects individual borrowers and lenders directly, eliminating banks as
intermediaries.

Initial Coin Offering (ICO)

An ICO is a fundraising method in which a company raises capital by issuing and selling digital
tokens (cryptocurrencies) to investors.
https://www.youtube.com/watch?v=VcEi2HO9whM
https://www.youtube.com/watch?v=a2Yd9mbfAos

Features of an ICO:
1. Utility Tokens Most ICOs issue utility tokens, which give investors access to the product or
service that the company is developing.
These tokens do not represent ownership in the company or any legal rights.
2. Unregulated: ICOs do not involve any regulatory oversight.

Example:
In 2014, Ethereum launched an ICO to fund the development of its blockchain platform. It raised
approximately $18 million by selling ETH tokens to early investors. Investors who purchased ETH
during the ICO saw significant gains once Ethereum's blockchain became widely adopted.

Security Token Offering (STO)

An STO is a fundraising method where a company issues digital tokens that are backed by real-
world assets (e.g., equity, debt, real estate) and comply with securities regulations. These tokens
represent ownership or a stake in the company or its assets.
https://www.youtube.com/watch?v=YeVDlY_-UsE&t=7s

Features of an STO:
Security Tokens: Security tokens represent ownership. They are similar to traditional securities
like stocks or bonds but issued digitally on a blockchain.
Regulated STOs comply with securities laws and are subject to regulatory oversight,
making them more transparent and secure for investors.

Example:
tZERO, a subsidiary of Overstock.com, launched an STO in 2018 to raise funds for its blockchain-
based trading platform.
Investors received security tokens that entitle them to a portion of the company’s profits.

Islamic Finance
Islamic Finance Principles
Legitimate Trade Wealth should be generated from actual trade and business activities.
Earning money simply from money (such as charging interest) is prohibited.
Ethical & Social Investments should not only focus on financial returns but should also
Investment benefit society ethically and socially.
Example:
Investing in a hospital, school, or renewable energy project.
Risk Sharing Financial risks should be shared among involved parties rather than shifted
entirely to one party.
Example:
A bank loan with a fixed repayment schedule regardless of business
performance is prohibited.
Risk Sharing

A bank loan with a fixed repayment schedule regardless of business

performance is prohibited.
Avoidance of Any activities or businesses considered unethical should be avoided.
Harmful (Haram) Example:
Activities
Investing in a brewery or a casino is prohibited.

Islamic Finance Instruments

Islamic financial instruments comply with Sharia law by avoiding interest (riba) and instead focus
on ethical investments, profit-sharing, and risk-sharing
1. Murabaha A form of cost-plus financing where a bank buys an asset and sells it to a
(Trade Credit) customer at a markup, payable on a deferred basis.
Example:
A person needs to buy machinery worth $10,000. The bank purchases it and
sells it to the person for $12,000, payable in instalments over two years.
2. Ijara (Lease The bank leases an asset to the customer for a fixed period, charging rent.
Finance) Ownership may transfer to the customer at the end.
Example:
A bank leases a property to a customer for $500 monthly rental for 5 years.
At the end of the term, the customer pays an additional amount to take
ownership of the property.
3. Mudaraba A partnership where the bank (investing partner) provides capital, and the
(Equity Finance) customer (managing partner) manages the project. Profits are shared based
on an agreed ratio, and the bank bears all losses.
Example:
A bank funds a startup with $20,000. Profits are shared 70% (customer) and
30% (bank). If the startup incurs losses, the bank loses its investment.
4. Musharaka A joint venture where both parties contribute capital and share profits /
(Venture Capital) losses based on their contribution.
Example:
Two partners contribute $10,000 each for a construction project. Profits are
shared equally, but if there is a $4,000 loss, each partner bears $2,000.
5. Sukuk (Islamic A bond structure where investors earn returns from asset-generated income,
Bonds) avoiding fixed interest payments.
Example:
A bank issues sukuk to fund a shopping mall. Investors earn rental income
from the mall rather than a fixed interest.
6. Hibah (Gift) A voluntary gift by the bank from profits earned on a customer's deposits.
Example:
A customer maintains a savings account. At year-end, the bank gives a $10
gift as goodwill for their balance.
7. Qard Hassan A no-interest loan where the borrower repays only the principal; additional
(Benevolent Loan) payment is optional.
Example:
A borrower takes a $50,000 loan to cover medical expenses. He repays the
principal over two years, optionally giving an extra $5,000 as a goodwill
gesture.
(1) FALSE
An inverted yield curve occurs when long-term interest rates are lower than
short-term interest rates. An inverted yield curve often signals an economic
recession.

(2) FALSE
A rising (or normal) yield curve typically happens when long-term interest
rates are higher than short-term rates. It reflects requirement of investors for
higher yield for long tenures because of deferred consumption.
Cost of Investment 50,000 $
Scrap Value 10,000 $
Useful Life 5 years
Depreciation p.a. 8,000
No of Units p.a. 20,000

$
Selling Price per unit 3.00
Variable Cost per unit 1.65
Contribution per unit 1.35
Contribution 27,000
Fixed Cost 10,000
Operating Cash Flow 17,000
Depreciation 8,000
Operating Profit 9,000

(1)
Payback Period 2.9 years

(2)
Avg Investment 30,000 $
Avg Profit 9,000 $
ROCE 30%

(3)
Year 0 1 2 3 4
Cash Flow -6.50 2.40 3.10 2.10 1.80
DCF @ 15% 1.00 0.87 0.76 0.66 0.57
PV of Cash Flow -6.50 2.09 2.34 1.38 1.03
NPV @ 15% 0.34

Year 0 1 2 3 4
Cash Flow -6.50 2.40 3.10 2.10 1.80
DCF @ 20% 1.00 0.83 0.69 0.58 0.48
PV of Cash Flow -6.50 2.00 2.15 1.22 0.87
NPV @ 20% -0.27

IRR a% + ((NPVa / (NPVa - NPVb)) x (b% - a%))

IRR 17.8%
Current Share Price 6.00 $
No of shares 800.00 m
NPV ($m) Effect per Share ($) Announcement
Product A 40.00 0.05 Tomorrow
Product B 160.00 0.20 This morning

Semi-strong
In a semi-strong form efficient market, the markets value shares based on information
relevant to past movements and also published information.
The share price will react to the NPV of Product B today, as news is released.
Share Price at the end of today 6.20 $

Strong
In a strong-form efficient market, the share price reflects historic information, published
information and insider information.
The current share price is already reflecting the NPVs of both new products as the decision to
launch them was taken two days ago.
Share Price at the end of today 6.00 $
(ii) Operating Cost
Potential increase in operating costs:
The rise in interest rates could increase the cost of borrowing. When borrowing becomes more
expensive, businesses across the supply chain face higher costs.
Therefore, Flopro may need to pay more for raw materials, leading to higher operating expenses.
Further, if inflation is rising, employees might expect higher wages to keep up with the increased cost of
living. Therefore, Flopro may need to pay more for labour costs.
The rise in operating costs may occur more gradually, as it takes time for increased borrowing costs to
ripple through the supply chain and affect materials & labour prices.

Deflationary Effects on Consumer Demand

Higher interest rates tend to reduce consumer demand because borrowing becomes costlier and
disposable incomes decreases. This would lead to reduced sales for Flopro.
A drop in consumer demand might offset some of inflationary pressures on input and labour costs.