The document discusses restrictive covenants in debt contracts and their role in addressing moral hazard. Restrictive covenants are included in debt contracts to discourage undesirable behavior by borrowers, encourage desirable behavior, keep collateral valuable, and provide information to lenders. By monitoring compliance with covenants, lenders can reduce moral hazard which arises from asymmetric information between borrowers and lenders. Complicated legal language and many covenants are used because debt contracts involve transaction and information costs.

1. An Economic Analysis of
Financial Structure (Q & A)
Submitted By
Anuj Goyal
NMIMS

2. 1. Do you support “too big to fail” theory? If your answer is YES give one reason why
you are for it. If you answer is NO give one reason why you are against it.
The banks or any other institutions which are benefitted from this policy have the govt back
up in case of any difficulty. The govt backs up these institutions because they are so large that
their failure implicitly affects the economy i.e there is a huge social cost associated with the
failure of these institutions.
I don‟t support too big to fail theory because a financial institution that tries seeking benefit
from this protective policy. They may seek position in high- risk high return transactions
presuming that in case of any failure ,they have a govt support to bail them out.
Hence there is a moral hazard associated with this theory.
Businesses use mostly internal financing and secondly external financing in the form of
bank loans. Why?
Advantages of Internal Financing over External Financing in the form of Bank Loans.
1. Retained Earnings in the form of profits can be put back into the business to help it
grow and can be utilised for capex requirements and working capital.
2. The main advantage of using internal sources of funds is that it comes at no cost
unlike Bank Loans. Bank Loans have very high rate of interest alongwith other
processing fees. Many corporates find it inconvenient to borrow from banks due to the
above reasons. Following charges are associated with bank borrowings.
a. Interest Charges
b. Processing Fees
c. Late payment penalties
d. Arrangement Fees
e. Exchange differences (if any)
These charges make it even more inconvenient for the corporate to borrow from banks in
case of urgent requirement of funds. Although banks have facilities such as Overdraft etc.,
these facilities are provided to corporate which have existing relationship with the banks and
not to new companies.
3. Loans are given to companies based on the financials and many a times the amount
falls short of the requirement. Thus many corporates prefer internal sources of funds
rather than bank loans.
4. Application formalities for bank loans are very cumbersome.
5. Sale of underused or unused assets are also an important way of internal source of
funds and it makes sense to make use of such sources of funding.

3. 6. Unlike bank loans, internal sources of funds don‟t have to be repaid. If for some
reason, the business is not doing well, bank loans repayment becomes even more
difficult. Internal funding arrangements are more suited in such instances.
10 Functions of Financial System:
1. To facilitate trades of goods and services. An efficient financial system reduces
information and transaction costs in trade and helps the payments.
2. To increase saving mobilization by an improvement of the savers confidence.
3. To produce information on the investment projects. It can be difficult to obtain reliable
information on the projects or on the borrowers. The financial system can reduce this issue by
devoting some agents to the screening of projects.

4. To afford a better repartition and diversification of risk, and finally a better risk
management. A higher diversification allows risk adverse people to invest in riskier projects
with higher returns. In addition, a well-performing financial system reduces liquidity risk:
some products used to finance risky projects can be easily converted into money.
5. To favor the monitoring during all the investment process, and develop a corporate
governance control.
6. The financial markets provide protection against life, health and income risks. These are
accomplished through the sale of life and health insurance and property insurance policies.
The financial markets provide immense opportunities for the investor to hedge himself
against or reduce the possible risks involved in various investments.

4. 7. The financial markets provide the investor with the opportunity to liquidate investments
like stocks bonds debentures whenever they need the fund.
8.The government intervenes in the financial system to influence macroeconomic variables
like interest rates or inflation so if country needs more money government would cut rate of
interest through various financial instruments and if inflation is high and too much money is
there in the system then government would increase rate of interest.
9. Public saving find their way into the hands of those in production through the financial
system. Financial claims are issued in the money and capital markets which promise future
income flows. The funds with the producers result in production of goods and services
thereby increasing society living standards.
10. Financial system has to deal with two kinds of information asymmetries:
a) The adverse selection problem: if a lender is not able to evaluate the quality of some
investment projects, he will ask for an average return. This price will be too high for
the less risky projects, hence only risky projects will be financed. It can result in a
significant reduction of the capital market size.
b) Moral hazard arises because an individual or institution does not bear the full
consequences of its actions. In finance, borrowers may not act prudently when they
invest or spend funds.
This contingency can prevent the contract conclusion.
To resolve these issues we have 2 types of systems namely : Bank based systems and
Market based sysytems
19. What is the main argument against „Investor fee paying‟ model in credit rating
business?
Main argument against investor fee paying model in credit rating business is that it will led to
free riding problem.

5. As the fewer investors will pay for obtaining the original copy of the rating of security done
by the credit rating agencies rest will use the same by information sharing for their benefit
without paying.
Ultimately credit rating agencies will face a downturn in their business hence resulting in
losses. To compensate the same they have to cut down the cost of their staff and other
resources which will deteriorate the quality of security investigation and hence the rating
done by them.
For more details please refer the attached link
https://www.msu.edu/~jiangj/Jiang%20Stanford%20Xie%202012.pdf
1. Peter Thiel, a prominent Facebook investor, said it was generally
desirable for technology companies to defer an IPO for as long as
possible. He said Google set a good example by not going public for a
nearly six years, until it dominated the search wars. What in your opinion
is the main reason? (give only ONE rationale which you think is the most
important)
ANSWER: As per my opinion, Mr. Peter is correct. We need to look after the future
performance of the technology companies too because whenever a new techno company
comes with a n idea it may hit the market for that time only and enjoy some benefit of
monopoly but in long run it may not deliver the expected performance as there will be many
other firms who would like to play in the same area. It may also happen that at the beginning
the user finds it very useful but when a other company comes with some extra feature, the
users will have a high intention to switch to the new company as there is no cost involved for
the users to switch.
For example, the same happen with ORKUT it was very popular few years back but as
facebook came with new attractive feature, people switched to facebook and orkut is having
very low market share in this segment.
The main reason for my opinion is investor‟s should be protected at much as possible. Since
initial investment with techno companies is like to be risky, its better to watch their
performance for few years and the allow then to collect money from the public.
A company like google is less likely to fall because of its operation for long time proved that
it has enough back up to sustain in future.

6. 14. "If a company does not do better than its competitors but the stock market goes up,
executives do very well from their stock options. This makes no sense".
Discuss this viewpoint. Can you think of alternatives to the usual employee stock option
plan that takes the viewpoint into account.
Ans: A phantom share essentially reflects the commercial effect of an ESOP, except that no
shares are issued in reality but the benefit to the employee is paid in cash by a charge to the
revenue account of the company. The employee is granted options on a notional number of
phantom shares in the same manner as real shares in the case of conventional ESOPs. On
exercising the options, the employee is entitled to the growth in the value of the underlying
real shares exactly in the same manner as exercise of ESOPs, except that the growth in value
is paid out in cash and no new shares are issued.
If the employee is bullish about the company he/she may continue to hold the
vested/exercised shares. In the case of phantom shares, the cash received from the company
can be used to purchase its shares from the market with the same economic consequences.
Thus phantom share plans can be structured on the same lines as employee stock option
schemes and can pass on the same economic benefits to employees that an ESOP scheme can.
Phantom shares are often used in the case of closely held companies and in companies that
have exhausted certain share issue limits or those who do not wish to upset existing
shareholding structures.
Critics have argued that phantom shares do not provide the employee with the same sense of
ownership that real shares do and as a result may fail to effectively motivate the employee.
While there may be some merit in the argument, there is no denying the fact that the
fundamental reason for owning any financial asset is to realise economic benefits.
This purpose is well served by the phantom share mechanism and it is possible to own real
shares from the cash compensation that an employee gets from exercising the phantom
shares.

7. -A bond issued by Standard Oil some time ago worked as follows. The holder received
no interest. At the bond's maturity the company promised to pay $1000 plus an
additional amount based on the price of oil at that time. The additional amount was
equal to the product of 170 and the excess (if any) of the price of a barrel of oil at
maturity over $25. The maximum additional amount paid was $2250(which
corresponds to a price of $40 per barrel). Show that the bond is a combination of a
regular bond, a long position in call options on oil with a strike price of $25, and a short
position in call options on oil with a strike price of $40.
Let ST denote the price of oil at the bond‟s maturity. The addition
to $1000 the standard oil pays
0 ST < $25
170(ST − 25) 25 < ST < 40
2, 550 40 < ST
This is a payoff from 170 call options on oil with a strike price of 25 less the payoff from 170
call options on oil with a strike price of 40. Thus the the bond is equivalent to a regular bond
plus a long position in 170 call options on oil with a strike price of $25 plus a short position
in 170 call options on oil with a strike price of $40.
1. Why debt contracts are complicated legal documents with restrictive
covenants?
Covenants are type of formal agreement that the certain activities will be carried out.
Covenants can cover everything from minimum dividend payments to levels that must be
maintained in working capital. Throughout the world, debt contracts typically take the form
of lengthy legal documents with extensive restrictive covenants, i.e., provisions restricting the
behavior of the borrower. For example, a borrower receiving a real estate loan may be
required to carry liability insurance covering accidents at his construction site.
Why Debt contracts are complicated?
A debt contract is intended to be a productive activity in the sense that a contractually
determined amount of loaned funds (input) is used by a borrower to produce a stream of
returns (output) that is expected to cover debt payment obligations (input costs) while leaving
some positive net return (profit) for the borrower.

8. A debt contract entails two distinct types of transaction costs: (a) the organizational costs
associated with finding and bringing together the borrower and lender; and (b) the
organizational costs associated with the actual writing up and signing of the debt contract. In
addition, a debt contract typically involves information costs in that the behaviour of the
borrower must be monitored in an attempt to ensure that the borrower meets the terms of the
debt contract as specified in its payment schedule and restrictive covenants.
The concept of "transaction costs" is actually quite tricky to define in a manner that is both
clear and useful. Roughly speaking, transaction costs are the costs associated with the
organization of productive activities, such as the costs arising from the need to search for
customers and to prepare contracts for longer-term customer-supplier relationships. In
contrast, production costs are the costs arising from the need to pay for direct inputs to
production, such as salaries (the price of labor services) and rental payments (the price of
capital services generated by rented capital equipment).
The concept of "information costs" is more straightforward. Information costs are the costs
incurred when attempts are made to reduce moral hazard and adverse selection problems
arising from conditions of asymmetric information.
Due to the presence of all these costs in a debt contract, they become complicated with
restricted covenants.
• Basically Restrictive Covenant is a Tools to Help Solve Moral Hazard in
Debt Contracts
1. Net Worth
2. Monitoring and Enforcement of
Restrictive Covenants. Examples are covenants that …
1. discourage undesirable behavior
2. encourage desirable behavior
3. keep collateral valuable
4. provide information
• Covenants to discourage undesirable behavior
• Some covenants mandate that a loan can be used only to finance specific activities,
such as the purchase of particular equipment or inventories.
• Covenants to encourage desirable behavior
• They encourage the borrower to engage in desirable activities that make it more likely
that the loan will be paid off
• Life insurance that pays off the mortgage upon the borrower‟s death

9. • Covenants to keep collateral valuable
• Restrictive covenants can encourage the borrower to keep the collateral in good
condition and make sure that it stays in the possession of the borrower
• Insurance on the home
• Covenants to provide information
• Restrictive covenants can require a borrower to provide information about its
activities periodically
• Balance sheet, income reports
• A debt contract is a contractual agreement by the borrow to pay the lender fix dollar
amount.
• the risk that one party to a transaction will engage in behavior that is undesirable from
the other party‟s point of view.
•
How Moral Hazard Influences Financial Structure in Debt Markets
• Debt Contracts are still subject to
moral hazard even with the advantages
• Borrowers have an incentive to take on
investment projects that are riskier than
lenders would like.
Tools to Help Solve Moral Hazard
• Net Worth and Collateral
• Monitoring and Enforcement of Restrictive Covenants
• Financial Intermediation
• Restrictive covenants are directed at
reducing moral hazard either by ruling
out undesirable behavior or by
encouraging desirable behavior
Forms of Covenants
1. to discourage undesirable behavior
2. to encourage desirable behavior

10. 3. to keep collateral valuable
4. to provide information
Covenants to discourage undesirable behavior
• Function in two forms:
- restricting the use of money so that it can
only be used on certain criteria
- barring the use of the capital so it can not be
used for certain purposes.
Covenants to encourage desirable behavior.
• Require a firm to maintain certain good business practices, such as minimum holdings
and insurance.
Covenants to keep collateral valuable
• Require proper protection of the asset, an example would be homeowners insurance
as part of a mortgage
Covenants to provide information
• Require the provision of information by the borrower to the lender, making it easier to
monitor the firm.
How does the free-rider problem aggravate adverse selection and moral hazard
problems in financial markets?
As described in Mishkin on page 189, one partial solution to the problem of lenders
(purchasers of securities) having less information than borrowers of funds is to have private
companies collect and produce information that helps lenders distinguish between good and
bad firms selling securities. The free rider problem arises here when some people purchase
the information about firms and the people that do not purchase it take advantage of the
information the others have paid for. Lenders who have purchased information will purchase
securities from high quality, undervalued firms and in doing so will reveal to free-riding
investors which firms are the ones they should invest in. If many investors free ride, this will
push up the price of good firms‟ securities and make it less profitable to purchase information
in the first place. If many investors find it unprofitable to purchase information, then it may
not be gathered and produced by private firms: “The weakened ability of private firms to
profit from selling information will mean that less information is produced in the
marketplace, and so adverse selection (the lemons problem) will still interfere with the
efficient functioning of securities markets” (Mishkin, p. 189).

11. As decribed in Mishkin on page 194, free riding can also aggravate the moral hazard
problem. The principle-agent problem is a problem of moral hazard that occurs because
managers have more information about their activities and actual profits than stockholders
do. Stockholders can partially overcome this problem by spending time and money on
frequent audits of the firms they have invested in and closely monitoring what management is
doing. Similar to the adverse selection case, free riding can reduce the amount of information
about managment and firm activities produced by stockholders through costly audits or other
forms of monitoring. Each stockholder will be unwilling to invest in monitoring activities,
preferring to free ride on the monitoring expenditures of other stockholders. If all
stockholders think this way, however, none of them will invest in monitoring and little or no
information about management and firm activities will be produced. Less information for
stockholders means the moral hazard problem will be aggravated.
Rachana‟s Questions
1. Discuss Adverse Selection and Moral Hazard as impediment to a well functioning
financial system. Discuss how „free-rider problem‟ aggravates the problem of Moral
Hazard and Adverse Selection?
Ans:
A crucial impediment to the efficient functioning of the financial system is asymmetric
information, a situation in which one party to a financial contract has much less
accurate information than the other party. For example, borrowers who take out loans
have much better information about the potential returns and risk associated with the
investment projects they plan to undertake than lenders do. Asymmetric information
leads to two basic problems in the financial system:
Adverse selection(hidden information)
Adverse selectionoccurs before the transactionoccurs when potential bad credit risks are
the ones who most actively seek out a loan. Thus,the parties who are the most likely to
produce an undesirable (adverse) outcome are mostlikely to be selected. For example,
those who want to take on big risks are likely to be themost eager to take out a loan
because they know that they are unlikely to pay it back. Sinceadverse selection makes it
more likely that loans might be made to bad credit risks, lendersmay decide not to make

12. any loans even though there are good credit risks in themarketplace. This outcome is a
feature of the classic “lemons problem”.
Moral hazard(hidden action)
MHis where one party is responsible for the interests another, but has anincentive to put
his or her own interests first.Financial examples
I might sell other a financial product not because I want cash but because it is of low
quality.
I might pay myself excessive bonuses out of funds that I am managing on other behalf.
I might take risks that other people then have to bear.
Any situation in which one personmakes the decision about how much risk to take,
while someone else bears the cost if things go badly.
Asymmetric information and adverse selection, moral hazard may prevent
financialmarkets from functioning efficiently during a crisis. It calls for government
intervention and for regulation to ensure the continuous functioning of financial
markets. If someone takes a risk, someone has to bear it. If I take a risk, then it should
be ensured that I be made to bear it. But if I take a risk at others expense, then that‟s
moral hazard and that‟s bad. As the late, great Milton Friedman might have put it:
“there ain‟t no such thing as afree risk.”
Free riding
One solution to Ass Info is to have private companies collect and produce information
that helps lenders distinguish between good and bad firms selling securities. The free
rider problem arises here when some people purchase the information about firms and
the people that do not purchase it take advantage of the information the others have paid
for. Lenders who have purchased information will purchase securities from high
quality, undervalued firms and in doing so will reveal to free-riding investors which
firms are the ones they should invest in. If many investors free ride, this will push up
the price of good firms‟ securities and make it less profitable to purchase information in
the first place. If many investors find it unprofitable to purchase information, then it
may not be gathered and produced by private firms: “The weakened ability of private
firms to profit from selling information will mean that less information is produced in
the marketplace, and so adverse selection (the lemons problem) will still interfere with
the efficient functioning of securities markets”.
Free riding can also aggravate the moral hazard problem. The principle-agent problem
is a problem of moral hazard that occurs because managers have more information
about their activities and actual profits than stockholders do. Stockholders can partially
overcome this problem by spending time and money on frequent audits of the firms

13. they have invested in and closely monitoring what management is doing. Similar to the
adverse selection case, free riding can reduce the amount of information about
managment and firm activities produced by stockholders through costly audits or other
forms of monitoring. Each stockholder will be unwilling to invest in monitoring
activities, preferring to free ride on the monitoring expenditures of other stockholders.
If all stockholders think this way, however, none of them will invest in monitoring and
little or no information about management and firm activities will be produced. Less
information for stockholders means the moral hazard problem will be aggravated.
2. Define Hedging, Insurance and Diversification – the three dimensions of Risk
Management. Discuss how the Investors payoffs vary with each of these techniques.
Ans
Diversification-
It mixes a wide variety of investments within a portfolio. The rationale behind this
technique is that a portfolio of different kinds of investments will, on average, yield
higher returns and pose a lower risk than any individual investment found within the
portfolio. Diversification strives to smooth out unsystematic risk events (industry or
company specific risk) in a portfolio so that the positive performance of some
investments will neutralize the negative performance of others. Therefore, the benefits
of diversification will hold only if the securities in the portfolio are not perfectly
correlate. However a firm shall still be exposed to systematic risk ( market risk).
Hedging-
It allows for elimination of risk through the spot sale of risk, or through a transaction in an
instrument that represents an obligation to sell the risk in future.
Making an investment to reduce the risk of adverse price movements in an asset. Normally, a
hedge consists of taking an offsetting position in a related security, such as a
futurescontractAn example of a hedge would be if you owned a stock, then sold a futures
contract stating that you will sell your stock at a set price, therefore avoiding market

14. fluctuations. Investors use this strategy when they are unsure of what the market will do. A
perfect hedge reduces your risk to nothing (except for the cost of the hedge).
Insuring.
• Insurance is a precise approach to risk managementActuarial insurance is the
traditional product offered by insurance companies that helps individuals manage
risks associated with their tangible wealth or human capital, e. life, health,
homeowner of automobiles insurance.Guarantees provide the same pattern of risk
protection as actuarial insurance.Options, like calls and put options are another
example of a type of insurance contract. Exclusions are losses that might seem to
meet the conditions for coverage under the insurance contract but are
specifically excluded.Caps are limits placed on compensation for particular
losses covered under an insurance contract.A deductible is an amount of money
that the insured party must pay out of his or her own resources before receiving
any compensation from the insurer.A copayment feature means that the insured
party must cover a fraction of the loss
• When you hedge, you eliminate the risk of loss by giving up the potential for
gain.
• When you insure, you pay a premium to eliminate the risk of loss and retain the
potential for gain.
3. The functional perspective views financial innovation as driving the financial system
toward the goal of greater economic efficiency. Give five examples in support.
Pooling of resources
Managing Risks
Managing Incentive Problems
Payment system of goods and services
Transfer of resouces across time and space
4. List out 10 activities in the financial system, which are multi-functional in nature.
Clearly mention the activity and the functions involved.
Banks use options and future markets trasactions toprovide stock to bond value
insurance that guarantees a minimum return oncustomer portfolios.
Banks dealing in securities dealing

15. Banksengaged in real estate business
5. Do you agree that demand for pooling by the deficit units viz., businesses is reflected
in multiple bilateral contracting and demand for pooling by the surplus units viz.,
households is reflected in multilateral contracting.
Yes.
6. What is the relationship between economic growth and financial development?
Market Frictions(information costs,Trasactions costs) are present- Financial
Markets and Intermediaries provides Financial Functions(6 functions)leads
to growth channel(Capital Acumulatiion and technological
innovations)Economic Grwoth
Economic growth depends on two major factor- Savings and Investment. Savings
denotes the surplus side and Investment Denotes the Deficit side.Financial institutions
and markets can foster economic growththrough several channels, i.e. by (i) easing
the exchange of goods and services through the provision of payment services, (ii)
mobilising and pooling savings from a large number of investors, (iii) acquiring and
processing information about enterprises and possible investment projects, thus
allocating savings to their most productive use, (iv) monitoring investment and
carrying out corporate governance, and (v) diversifying, increasing liquidity and
reducing intertemporal risk. Each of these functions can influence saving and
investment decisions and hence economic growth. In economies,however,there exists
certains frictions and imperfections. Such things are offset by the introduction of
Financialintermediearies. Financial Development increase savings in the form of
financial assets.
7. Businesses use mostly internal financing and secondly external financing in the form
of bank loans. Why?
8. Why issuing marketable securities not primary funding source?
Because it may lead to the problem of adverse section and moral hazard. It will create a
lemons problem, where the new firms with high risk enter the market where there are
good firms. With information assymentry,the investor will invest at average return not
knowing the actual price. So the lemon firms will jump to the offer where as the peach
firms will not accept and leave. This will increase the quality of securities availiable in
the market and eventually less investors will start to invest after sometime.

16. 9. Why indirect finance (financial intermediation) is more important?
10. Is financial system is heavily regulated? If yes, why?
11. Why only large, well-established firms have access to securities markets?
12. Why debt contracts are complicated legal documents with restrictive covenants?
Restrictive Covenants for bonds, bank loans or mortgages can minimize or eliminate moral
hazard:
1. Restrictions in loan to prevent borrower from engaging in risky activity. Restrictions on
what the money can be used for - only certain investments are allowed. Restrictions on
dividends.Restrictions on altering real estate.
2. Encourage desirable behavior. Require insurance and taxes to be paid to the mortgage
company. Require high net worth - example 20% down for house. Requirement to maintain
certain asset base for businesses. Require a sinking fund.
3. For secured loan, Requirement to keep collateral in good condition. Property or
equipment.Example: collision insurance is required for car loans. Home: keep house in
saleable condition, maintain insurance.
4. Requirement to provide information to bondholders or bank on a regular basis so they can
be monitored. Example: small company has to provide quarterly income statements to bank,
company may have to provide quarterly financial statements to bondholders.
Point: restrictive covenants can reduce moral hazard problem
13. Do mature financial markets experience turbulence?
14. What will technology do to financial structure?
15. Do you support “too big to fail” theory? If your answer is YES give one reason why
you are for it. If you answer is NO give one reason why you are against it.
AnsFinancial bail-outs of lending institutions by governments, central banksor other
institutions can encourage risky lending in the future, if those that take the riskscome
to believe that they will not have to carry the full burden of potential losses.
Lendinginstitutions need to take risks by making loans, and usually the most risky
loans have the potential for making the highest return.So-called "too big to fail"

17. lending institutions canmake risky loans that will pay handsomely if the investment
turns out well, while being bailed out by the taxpayer if the investment turns out
badly.
16. Peter Thiel, a prominent Facebook investor, said it was generally desirable for
technology companies to defer an IPO for as long as possible. He said Google set a
good example by not going public for a nearly six years, until it dominated the search
wars. What in your opinion is the main reason? (give only ONE rationale which you
think is the most important)
17. Why debt contracts are complicated legal documents with restrictive covenants?
18. Many participants in the market are forecasting GOLD to beat $2000 in the next year.
What are they essentially betting against?
19. What is the main argument against „Investor fee paying‟ model in credit rating
business?
Ans. The main income for credit rating agencies is the fees they collect from giving
ratings. In the investor fee paying model, the investor subscribes to rating released by
the agencies and these subscriptions revenues are the main souce of income. Back in
1970, this model was wildly used.If the credit rating business offers an investor fee
paying model, where the investors pay, this might result in a problem of free riding
where once investor pays for the subscriptions gets the publication and shares this
with others. This will reduce the number of prospected subscribers for the rating
agencies and reduce revenue of the firm. Also with the invention and growth of
photocopiers,the reports were Xeroxed,reduing the number subscriptions even more
further.jence rating agenies adopt issuer fee model where the issuer himself pays for
the rating.
20. Why venture capitalists insist on having hybrid securities?
Ans.Venture Capitalist Features
High return expectation due to high risk
Consultants to the firm as new firm is inexperienced.
Active Governance- One partner always sits on the board of the firm
Funds through stages.
Severity of penalties for not performing provides the entrepreneur powerful
incentiveto work.
The securities that the venture capitalistreceives in exchange for investing funds in the
portfolio firm are more complicated thansimple debt or equitycontract.The venture
capitalist usually receives convertiblepreferred stock. Like a debt contract,

18. preferredstock requires the firm to make fixed paymentsto the stock‟s holder.And the
promisedpayments must be made before any commonstockholder gets dividend
payments, that is, thepreferred stockholder has priority over commonstockholders.
Hence, the venture capitalistcan make sure that the entrepreneur is notpaying himself
a high salary disguised as dividends.It also means that if things turn out badlyand the
firm is liquidated, the venture capitalistgets back her investment in the firm beforethe
entrepreneur gets paid anything.Unlike preferred stockholders in many other
settings, the venture capitalist usually has votingrights.the venture capitalist
can cash out shares at some predetermined price whenever it wants. The right to
convert the financial calims into shares focuses the vision of VC in maximizing the
firms value. This helps in creating harmony between the entrepreneur and theVC as
max firms value will max their wealth.
21. Lending is a multi-functional activity. Agree? Mention all the functions involved in
lending.
Ans
To illustrate application of the functional perspective to a financial activity, consider lending.
Lending isoften treated as a homogeneous activity in both private sector and public sector
decision-making. Butfrom a functional perspective, lending in general is multi-functional,
involving two of the six basicfunctions of the financial system.
Lending in its “purest” form is free of default risk, so it falls under a single basic functional
category:
theintertemporal transfer of resources. But, of course, with few exceptions, payments
promised in loanagreements are subject to some degree of default risk. Lending therefore also
involves a second basicfunctional category: risk management. When a loan is made, an
implicit guarantee of that loan (a formof insurance) is involved.
To see this, consider the fundamental identity, which holds in both a functional and a
valuation
sense:
Risky Loan + Loan Guarantee = Default-Free Loan
Risky Loan _ - Default-Free Loan _ = Loan Guarantee
Thus, whenever lenders make dollar-denominated loans to anyone other than the United
States government, they are implicitly also selling loan guarantees. The lending activity
therefore consists oftwo functionally distinct activities: pure default-free lending (the
intertemporal transfer function), andthe sale of default risk insurance by the lender to the
borrower (an example of the risk managementfunction.The relative weighting of these two
functions varies considerably across the various debtinstruments. A high-grade bond (rated
AAA) is almost all default-free loan with a very small guaranteecomponent. A below-
investment-grade or “junk” bond, on the other hand, typically has a largeguarantee
component.
Free-float Concept:
Understanding Free-float Methodology Concept

19. Free-float Methodology refers to an index construction methodology that takes into consideration only
the free-float market capitalization of a company for the purpose of index calculation and assigning
weight to stocks in the Index. Free-float market capitalization takes into consideration only those
shares issued by the company that are readily available for trading in the market. It generally
excludes promoters' holding, government holding, strategic holding and other locked-in shares that
will not come to the market for trading in the normal course. In other words, the market capitalization
of each company in a Free-float index is reduced to the extent of its readily available shares in the
market.
Subsequently all BSE indices with the exception of BSE PSU index have adopted the free-float
methodology.
Major Advantages of Free-float Methodology
A Free-float index reflects the market trends more rationally as it takes into consideration only
those shares that are available for trading in the market.
Free-float Methodology makes the index more broad-based by reducing the concentration of
top few companies in Index.
A Free-float index aids both active and passive investing styles. It aids active managers by
enabling them to benchmark their fund returns vis-à-vis an investible index. This enables
an apple-to-apple comparison thereby facilitating better evaluation of performance of active
managers. Being a perfectly replicable portfolio of stocks, a Free-float adjusted index is
best suited for the passive managers as it enables them to track the index with the least
tracking error.
Free-float Methodology improves index flexibility in terms of including any stock from the
universe of listed stocks. This improves market coverage and sector coverage of the index.
For example, under a full-market capitalization methodology, companies with large market
capitalization and low free-float cannot generally be included in the Index because they
tend to distort the index by having an undue influence on the index movement. However,
under the free-float Methodology, since only the free-float market capitalization of each
company is considered for index calculation, it becomes possible to include such closely
held companies in the index while at the same time preventing their undue influence on the
index movement.
Globally, the free-float Methodology of index construction is considered to be an industry best
practice and all major index providers like MSCI, FTSE, S&P and STOXX have adopted
the same. MSCI, a leading global index provider, shifted all its indices to the Free-float
Methodology in 2002. The MSCI India Standard Index, which is followed by Foreign
Institutional Investors (FIIs) to track Indian equities, is also based on the Free-float
Methodology. NASDAQ-100, the underlying index to the famous Exchange Traded Fund
(ETF) - QQQ is based on the Free-float Methodology.
Definition of Free-float
Shareholdings of investors that would not, in the normal course, come into the open market for trading
are treated as 'Controlling/ Strategic Holdings' and hence not included in free-float. Specifically, the
following categories of holding are generally excluded from the definition of Free-float:
Shares held by founders/directors/acquirers which has control element
Shares held by persons/ bodies with "Controlling Interest"
Shares held by Government as promoter/acquirer
Holdings through the FDI Route
Strategic stakes by private corporate bodies/ individuals
Equity held by associate/group companies (cross-holdings)
Equity held by Employee Welfare Trusts
Locked-in shares and shares which would not be sold in the open market in normal course.
The remaining shareholders fall under the Free-float category.