Course: Financial Institutions and Markets

Answer to Question No. 1

Introduction
A mutual fund is an investment vehicle where many investors pool their money to earn
returns on their capital over a period. Mutual funds combine money from many investors to
buy a variety of investments. The combined holdings of the mutual fund are known as its
portfolio. Investors buy shares in mutual funds. Each share represents an investor’s part
ownership in the fund and the income it generates. The corpus of funds is managed by an
investment professional known as a fund manager or portfolio manager. It is his/her job to
invest the corpus in different securities such as bonds, stocks, gold and other assets and seek
to provide potential returns. The fund's performance depends on how its collective assets are
doing. When these assets increase in value, so does the value of the fund's shares.
Conversely, when the assets decrease in value, so does the value of the shares . The gains (or
losses) on the investment are shared collectively by the investors in proportion to their
contribution to the fund.

Concept & Application

Mutual funds offer multiple product choices for investment across the financial spectrum. As
investment goals vary – post-retirement expenses, money for children’s education or
marriage, house purchase, etc. – the products required to achieve these goals vary too. The
Indian mutual fund industry offers a plethora of schemes and caters to all types of investor
needs. There are different types of mutual funds in India. Each fund type aims to achieve
specific goals. Mutual funds can be classified on the basis of asset class, structure and
investment objectives. The classification is as follows:

Types of mutual funds on the basis of asset class

 Debt funds - These funds invest in fixed income instruments like bonds, government
securities, and other debt instruments. They are generally less risky compared to
equity funds and provide regular income.
 Equity funds - These funds invest primarily in stocks and aim for high growth. They
are suitable for investors with a higher risk appetite and a longer investment horizon.
 Hybrid funds - These funds invest in a mix of equities and debt to balance the risk and
reward. They aim to provide growth and regular income.
Types of mutual funds on the basis of structure
 Open-ended mutual funds – Open-ended mutual funds allow investors to make
investments on any business day. The Net Asset Value (NAV) of these funds is used
for both purchase and sale. Because you can redeem your units from an open-ended
fund at any time on a business day, open-ended funds are very liquid.
 Closed-ended mutual funds - Closed-ended funds have a maturity period that is pre-
determined. Only during the fund's launch can investors make contributions, and they
can only take their money out of the fund when it matures. Similar to shares on the
stock market, these funds are listed. But because of the extremely low trading
volumes, they are not highly liquid.
Types of mutual funds on the basis of investment objectives
 Growth funds – The primary objective of growth funds is capital appreciation. These
funds invest a substantial percentage of their capital in stocks. Investing in these funds
 over the long term is advised because of their strong exposure to equity, which can
make them relatively riskier.
 Income funds - Income funds aim to give investors a consistent income. These debt
funds primarily make investments in certificates of deposit, bonds, and other
government securities. They fit investors with a lesser tolerance for risk as well as
those with a variety of long-term objectives.
 Liquid funds - Term deposits, commercial papers, Certificate of Deposits (CDs),
Treasury bills, and other short-term money market instruments are investments made
with liquid funds. Liquid funds are useful for setting up an emergency fund or parking
extra cash for a few days to several months.
 Tax saving funds - Under Section 80C of the Income Tax Act, tax-saving funds
provide you with tax advantages. Investing in these funds entitles you to annual
deductions of up to Rs. 1.5 lakh. An example of investment that can save taxes is the
Equity Linked Savings Scheme (ELSS).

There are many benefits of investing in mutual funds. Some of the important benefits are:
 Diversification - Compared to investing in a single security, mutual funds lower the
risk of losses by holding a diverse portfolio of securities.
 Professional expertise – Mutual funds are managed by professional who have
experience in portfolio management and investment selection that is advantageous to
people who might not have the time or knowledge to manage their own assets.
 Liquidity - You can purchase and sell your units of mutual funds on any business day
because they have significant liquidity. It's crucial to confirm this before investing
because certain funds have lock-in periods.
 Transparency - Mutual funds are subject to industry regulations meant to ensure
accountability and fairness for investors. They are regulated by SEBI which ensures a
level of transparency and protection for investors.
 Convenience - It's comparatively simple to invest in mutual funds. With Systematic
Investment Plans (SIPs), you can begin investing with small sums and continue on a
regular basis.

Conclusion
Mutual funds provide Ms. Suraksha with professional management, liquidity, diversity, and
convenience, making them a great option for an investment. Her savings can be progressively
increased and her long-term financial objectives can be met by beginning with modest,
consistent deposits made through SIPs. However, before to selecting the kind of mutual fund
to invest in, she should evaluate her time horizon, investing objectives, and risk tolerance.

Answer to Question No. 2

Introduction

Market efficiency refers to the degree to which market prices reflect all available, relevant
information. If markets are efficient, then all information is already incorporated into prices,
and so there is no way to "beat" the market because there are no undervalued or overvalued
securities available. This means that the stock prices are always fair. It is impossible to buy
undervalued stocks or sell stocks for inflated prices because everything known about the
stock is already factored into its price. Therefore, trying to outsmart the market to make quick
profits is very hard since you are not the only one with access to all the information. Efficient
Market Hypothesis has been propounded by Eugene Fama, who is a very renowned American
Economist. He had a belief that the stock market is informationally quite efficient, i.e., any
data/information/news that comes in the market is automatically absorbed by the stocks.
Therefore, any investor in the market cannot make abnormal returns in the long run, reason
being that the information is already exhibited in the prices of the securities. For an investor
to generate higher returns, the only way out is to make riskier investments.

Concept & Application

The Efficient Market Hypothesis (EMH) is a type of financial theory that states that asset
prices fully reflect all available information. As per EMH, stocks always trade at fair value on
stock exchanges, making it impossible for investors to either buy undervalued stocks or sell
stocks for inflated prices. The most important assumption underlying the efficient market
hypothesis is that all information relevant to stock prices is freely available and shared with
all market participants.
There are three variations of the hypothesis which represent three different assumed levels of
market efficiency. They are as follows:
 Weak Form - The weak form of the EMH assumes that the prices of securities reflect
all available public market information but may not reflect new information that is not
yet publicly available. Additionally, it makes the assumption that information from
the past about volume, price, and returns will not affect pricing in the future. The
weak form, while it discounts technical analysis, leaves open the possibility that
fundamental analysis may provide a means of outperforming the overall market
average return on investment
 Semi-Strong Form - The semi-strong form of the EMH incorporates the weak form
assumptions and expands on this by assuming that prices adjust quickly to any new
public information that becomes available. The semi-strong form of the theory
dismisses the usefulness of both technical and fundamental analysis.
 Strong Form - Prices always reflect all available information, both public and private,
according to the strong form of the Efficient Market Hypothesis. This covers any
information that is freely accessible to the public, including insider knowledge as well
as information that is recent or new. It's considered that the firm's current stock price
always takes into account information that isn't readily available to investors, like
confidential information.

Testing market efficiency is crucial for making informed investment decisions. Here are
some ways to test market efficiency:

Weak Form Efficiency Tests: Three types of test have been employed to empirically verify
the weak form of Efficient Market Theory. These are:
 Runs Test: A runs test is a statistical procedure that examines whether a string of
data is occurring randomly from a specific distribution. The runs test analyzes the
occurrence of similar events that are separated by events that are different. Traders
who focus on technical analysis can use a runs test to help analyze the price action of
a security.
 Serial Correlation Test: Serial correlation is a statistical term used to describe the
relationship – specifically, the correlation – between the current value of a variable
and a lagged value of the same variable from earlier time periods. Serial correlation,
also referred to as autocorrelation, is often used by financial analysts to predict future
price moves of a security, such as a stock, based on previous price moves.
  Filter Rules Test: The filter rule evaluates the weak version of the efficient market
hypothesis, which holds that historical prices don't include any information that could
lead to returns higher than those of a simple buy and hold approach.

Semi-Strong Form Efficiency Tests: Testing for semi-strong form efficiency includes:
 Event Studies: Event studies are widely used to test the semi-strong form efficiency.
They involve analyzing the stock prices' reaction to the public information, such as
earnings announcements, dividend announcements, and stock splits. The empirical
evidence from event studies suggests that the stock prices react quickly and efficiently
to the public information, and that the investors cannot earn abnormal returns by
trading on the public information.
 Regression/time Series Tests: Regression series testing is a statistical technique that
looks at the correlations between time series data in order to find patterns and possible
predictability in the financial markets. By evaluating whether historical data can
forecast future prices or returns, this test can aid in the evaluation of market
efficiency.

Strong Form Efficiency Tests: Testing for strong form efficiency involves:
 Insider Trading Analysis: Assessing the consistency with which insiders - such as
executives and directors - earn abnormal gains from their trading. Steady insider
profits imply that stock prices do not accurately reflect all available information.
 Mutual Fund Performance Studies: A thorough examination of mutual fund and
professional portfolio manager performance can shed light on strong form efficiency.
If these experts routinely beat the market, it can mean they have access to knowledge
that the general public does not.

Conclusion
Investment firms can find possibilities for excess profits by understanding the market and
evaluating for efficiency. Although markets are generally efficient, inefficiencies do
occasionally occur, especially in less liquid or less actively traded stocks. Businesses are able
to assess market efficiency and modify their strategies by utilizing a mix of these tests.
Furthermore, understanding that various markets may display differing levels of efficiency is
essential for global investment plans.

Answer to Question No. 3(a)

Fraud is essentially defined as any dishonest act or behaviour by which a certain individual
gains or has the explicit intent to gain an advantage over another person. The PNB fraud case
is basically a case of financial fraud that was committed by Nirav Modi and his associates
who colluded with senior Punjab National Bank employees. It is one of the biggest bank
frauds in the country where fugitive diamantaire Nirav Modi and his uncle Mehul Choksi
created a complex web of deception through fraudulent Letters of Undertaking (LoUs) to
siphon off Rs 14,000 crore from state-owned Punjab National Bank in connivance with some
bank officials.

The detail analysis of the events in the PNB fraud case are as follows:

1. January 25, 2018

  Discovery: On this day PNB detected the fraud. It was found that some of the
employees are engaged in fraud by issuing Letters of Undertakings (LoUs) and
Foreign Letters of Credit (FLCs) without authorization. The purpose of the
documents was to get buyer’s credit from Indian bank branches abroad.

2. January 29, 2018

 Reporting of Fraud: Fraud was reported to Reserve Bank of India (RBI) by PNB for
the first time.
 Filing of Criminal Complaint: In order to register a First Information Report (FIR),
PNB filed a criminal complaint with the Central Bureau of Investigation (CBI).

3. February 07, 2018

 Second Fraud Report: Upon the discovery of more fraudulent activity, PNB filed a
second fraud report with the RBI.
 Subsequent CBI Complaint: In consideration of the new fraudulent actions that were
uncovered, a second complaint was made to the CBI.

It is essential to take into account the potential risks and weaknesses in the financial sector in
light of the PNB fraud case. It caused regulatory frameworks, internal controls, and risk
management procedures used by banks to be re-evaluated. For the financial system to remain
stable and to regain public trust, these issues must be resolved.

Answer to Question No. 3(b)

The fraud case at Punjab National Bank (PNB) brings to light a number of risks in the
banking and financial sectors. To avoid such occurrences in the future and to increase overall
financial stability, it is crucial to understand these risks. The risks that are highlighted in the
PNB fraud case are as follows:

1. Operational Risk: Weaknesses in internal controls, particularly the improper use of the
SWIFT system and absence of appropriate checks and balances, made the fraudulent
actions possible. Employees of banks working together with outside parties increases
the possibility of insider fraud.
2. Reputational Risk: Customers and investors lost faith in PNB as a result of the scandal,
which seriously hurt the company's reputation. Other financial firm’s reputations
suffered as a result of the increased scrutiny regarding the banking industry as a whole.
3. Credit Risk: Due to the fake LoUs lack of sufficient collateral, the bank was put at
serious credit risk. There was a chance that other banks that gave credit based on the
forged LoUs might suffer losses.
4. Liquidity Risk: PNB's capacity to satisfy short-term obligations was harmed by the
significant financial loss, which also affected its liquidity situation.
5. Compliance Risk: There was a serious risk to compliance since the bank failed to
adhere to regulatory norms and internal policies. For a long time, the fraudulent
operations went unnoticed due to ineffective audits and oversight.

Risk is a probability that actual results will differ from expected results. In general, there are
two main categories of risk: Systematic and Unsystematic risk. Systematic risks, also known
as market risks, are risks that can affect an entire economic market overall or a large
percentage of the total market. Unsystematic risk, also known as specific risk or idiosyncratic
risk, is a category of risk that only affects an industry or a particular company. The difference
between systematic risk and unsystematic risk are as follows:

Systematic Risk Unsystematic Risk

1. Affects the entire market or economy. 1. Specific to a particular industry,
sector or company.
2. Arises from external factors that are 2. Arises from internal factors specific
beyond the control of investors. to a company or sector.
3. Cannot be eliminated from 3. Can be reduced or eliminated through
diversification. diversification.
4. Impacts the entire portfolio. 4. Impact the specific investment within
a portfolio
5. Examples are inflation, recession, or 5. Examples are change in management,
interest rate risk. a product recall or a regulatory
change.

In the PNB fraud case, the potential impact on the broader banking system and financial
markets due to the scale of the fraud highlights systemic risk while the specific operational
and credit risks faced by PNB exemplify unsystematic risk. Addressing both types of risks
requires a combination of robust internal controls, regulatory oversight, and effective risk
management practices. By understanding and mitigating these risks, financial institutions can
enhance their resilience against potential threats and ensure long-term stability.