Glossary Of Financial Terms starting with F

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List of Financial Terms (Alphabet Wise)

Factoring An arrangement for obtaining funds by selling receivables to a specialized financing agency (the factor), generally without recourse. When factoring is contemplated, a firm's sales to different customers must have prior approval of the factor. Typically, a factor pays up to 80 percent of the invoice value to its client (firm) upon receipt of the copy of the invoice relating to goods delivered. The balance is paid after receiving the amount due from the firm's customer. In order to ensure timely collection, the factor may follow up with the customer after furnishing the details of receivables. The agency, i.e., the factor, bears the responsibility and attendant RISK of collecting the dues from the company's customers.

There are two basic components to the charges levied by a factor: interest or DISCOUNT charge and service fee. Whereas the interest rate depends on the cost of money and competition among factors, the service commission is for bearing risk, processing and collecting the receivables and handling the book-keeping. Factoring is thus a financial package of credit, debt collection and sales ledger administration resulting in regular cash flows to companies whose credit sales comprise a significant portion of the total sales. The main drawback with factoring is that it is usually very expensive.

Among the reasons why factoring has not caught on in India are competition from alternative sources of financing particularly bill DISCOUNTING as well as funds constraint and lack of credit information. The task of debt collection is also considered to be a major impediment.

Financial Futures These are contracts guaranteeing delivery of specified financial instruments on a future date, at a predetermined price. The financial instruments traded in the U.S. futures markets consist of foreign currencies and debt securities e.g., TREASURY BILLS, long-term U.S. Treasury BONDS, COMMERCIAL PAPER, etc. The futures contracts on debt securities are commonly known as interest-rate futures. They offer companies, banks and institutions a means to insulate themselves from adverse interest rate movements through HEADING. The objective behind hedging is to establish in advance, a certain rate of interest for a given time period. That apart, financial futures offer considerable profit potential which attracts speculators and individual investors too.

Financial Institution A non-banking financial intermediary (company corporation or co-operative society) carrying on any of the activities specified in the relevant section of the Reserve Bank of India Act. These activities include lending, investing in shares and other securities, HIRE-PURCHASE, insurance and CHIT FUNDS.

In general, this term refers to the Development Finance Institutions such as IDBI and IFCI, as well as the Unit Trust of India (UTI) and the Life Insurance Corporation of India (LIC). However, a more specific classification could be as shown below :

SIDBI : Small Industries Development Bank of India.
SFCs: State Financial Corporations.
TFCI: Tourism Finance Corporation of India Ltd.
TDICI : Technology Development and Information Company of India Ltd.
RCTD : Risk Capital and Technology Finance Corporation Limited.

Financial Leverage The ability to magnify earnings available to equity shareholders, by the use of debt or fixed-charge securities. Generally, the higher the amount of debt in relation to total financing, the greater will be the impact on profits available to equity shareholders, other things being equal. A simple illustration is shown below.

The Sparking Water Company has total assets of Rs.3,00,000. The impact of the use of debt becomes evident by comparing the EARNINGS PER SHARE (EPS) under different financing alternatives as shown below.

The effect of financial leverage is that an increase in the firm's PBIT results in a greater than proportionate increase in its EPS. For instance, in Plan B, a 50 percent increase in PBIT (from Rs.1,20,000 to 1,80,000) results in a 56 percent increase in EPS. Hence DFL, the degree of financial leverage, at a given PBIT can be measured by the formula:

DFL = Percentage change in EPS
Percentage change in PBIT
At PBIT ` 1,20,000, DFL = 56/50 = 1.12.

Though debt finance is tax-deductible, and hence an attractive source of funds, leverage is a double-edged sword, since the firm using leverage attracts not only higher returns but a risk as well. This is because an increase in debt raises fixed interest expenses and, thereby, the chances of financial failure.

Plan A : 0% debt; equity Rs.3,00,000 (3,000 equity shares of Rs.100 par)
Profits before interest and taxes (PBIT) Interest Profits before taxes(PBT) Taxes-50% EPS
1,200,000 0 1,20,000 60,000 20
1,80,000 0 1,80,000 90,000 30
2,40,000 0 2,40,000 1,20,000 40
Plan B : 30% debt at 15% interest per annum (2,100 shares at Rs.100 par)
PBIT Interest PBT Taxes (50%) EPS
1,20,000 13,500 1,06,500 53,250 2536
1,80,000 13,500 1,66,500 83,250 39.64
2,40,000 13,500 2,26,500 1,13,250 53,93

Financial Markets The transactions which result in the creation or transfer of financial ASSETS and LIABILITIES, mostly in the form of tradeable securities. The term connotes a vast forum rather than a specific physical location for trading activity. The constituents of financial markets are shown below :

The Money Market is that segment of the financial markets wherein financial instruments having maturities of less than one year are traded. These different instruments are listed below :
Instrument Typical MATURITY (in days)
CALL MONEY and NOTICE MONEY 1 and up to 14
The money market is useful to any entity, whether a government, bank, business or wealthy individuals having a temporary surplus or DEFICIT. Hence, it may be viewed as a forum for adjusting their short-term LIQUIDITY positions. The open money market does not have any physical trading locations. It is essentially a network of the major players and intermediaries linked by telephones and other media. However, the Reserve Bank of India plans to introduce screen-based trading system for this segment. The DISCOUNT AND FINANCE HOUSE OF INDIA LIMITED (DFHI) plays an important role as a MARKET MAKER in money market securities.

The Capital Market is that segment of the financial markets in which securities having maturities exceeding one year are traded. Examples include DEBENTURES, PREFERENCE shares and EQUITY SHARES.

Over-the-Country Exchange of India (OCTEI) offerings may originate as a public issue or a BOUGHT-OUT DEAL. EURO ISSUES and overseas offerings include GDRs, FOREIGN CURRENCY CONVERTIBLE BONDS, ADRs, FOREIGN BONDS and private placement with Foreign Institutional Investors (FIIs), all of which bring inflow of foreign exchange.

Over-the-counter transactions refer to the trading in securities including shares, that goes on at places other than exchanges, e.g., KERB DEALS or transactions at investors' clubs.

Fiscal Policy The use of tax and expenditure powers by a government. Government all over the world, are vested with the task of creating infrastructure (e.g., roads, ports, power plants, etc.) and are also required to ensure internal and external security. These responsibilities entail government expenditures on various fronts – capital outlays, the defense forces, police, the administrative services and others. Taxes are a major source of revenue to meet these outflows. Thus, the Union Government collects income tax, EXCISE DUTY, customs duty, etc., through its different arms.

An increase in government spending without a matching increase in inflows may cause or exacerbate a DEFICIT. But, government spending also contributes to aggregate demand for goods and services – directly, and indirectly by increasing private incomes which stimulates private demand.

Float The interval between the issuance of a cheque and its payment by the drawer's bank, through the clearing system. The time involved in clearing cheques through the banking system allows greater flexibility in cash management funds need not be deposited in an account as soon as a cheque is issued.

Floating Exchange Rate The exchange rate of a currency that is allowed to float, either within a narrow specified band around a reference rate, or totally freely according to market forces. These forces of demand and supply are influenced by factors, such as, a nation's economic health, trade performance and BALANCE OF PAYMENTS position, interest rates and INFLATION.

Floating Rate Bond A debt security whose COUPON RATE is periodically adjusted upwards or downwards, usually within a specified band, on the basis of a benchmark interest rate or an index. These securities, also termed 'Indexed Bonds', were introduced to offer investors protection from INFLATION and INTEREST RATE RISK that are inherent in a DEBENTURE or BOND bearing a fixed coupon. When interest rates and bond YIELDS go up, the coupon is raised as indicated by the issuer. The disadvantage is when rtes fall, because the bondholder's coupon receipts will fall. Moreover, the downward revision of the coupon would also preclude any CAPITAL GAINS by way of price appreciation, accruing to the holder. In India e.g., the first such instrument was introduced by the State Bank of India in December 1993. The bonds carry a floating rate of interest for 3 percent over the bank's maximum term deposit rate, with a minimum coupon rate of 12 percent per annum; the coupon rate will be adjusted at regular intervals of six months on January 1 and July 1 throughout the tenure of the instrument. (See also GOVERNMENT SECURITIES.)

In December 1997, Capital Indexed Bonds of the Government of India were introduced. These bonds provide investors a complete hedge against inflation for the principal amount of investment, on the basis of the Wholesale Price Index.

Foreign Currency Convertible Bond (FCCB) An unsecured debt instrument denominated in a foreign-currency and issued by an Indian company which is convertible into shares, or in some cases into GDRs, at a predetermined rate. That is, the CONVERSION PRICE and the exchange rate are fixed. The BOND which bears a certain coupon enables the issuing company to economize on interest cost by tapping foreign markets and also to postpone a DILUTION in the EARNINGS PER SHARE. The advantage to the investor is the option of retaining the security as a bond till REDEMPTION, if the stock does not rise to the desired level. Moreover, the interest rate on the security is higher as compared to bonds of foreign companies. Subject to the rules prevailing, put and call OPTIONS may be attached to the instrument. The put enables investors to sell their bonds back to the issuer. The call allows the issuer to undertake REFINANCING or to force conversion. Incidentally, one dimension of FCCBs is that they add to India's external debt. Moreover, until conversion, the interest is paid in foreign currency. If the option to convert is not exercised, redemption too will entail an outflow of foreign currency. Therefore, the exchange risk, i.e., the depreciation cost, must be taken into consideration. In some respects, an 'Alpine Convertible' bond (issued to Swiss investors) scores over others; the issue costs are lower and the placement process is shorter. (See also EURO ISSUES and GDR.)

Forfeiting This refers to the sale of export receivables. It amounts to DISCOUNTING receivables by a forfeiting company, but without recourse to the exporter. Therefore, it serves to convert as sale of goods on credit into a cash sale. Under this arrangement, the exporter receives the proceeds on surrendering to the forfeiter, the endorsed debt instrument duly accepted by the importer and co-accepted by his bank. Unless otherwise specified, the forfeiter bears the risk of default in payment by the importer. So, the forfeiter's fee depends on the country of the importer apart from the due date of payment. For instance, the fee for forfeiting bills accepted by an importer in Uganda could be higher than for an importer in U.K. in India, the EXIM BANK introduced forfeiting in 1992. Authorized Dealers in foreign exchange may also enter this business.

Forfeiture It means the deprivation of shares held by an investor, usually as a consequence of default in paying money, called upon allotment, to the company. As a result of a forfeiture, the investor ceases to be a shareholder insofar as the forfeited shares are concerned; however, he remains liable for the sum due.

Formula Plans These are mechanistic methods of timing decisions relating to the buying and selling of securities. There are different formula plans that include the Constant Dollar Plan and the Constant and Variable Ratio Plans. These methods are for the patient, conservative investor who seeks protection from large losses and is not confident of timing his decisions correctly. (See DOLLAR COST AVERAGING).

Forward Contract A transaction which binds a seller to deliver at a future date and the buyer to correspondingly accept a certain quantity of a specified commodity at the price agreed upon, which is known as the 'Forward Rate'. A forward contract is distinct from a futures contract because the terms of the former can be tailored to one's needs whereas, the latter is standardized in terms of quantity, quality and delivery month for different commodities. In other words, forward contracts are customized contracts that enable the parties to choose delivery dates and trading units to suit their requirements. (See also COMMODITY FUTURES.)

Forward Discount The differential by which a currency is less expensive in the forward market as compared to the SPOT MARKET.

Forward Premium The amount by which a currency's forward rate exceeds the spot market rate. (See INTEREST RATE PARITY THEOREM).

Fund-based This term is used to describe financial assistance that involves disbursement of funds. Examples include the CASH CREDIT facility, bill DISCOUNTING, equipment leasing, HIRE-PURCHASE and FACTORING. In contrast, non-fund based services involve the issuance of LETTERS OF CREDIT, BANK GUARANTEES, ACCEPTANCE and fee-based services such as security issues management, LOAN SYNDICATION and advisory assistance.

Funding The technique of extending the MATURITY of debt by substituting long-term debt instruments for short-term securities through REFINANCING operations. Sometimes, this is also referred to as 'debt roll-over' or 'conversion'. In India, funding has been applied to Ad hoc TREASURY BILLS held by the Reserve Bank of India. Subsequently, it has been extended to 364-day and 91-day auctioned bills. The consequence of such substitution of 'floating debt' (TREASURY BILLS or WAYS and MEANS ADVANCES) by 'funded debt' (LONG-DATED or undated GOVERNMENT SECURITIES) is an increase in the interest burden as a result of the longer maturity of government debt, even though the quantum has not changed. Funding operations also result in replenishment of the floating stock of Government Securities, which facilitates OPEN MARKET OPERATIONS and statutory investment by banks.

This practice of debt roll-over may be employed during tight LIQUIDITY conditions in the financial markets or alter-natively with the objective of matching outflows to receipts. However, such a change in the MATURITY profile of debt that causes the interest obligations to become more onerous, as stated above, may aggravate the repayment situation. The latter contingency can, however, be overcome if the Government's coffers get filled due to a growing economy, (See also STATUTORY LIQUIDITY RATIO.)

Futures Market A market in which contracts for future delivery of certain commodities or securities are traded. (See also COMMODITY FUTURES and FINANCIAL FUTURES.)

GDR An acronym for Global Depository Receipt. It is an instrument denominated in foreign currency that enables foreign investors to trade in securities of alien companies not listed at their exchanges. So, e.g., a dollar-denominated GDR issued on behalf of an Indian company represents a certain number of rupee-denominated equity shares, which are issued by the company to an intermediary termed the 'Overseas Depository Bank' (ODB), in whose name the shares are registered. The shares, however, rest with the local custodian bank. The GDR which is issued by the ODB may trade freely in the security markets overseas; e.g., DGRs of Indian companies are listed on the Luxembourg Stock Exchange and some on the London Stock Exchange. Also, a GDR holder, not wanting a continue holding the instrument, may opt for cancellation of the same after the specified period by approaching the ODB and having the underlying shares released by the custodian in India for sale. The proceeds, adjusted for taxes, and converted into foreign currency will be remitted to the foreign investor subsequently. As an example, the GDR of G.E. Shipping issued in February 1994 at a price of U.S. $ 15.94 has five underlying shares. GDRs are generally issued at a modest DISCOUNT to the prevailing market price. A bigger discount may trigger off widespread ARBITRAGE trading.

The advantage of an issuing company is the inflow of foreign currency funds. Further, DIVIDEND payments are in rupees and, therefore, there is no exchange risk. Moreover, the increase in equity is clearly known unlike with FOREIGN CURRENCY CONVERTIBLE BONDS. Administratively too, in matters regarding dividends, company meetings, etc. it becomes easier for the company to interact with the single ODB that accounts for a large shareholding. The management may enter into a suitable understanding with the ODB as regards the exercise of voting rights. Besides holding the shares, the ODB also performs the functions of distribution of dividends and issue of GDR certificates to replace those lost, mutilated, etc.

There are no stipulated norms regarding turnover and MARKET CAPITALIZATION. However, prospective issuers are expected to have a minimum turnover of Rs.500 crore and market capitalization in the range of Rs.1200 to 1500 crore. (See also FUNGIBLE.)