Saturday, January 31, 2015

Balance of Payment

Balance of Payments (BOP) of a country is its record of all financial transactions performed between the residents (meaning individual, firms, government) and the rest of the world (albeit within a period, usually a financial year).

Here a point need to be mentioned, BOP data isn't concerned with actual 'payments', rather with 'transactions'.


Now the question is does it really 'balances'?
The answer is may not be. Though theoretically it should be zero, meaning that assets (credits) and liabilities (debits) should balance, but in practice there is mostly a mismatch.

It generally happens, when the outward transaction is more than the inward transaction, and then is termed as Balance of Payment Deficit (BOP deficit) Also, BOP surplus is possible, for the reverse case.


BOP Accounts
For the international trade, a country's BOP deals with three types of accounts -

  1. Current Account - It is the most important of the three. It has mainly four components - goods, services, income and current transfers (meaning worker's remittances, donations, aids, etc.). It is very obvious now - if the outflow of this components are more than the inflow, it will result in Current Account Deficit (CAD).
  2. Capital Account - All international capital transfers are recorded here (Capitals meaning non-financial assets, such as land and non-produced assets, such as mine)
  3. Financial Account - It contains the direct investment (remember FDI, ODI), portfolio investment, reserve assets, etc.
Often the last two accounts are mentioned as a single one - Capital and Financial Account.


Trade Deficit
From the above discussion you hopefully learned the concept of BOP deficit and Current Account Deficit (CAD). Since we are talking about 'international' transactions, its better to know about the Trade Deficit.

It is very much simple - negative balance of trade, meaning country imports more than exports. As a result currency is flowing outward
(On a personal note - Reduce gold use. Indian currency flows outward. Government spends a lot for importing gold from foreign countries!)


Other types of deficits - Revenue Deficit, Fiscal Deficit, Primary Deficit - will be discussed later.


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Forex

Foreign-exchange reserves (forex) are assets of a country, generally held by the central bank, and held in foreign currencies. For India, RBI is authorized to maintain Indian forex, which is generally held in US Dollar, or other foreign currencies.

But the question is why do a country hold forex reserve?
There are few reasons behind this. However most important is -

  • Influence Exchange RateIf India has a large amount of forex, then it can target a certain exchange rate. For example, If India wants to increase the value of Indian Rupee (INR), India could sell its dollar reserves to buy INR on the foreign exchange market. The increased demand would appreciate the INR. In a fixed exchange rate, forex reserves can play an important role in trying to keep a target exchange rate.
  • Guarantor for External Debts / Liabilities - If India holds a large amount of forex, then foreign countries, or foreign banks (like, World Bank, ADB, etc) will be much willing to provide long term or short term loans. Because, they will understand that India has the ability to payback the loan. It reflects as credit worthiness.

Indian forex
India has four types of forex assets -
  1. Foreign Currency Assets - This is the most important part of forex, and holds the maximum portion of it. It simply means how much foreign currency (generally dollar) India holds (Jan 23, 2015 - USD 2,97,510)
  2. Gold Reserves - This is the next most important part. How much gold India holds (Jan 23, 2015 - USD 19,377 worth gold)
  3. Special Drawing Rights (SDR) - These are the drawing rights, or a claim to currency, that a country holds with IMF, that can be sold or bought. Note that it can be exchanged with currencies. (Jan 23, 2015 - USD 4,047)
  4. Reserve Position in the IMF - Also known as Reserve Tranche Position (RTP). It also represents a forex, to some extent (Jan 23, 2015 - USD 1,101)

In Jan 23, 2015, India holds total USD 3,22,037 as forex


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Sensex

Share Index
After a private company goes public, through Initial Public Offering (IPO), or become a public company, it is important to know about how the 'public company' is working. Would it be better to invest in that particular company than some other? For facilitating investors interests, the concept of share market index has aroused.


Sensex
Indian version of the share index is Sensex (Sensitive Index, coined by Indian stock market analyst, Deepak Mohoni). It is maintained by Bombay Stock Exchange (BSE) in Mumbai, the business capital of India. It takes care of 30 financially sound and well-established Indian public companies shares or stocks (already discussed about shares in previous post 'Equity & Debt')

Now, let's clear about primary and secondary market.

  • Primary Market - You buy shares from company itself
  • Secondary Market - You buy shares from some other shareholder, rather than the company, meaning the share is already gone through the Primary market.

Types of Shares
Before going to how you could calculate sensex, it is important to know about different types of shares -
  • Restricted Shares - restricted to its own employees, or insiders, cannot be issued to public without special permission
  • Float Shares - freely bought of sold in public (consider as floating in public market)
  • Outstanding Shares - represents all the shares the company actually issued, either to the public or to its own employees (meaning, restricted shares + float shares)
  • Authorized Shares - maximum share that a company can issueShareholder's Vote is necessary to increase or decrease it. 


    Now clear this types with a suitable example -

    Suppose company X has 1,000 Authorized shares. But, it issued 300 shares to public (Float Shares), 200 shares to own employees/executives (Restricted Shares), and retained remaining 500 shares in its treasury
    Therefor, Outstanding shares makes to 300 + 200 = 500 shares


    Sensex Calculation - free-float capitalization method

    Step 1 - Find Market Capitalization (no. of outstanding shares x price per share)
    Step 2 - Multiply with free-float factor (which is determined by percentage of floated shares to outstanding shares)

    Now, think do a public investor need to know about the shares that are kept in the treasury of the company, while investing? Answer is no. What shares are in the public market (floating share) is important instead.

    From the above example
    Percentage of floating shares to outstanding shares = (floating / outstanding) x 100 %
    = (300 / 500) x 100 %  =  60 %
    This percentage makes free-float factor = 0.6

    Now, suppose the price of each share of the company X is Rs. 150. Then market capitalization of the company is = outstanding shares x price per share
    = 500 x Rs. 150  =  Rs. 75,000

    Therefore, the free-float market capitalization becomes = market cap x free-float factor
    = Rs. 75,000 x 0.6  =  Rs. 45,000


    Note - This is a demonstrative example, not actual figure, just for learning purpose.


    Nifty
    While Sensex is the name of the share index of 30 companies in S&P BSE, CNX Nifty is the name of the share index of 50 companies of S&P National Stock Exchange (NSE)

    S&P - Standard & Poors, an international financial services company
    CNX - CRISIL NSE Index




    Hope this post will help you clear a lot of doubts.
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    Money Market - Part II

    Instruments of Money Market
    Now, its time to learn about the several instruments that work in Money Market. Note that the tenure of the money market is overnight (1 day) to 1 year (365 days). So, all the instruments here works within this tenure. Though there is no such restriction, or no such obvious line of distinction.


    Government Instruments

    1.  Treasury Bills (91 - 364 days)
    Treasury Bills or T-Bills are the most important and used mean for the government to acquire money from the market, to maintain its money requirements. On behalf of the government, RBI issues T-Bills to public as auction on some fixed date.

    These are the least risky money market instrument and have 3 maturity periods - 91 days, 182 days, 364 days (meaning you can claim for your return only after these term periods). Note that Treasury Bill is a type of debenture (already discussed in the article - Equity & Debt), hence doesn't require any collateral as security. You only buy a T-Bill, because you know that government will never default on your payment.

    Treasury Bills are issued on discount basis and can be redeemed at par, and it doesn't bear any interest. Let clear with an example -

    Suppose you want to buy a T-Bill of Rs. 10,000 with 91 days maturity. RBI may tell you that the
    discount rate is 1.5 %. So you can redeem a discount of = 10,000 x 1.5/100 = Rs. 150. 
    This means you can buy the treasury bill in Rs 10,000 - 150 = Rs. 9,850 (your profit will be Rs. 150, which you can redeem as discount). After 91 days (the maturity), you go to RBI to get the return, and RBI will give you Rs. 10,000.
    Summary - You buy the T-Bill in Rs. 9,850 and get in return Rs. 10,000 (face value). Note that, there is no interest involved in T-Bill.


    2.  Cash Management Bill (CMB) (< 91 days)
    Government can take loans from RBI as Ways and Means Advances (WMA; will discuss in later posts). But there is a limit on WMA advances, and the loans above the limit bears extra interest. Therefore, it is better for the government to acquire money from the general public. Cash Management Bill (CMB) is such instrument that helps government to maintain its temporary cash requirements for less than 90 days.

    Note that, T-Bills can not be used for the temporary (upto 90 days) or urgent requirements. CMB comes handy for this purpose, instead of high interest loans.

    Features of CMB is almost similar to that T-Bills including auction process, discount to the face value, etc.


    3.  Dated Securities
    Though definition-wise this doesn't come under Money Market. But it is better to discuss it here in government security section.
    Dated Securities are long-term securities that helps government to take money from public for more than 1 years. Here government issues securities that bear a date of a distant future, which could help in long-term development projects, or otherwise.

    It is important to mention here, that state governments cannot issue T-Bills to public. So state governments can issue only Dated Securities for a long term. These are known as State Development Loans (SDL).


    Gilt-edged Security - All the government securities are collectively called gilt-edged securities, or government securities.



    Hope this post will help you clear a lot of doubts.


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    Non Residential Indians (NRI) Accounts

    Non-Resident Ordinary (NRO)
    You are a citizen of India. You work here, and you have a good income. Now suppose, you want to move to a foreign country (for whatever purpose) (meaning you are going to be an NRI). Then what will you do to for your Indian earnings, like rent, dividends? Or may be you want to send remittances from foreign country. Then the handy account for you is Non-Resident Ordinary (NRO) Rupee Account.

    The balance maintained in this type will be Rupee (INR) dominated. You can open Savings, Current, Fixed, Term - types of account. 


    Non-Resident External (NRE)
    You are already an NRI. You have foreign currency with you. You can open this type of NRE Account. Note that you have to deposit foreign currency while opening this account (can use traveler's cheque or notes).

    The balance will be maintained in Rupee (INR). This will facilitate mostly in your remittances to India. You have several options or opening Savings, Current, Fixed, Term accounts.


    Foreign Currency Non-Resident Bank (FCNR(B))
    This is another type of account for NRIs and almost similar to NRE account. However there are some major differences -
    • You can only maintain your FCNR(B) account in foreign currencies (like, Pound, Dollars, Euro, Yen, etc)
    • Only one type of deposit is allowed - term deposit of 1 to 5 year maturity.


    Now, try to compare these three types of accounts -


    Non-Resident (Ordinary) Rupee Account (NRO)
    Non-Resident (External) Rupee Account (NRE)
    Foreign Currency Non-Resident (Bank) Account (FCNR(B))
    Currency
    Rupee Denominated (INR)
    Rupee Denominated (INR)
    USD, Pounds, Euro, Yen, etc.
    Who can open?
    NRI, Resident before becoming an NRI
    NRI
    NRI
    A/c type
    CASA, Fixed/Term
    CASA, Fixed/Term
    Only Fixed/Term
    Purpose
    To park Indian earnings, like rent, Indian salary, dividend, etc.
    To park overseas savings remitted to India by converting to INR
    To maintain account in foreign currency. Only term deposit of 1 to 5 years
    Repatriation
    Only interest on NRO account balance (after deducting TDS)
    Yes
    Yes
    Tax
    Taxed as per applicable slab rate
    Tax free
    Tax free



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    Friday, January 30, 2015

    Money Market - Part I

    Money Market
    It generally provides investment avenues of short time tenor, by definition for a maximum one year. Money market transactions are generally used for funding the transactions in other markets including Government securities market, Capital market and meeting short term liquidity mismatches.

    The one year tenor can be classified into -
    1. Overnight market - tenor of transactions is one working day (also called Call Money market)
    2. Notice Money market - tenor from 2 days to 14 days
    3. Term Money market - tenor from 15 days to 1 year

    Instruments used
    Money market instruments include Call Money, Repos, T-Bills, Commercial Papers (CP), Certificate of Deposits (CD), and Collateralized Borrowing and Lending Obligations (CBLO).


    Borrowing money from RBI
    Banks can borrow money from RBI with or without securities, and for 1 day to 1 year period. Depending on these, there are 3 ways to borrow money from RBI, and hence 3 rates -


    1.  Repo (Repurchase) rate
    This is a type of collateral lending by RBI. Here, banks sells securities (gov. securities) to RBI with a repurchase agreement (meaning banks will buy back those securities at future date with extra interest). The rate charged by RBI is known as Repo rate.

    It comes under Liquidity Adjustment Facility (LAF) of RBI monetary policy (i.e., a way to adjust market liquidity, along with reverse repo).

    Banks borrow money by repo to meet their daily mismatches. Repo auctions are conducted by RBI on a daily basis, except Saturdays. Here, minimum bid size is of Rs. 5 crore and multiple. All commercial banks (except RRBs) can borrow through repo facility. Repo borrowings have a tenure of 1 day to 90 days.


    2.  Marginal Standing Facility (MSF) - 
    Now think what will happen if banks are not able to maintain their daily mismatches even with repo (it happens!). Hence RBI provided (from 2011) one more facility to banks - Marginal Standing Facility (MSF). Albeit its a penalty rate (because banks are not able to maintain their mismatches with repo), and always higher than repo rate (currently 100 basis point higher).

    In this scheme, banks borrow money with minimum bid size of Rs. 1 crore and multiple. The tenure is of 1 day only, and banks can borrow 1 % of their respective NDTL under this scheme.


    3. Bank Rate -
    For the long term, i.e., 90 days to 1 year, banks can borrow money from RBI with bank rate. As it is a long term borrowing, the rate is higher than repo rate

    Banks doesn't need any collateral or security, while borrowing for a long term under Bank Rate. It is not used as a monetary policy to adjust the market, rather used to re-discount Bills of Exchange (refer our previous article on Discounting Bills of Exchange), or other Commercial Paper.



    Lending money to RBI
    Now come to the lending part. Now think, what is the purpose of Reverse Repo? Why banks will lend money to RBI, and when?

    If a bank is able to maintain its money requirements properly, and has surplus money, then it would be better for the bank to lend to RBI, rather than keeping it with itself. Because, lending money will give the bank interests in reverse repo rate.

    Its again a collateralized lending to RBI with repurchase agreement, as repo (works as opposite to repo).


    Liquidity Adjustment Facility (LAF)
    Repo and Reverse Repo together forms the Liquidity Adjustment Facility. It is a very essential and efficient tool of RBI to adjust the market liquidity. Since raising or reducing the rates, will make the banks raise or reduce its own rates to its customer (public), and of a short term tenure.


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    Equity and Debts

    Investment in Corporate Sector
    Suppose, you want to invest in a corporate sector. What options do you have?

    You have two options for investment - invest in stocks/equity/share or invest in bonds/debentures of the company.

    First option points to Equity instrument, whereas the second option to Debt instrument.

    Equity Instrument
    If you buy an equity instrument (i.e., shares), then you will be a (kind of) owner of the company, known as stakeholder or shareholder. The company is not liable to you. If the company generates profit, then you will get a part of it (as dividends, will explain later), and if generates loss, then you too have to bear it.

    You buy a share by paying an amount to the company, you don't get anything in return except the claim of being a stakeholder or shareholder. You will be only profited (i.e, benefited), when the company provides dividends to its shareholders.


    Debt Instrument
    If you buy a debt instrument (i.e., bonds, debentures), then you will be a liability of the company, and you won't be the (kind of) owner of it. Whether the company generates profits or make loss in its business, it is bound to provide you the investment you made as bonds or debentures, with interest.

    You buy a bond, you will get monthly/quarterly (whatever the payment time is) return from the company, where you invested. But you will never be a stakeholder.


    Now, try to summarize the differences of equity and debt instruments -


    Equity
    Debt
    Nature
    Equity, or Stock are securities that are a claim on the earnings and assets of a corporation.
    Debt instruments are assets that require a fixed payments to the holder, usually with interest.
    Use
    Allows a company to acquire funds, often for investment, without incurring debts
    Issuing a bond (debt instrument) increases the debt burden of the bond issuer because contractual interest payments must be paid – unlike dividends, they cannot be reduced or suspended
    Ownership
    Those who purchases equity instruments (e.g., stocks) gain ownership of the business, whose shares they hold. In other words, they gain the right to vote on the issues important to the firm. In addition, they have claims on the future earnings.
    Bond holders do not gain ownership in the business or have any claims to the future profits of the borrower. The borrower’s only obligation is to repay the loan with interest
    Risks
    Share holders gets profits or losses, as and when business makes it, making it highly risky
    Bonds are less risky – should the company run into trouble, bond holders are paid first, before other expenses are paid.
    Earnings
    Investors only earns when company issues dividends, that happens when the company wants to share the profit to their share holders
    Returns are periodic and almost fixed. Coupons or monthly interest is earned.
    Raising Capital
    Raising capital using equity is that the company who issues shares need not pay any money to the share holders.
    Raising capital using debt is a burden to the company, as they have to pay the interest monthly
    Instruments
    Shares, Dividends
    Bonds, Debentures, Certificates, Mortgages, Leases, Notes, or other agreements between a lender and a borrower




    Dividends and Debentures
    Now come to dividends and debentures. Don't get confused on these two. Dividends is a equity instrument, whereas debenture is a debt instrument.

    Dividends - When a company generates profits, it can use that amount whether as reinvestment in the company (to extend business, or buy new equipment, etc.), or as to share among the stakeholders / shareholders, or both.
    If it shares the profit among the shareholders, then it is known as Dividends (generally denoted as Dividends Per Share, or DPS). Shareholders gets dividends on per share basis.

    Debentures - It is a kind of debt instrument, but without collateral. You will buy a debenture only because you believe that the issuer (may be a company or government) will not default on its payment to you. They will not provide any security as collateral for your investment. The reputation of the issuer is enough for you to buy a debenture.

    The best example could be a Treasury Bill (T-Bill), issued by government. You know that government will never default on payment, so you buy a T-Bill, which is a debenture. (I shall elaborate T-Bill in next blogs)



    Hope I have cleared your doubts about these complex concepts. You are welcome to ask for more help about these in comments section below.


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    Non Banking Financial Corporations (NBFC)

    Non Banking Financial Companies (NBFC)
    NBFCs are financial institutions that provides almost similar banking services (like providing loans and credits) but doesn't possess banking license. So there are some limitation / restriction in its services.
    NBFCs are registered under the Companies Act, 1956, whereas banks are regulated under Banking Regulation Act, 1949.

    Differences between a Bank and an NBFC
    • It cannot accept Demand Deposits from public. If someone want to invest in an NBFC, it could have some maturity (like happens in time deposits). Though some special permission is given to LIC and GIC by RBI. These two NBFC can take demand deposits.
    • It is not a part of the Payments and Settlement System of India.
    • It cannot issue cheques drawn on itself.
    • Deposits are not insured or covered under Deposit Insurance and Credit Guarantee Corporation (DICGC), which generally covers the bank accounts.

    White Label ATM (WLA) - NBFC ATMs
    Most of the ATMs belong to banks, but the cash dispensing machines that are owned and operated by NBFCs are called White Label ATMs. Surely they charge extra money for providing this service, and generally operates in semi-urban and rural areas (tier III to VI areas)

    NBFCs that provides WLA - Tata Communications Payment Solutions, Prizm Payment Services Pvt. Ltd, Muthoot Finance Ltd, Vakrangee Ltd, BTI Payments Pvt. Ltd., Srei Infrastructure Finance Ltd, RiddiSiddhi Bullions Ltd. (total 7 as of May 2014)


    NBFC businesses -
    • loans and advances
    • acquisition of shares, stocks, bonds
    • insurance, etc.

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    Letter of Credit

    Letter of Credit (L/C)
    It is a guarantee in the form of a letter, issued by a buyer's bank. Suppose you want to buy or sell some goods from or to a foreign country. It is very much possible that you don't know the seller or buyer. And also the laws regulating the trade may be different. Therefore, both the seller and the buyer need some kind of guarantee to seamlessly perform the trade. Here Letter of Credit comes into action.

    The steps involved is very much as follows -

    Step 1 - First a contract is signed between the buyer and the seller.
    Step 2 - The buyer comes to his bank, and the bank issues a Letter of Credit, on behalf of the buyer, to the seller.
    Step 3 - After getting the Letter of Credit, seller knows that he will be paid surely. So he consigns the goods to a Carrier, in exchange of a Bill of Lading (Carrier provides it to the Seller)
    Step 4 - Seller takes the Bill of Lading and provide it to his bank (i.e., seller's bank), who eventually transfers it to buyer's bank, who then provides it to the buyer.
    Step 5 - Buyer takes the Bill of Lading, and gives it to the Carrier. The Carrier then getting his own Bill of Lading, delivers the goods to the buyer.
    Step 6 - Carrier then asks his payment from the Seller, by providing his Bill of Lading, that he has actually delivered the goods.
    Step 7 - Seller then asks his bank (i.e., sellers bank) for payment, who eventually asks the buyers bank. The buyers bank settles the payment.

    Now you can see that the risks involved is much minimized by using the Letter of Credit, as the seller is guaranteed to be paid by the buyers bank upon delivery of goods.

    Even in case, if the buyer doesn't pay the full amount to his bank (buyers bank), the buyers bank is obliged to pay the amount to the sellers bank. The buyers bank can later settle the amount with his buyer, as happens in loans or advances.



    Since bank guarantee also provides a type of guarantee. Then what is the difference between a Letter of Credit and Bank Guarantee?



    Letter of Credit
    Bank Guarantee
    Nature
    Paid only if the contract is satisfied Paid only if the contract is breached, i.e., not satisfied
    Use
    Ensures a transaction proceeds as planned
    Insures a buyer or seller from loss or damage due to non-performance by the other party




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    Bill Discounting

    If the drawer of the bill does not want to wait till the due date of the bill and is need of money, he may sell his bill to a bank at a certain rate of discount. The bill will be endorsed by the drawer with a signed and dated order to pay the bank. The bank will become the holder and the owner of the bill. After getting the bill, the bank will pay cash to the drawer equal to the face value less interest or discount at an agreed rate for the number of days it has to run. This process is known as discounting of a bill of exchange.

    For example, a drawer has a bill of Rs. 10,000. He discounted this bill with his bank 2 months before its due date, at 15 % p.a. rate of discount. Discount will be = Rs. 1,000 x 15/100 x 2/12 = Rs. 250. Thus the drawer will receive a cash worth Rs. 9,750 and will bear a loss of Rs. 250.
    The bank will keep this bill in possession till the due date. On maturity (due date) the bank will present the bill to the acceptor and will receive cash from him (if the bill is honored). In case, the acceptor does not make the payment to the bank, then the drawer or any person who has discounted the bill have to take this liability and will pay cash to the bank.

    N.B. Until the bill is honored on the due date, there is always a chance the drawer will become liable on the bill. This is called a Contingent Liability – a liability that will only arise if a certain event occurs – the acceptor does not honor the bill.


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    Lending Money - Cash Credit and Overdraft

    Lending money is one of the two major activities of any bank. Banks accept deposits from public for safe keeping and pay interest to them. They then lend this money to earn interest on this money. In a way, the banks act as intermediaries between the people who have the money to lend and those who need the money to carry out business transactions.

    Spread The difference between the rate at which the interest is paid on deposits and is charged on loans, is called the “spread”.

    Lending Activity – Commodities, Debts, Financial instruments, Real Estate, Automobiles, Consumer durable goods, Documents of title.

    Apart from the above categories, the Banks also lend to people on the basis of their perceived personal worth. Such loans are called clean and the banks are understandably cagey about extending such loans. The credit card arms of the various banks, however, fill up this void.

    a.    CASH CREDIT (CC) ACCOUNTThis account is the primary method in which banks lend money against the security of commodities and debt. It runs like a current account except that the money that can be withdrawn is not restricted to the amount deposited in the account. Instead, the account holder is permitted to withdraw a certain sum called “limit” or “credit facility” in excess of the amount deposited in the account.
    Cash Credits are, in theory, payable on demand. These are, therefore, counter part of Demand Deposits of the banks.

    b.    OVERDRAFT (OD)The word “overdraft” means the act of overdrawing from a bank account. In other words, the account holder withdraws more money from a bank account that has been deposited in it.


    Now try to understand about the differences between these two -

    The primary differences between cash credit and over draft is how they are secured and whether the money is lent out of a separate account.



    Cash Credit (CC)
    Over Draft (OD)
    User
    More commonly offered for businesses than individuals
    Can be used for any purpose, individual or business
    Security
    Security can be a tangible asset, such as stock, raw materials, or some other commodity
    Allowed against a host of other securities including financial instruments, like shares, units of MFs, surrender value of LIC policy and debentures etc. Some ODs are even granted against the perceived “worth” of an individual, known as clean ODs.
    Credit Limit
    A certain percentage of the value of the commodities / debts pledged by the a/c holder
    Acts more like a traditional loan. Money is lent as with a cash credit account, but a wider range of collateral can be used to secure the credit.
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    Demand Draft (DD)

    Demand Draft
    It is a negotiable instrument similar to a bill of exchange, with some special features.

    Demand Draft or DD is always issued by a bank (drawer) on behalf of its customers after taking the amount from him/her. The bank then directs another bank or its own branches (drawee) to pay a certain sum (the amount received from the customer) to the specified party (payee, whom the customer wants to pay).

    You could think that why would you use a Demand Draft instead of a Cheque. There are few good reasons behind it -

    • Before issuing a DD, the bank will take the amount (advance payment) from the customer, i.e., the payment is guaranteed. But in case of Cheque, it could bounce, if the account of the customer doesn't have sufficient balance in it. So, to eliminate the risk, the payee could ask you to provide a DD instead of a Cheque.
    • For issuing a DD, you don't need a bank account, you can go to the bank counter, and issue it. But cheque is inherently related with a bank account.

    Now, try to understand about the differences between a Demand Draft and a Cheque -


    Demand Draft (DD)
    Cheque
    Parties
    Drawer – bank only (individual pays), Drawee – Same or other banks, Payee – any party
    Drawer – individual/ac holder, Drawee – banker of individual, Payee – any party
    Negotiability
    DD can only be made payable to a specified party, also known as pay to order
    Cheques can also be made payable to the bearer, along with pay to order
    Payments
    Orders of payment by a bank to another bank
    Orders of payment from an account holder to the bank
    Honor
    Always honored, because already paid
    Can be dishonored, depending on account balance
    Guarantee
    Issuer party is backed by a bank guarantee
    Issuer party is liable to the cheque and not backed by a bank guarantee
    Defined
    Not precisely defined in NIA Act
    NIA Act, 1881

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