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OutNotes - AFM Regular Concept Notes

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33 views323 pages

OutNotes - AFM Regular Concept Notes

Uploaded by

suhail.saeed.25.2002

We take content rights seriously. If you suspect this is your content, claim it here.

Available Formats

Download as PDF, TXT or read online on Scribd

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2 Amazing Features

Changing student's experience... Pg

123
day counting Rule
71
Month
Rounding off Rules
SCANNABLE
COMPILER

Audio Solutions

UNIQUE STRUCTURED
CONCEPT NOTES
OutNotes vs. ICAI Chapters
No. ICAI Chapter Name OutNotes Chapter Name

1 Financial Policy and Corporate Strategy Financial Policy and Corporate Strategy

2 Risk Management
Risk Management & Security Analysis
4 Security Analysis

3 Advanced Capital Budgeting Decisions Advanced Capital Budgeting Decisions

5 Security Valuation

Preference Share Valuation

Bond Valuation Fixed Income Securities

Money Market Securities

Equity Valuation
Equity & Business Valuation
13 Business Valuation

6 Portfolio Management Portfolio Management

7 Securitization Securitization

8 Mutual Funds Mutual Funds

9 Derivatives Analysis and Valuation

Derivatives & Interest Rate Risk
Management
12 Interest Rate Risk Management

Foreign Exchange Exposure and Risk

10
Management Foreign Exchange & International
Financial Management
11 International Financial Management

Mergers, Acquisitions and Corporate Mergers, Acquisitions and Corporate

14
Restructuring Restructuring

15 Startup Finance Startup Finance

Table of Content
Chapter No. Page No.

Basics of AFM 1

Equity & Business Valuation 9

Mergers, Acquisition & Corporate Restructuring 37

Fixed Income Securities 61

Portfolio Management 73

Mutual Fund 115

Derivatives & Interest Rate Risk Management 119

Foreign Exchange & International Financial

157
Management

Advanced Capital Budgeting Decisions 193

Risk Management & Security Analysis 205

Theory Topics 209

Tables 288
Important Instructions
before we read this book...
This book has been creatively designed to help you understand and
remember the concepts easily. For this purpose, concepts have been
presented in diagrams and charts format. However, for theory topics,
answers must be written in simple pointers and paragraph format in
exams.
The purpose of text in Grey Colour is to give you the background of the
main concept, which will be more useful while reading first time. At the
time of revision, you should make use of colour coding & ignore grey text.
Below theory chapters & topics have more importance and should be
studied on priority to other chapters:
Chapters:
1. Start-Up Finance
2. Securitization
3. Financial Policy and Corporate Strategy
4. Risk Management
5. Security Analysis

All the best!

Rounding off Rules
Δ If the number being calculated naturally has only 2, 3 or 4 digits after
decimal point, then there is no need to round off and student can continue
to use that number in the solution. However, if there are many digits after
the decimal point then rounding off should be done as follows :

No
of digits after decimal points
T ROE α
Returns Ke RF ECR T
Weights probabilities CNAV
1
2 Mutual Fund Units
or crore
Amount not in Lakhs million

Beta β
PVF IVF etc
Duration Macaulays modified
3 Correlation 8
Exchange Ratio M A

Weights probabilities decimals

has some
Exchange Rate other question
unless
flowl
4 Binomial model b E d
de d2 N del Nedal
B S
Mutual Fund NAV
or crore
Amount in Lakhs million
Basics of AFM

A. Basic Ratios
1) Earnings Per Share

Earnings Per Share (EPS) P&L extract:

EAES Particulars Amount

EPS
n PAT Net profit XX
No 1 Pref dir XX
h of Equity shares
In the absence of preference dividend, EAES = PAT.
EAES XX
1 1 Eq div XX
2) Price Earnings Ratio & Market Price per Share
RE XX
Price Earnings Ratio (PE Ratio): PE Ratio
is ‘how many times are the investors PE MPS times
ready to pay for every rupee of income Ratio EPS
earned from the share of a company’.
And a lot more…

Market Price Per Share (MPS)

EPS PE Ratio

3) Dividend: Absolute & Percentage

Dividend Per Share (DPS) Total dividend

Dividend Rate Dividend Yield Payout Ratio Retention Ratio

(as a % of FV) (as a % of MPS) (as a % of EPS)
DPS DPS s
FV Tffs EPS
EPs
Fah fffton
FUX DPS payout
DP g
Pfe Ratio 1001

Note Jab bhi Yield word

Self ad jaage it means
1
Adish Jain CA CFA
no ratio based on MPS hoga
Basics of AFM

4) Market Capitalization
Market Capitalisation (M-Cap) means total market value of equity shares of the company.
Example: Justdial Ltd has 1000 equity shares outstanding. Current market price is ₹ 15 per share.

Number of
Shareholding Pattern
Shares
Holding % 450
30%
Promoters 700 70% 70%

General Public 300 30%

15000
Total or Full Market Cap Free-float Market Cap

It is the total value of all equity shares of the It is that part of total market cap that is not
company. held by promoters i.e., held by general public

Calculation of M-Cap

Total no_of MPS Free float MPS

shares no
of shares
1000 15 300 15

15000 4500
Non promotes
Total
M cap holding
NA 15000 301

4500
5) Return on Equity
Return on Equity (ROE) is
the return (profit) earned by
the company on the capital EAES EPS
of equity shareholders as
per books. ESHF BUPS

2
Adish Jain CA CFA
Basics of AFM

6) Book Value per Share

Book-value per Share (BVPS) is
ESHF
the per share value of equity BUPS
shareholders in the net assets of M
the company as per books.

Equity Shareholders Funds (ESHF) or Net Worth is the total value of equity shareholders in the
net assets of the company as per books.

ESHF Assets liabilities P L

pref
_________________________________________________________________________________________
miss
Exp Dr
_________________________________________________________________________________________
_________________________________________________________________________________________

RES miss P L
_________________________________________________________________________________________
Eq share
capital Exp D8

B. Different types of Rates of Return

1) Required Rate of Return
It is the minimum rate of return required to be earned from an investment based on the risk
involved in it. Also called as Opportunity Cost, it is used as discounting rate to calculate PV of
cash flows.

Real Risk-free Rate 2 Inflation Premium 3 Risk Premium

Compensation for Compensation for loss Compensation for taking
allowing use of money of purchasing power of risk while making a risky
to other money invested investment

The rate of discounting to be used always depends on the nature of cash flows:

Real Cash Flows Nominal Cash Flows

Risk-free Cash Flows Real Risk Free Rate Nominal RiskFree Rate
1 1 92
Risky Cash Flows Real Risky Rate Nominal Risky Rate
193 19 2 93
3
Adish Jain CA CFA
Basics of AFM

2) Expected Rate of Return

It is the rate of return that an investor estimates (expects) that he will earn on an investment. It
reflects the perception of investor for that investment. It is usually calculated from 1 year’s
perspective on the share of the company.
115 100 0
Example: A share is bought today @
₹ 100 and investor estimates that it
P1 Po D
100
can be sold @ ₹ 115 after a year. Po
Then, expected rate of return on the 15
investment is 15%.

I
Technique PIÑO Po
3) Internal Rate of Return
CG yield Div yield
It is the discounting rate at which PV of cash inflows from an investment is equals to initial cash
outflow. It is calculated to determine the compounded rate of return actually earned (in case of
ex-post data) or to be earned (in case of ex-ante data) on any investment.
past
Example: future
Years CFs (₹)
0 - 110 p
I 121
1 11 110
2 121
PV Int FV PV IV Int

It 121 Trial
110 error
8 11 212 method
8 10 p.ae
Verifying the return earned:
Year Amount Invested Return 10.1
Accrued Return received Due Amount

110 11 11 110
2 110 11 121.00
4
Adish Jain CA CFA
Basics of AFM

C. Time Value of Money

Years: 1 2 3 4 5
Cash Flows (₹) 200 200 200 200 200
Example: Discounting rate = 10%

Future Value Present Value

Single Sum:

Value of today’s ₹ 200 at the end of 5th year: Today’s value of ₹ 200 of 5th year end:

FV PV X PV FV PVFGoi.gl
FVFgo.gs
FV 1
PV X 1 10 7 11 101.5
200 1.611 200 0.621

322.2 124 2

5
Adish Jain CA CFA
Basics of AFM

Annuity (A):

Regular Annuity

Value of all CFs at the end of 5th year assuming Value of all CFs today assuming CFs occur at
CFs occur at the end of the year: the end of the year:

It t t
11 1m PV Ax PVAFHO i.TT
m
m
m
200 3 791

758.2
FV AX FVAFcioi.si
200 60105
É 1221

Annuity Due

Value of all CFs at the end of 5th year assuming Value of all CFs today assuming CFs occur in
CFs occur in the beginning of the year. the beginning of the year.
11 8 11 8

FV 200 6 716 PV 200 4.170

1343.2 834

Perpetuity

Value of infinite number of CFs of ₹ 200 at the

Value of infinite number of CFs of ₹ 200 today:
end of infinite period:

PV
Not
possible
2 2000

6
Adish Jain CA CFA
Basics of AFM

D. Types of Cash Flows

Nominal Cash Flows Real Cash Flows

Nominal cash flows are the amount of future When effect of inflation is removed from such
revenues or expenses the company expects to future cash flows, they are called Real cash
receive or pay. Nominal cash flow has effect of flows. Real cash flow does not have effect of
inflation included in it. inflation included in it.

8
Relationship between Nominal
cash flow and Real cash flow: YES 1
Inflath
To calculate PV of nominal cash flow, nominal To calculate PV of real cash flow, real
discounting rate is used. discounting rate is used.

Relationship between Nominal 1 nominal

and Real discounting rate:
Rate Ref ftp.ddi
Example: Cipla Ltd has forecasted cash inflow of ₹ 100 crores to be received at the end of 2nd year.
Real discounting rate is 10% and inflation in the economy is at 5%. Calculate PV of future cash
flow using Nominal discounting rate and Real discounting rate.

Using Nominal discounting rate: Using Real discounting rate:

18 Nominal CF2 100 18

Nominal CF2 100

Nominal Rate 1 1 1 05 Real CFz 100 8

15.5
1 5.1.72
90.70
PV 100 8
90.70
11 155 72 PVO
11 10 1.72
74.96 r 74.96 8

7
Adish Jain CA CFA
Basics of AFM

4) Other ratios used in practical questions compiled at one place:

i e
operating op profit EBIT

margin Sales

Asset Assets Asset Sales Rev

to sales Turnover
Sald total
Ratio Ratio Avg Assets

Debt Debt Debt

to
Ratio Debt ESHF
Equity
Ratio
Interest PAT Interest capital Shore
Fixed
Debt Pref
gearing Cafutal
dividend Interest pref div Ratio ESHF
coverage

Debt Return EBIT

Debt
of
IE Debt 1 Equity
SF
pref E Debtt Equity
SH
pref

Inventory COGS Debtor credit sales

10
TO 9mV Aug Debtors
ratio Ratio
Cahited
NPA NPA Adequacy Equity capital
Ratio Advances Ratio
02
Risk weighted
8 capital to Assets
Adish Jain CA CFA Risk weighted
Asset ratio
Format of Income statement

Rov XX
COGS IEx depn XX
GP op
XP
Admin General Ex depn Xx
1 marketing distribution g XX

EBITDA XX
1 Amorth XX
Dep
EBIT operating profit XX
C1 Interest xx

PBT XX
c Tax xx

PAT XX
Ius
here
Equity & Business Valutaion
Equity & Business Valuation

Dividend Based Valuation Models

• Zero Growth Model
• Constant Growth Model
• Variable Growth Model
• H Model

Cash Flow Based Valuation Models

• Free Cash Flow to Firm Approach
• Free Cash Flow to Equity Approach

Asset Based Valuation Models

• Net Asset Value Method

Earnings Based Valuation Models

• Earnings Capitalisation Method
• Walter's Model

Relative Valuation
• Equity Value Multiples Based Valuation
• Enterprise Value Multiples Based Valuation
• Chop - Shop Approach

A. Dividend based Valuation Models

Fundamental Principle of Valuation: Value of any asset today is the present value (PV) of all
future cash flows (CFs) generated from that asset. Value of:

Equity Share
PV Div Sales priie
Bonds
PV coupon Redemption Value
Any other asset
PV CFs from that asset
Common sense behind the principle:
Suppose a share can be sold @ ₹ 110 at _____________________________________________
the end of one year. Your required rate
of return is 10%. How much will you be 7 110
_____________________________________________

ready to pay for that asset so that you 100

_____________________________________________
Distounting means
earn required return of 10%? Reg eliminating the
_____________________________________________

Rate 10.1
Interest return comp
onent from FV
Dividend Discount Models (DDMs) use dividends as the basis of calculating Intrinsic Value (IV-
what should be the valued) of shares.

Definite number of years

Value of Share: PV D1 D2 Dn PV sales priten

today
Yes Bank is expected to distribute dividends of ₹ 10 and ₹ 12 next year and a year
thereafter. At the end of this period, its share is expected to be sold at ₹ 150.
Calculate the value of share if discounting rate is 15%.

Ivo 10 12 150 131.19

1 157 1.1572
Indefinite number of years

Apply
Value of Share:
PV Ds 2 3
DDMJ
today
10
Adish Jain CA CFA
Equity & Corporate Valuation

Calculation of cost of equity Rateof return on Risk free scurity

ie GoI Bonds
We know that dividends belong to ESHs, therefore, discounting rate to be used to calculate PV
will be required rate of return to ESHs i.e., Cost of Equity (Ke):
Rate of return one
IE
ECRi f
 Preference # 1: CAPM*

Rj RF β Rm RF
__________________________________________________________________________
or
__________________________________________________________________________
market risk premium
__________________________________________________________________________
risk
security premium
*CAPM is covered in detail in the chapter ‘Portfolio management’.

 Preference # 2: Gordon’s Formula

Without Floatation Cost With Floatation Cost

D Ke DI
Ke g g
Netproceeds
Po
Netproceeds Iggy 818
 Preference # 3: Earning’s Yield

Ke EPS 08
TPE
__________________________________________________________________________

MPS Ratio
__________________________________________________________________________
__________________________________________________________________________

Required Rate of Return (Rj) vs Expected Rate of Return (E(Ri))

Many times, examiner uses the words ‘Required Rate of Return’ and ‘Expected Return’
interchangeably. This is simply because:

If E(Ri) = Rj then P0 = IV OR If P0 = IV then E(Ri) = Rj

ie
fairlyvaluing
It means that examiner is assuming the security as fairly valued. Hence, by whatever name (E(Ri)
or Rj) rate is given in the question, it will be used as discounting rate to calculate IV.
Conclusion: In other words, solve the question normally by treating the given rate as Rj.

in the abseuse of any info ICAI assumes security 11

to be fairly valued Exp Reg rate are Adish Jain CA CFA
interchangeably
used
is under over valued then we can't
now and if sec
use those Vechegeably

Equity & Corporate Valuation

1) Zero Growth Model | Constant Dividend Model

Practical Questions: _ Practice Problems: _

This model is applied, when there is no

growth in the dividends i.e., same amount of Ivo
dividend is received till infinite number of
years. Therefore, using formula of PV of a
perpetuity:
PV DI Do Po
or
Fi
2) Constant Growth Model | Gordon’s Model

Practical Questions: _ Practice Problems: _

This model is applied when dividend grows at a constant rate for infinite number of years. Value
of share as per this model is PV of growing perpetuity.
Do
PY IDI
IVO De
D1 : ______________________________________
Div of year 1
dividends
08
of
g : ______________________________________
Constant growth Rate from 1 till a
ke g
Po sustainable growth rate
______________________________________

In the absence of D1,

Intrinsic Value of share can Do 1 9
be calculated using D0 as:
Ke g

Important observations about Gordon’s Model:

 Relationship between Ke & g: For this formula to mathematically workout, Ke should be
greater than g.
 D1 (& not D0): Dividend used in the formula is D1 (& not D0). It may be given directly or
calculated using D0.
Note: If language of the questions is unclear about the timing of the dividend, then assume it
as D1.
Hatopay D has paid D 0
12
Adish Jain CA CFA
just declared
Co pays a dividend DDI
Equity & Corporate Valuation

 Y0 (& not Y1): Although dividend used in the formula is D1, but value so arrived is as at Y0 (&
not Y1)
 g from D1 till D∞: g used in the formula is growth consistent from D1 till D∞. It does not include
the growth from D0 to D1. Hence, growth from D0 to D1 can be different.
 g in EPS = g in D: Unless otherwise specified, dividend pay-out ratio is assumed to be constant.
Therefore, g in EPS is equal to g in DPS. I 22
EPS E
Calculation of Sustainable Growth Rate (g): for
 RR ROE DPS
Formula of Growth: ___________________________________
50 55
g 10
___________________________________

Common sense behind the formula...

opening closing
21000 ROE 10 EAES 100
yeart 40 Div 40
60 RE 260
9 7
61

ROE 10
year 2 1060 EAES 106
401 Div 42.4
60 RE 63.66
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
Since Gordon’s formula assumes constant pay-out ratio, growth in EPS, DPS, BVPS and MPS
is same at g %.

13
Adish Jain CA CFA
Equity & Corporate Valuation
u years
 Using Historical Data: not 5 years
Year 2015 2016 2017 2018 2019
Historical EPS or DPS
100 115 110 125 140
__________________________________________________________________________

FV PV 1 8
__________________________________________________________________________
__________________________________________________________________________

140 100 11 8.74

__________________________________________________________________________
__________________________________________________________________________

9 0.0878 08 8.78
__________________________________________________________________________

Derivation of Gordon’s Formula... Relevant

only for conceptual clarity

3) Variable Growth Model

Practical Questions: _ Practice Problems: _

This model is applied when growth in dividend is not constant i.e., when dividend grows at
different rates for few years and then grows at a constant rate for infinite number of years.

Ivo Po Pro D Da D PV.EU

Terminal Value (TV) represents the PV of all future dividends received for infinite number of years
growing at a constant rate. TV is calculated using Gordon’s Formula.

Example:

D0 = ₹ 100 For year: 1 2 3 4 5 & onwards

Ke = 12% Growth:
151 121 13 15 1 101
3
151 1121 2131 154 101 5101
100 115 128.8 145.54 167 38
18,4ft y
Alternative 1: Calculating TV at the end of:
4ᵗʰ year Try
Years Nature of CF Amount PVF DCF

I 115 0.893
2 D2 0 797
128.8
3 03 145.54 0.712
4 Dy 107.38 0.636
4 V4 167.38 1 10 1.1 0.636

Doke g
0.12 01
9205.9
6270.35
15
Adish Jain CA CFA
Equity & Corporate Valuation

Can we calculate the TV @ year 3 also? Yes! Let’s see how.

Du Do
Alternative 2: Calculating TV at the end of: 3rd
year TV3
Years Nature of CF Amount PVF DCF

DI 115 0.893
7 Dr 128.8 0 797
3 03 145.54 0 712
TV3 167.38 0.712
3 836g
He 0.12 010
g
6267.70
Then, which alternative to follow in exams?
Alternative 1 will be preferred. However, in certain cases, alternative 2 will automatically look
more suitable because of the type of data given in the question. In such cases, it will be used.
Refer question number: __________________________________________________________

Questions with points of special consideration:

_____________________________________________________________________________

Note Questions variable growth mode in

_____________________________________________________________________________
1
of
_____________________________________________________________________________
which
payout ratio is changing in
the second alternative is
_____________________________________________________________________________
future
to be applied
_____________________________________________________________________________
_____________________________________________________________________________

Note 2
_____________________________________________________________________________
In
question while payout ratio
changing in future dont
_____________________________________________________________________________
is
the DP'S
_____________________________________________________________________________
g
apply on

directly Rather apply it on EPS

_____________________________________________________________________________

and EPS
_____________________________________________________________________________
then calculateDAS
ratio
from
16 using payout
Adish Jain CA CFA

Notes ware to athly gordon's model for TV

ps the for were
p constant
DPS not EPS growth is

Equity & Corporate Valuation

4) H Model

Practical Questions: _ Practice Problems: _

This model is a formula-based

approach to calculate the IV growth
when there is super-normal
growth rate at initial stage which
later declines to sustainable
(normal) growth rate linearly
Gsa
over the time.
Value of share is sum of:
1. Value of share assuming
only normal growth even
Gm
in initial stage.
2. Premium in value for
supernormal growth in years
initial stage. transitionPeriod
____________________________________________________________________________

normal
____________________________________________________________________________
Gs Super
Do Gn Dox
____________________________________________________________________________
xH
9s Gn growth rate
Ff
____________________________________________________________________________
Ke 9m Ke gn gn
____________________________________________________________________________
normal growth
rate
____________________________________________________________________________
H transition period
2
____________________________________________________________________________
____________________________________________________________________________
Note: Use H-Model only when question specifically asks to do so.

17
Adish Jain CA CFA
Equity & Corporate Valuation

B. Cash Flow Based Valuation | Discounted Cash Flow Models

Cash flow based valuation models are also based on Fundamental principal of valuation. These
models consider Free Cash Flows (FCFs) to arrive at the intrinsic value of the share. FCFs means
CFs which are freely distributable to the providers of the capital to the business i.e., debtholders,
preference shareholders and equity shareholder. From the point of view of:
1. All the providers of capital as a whole (i.e., debtholders, preference shareholders and equity
shareholder): FCFs means CFs on which all of them have claim i.e., CFs generated by business
net of all operating cash outflows and capital expenditure. This CF is called as Free Cash Flow
to Firm (FCFF).
2. Equity Shareholders (ESHs): FCFs means CFs on which only ESHs have claim i.e., CFs
generated by business net of all operating cash outflows and capital expenditure and also
after deducting the claims of debtholders and preference shareholders. This CF is called as
Free Cash Flow to Equity (FCFE).

How to identify which model to use - FCFF or FCFE Model?

 In almost all practical questions, which model to use for valuation will not be specified. First
preference should be FCFF Model.
 But FCFF Model can be applied only when Ko is either given or it can be calculated.
 If there is any ambiguity regarding discounting rate, see which FCF is given or can be
calculated - FCFF or FCFE?
Note that in case of an all equity company, FCFF and FCFE would be one and the same.

Other points of consideration:

Practical Questions: _ Practice Problems: _

18
Adish Jain CA CFA
Equity & Corporate Valuation

FCFF FCFE
Calculation of FCF

Particulars Amount
Particulars Amount
EBIT Int t t XX
EBIT 61 t XX XX
Depn
XX
Dep Inv in WC xx
Inv in WC XX
Copex XX
Copex XX ft Repayment Borrowing XX
Prof div xx
It Redempt Issue of xx
pref shaves

FCFF XX FCFE XX
Relation b/w
FCFF and FCFE: _______________________________________________________________

Hence, when there will be no debt and preference share capital, FCFF = FCFE.

*Note: While calculating FCFF, interest will not be deducted from EBIT and tax will be calculated
directly on EBIT.

Discounting Rate used to calculate PV?

Discounting rate will be the required rate to return to the capital providers from whose
perspective valuation is done

Ko
KexWe kdxwd ke
ga
In the calculation of KO, weights (i.e., We, Wp and Wd) should be based on below priorities:
1. Target Capital Structure Ratio
2. Market Values (MVs)
3. Book Values (BVs)

19
Adish Jain CA CFA
Equity & Corporate Valuation

Calculation of Value of Firm or Equity

And who all does value belong to?

FCFF has claims of all capital providers,

Since, FCFE has claims of only ESHs, therefore,
therefore value so calculated is called Value of
value so calculated is called Value of Equity.
Firm.

Value of Firm:
VF PV FCFF
Value of Equity:
VE PV FCFE
Therefore, in case of: Therefore, in case of:

1. Zero growth 1. Zero growth

FCFFI FCFEI
Vp VE
ko Ke
2. Constant growth 2. Constant growth

FCFFI FCFEI
VF VE
ko g ke g
3. Variable growth 3. Variable growth

VF PV IFCFF.az n
VE PV FCFEI.rs n

PV Tvn PV Tun

Value of Equity can be calculated as... Value of Firm can be calculated as...

VE VE MV D
VF VET MV D
MV Pref mV pref
Note: There are some questions of valuation which are based on the logic of NPV or FCF Valuation.
They have been separately categorized as ‘NPV based questions of Valuation’ after question of
Cash Flow Based Valuation.

20
Adish Jain CA CFA
Equity & Corporate Valuation

C. Asset Based Valuation Models

1) Net Asset Value | Net Realizable Value | Replaceable Value Method

Practical Questions: _ Practice Problems: _

These methods of valuations have Balance Sheet as its start point. It involves identifying the
individual tangible & non tangible assets, long-term liabilities and preference share capital held
by the company and assigning them value based on the exact method to be followed:

Method Value of assets & liabilities

Net Asset Value

mV or FV
Net Realizable Value, Liquidation
Value, Adjusted Book Value NRV MV or FV selling cost

Replacement cost
Replaceable Value

Value of Equity is equal to the market value of Net Assets held by the company.

Particulars Amount

value
of All Assets.EE xxx
less Value of External liabilities XX
loss Value of prefence shares XX
Total Net Asset Value Net worth X
No
of Equity share
NAV share XX
per
Points to consider:
 When MVs are not available, consider BVs.
 Value of contingent liability will also be deducted if it is expected to materialize.
 MV of preference share is also required to be deducted to arrive at the value of equity.

21
Adish Jain CA CFA
g I
Tsp
Equity & Corporate Valuation

D. Earnings based Valuation Models

1) Earnings Capitalization Method

Practical Questions: _ Practice Problems: _

This method considers capitalization of earnings of the company to arrive at the value of the
2)company.
Walters Model
Future maintainable PAT
Practical
Value Questions: _______________________
of Business/Equity: X
Practice Problems: _______________________
Chitalization Rate

of debt Pref shares

Less: Value XX
Total value of Equity XX
no
of shares
where, Capitalization Rate =
Efp Value XX
HPE per share
learning's
Calculation of Future Maintainable Profits yield
(FMP):

Reported PBT XX
Add Extra ordinary losses XX
less Extra ordinary Income XX
Add Add future income
less Add future expenses xx
Future maintainable DBT XXX
less Future tax rate
Future maintainable PAT XXX

Note that when weights are

É FD
Fair Value: given, weighted average of NAV
08 Aug and ECV will be calculated.
Fairprise
22
Adish Jain CA CFA
2 WALTERS MODEL Equity & Corporate Valuation

According to this model, the value of equity share is the PV (Dividend and Price appreciation)
earned by the shareholders every year till infinite period of time.

D Dividend
__________________________________

ROE tidy ROI

__________________________________
8
Value D
E D
Ke cost of Equity
__________________________________

of fe E
__________________________________
Earning
Equity Ke CE D Retainted
__________________________________
Earnings
Use of Walters Model is not limited to calculation of value of share. It also helps in determining
the optimum payout. Optimum Payout means the payout at which price of the share is maximum.
Example: EPS is ₹100 & Ke is 12.5%. Calculate value of share if:
Payout = 0% Payout = 50% Payout = 100%

100 50 504 100

r = 15%
75
12.5 it 12.5 1
12.5.1
960 880 800

r = 12%

800 800 800

r = 10%

640 720 800

23
Adish Jain CA CFA
Equity & Corporate Valuation

We can observe that some relationship between r and Ke can be drawn to determine the optimum
payout.
Conclusions:
Relationship
When Correlation between Share price and payout Optimum Payout:

Payout Ratio
r > Ke 0
Value y
Payout Ratio
r < Ke 100
Value

r = Ke
Indifferent Indifferent
Note that when question asks for optimum payout ratio, we will not just have to advise the
optimum payout ratio, buy also show the value of share in case of optimum payout ratio.

23.67
_____________________________________________________________________________

Common sense behind Relative Valuation

220 times
_____________________________________________________________________________
Comprafe
_____________________________________________________________________________
Industry
_____________________________________________________________________________

EPS
_____________________________________________________________________________
1 Price 20
_____________________________________________________________________________

Company EPS
_____________________________________________________________________________

65
_____________________________________________________________________________
whose valuation
is
being done
_____________________________________________________________________________
130.0
If
_____________________________________________________________________________
5
_____________________________________________________________________________

EPS
____________________________________________________________________________ PE of
the
of
co
comparable
Co s
24 financial value
Adish Jain CA CFA parameted multible
Equity & Corporate Valuation

E. Relative Valuation
Under this approach, we arrive at the value of equity or enterprise value by multiplying the Value
Multiples of comparable entities with the financial parameter on which that multiple is based.
Value so arrived is called as Relative Value or Value by Multiples.
 Financial Parameter means any financial variable that demonstrate something about Scale of
F.PT operations (like sales), Profitability (like EBIT, net profit, etc) or Financial position (like Assets,
book value) of the company.
 Value multiple means financial ratio of which numerator is value of equity or enterprise and
denominator is financial parameters like earnings, sales, BV, etc.
 Comparable entity means entities in the same industry with similar risk characteristics.

A basic example would be:

Value of Equity : Earnings of company X Price to Earnings ratio
to be valued of comparable firms

Enterprise Value: Sales of company X Enterprise Value to Sales ratio

to be valued of comparable firms

Note that if question gives data of multiple comparable entities, then we will have to calculate
average value multiple of such entities. This average multiple will be then multiplied with the
given financial parameter to arrive at value of the company.

1) Equity Value Multiples Based Valuation

Practical Questions: _ Practice Problems: _

Below are the examples of Financial Parameters and respective Equity Value Multiples:
FP
Financial Parameter Equity Value Multiples Value of Equity =

EPS Price Earning Ratio FP value

multible
Sales ofbeing
Price to sales Ratio co me
of the
valued comparable
B V Prile BV Ratio entity or
industry
25
Adish Jain CA CFA
Equity & Corporate Valuation

2) Enterprise Value Multiples Based Valuation

Practical Questions: _ Practice Problems: _

Equity Value means value of only equity shareholders in the value of overall business. Enterprise
Value (EV) means value of firm as a whole for all classes of investors (capital providers).
 Includes value of debt and preference share also.
 Excludes surplus cash & cash equivalents

ENTERPRISE VALUE

MV MV mV Cash
shores Debt C E
Equity Pref
Since, EV (which is the numerator of EV Multiples) includes the claims of all the investors, then
financial parameter (which is the denominator) should also include the claims of all of them.
Hence, denominators of EV multiples will slightly vary as compared to Equity Value Multiples.
Below are the examples of Financial Parameters and respective EV Multiples:

FinancialFPI
Parameter EV Multiples Enterprise Value=

EBIT EV ratio FP
EBIT time
EV
sales Sales Ratio of me of the

Cop Empd
EV
capital Empd Talked comparable
entity or
Calculation of Value of Equity from EV: industry

Enterprise Value XX
Less:
MV Debt Xx
Less:
MV
Pref xx
Add:
Cash Cash
Eq X
value of Equity XXX
26
Adish Jain CA CFA
Equity & Corporate Valuation
no
p.fr 3) Chop - Shop Approach | Break-up Value Approach | Sum of Parts Approach
0.66 Practical Questions: _______________________ Practice Problems: _______________________

This method is applied when a company operated in different business segment. According to
this approach, Value of firm is equal to the sum of values of its different business segments,
where, values of these business segments is calculated using Value Multiples read in earlier two
methods.
Example: Let us say ITI has three divisions. Below are their names and relevant value multiples:

Division Value Multiple Financial Parameter

Iron & Steel EV to Capital Invested Capital invested
Telecom EV to EBITDA EBITDA
IT Price Earnings Ratio Earnings

Value of firm:
Division Calculation Amount

Ratio based
_____________________________________________________________________________

Refel 2 miscellencoy 72973

_____________________________________________________________________________
_____________________________________________________________________________

before the start of

F. Other Important Topics

1) Economic Value Added

Practical Questions: _ Practice Problems: _

Economic Value Added (EVA) is the excess return earned by the company over its WACC. In
simpler words, it the amount of earnings left with company after deducting capital charge of
debt, preference and even equity.

Income Statement Other Details

Sales Capital Structure:
200
Cash Operating Cost
60 Equity
2100
Depreciation
140 12% Debenture
100
EBIT
100 Return from Market
121
1121
Interest Risk Free Rate
61
PBT
88 Beta
1.5
Tax @ 151
251 22 161 1.5 12 6
PAT
Ke
66 Kd 12 11 25 1 9
Cost of Equity
115
Earnings after all capital charges
51 Ko 151 70 91 50
Above discussion was based on common sense just to understand the concept of EVA. But there
is a standardised formula of calculating it: 12

Economic Value Added: NOPAT capital charges

EBIT 1 t Capital empd
__________________________________________________________________________ WACC
100 1 251 200 X 12
__________________________________________________________________________

51
__________________________________________________________________________

28
Adish Jain CA CFA
Equity & Business Valuation

1. Capital Employed:

E PS mV
__________________________________________________________________________
mV mV D
__________________________________________________________________________

Note Consider BV not available

__________________________________________________________________________
if mV is
__________________________________________________________________________

2. WACC:

Ke:
As per CAPM ke RF β Rm R
______________________________________________________________
______________________________________________________________

Kd:
Ipostrax
Interest 1 1 t 08 Interest 1 t
______________________________________________________________ 1
mV debt
______________________________________________________________
of
WACC (Ko):
Kex 1 Kdx Wd
______________________________________________________________
We
______________________________________________________________

or Kex E Kd
______________________________________________________________
consider ETD
______________________________________________________________
MVs for Wedwd
Why interest is not deducted while calculating NOPAT even when it is tax deductible expense?
Since, Kd is calculated net of tax, it means that we have already taken tax benefit on interest in
our calculation. Note that same logic applies in the calculation of FCFF also, where we calculate
the tax directly on EBIT.

Value of firm using EVA Approach: Discussed in detail in the section of MVA.

Concept of Financial Leverage:

Financial EBIT
_____________________________________________________________________________
Leverage
EBT
_____________________________________________________________________________
this actually
is
_____________________________________________________________________________
degree of financial
EBIT
_____________________________________________________________________________
leverage Int
EBT 29
Adish Jain CA CFA
Equity & Business Valuation

2) Market Value Added

Practical Questions: _ Practice Problems: _

Market Value Added (MVA) is the excess of market value of firm (i.e., Equity, Preference Share
and Debt) over its book value (i.e., capital employed).

MV E PS D BV E PS D
Note that in the absence of actual market values of equity, preference capital or debt, MVA can
be calculated using Intrinsic Value of Firm (i.e., value of firm calculated using FCF models). The
value so arrived will be intrinsic MVA.

Calculating MVA using EVA

MVA can be calculated as PV of future

EVA. This is applicable possible only in
case of no growth firm.

Note that the value so arrived will be Intrinsic MVA.

Calculating value of firm using EVA Approach

Using above two concepts, we can calculate the Intrinsic Value of Firm using EVA:

Hence, Value of Equity:

___________________________________________________________________________
___________________________________________________________________________

Note that, as already read, this method of valuation will give a correct value only when there is
no growth in NOPAT. But, if question asks us to do so, we will have to apply this method even
when there is growth. Refer question number:

30
Adish Jain CA CFA
Equity & Business Valuation

3) Concept of Rights Issue

Practical Questions: _ Practice Problems: _

Rights issue is a way of raising funds in which company gives an option (called as Right) to its
existing shareholders to subscribe to the newly issued shares (called as Right shares) in
proportion to their holding.
 The ratio in which right shares are issued against existing shares is called as Rights Ratio

 SH who has received the right has a choice to either:

 Exercise the right i.e., buy the share
 Renounce the right i.e., sell the right so that it’s buyer can subscribe right shares
 Ignore the right i.e., let the right lapse
 Understanding important terms and dates on timeline:
o Pre-Right or Cum-Right price is the price of share till ex-date i.e., the date till which
shares is entitled for rights.
o Post-Right or Ex-Right price is the price of share immediate from ex-date i.e., the date
from which shares is not entitled for rights.
o Dates:

Announcement Date Record or Ex-Date Expiry or Exercise Date

The date on which the The date after which the The date before which
company announces the shares will trade without rights can be exercised
right issue. the entitlement of rights. or renounced.

Example:
Pre-right market price per share:
Po 100
Pre-right number of shares:
No 1000
To fund a project, company wants to raise:
20 000
Only two of these will be
Company offers rights in the ratio:
given 1 4
Issue price of right shares: 80
31
Adish Jain CA CFA
Equity & Business Valuation

PI
MI shares to be issued and Issue Price:
Calculation of Number of rights

When Amount raised & Rights ratio are given:

1000 44 250
______________________________________________________________________
he shares
______________________________________________________________________

Pt 20,000250 280
______________________________________________________________________
share
______________________________________________________________________

When Amount raised & Issue price are given:

______________________________________________________________________

Me 20.00080 250 shakes

______________________________________________________________________
______________________________________________________________________
80
______________________________________________________________________
Ps
When Rights ratio & Issue price are given:
______________________________________________________________________

N1 1000 250
______________________________________________________________________
shares
______________________________________________________________________
80
______________________________________________________________________
P1
Calculation of Ex-Right Price
___________________________________________________________________________
Ex Right prile
___________________________________________________________________________
___________________________________________________________________________

Pot 1000 100

___________________________________________________________________________
Nox nIxP1 250 80
1000 250
___________________________________________________________________________
not 71
96
___________________________________________________________________________

* Note that whenever question gives the data of future CFs to be generated from the project
(project for which rights issue has been made), rather than Subscription amount raised we

984
shall consider intrinsic value of that project i.e., PV of future CFs to be generated from it.

32
Adish Jain CA CFA
Equity & Business Valuation

Calculation of Value of Right Alone

Value of right means the price at which it can be renounced in the market. The maximum price
that a buyer of right would pay for it will be equal to the benefit (or gain) he will get from it.

Value per Right:

Issue price
_______________________________________________
Ex
right96
price
80
_______________________________________________

I 16
_______________________________________________
per right
Value of Right per Share: 216 4
_______________________________________________
4 per share
_______________________________________________
_______________________________________________

Note: When question is silent calculate both of the above

Calculation of gain or Loss to the SHs

Assume
Gain or loss to the shareholders will be equals
holding 100 shares
to the change in their wealth.

Pre-right Wealth: 100 shares 2100

_______________________________________________
I 10,000
Post-right Wealth:
 Rights are subscribed:
100 25 shares
_______________________________________________
296 12,000
less Cash paid 25 80
_______________________________________________
2000
10,000
_______________________________________________
_______________________________________________
No change in wealth
 Rights are renounced: _______________________________________________
100 9600
shares 9.6
Add Cash Risd 25 16 400
_______________________________________________

I
_______________________________________________
10,000
_______________________________________________
No change in wealth
 Rights are ignored: _______________________________________________
100 9600
shares 96
_______________________________________________
9600
Decrease in wealth
33
Adish Jain CA CFA
Equity & Business Valuation

4) Concept of Buy-back

Practical Questions: _ Practice Problems: _

Issue
When a company buys its own equity
shares back from the market, it is called as Buy
Buy Back.
ZEZ
 Unlike rights, the price at which shares COMPANY COMPANY
are bought back (Buyback Price) is
normally higher than its market price to
E E Buy

attract the investors.
The shares bought back by the
ET Back
company ceases to exist. pris

Number of shares bought back: EEE

BB Pre BB
Surplus funds POSI shares
available n B B
BB price
Post Buyback EPS
posttax
Pre BB EAES Interest Cost
Pre BB shares
n BB
Note: Ignore Interest paid or lost in the absence of information.

Post Buyback Market Value or MPS

Post BB Post BB Post BB

mV mps n

34
Adish Jain CA CFA
Equity & Business Valuation

5) Concept of Bonus Issue

Practical Questions: _ Practice Problems: _

Bonus issue means issue of further shares to the SHs in proportion to their existing shareholding
without any consideration. Shares so issued are called Bonus Shares.
 Total number of Shares will increase by the number the bonus shares issued.
 Note that, bonus does not involve any cash flow in the entire event and theoretically, total
market cap and total earnings of the company remains unchanged.

Calculations involved in Bonus Issue questions:

Post Bonus Pre Post Bonus Pre

PAT Bond Bones
my
PAT MV

Post Bous PAT Post Bous mV

EPS Post Bones MPS post Borus
n D
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
____________________________________________________________________________

35
Adish Jain CA CFA
Equity & Business Valuation

____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________

36
Adish Jain CA CFA
I
1 i
Mergers, Acquisition & Corporate Restructuring

A. Basics of Merger & Acquisition

1) Understanding M & A and our perspective for it
Merger, acquisition and takeover are interchangeably used words. Broadly speaking, Merger,
Acquisition or Takeover is a corporate restructuring transaction in which:
a) one company buys the business (i.e., assets and liabilities) of another company and another
company thereafter legally dissolves.
b) a newly formed company buys the business of two or more existing companies and existing
companies thereafter legally dissolve.
c) one company buys the shares of another company rather than its business and both the
companies continue to legally exist even after the transaction.
Company acquiring the business is called Acquirer (A Ltd) and company whose business is
acquired is called Target (T Ltd) which will cease to exist after the merger.
Since these words are used interchangeably, for our purpose, substance of such transactions is
more important than its form. Focus of our syllabus has been on transactions (a) & (b) above
i.e., transactions in which A Ltd continues to exist even after merger and T Ltd dissolves.
Shareholders (SH) of T Ltd get compensated either in cash or in equity shares of A Ltd.

2) Basic Ratios if no pref shares

EAES PAT EPS × PE MPS

n n
n
PAT × PE MV or m Cap

3) Types of M & A Deal

Stock Deal Cash Deal

M&A deal in which purchase consideration is M&A deal in which purchase consideration is
redeemed by issuing equity shares of A Ltd. paid in cash.

Will SH of T Ltd have claim

share
Yes in post-merger earnings No
and value of A Ltd?

37
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

4) Swap Ratio (SR) or Exchange Ratio (ER)

In case of a stock deal, A Ltd will issue its equity shares to the SH of T Ltd. mmP f 88
Example: Number of equity shares of A Ltd (nA) and T Ltd (nT) are 400000 and 200000 respectively
and the companies have agreed to an exchange ratio of 1:2. It means that:

1 : 2 or 0.5
___________________________________________________________________________

of Altd 608 share

way Teld
___________________________________________________________________________
1 share 2
of
In case of a stock deal, number of shares issued to SHs of T Ltd is normally calculated in one of
the two ways, depending upon the data given in the question:

Method 1: When
MIX ER
ER & nT are given:
2,00000 12 1,00 000 shares
of Altd
Method 2: When PC &
Issue price are given: PC Ntx MPST 200,000 2100
E 2,00 00,000
of shares 0000000
Ffg
no
of 100 fares
L'd 200
There are various parameters based on which A Ltd & T Ltd can agree to an exchange ratio. For
example, EPS, MPS, BVPS, NPA Ratio (in case of banks), etc.

Exchange ratio can

Positive Parameter Negative Parameter
be based on:

Means parameter
Higher is Better Lowes is bettes
which is better:

For example:
EPS MPS BUPS NPA ratio DIE rate
Exchange Ratio:
Parameterof Titd Parameter of A lid
Parameter of A lid Parameterof Titd

A T
Example EPS NPA
f Io
38
Adish Jain CA CFA 20 10
ER 1 2 ER 1 22
Mergers, Acquisition & Corporate Restructuring

Note that:
 ER is always based on per share parameters. For example: it can be based on EPS, MPS, BVPS
but not on total earnings, total market-cap or total net worth of the companies.
 If question is silent about ER, always assume it to be based on MPS. Ex 05
 It is possible to have exchange ratio higher than 1. This happens when per share parameter
of T Ltd are better than per share parameter of A Ltd.

5) Synergy
Synergy is when post-merger earnings or value of A Ltd is more than simple summation of pre-
merger earnings or value of A Ltd and T Ltd.

Is there synergy? Amount of synergy

Profit of A Ltd and T Ltd are ₹ 24 lakhs and ₹

SE 1 lakh
10 lakhs. After merger profit is ₹ 35 lakhs.
Yes SE
Values of A Ltd and T Ltd are ₹ 140 lakhs and
Yes Sv 20 lakhs
₹ 30 lakhs. After merger value is ₹ 190 lakhs.
Sv
Synergy is when: Amount of Synergy:

SE PATAT PATAT PAT PATAT PAT PATT

SV VAT VA VT VAT VA VT

Calculations involved in M & A

Post-merger EPS & related calculation Post-merger MPS & related calculation

Post-merger MV or Synergy in value given Not given

given

Cash Deal & Stock Deal

39
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

B. Post-merger EPS and related calculations

Practical Questions: _______________________ Practice Problems: ________________________

Particulars A Ltd T Ltd

Case 1: Stock Deal
EAES (₹) 2,40,000 80,000
PAT ER = 1:2
Number of Shares 30,000 20,000
EPS (₹) 8 4 Case 2: Cash Deal
PE ratio (times) 8.5 6 Cash paid = ₹ 45/share
Market Price (₹) (Cash paid as PC is
68 24
borrowed @ 10%.)
Synergy in earnings (₹) 1,60,000
tax rate 30

CASE 1: STOCK DEAL

1) Post- merger EPS
of Altd
_______________________________________________________________________________
shares issued
_______________________________________________________________________________
to Tetd
_______________________________________________________________________________

2,49000 80,000
_______________________________________________________________________________
1.60.000
30,000 20000
_______________________________________________________________________________
42
_______________________________________________________________________________
I 12 A ltd
_______________________________________________________________________________
per share of
_______________________________________________________________________________
_______________________________________________________________________________

2) Equivalent or Adjusted EPS

It means EPS in A Ltd to the SHs of T Ltd, equivalent to every 1 share of T Ltd

_______________________________________________________________________________
112 6 2 old
_______________________________________________________________________________
per share
of Titd
40
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

3) Gain/(loss) to SH of A Ltd and T Ltd in terms of EPS or Earnings

Alternative 1: Per Share Basis

Preferred
Particulars A Ltd T Ltd

Post merger EPS 12

EPS 6
Equivalent
1 I Premerges EPS 8 4
G CL per share 4 2
POEMERGER N 30,000 20,000
Total gain 110 s 120,000 40,000
Alternative 2: Totality Basis
Particulars A Ltd T Ltd

n with SH 30,000 20.000 1 10,000

Postmages 2
claim of shs.in 4.80.000 30440k 4.80.000 101440k
Post merger PAT
3 60,000 1,20 000
less
premerges 1240000 80,000
PAT
Gain doss 1 20,000 40,000
Understanding how does change in exchange ratio affects SHs of A Ltd and T Ltd:
A Ltd T Ltd
 Case 2: If ER = 0.3 or 3:10

Share in post-merger earnings

Less: Pre-merger earnings

Gain / (Loss)

41
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

 Case 3: If ER = 1.5 or 3:2

Share in post-merger earnings

Less: Pre-merger earnings

Gain / (Loss)

Note that in all cases, combined

Gain or loss to SH of A & T Ltd = amount of SE 1 60,000
Important takeaways, applicable to stock deal:
1. Combined gain or loss in terms of earnings to the shareholders of both the companies is equal
to the amount of synergy in earnings i.e., ₹ 1,60,000 in this case.
2. Therefore, when there is no synergy in earnings, gain of one company will be equal to the loss
of other. Hence, if there is no gain or loss to SHs of one company, then there can’t be any loss or
gain to SHs of another company.

4) Breakeven, Maximum & Minimum ER on the basis of EPS

A. Breakeven Exchange Ratio

a) When words of the question are: ‘Recommend an ER at which,

 EPS of A Ltd is maintained...’
 SHs of A Ltd (or T Ltd) are not at loss in terms of earnings...’
 Post-merger EPS of A Ltd is same as pre-merger...’
 Earnings of the SHs are not diminished by the merger...’
It means that question is asking us to recommend an exchange ratio at which shareholder of both
A Ltd and T Ltd are neither at gain nor at loss in terms of earnings.

Breakeven ER EPS of Titd 1 2

EPS of Aild
Situation of no gain-no loss in terms of earnings to both the groups of SHs is possible only when
there is no synergy in earnings. Therefore, to solve this part of the example, where we are learning
to calculate breakeven ER, let us assume that there is no synergy.

42
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

Proof of no gain – no loss:

Note: Below proof is to be shown as a part of the solution in exam also, only writing the ER won’t
get us marks.

Post EPS 80,000

_______________________________________________________________________________
240,000
merges
Iff ER 1 2
_______________________________________________________________________________
30.000 20.000 112
8
_______________________________________________________________________________
per share
_______________________________________________________________________________

Equivalent EPS 8 42
_______________________________________________________________________________
I 4 per share
_______________________________________________________________________________

Gain Post 8 4
_______________________________________________________________________________
lossto 5 17 mages
_______________________________________________________________________________
61 premerge
B. Maximum Exchange Ratio

b) When question specifically asks for ‘maximum exchange ratio’, it means we need to calculate the
maximum ER to which SHs of A Ltd will agree.

ER 1.5
_______________________________________________________________________________
1
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________

43
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

C. Minimum Exchange Ratio

c) When question specifically asks for ‘minimum exchange ratio’, it means we need to calculate the
minimum ER to which SHs of T Ltd will agree.

80,000 1 160.000 ER 4
_______________________________________________________________________________
2,99000
30.000 20000 ER
_______________________________________________________________________________
_______________________________________________________________________________

ER 0.3 1
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________

44
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

Practical Questions: _ Practice Problems: __

CASE 2: CASH DEAL

1) Post- merger EPS

ntx ask.PE antc.io xC1 t

_______________________________________________________________________________
x
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
24L 0.8L 1 GL 0.2 45 101 1 301
_______________________________________________________________________________

30,000
_______________________________________________________________________________

13.9 per
share
_______________________________________________________________________________

 Note that if interest & tax rate are not given in the question, then it can be ignored.

2) Equivalent or Adjusted EPS

NOT APPLICABLE
Since Equivalent EPS is calculated using ER and in case of a cash deal, there is no ER.

3) Gain/(loss) to SHs of A Ltd in terms of EPS or Earnings

Alternative 1: Per Share Basis

Particulars A Ltd T Ltd

post merges EPS 13.9

I pre merge EPS 8
gain Idess per share 59
no
of shore 30,000
Total loss 1 77,000
gain
45
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

4) Maximum Cash per share considering EPS

It did will decide
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________

Ghae
_______________________________________________________________________________
n Int 1 7
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________

1
_______________________________________________________________________________
2.41 81
0 1.61 0.2 6888 11 101
_______________________________________________________________________________
30 88
30000
_______________________________________________________________________________
_______________________________________________________________________________

Max Cash per share 171.43

_______________________________________________________________________________
_______________________________________________________________________________

C. Post-merger MPS and related calculations

As read in the previous section, while calculating post-merger EPS and related stuff, if the
question does not specifically mention any synergy in earnings, we used to assume it as zero.
While calculating post-merger MPS and related stuff, which involves use of synergy in value, we
have a different approach. There can be two possibilities with regards to synergy in value:

2) Question specifies Post-merger MV,

Use it directly
Synergy in Value or way to calculate it

1) Question is silent about synergy in value Calculate using earnings

1) When question is silent about synergy in value

Practical Questions: _ Practice Problems: __

46
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

Particulars A Ltd T Ltd

Case 1: Stock Deal
EAES (₹) 2,40,000 80,000
ER = 1:2
Number of Shares 30,000 20,000
EPS (₹) 8 4 Case 2: Cash Deal
PE ratio (times) 8.5 6.0 Cash paid = ₹ 45/share
Market Price (₹) (Cash paid as PC is
68 24
borrowed @ 10%.)
Synergy in earnings (₹) 1,60,000
tax rate 30

CASE 1: STOCK DEAL

1) Post- merger MPS

of A lid
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________

12.4L 0.8 Lt 1.6L 8.5

______________________________________________________________________________
0.3 Lt 0.21
______________________________________________________________________________
42
______________________________________________________________________________

40.8L
______________________________________________________________________________

0.4k
______________________________________________________________________________
______________________________________________________________________________
102 shore
______________________________________________________________________________
pct
 If question is silent about post-merger PE Ratio of A Ltd, it is assumed to be same as pre-
merger PE Ratio

47
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

2) Equivalent or Adjusted MPS

Alternative 1: Per Share Basis

Particulars A Ltd T Ltd

Post merger MPS 102

MPS 51
Equivalant
1 MPS 68 24
Premagel
Gain loss per share 34 27
30,000 20,000
Premerger n
Total gain loss 10.20.000 5.40.000
Alternative 2: Totality Basis
Particulars A Ltd T Ltd
1 2 10,000
Post merger in with SH 30.000 20,000
40.8L 40 8L
Claim
of 5H of 20 481K
A Teld in
mV 30 60,000 10.20.000
post merger
0 31 68 0.24 24
1 premagel
20,40 000 4 80,000
mV
Gain loss 10,29000 5 40,000

48
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

Understanding how does change in exchange ratio affects SHs of A Ltd and T Ltd:
A Ltd T Ltd
 Case 2: If ER = 0.1 or 1:10

Share in post-merger value

Less: Pre-merger value

Gain / (Loss)
 Case 3: If ER = 1.5 or 3:2

Share in post-merger value

Less: Pre-merger value

Gain / (Loss)

Note that in all cases, combined

gain/loss of SH of both A & T Ltd =
Key takeaways, applicable to stock deal:
1. Combined gain or loss in terms of value to the shareholders of both the companies is equal to
the amount of synergy in value i.e., ₹ 15,60,000 in this case.

Sv MVA MVA MVT

49
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

4) Maximum & Minimum ER on the basis of MPS

A. Maximum Exchange Ratio

B. Minimum Exchange Ratio

50
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

Practical Questions: _ Practice Problems: __

CASE 2: CASH DEAL

1) Post- merger MPS

Alternative
_______________________________________________________________________________
2
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________

0841.62 8.5 0 21 45
_______________________________________________________________________________
24
_______________________________________________________________________________
03 L
_____________________________________________________________
106
For rest of the solution, we will continue with the post-merger MPS arrived under method 1...
Note that the first method (in which interest on PC in considered) is more preferable. However, in
the absence of interest rate, second method (in which entire PC is deducted) can be applied.

2) Equivalent or Adjusted MPS

NOT APPLICABLE
Since, equivalent MPS is calculated using ER therefore, calculation of equivalent MPS is not possible
and also not needed.

51
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

3) Gain/(loss) to SHs of A Ltd in terms of MPS or Value

Alternative 1: Per Share Basis
Particulars A Ltd A Ltd

post merger MPS 118.15

Cash PC per share 45
I 168 24
pre meager MPs
Gain loss pet store 50.15 21
Premoegel h 30,000 20,000
Total gain floss 15,04 500 4.20.000
_____________________________________________________________________________
_____________________________________________________________________________

Max Cash poe share

_____________________________________________________________________________
min
No specific question so far on this concept
_____________________________________________________________________________

similar to other situations

_____________________________________________________________________________
Concept is
_____________________________________________________________________________

Max Cash Such that

_____________________________________________________________________________
post MPs is
atleast equal to pre
my merger
from A
_____________________________________________________________________________
mps
merge
_____________________________________________________________________________

min cash pre MPS

_____________________________________________________________________________
merger
By T
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

52
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

2) When question specifies Post-merger MV, Synergy in Value or way to

calculate it

Practical Questions: _ Practice Problems: __

Particulars A Ltd T Ltd

Case 1: Stock Deal
EAES (₹) 2,40,000 80,000
ER = 1:2
Number of Shares 30,000 20,000
EPS (₹)
28 4 Case 2: Cash Deal
PE ratio (times) 8.5 6.0 Cash paid = ₹ 45/share
Market Price (₹) (Cash paid as PC is
68 24 borrowed @ 10%.)
Synergy in value (₹) 15,60,000

CASE 1: STOCK DEAL

1) Post- merger MPS

of Altel
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
30,000 68 20.000 24 115,600007
_______________________________________________________________________________
_______________________________________________________________________________
30.000 70,000 42
_______________________________________________________________________________
_______________________________________________________________________________
I 102 share
per
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
Any of these values may be given

53
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

2) Equivalent or Adjusted MPS

3) Gain/(loss) to SH of A Ltd and T Ltd in terms of MPS or Value

Alternative 1: Per Share Basis

Particulars A Ltd T Ltd

Post
maga MPS 102
Equivalent MPS 51
1 I pre merges MPS 68 24
Gain loss per share 34 27

premage n 30.000 20.000

10,20000 5 40,000
Alternative 2: Totality Basis
Particulars A Ltd T Ltd
Shares in total post mageln 30,000 20,000 1 2 10,000

Propostion of post 40.82 40.84

38
merger mV
30.6L 10.2L
premoegel 03 02
mu 1820.4 L 4.84
gain loss 10,20 000 540,000

Note that, combined gain or

loss of SH of both A & T Ltd =

54
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

4) Maximum & Minimum ER on the basis of MPS

A. Maximum Exchange Ratio

B. Minimum Exchange Ratio

55
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

Practical Questions: _ Practice Problems: __

CASE 2: CASH DEAL

1) Post- merger MPS

oft lid
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
68 30.000 24 20,000 45
_______________________________________________________________________________
1560,000 20,000
_______________________________________________________________________________
30,000
106
_______________________________________________________________________________

2) Equivalent or Adjusted MPS

NOT APPLICABLE (Similar to equivalent EPS)

3) Gain/(loss) to SHs of A Ltd in terms of MPS or Value

Alternative 1: Per Share Basis

Particulars A Ltd A Ltd

Post merged MPs 106

Cash 45
paid
premerge MPS 68 24
Gain class pis share 38 21
premerges n 30.000 20.000
Total gain class 11.40.000 4.20.000

56
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

4) Maximum & Minimum Cash per Share on the basis of MPS

A. Maximum Cash per share

B. Minimum Cash per share

The minimum amount of cash PC which SHs of T Ltd would agree, will be its pre-merger MPS
because MPS is minimum amount that they will receive if they sell their shares in the market. Hence,
they would expect atleast that much of amount from A Ltd.

minimum cash pile pre merger MPs

_______________________________________________________________________________
_______________________________________________________________________________
share

57
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

D. NPV from the Merger | True Cost of Acquisition or Cost of

Takeover or
merged
Refer example on page number:
Accordingly, gain of ₹ 5,40,000 to the SHs of T Ltd is NPV from the Merger to T Ltd, which is also
the amount paid as extra cost by A Ltd and therefore also called True Cost of Acquisition to A
Ltd. Similarly, gain of ₹ 10,20,000 to SHs of A Ltd is NPV from the Merger to A Ltd.

Gain in terms of value (on totality basis) to the SHs of:

A Ltd is aka NPV from the

merges to Altd
____________

T Ltd is aka NPV from the

merges to Tltd
Cost of to the 5H of A lid
Aq
E. Default Assumptions (means applicable when question is
silent)
 When question is silent about exchange ratio?
 It is assumed to be based on MPS of T Ltd and A Ltd
 When question is silent about post-merger PE ratio of A Ltd?
 It is assumed to be same as its pre-merger PE Ratio
 When question asks us to recommend the break-even, maximum or minimum exchange ratio
but is silent as to whether ER is to be recommended considering MPS or EPS?
 See what has been asked in the previous point of the question. If previous point talks about
EPS (or earnings), recommend ER based on EPS, whereas if previous point talks about MPS
(or value), recommend ER based on MPS.
 When question is silent whether gain or loss to shareholders to be calculated in terms of
earnings or value?
 First preference is always gain/loss in terms of value. However, based on the given data in
the question, if it is not possible to calculate gain/loss in terms of value, then calculate in
terms of earnings.

58
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

F. Demerger
Practical Questions: _______________________ Practice Problems: ________________________

Demerger means a company selling one of its divisions or undertakings to another company or
creating an altogether separate company.
There are different types of demerger like sell-off, spin-off, split-up, etc. These have been covered
in details in theory notes. Practical question covered in our syllabus is based in spin-off. In spin-
off, a part of the business is separated and created as a separate entity. The existing shareholders
of the firm get proportionate ownership in the newly created entity.
 There is no change in ownership and the same shareholders continue to own the newly created
entity.
 Total number of shares of existing firm will remain same as before demerger.

G. Management Buy-outs (MBO)

Since, management of the company has better understanding of the business and operations of
the company, they sometimes consider buying out a company facing financial difficulties.
Buyouts initiated by the management team of a company are known as a management buyout.

59
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

60
Adish Jain CA CFA
Fixed Income Securities

Fixed Income Securities means investment instruments in which cash flows generated in future
(in the form of coupon and redemption value) are predetermined. It includes:
 Money Market Fixed Income Securities: These securities have maturity of less than 1 year.
Example: Treasury Bills, Commercial Paper, Certificate of Deposit, etc.
 Capital Market Fixed Income Securities: These securities have maturity of more than 1 year.
Example: Government Bonds, Corporate Bonds, etc. or more

Interest Rate or yield

A. Capital Market Fixed Income Securities 1 100 bps
Also called as Bonds, these securities have maturity of more than 1 year.
Terminologies related to the bonds:
 Par Value or Face Value (FV): Face value of the bond
 Issue Price (IP): Price at which bond is issued. It can be different from face value
 Redemption Value (RV): Value at which bonds will be redeemed i.e., amount which will be
paid back to investor.
 Maturity Date: It means the date on which redemption will occur.
 Original Maturity: It means the time period between issue date and maturity date.
 Time to Maturity (n): It means the time period left till maturity. As the time will pass, time to
maturity will reduce.
 Coupon rate: An annual rate (as a % of FV) at which company pays coupon (‘interest’ in
layman’s language) on bonds. Coupons can be paid annually, semi-annually, quarterly, etc.
CMP current market price of the loud which it falls
at_given in its end
ZCB / Deep Coupon Bearing Perpetual Bonds / point
Amortised Bonds
Discount Bond Bonds Irredeemable bonds life
As name says, no Coupon on these Life of these bonds is Equal principal amount
coupon is paid on bonds is paid at a indefinite i.e., maturity is redeemed at the end
these bonds. They fixed coupon rate of these bonds is not of each period along
are issued on at the end of every specified. Therefore, with coupon. It means
discount and fixed period. we consider that at the end of each
redeemed at par. Principle amount principal amount will period; coupon is paid
is redeemed in one never be redeemed only on the principal
shot on maturity and only coupon will amount outstanding at
be received at the end the beginning of the
of each period. period.

61
Adish Jain CA CFA
Concept
Fixed Income Securities
Fixed v S
Floating Rate Bonds
1) Valuation of Bonds Refer pg no
of Derivatives
015
Practical Questions: _______________________ Practice Problems: _______________________

Valuation of Bonds is simply based on Fundamental Principal of Valuation i.e., value of any asset
today is PV of all future cash flows generated from that asset.

4
8.1 f p p
C 8 8 8
piece Cp

CMP
Basics of TVM & its application: RRR or YTM

Reg rate
of return

IV Coupon RV

PV Interest Eu
Baghdad
MP Coupon RV

YTM
016 where
IV CMP
Conclusion: We will always have the amount of Coupons & RV. From the rest two (i.e., CMP/IV
or RRR/YTM), if anyone is given, we can find out the another one!
 Discounting Rate used to calculate intrinsic value of bond will be Required Rate of Return
(RRR) or Yield-to-maturity (YTM) of the investor. It is also called as Cost of Debt (Kd) from
issuer point of view.
 RRR is the rate of return that an investor can earn by investing in any other bond having
similar characteristics.
Concept Relat b w YTM Price
62 TTM Price
Adish Jain CA CFA
I 2 n no
of years Fixed Income Securities
no
of periods
cmp
Calculation of Intrinsic Value (i.e., what should be the value) of different types of bonds:

IV RV
Zero Coupon Bond
MP 11 Ytm

Coupon Bearing Bond

PVCa.E cn tPVirun
igon.Ehf C1 Run
T.ms g 4m z
47m 11 YTM

Eh
Perpetual Bond
m

Amortised Bond IV
Cmp
EE Imy EI mp
Note that compounding frequency of YTM or RRR is assumed to be same as frequency of coupon
payment. Simply saying, if coupons on the bond are paid semi-annually, then given YTM/RRR
(used for discounted) is also assumed to compound semi-annually.

Premium vs Par vs Discount Bond

a parate but
gives an intuition of
FV = 1000 | Coupon = 10% | N = 4 years | RV = FV compounding rat
YTM Value If… Then… Conclusion

81 1066 24 C YTM IV FV Premium

101 1000 YTM IV FV Por
c erm Inser Discount

9.25
2) Yield from Bonds: TYM, Current Yield & Realised Yield

an intuition
gives
Practical Questions: _______________________ Practice Problems: _______________________

of discounting
rate
63
Adish Jain CA CFA
Fixed Income Securities

Yield to Maturity (YTM)

It is the annualised rate of return that an investor will earn if the bond is purchased at its CMP &
held till maturity. It is the IRR of the bond.
Solve below equations for
Periodic YTM of different types of bonds:
YTM

Zero Coupon Bond CMP IP RV

1 YTM
Coupon Bearing Bond
no of
periodic periods
p PE y
If
MP
 Precise Method t 4m
compound interest
47m
my
based
Solve it
using Trial error method and then
interpolation
IP CMP
 Approximate Method YTM.sc ij s.tRV
simple interest IP CMP RV
based
2
Periodic Periodic
Perpetual Bond CMP IP
Coupon YTM Coupon
YTM CMP IP

Amortised Bond
N.A

Annualised YTM
If frequency of coupons is not annual, then period
above calculated periodic YTM will not be K
annualised. Therefore, annualised YTM can TTM Tffompounding
be calculated from periodic YTM as:
Freq in a year
Note that Approximate method can be used to calculate YTM since it is easier. However, in the i e no
below two situations Precise method should be used: in
1. Question gives the data of PVFs to be used for trial & error method 9.12.13
coupons a year
2. YTM to be calculated will have to be further used in some other calculation (for example,
Duration, etc)
928
64
Adish Jain CA CFA
diff 6 00 Yields of bonds
spread the
YTM YTM Fixed Income Securities
Bond 1 Bonds
Investment Decision based on CMP vs IV and RRR vs YTM:
al If... Means... Pricing Status Action

MP IV YTM RRR Fair valued Hold

CMP IV YTM 8 RRR overvalued Sell
CMP IV YTM RRR Undervalued Buy
Current Yield Annual
This yield calculation only considers the current coupon
annual current income (i.e., coupons) of the
bond.
yield IMP

Realised Yield or Realised TTM

019 It is the annualised rate of return actually realised by an investor during his holding period even
after considering the reinvestment return on coupons.

0 1 2 3 4
I I 1

Eg 8,8
FVof pons
6
IE
0 40
reinvested
10.1
_____________________________________________________________________________

OF 95
_____________________________________________________________________________

IF
_____________________________________________________________________________
100 27.85
PV 1 81 FV
_____________________________________________________________________________
127.85
95 1 87 127 85
3) Valuation using Spot & Forward Interest Rates 8 7 71 P.a
compound
Practical Questions: _______________________ Practice Problems: _______________________

65
Adish Jain CA CFA
Spot rates Rateof Jut applicable to a Borrowing lending which
starts from today
0 488
Fixed Income Securities
48 rates Rateof Gut applicable to a Borrowing lending
that starts from a
future date
Spot vs Forward Interest Rates
Octoday

5
f p I
FB
ÉÉffÉÉÉIgÉ FR 1 4
5.2
FR 2
5.51 FR 3 4
Er 8 61
Any given spot or forward rate can be used to compound (PV to FV) the cash flows or to
_____________________________________________________________________________
Note
discount (FV to PV) the cash flows only for that time period to which that given rate applies.
_____________________________________________________________________________

Valuation of Bonds using Spot Interest Rates

20
I t I
80 80 80
Value 18800
Bond
of
5
5.21 5.5 t
6

Value 80
_____________________________________________________________________________
1.8 2 1 1198874
1 05 5513
_____________________________________________________________________________

1072.07
_____________________________________________________________________________
_____________________________________________________________________________

Diffe 610 YTM Spot fud rate

66 Both the rates are used for compounding or discounting. However, using YTM intermediate cash flows can
Adish Jain CA CFA also be discounted or compounded, but using spot or forward rate, intermediate cash flows cannot be
compounded or discounted.
Fixed Income Securities

Calculation of Spot Rates using Forward Rates

921
FR 2
1_____________________________________________________________________________
_____________________________________________________________________________
path
_____________________________________________________________________________
5 FR 1 2
_____________________________________________________________________________
2 FV
_____________________________________________________________________________
PV 1
_____________________________________________________________________________
5 2
_____________________________________________________________________________
FT
Path
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

FV Part FV Path 2
_____________________________________________________________________________
logically
ᵗx 11T FR1 2 1 5.2 72
_____________________________________________________________________________
1 5
54
_____________________________________________________________________________
FR1x2
_____________________________________________________________________________

Valuation of Bonds using Forward Interest Rates

022
I t I
80 80 80
191 xx
5
5 5.4
_____________________________________________________________________________
FR 2 3
5 5.4
_____________________________________________________________________________
5 5.4 FR 2 3 FR 3 9
_____________________________________________________________________________

Bond 80
_____________________________________________________________________________
price of 80
41.8 1.054 ios Fras 1.054 105

1080 67
FR3xy f1tFRz 1.054 1.05 Adish Jain CA CFA
bond C Acs interes
price paid to purchase a
Total is included in it
Fixed Income Securities
price calcuted after deducting aissued interest
price cleanpril from full price A bond is quoted in the
4)Dirty
Full Price vs Flat Price of a Bond Q 17 at this
market price

FV 1000 8.1 original maturity

_____________________________________________________________________________
Coupon
YTM 101
annual
_____________________________________________________________________________
Term to maturity
Efg
_____________________________________________________________________________
1 iffy 2 3 4
5
_____________________________________________________________________________
I do 80 810
1800
_____________________________________________________________________________
6m
_____________________________________________________________________________
949.96
_____________________________________________________________________________
ytm 10
_____________________________________________________________________________
1029.96
_____________________________________________________________________________

6m for 290
_____________________________________________________________________________
10

POICE 980.91
_____________________________________________________________________________
FULL
1 Accrued Interest 40
_____________________________________________________________________________
antrued coupon.ie 80 6 12
FLAT Price 940.91
5) Extension and Retirement Decisions
 Whether to extend the existing bond?
025 L extend the same 20g
98
___________________________________________________________________________
___________________________________________________________________________

p iii Ein cipon

___________________________________________________________________________
Decision
IP FV 121 Extend the
___________________________________________________________________________ old

 Whether to retire the existing bond?

Yes b 8 Issue menu
Q Y 8 continue the_old 2
2 ___________________________________________________________________________
Case 1
___________________________________________________________________________

Decision retire the old issue new F

___________________________________________________________________________
Find out PV of
case 2 1
allcash IF
___________________________________________________________________________
OF
under
68 Case 1 case 2
Adish Jain CA CFA loud OIF is the betel alternative
Price Risk especially
tment Risk
Gives
Fixed Income Securities

6) Risk Management of Bonds

Practical Questions: _______________________ Its ftp.r S

Practice Problems: _______________________
Price risk is the uncertainty of price at which a bond will be sold in the market if it is sold before
Yearly duration
value
maturity. Price at which
ofthe bond
the bond will be sold in market before maturity will depend on the YTM
Periodic of
desath
that point which keeps on changing in the market.
a) Macaulay’s Duration | ‘Duration’
28
Macaulay’s Duration is the weighted average time
Refa next pathcreep
if darationed www.t
taken to recover the amount invested in bond. dog
 Duration of a coupon bearing bond is less that its
maturity period.
42 02 nz wz
 Duration of a Zero-Coupon Bond is equal to its Duration n We CEDE
maturity period absolute
 Lower the duration, less risky a bond is. N2 002 E DCF

Evie EDCF
b) Modified Duration | ‘Volatility’ | ‘Sensitivity’
029 ie value ofBo
Modified Duration means approximate % change in
value of bond for each % change in interest rate.
TMI MD Macaulays
If interest rate increases, value of bond will decrease Duration
by modifies duration times percentage increase in
interest rate and vice versa. 1 YTM period
K Y TM
It denotes the risk of the bond and therefore, lower is
better. compfreq
UTM i to
approx
% Change in the price of Bond: Freq ofcoupo
Approx M D X ΔYTM
Δ in price

c) Immunization

Immunization is a risk management technique. To immunize:

Mac Duration
Note: Duration of portfolio of bonds = weight average desation
g
02 62
duration of individual bonds i e
Dex 61
means eliminating the price risk Reinvestment risk by nullifying
each other
That happens when we invest in such a bond or portfolio
whouse Mackay's duration equal is to duration
of outflow Idiability 69
Interpretation of MD of 3 Price Δ 3
Adish Jain CA CFA
If YTM Δ 1 Then
3 0 51
if YTM Δ 0.5 1
Actual prile using IV method
i.e PV of future CFI
Fixed Income Securities
Estimed prices using MD
d) Convexity
open
Recollect that Modified Duration
measured an approximate change in pricey
value of bond for change in interest V
rates.
Accurate change in the value of bonds
can be calculated by adjusting modified 1050 Adjustment
duration on account of convexity.

Calculation of Convexity: V0 000

V.TV 2Vo
55
Convexity
2 V0 x 1075m
4th
49 10
4
precise
Convexity Adjustment & % Change in price: assume some ITM Δ both sides
n

2
Δ in
MD ΔYTM Convexity ΔYTM
Bondprice

_____________________________________________________________________________

understanding macaways duration

_____________________________________________________________________________

FV 1000 47M n 3
_____________________________________________________________________________
10
10
_____________________________________________________________________________
Coupon
Years PVF 1011 DCF W
h_____________________________________________________________________________
Coypon
1 100 0.909 go.g 9 091
_____________________________________________________________________________

100 0.826 82.6 8.261

_____________________________________________________________________________
2
3 1100 0.751 826 1 82.611
_____________________________________________________________________________
999.6 100.1
_____________________________________________________________________________

the bonds is
_____________________________________________________________________________
value_of
recoved in patets over a
_____________________________________________________________________________

period of 3
_____________________________________________________________________________
years
Avg time taken
Ix 9.09.1
70 to recover
Adish Jain CA CFA 2x 8 26 10
3x 82.617
3 Y S

SONVERTIBLE BONDS

Premium Over Straight Value OR

of downside Risk
SV Ke comparision
me CMP kitha jyada

Straight value Value as per PV of C RV

IMP
Debenture
SEitiisiijk.fi
convert Karo
Shares me
to debenture ki value Kimi

i
shares Shares Conversion parity price
shares Shares Debenture buy Kar ke
CMP shard mei convert kro.to
stores ki cost Kitui

conversion premium
MP ke comparision ma
Conversion price Kitna
jyada mi
Fixed Income Securities
CP TBill CoD
B. Money Market Fixed Income Securities C Bill holding

Practical Questions: _ Practice Problems: _

go
trade Δ
Issue a Redeem
IP CMP RV
1) Call Money or Notice Money or Term Money
discount FV
Call Money, Notice Money or Term Money are unsecured form of borrowing or lending available
to banks and authorized financial institutions.

Period of borrowing or lending:

Call Money

Notice Money

Term Money

2) Commercial Bills | T-Bills | Commercial Paper | Certificate of Deposit

Commercial Bills arises out of a credit trade transaction. A bill of exchange is issued by the seller
of goods (drawer) and accepted by buyer (drawee). A bill of exchange that are accepted by
commercial banks are called commercial bill.
When banks discount a bill, it pays the amount of bill to the drawer net of interest and receives
the entire face value of the bill on maturity.

T-Bills, Commercial Paper & Certificate of Deposit: These instruments are issued at discount and
redeemed at its face value. These are issued by:

Treasury Bill
Gout
Commercial Paper
Corp
Certificate of Deposit
Bank
a) Discount Rate or Discount Yield

Discount Yield measures the amount of discount

given as a percentage of face Value. It is always FV CMP IP 100
calculated and mentioned on annualized basis by 369
using Actual Number of Days & 360 days. FV

71
Rule of day countingIn for Disc Addon Yicel Adish Jain CA CFA
1 15 NOV 15 Jan start from next day 16 NOV i e G days
new month
2 3 4 13 Jan 9 date
1st Nov i e 766
3 1 Nov 15 Jan stoat from 1st Nov
Fixed Income Securities
i e 76 day

b) Holding Period Yield | Money Market Yield | Effective Annual Yield add on yield
Holding Period Yield is the
return earned during the
FV CMP IP 100
holding period of the security. IP CMP
ANNUALIZATION
Simple interest based compound interest based
Money market yield | Bond Equivalent Effective Annual Yield
Yield | Interest Rates | Yield | Investment
Rate 3651h
365 1 HPY 1
HPY
n

It is always calculated and mentioned on annualized basis by using Actual Number of Days & 365
days.

3) Repo & Reverse Repo

The term Repurchase Agreement (Repo) and Reverse Repurchase Agreement (Reverse Repo)
refer to a type of transaction in which money market participant raises funds by selling securities
and simultaneously agreeing to repurchase the same after a specified time at a specified price,
which includes interest.
Repo rate is the rate at which RBI lends to Commercial Banks against Government Securities. On
the other hand, Reverse Repo is the rate at which Commercial Banks lend to RBI.
d I d
repotransact for rod
_____________________________________________________________________________
_____________________________________________________________________________
T.IE S Got Bonds
_____________________________________________________________________________
seeing
98
_____________________________________________________________________________

Bank Repomargin
RBI Bank RBI
_____________________________________________________________________________
_____________________________________________________________________________
295
It
_____________________________________________________________________________
95.26
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
Repurchase Agreement
Repurchase after 10 d
72
Repurchase price
Adish Jain CA CFA
95 1 10 4 109
3650
95.26
Reporate
Portfolio Management

Modern Portfolio Theory & Capital Market Theory

• Expected Return & Risk - Individual Security

• Expected Return & Risk - Portfolio
• Coefficient of Variation
• Minimum Variance Portfolio
• Efficient Frontier
• Capital Market Line

Sharpe Index Model & CAPM

• Systematic Risk - Individual Security

• Unsystematic Risk - Individual Security
• Systematic Risk - Portfolio
• Unsystematic Risk - Portfolio
• Return & Risk as per Sharpe Index Model
• Capital Asset Pricing Model & Security Market Line
• Sharpe Optimum Portfolio

• Arbitrage Pricing Theory

• Portfolio Rebalacing Strategies
• Portfolio Performance Evaluation
• Beta of an Unlisted Entity | Proxy Beta

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A. Modern Portfolio Theory & Capital Market Theory

Modern Portfolio Theory (MPT), Markowitz Model or Risk-Return
Optimization Theory was developed by Harry Markowitz
It guides investors about the method of selecting and combining
securities that will provide the highest expected rate of return for any
given degree of risk or that will expose the investor to the lowest
degree of risk for a given expected rate of return.
This theory assumes a risk averse investor i.e., he will choose a
portfolio with lower risk with same level of return or higher return for
same level of risk.

1) Expected Return – Individual Security

Practical Questions: _ Practice Problems: _

Denotation Exp Return of Searity E RA

a period 1141
The return that an investor can expect to for
Expected Return of security A: E(R )
receive in future and is called as Expected Mn A possible return
Return.
Suppose an investor purchased an equity Possible P1 Po D 100
share A today at a price P0. He expects the return
price of the share to be P1 at the end of year 1 p
and dividend of amount D during this period.
capital Dividend
Data given in the question will be either:
officiation
1. Ex-post (past) data of return of more than one previous year, or
2. Ex-ante (future) data of return along with the probability (P) of its occurrence.
In such cases, Expected Return of a security will be equal to the average of all such past or future
returns (referred as possible returns) that an investor expects to earn on that security.
In case of a single security or single portfolio, we will denote possible returns by X and in case of
two, we will denote them by X and Y and so on.

1. E(RA) based on ex-post data of price and dividend:

In this case, expected return is equal to the simple average of possible returns calculated using
given past data. Though, expected return is calculated using past data, but it is the return
expected in future.

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Possible
Years Price (₹) Dividend (₹) Return (X)

0 100 Not possible

115 100 5 20
1 115 5 100
110 115 0 4.35
2 110
115
130 110 10 27.27
3 130 10
110

Ex 42 92

E RA I K 4292 14.31
3

2. E(RA) based on ex-ante data of price and dividend:

In this case, expected return is equal to the weighted average of possible returns calculated
using future data. Say, P0 = 100
possible
Prob. (P) Price (₹) Dividend (₹) Return (X) P×X
1

110 100 5
30 110 5 15 4.5
100
95 100 0 5
201 95 0 1
100
115 100 10
10 25
501 115 100 12 5

ECRA Hop 16
Note that in case of ex-post data, in the calculation of each year’s possible return, P 0 will be
respective year’s opening price, whereas in case of ex-ante data, P0 will be current year’s opening
price (i.e., price today) for all cases of possible returns.

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2) Risk – Individual Security

Risk is where there is an uncertainty with respect to a future event. In case of investment in any
security, uncertainty of future returns gives birth to risk.

Security X:
more
108 certainty
FD less futuation
100 less risk

Security Y:
150 lessee restainity
TCS
110
more futation
100 more risk
90
1

Security Z: 780 least terrainity

Bitcoin most
130 fluctuation
100 most risk
50
1

Higher is the dispersion of possible returns of securities, more we find the security risky. Variance
and Standard Deviation are most widely accepted measures of dispersion.
 Risk of a security is measured by Variance (σ 2) or Standard Deviation (σ) of possible returns
of the security.
 It shows: On an average, how much do the possible returns deviate from the expected return.

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Broadly speaking, securities can be:

 Risk free (RF) security: security whose expected return is certain. Government securities are
considered as proxy of risk free securities. Needless to mention that σRF = 0.
 Risky Security (RS): Security whose expected return is uncertain. Examples of risky securities
include Equity Shares, Corporate Bonds, Preference Shares, etc. In this chapter, risky
securities will normally refer to equity shares.

Risk of the security A: σA2 or σA

1. σA2 or σA based on ex-post possible returns:

Years X DX = (X – 𝑿) DX2

1 20 20 14.31 569 3238

2 4 35 14.31 18.66 348.20
3257
3 27.27 14.31 12.96 167.96
Edge 548.54
Ex 42.92

ECRA x̅ ERIN 14 31.1

548.54 182 8501
V08 Endm 3
SD TA V08 182.85 13.52

2. σA2 or σA based on ex-ante possible returns:

P X P×X DX = (X – 𝑿) P × DX2

30 IT 4 5 15 16 1 111 30 0 3
20 5 5 16 21 6 21 4 20 88.2
50 25 25 16 9 1912 50 40.5
Ecp.se 16 129
p.dz
ECRA PXR 16

lpxdr 129.4
Vor 129 11.35
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3) Expected Return – Portfolio

Practical Questions: _ Practice Problems: _

Similar to expected return of a security, Expected Return of Portfolio is the return that an investor
expects to earns on the portfolio.

Expected Return of the Portfolio is calculated as weighted average of expected return of

individual securities in the portfolio, where weights (W) of the securities would be based on:
 the value of investment in securities (i.e., MPS × Number of shares)
 at the beginning of the period for which expected return is calculated (i.e., at time 0)

Expected Return of portfolio P: E(RP)

Expected Return of Portfolio P having two securities – A and B:

ECRA WA ECRA E Exp

___________________________________
RB
E RB WB return of security A B
___________________________________
___________________________________
WA WB Weights
ECR X WC
of security A Bp
___________________________________

I. Ex-post Data: E(RP)

Example:
Let’s consider the example of portfolio P comprising two shares A and B each. For the ease of
solving, we will assume there are not expected dividends. 1 NO
A
Year
Price/share B 2 No's
A B

2016
2017
2018
2019 200 300

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I I Expirated return
of bperiod
80 ECRA 111
ECRB 161
Portfolio Management
2
 Calculation the possible returns of Security A (X) & Security B (Y) and E(R A) & E(RB) thereon:
Years X Y

1 15 9
2 10 14
3 8 25
EN 48
33 Ey
33
ECR D Erin 3
11 J Eyn 48 3 16

 Calculation of weight of security A (denoted by WA) & security B (denoted by WB): Caution!
Security A Security B

1 200 300 2 600

MVA 200 MVB
200 600 75
A
251 WB
200 600 200 600

 Expected return of the portfolio:

ECRA WA ECRB WB
_____________________________________________________________________________

25 1 16 751 14 75
_____________________________________________________________________________
11
Verification: If we suppose the entire portfolio as a single security and calculate expected return:
Total Value of
Year Possible returns (X)
A B Portfolio

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Portfolio Management

II. Ex-ante Data: E(RP)

WA WB
Probabilities & Expected Price
Security No. of shares Price Today
20.1 50 3011
A 200
1
B 2 300
 Calculation the possible returns of Security A (X) & Security B (Y) and E(RA) & E(RB) thereon:
Security A Security B
P
X P×X Y P×Y

2011 101 2 151 3

161 8 141 7
556 6 10 11
20
ECRA 16 ECRB i

 Calculation of weight of security A (denoted by WA) & security B (denoted by WB):

Security A Security B

MVA 200 200 300 2 600

1 MVB
Wa 700 600 75
251 WB
2004 600 2004 600
Observe the difference in calculation of weights between ex-post and ex-ante data.

 Expected return of the portfolio: E RB WB

ECRAIX.UA
16 25 13 75.1
_____________________________________________________________________________

13 754
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

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4) Risk – Portfolio
Risk of a Portfolio means on an average, how much do the possible returns of a portfolio deviate
from its expected return. Risk of Portfolio P is measured by Variance ( σP2) and Standard Deviation
(σP) of its possible returns.
Apparently, calculation of risk of the portfolio also seems like the weighted average risk of its
individual security. But it’s NOT!
Let’s understand this with the help of a portfolio of equity shares of J Ltd and K Ltd:
Case 1

garnRA sec A

1 1
µ titryersth
yo
return cotel ang

petB t.FR

g
1 1
NM
yelers
Case 2

scornRA sec A gourmet sec

1 1
mm
yeah years
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return hotel avg

PFY IF ry
AEC
I.MN

Concept of Covariance and Correlation

Correlation means co-movement between two variables like returns of two securities.
 Positive Correlation: When returns of the securities move in the same direction. Example: in
one period, both the securities give good returns and, in another period, both give bad
returns.
 Negative Correlation: When returns of the securities move in the opposite direction. Example:
in a given period, when, one gives good returns, another gives bad returns and vice versa.
 No Correlation: When returns of one security has no relation with returns of another.

Correlation between the returns of two securities can be measured by:

 Covariance measures the correlation between returns of two securities. Covariance between
the returns of securities- A & B is denoted by CovAB.
 Being an absolute measure of interrelationship, it is incomplete to infer.
 It is used to calculate correlation coefficient.
 Casually referred as Correlation, Coefficient of Correlation measures degree of correlation
between returns of two securities. Correlation coefficient between the returns of securities-
A & B is denoted by rAB or ρAB.
 It is a relative measure of interrelationship rAB = + / - xx
and complete to infer. It can tell us about
both, nature and degree of correlation.
degree
 It can range from -1 to +1 and has no unit. direction of
correlation
of
correlation
Note that covariance and correlation between Whether the now
are
strongly
risk free security and any security is Zero. is same they
direction or correlated
82 opp direction to each other
Adish Jain CA CFA
Portfolio Management

Risk of the Portfolio

We know that risk of the portfolio is measured by the variance and standard deviation of its
possible returns.

Variance of portfolio P: σP2

In case of 2 securities in the portfolio:

TAWAY TBWB
2X TA WA TB WB JAB
In case of 3 securities in the portfolio:

Tp AWAY GWBP We
2X TAWA TB WB TAB
2x TB WB T We TBC
2 TWC TANAX JCA
Standard Deviation of portfolio P: σP

Tp 52
_____________________________________________________________________________

P ERA In
_____________________________________________________________________________
_____________________________________________________________________________
WA
_____________________________________________________________________________
8
ECRp
_____________________________________________________________________________ Tp
_____________________________________________________________________________

Price Y ECRB TB
_____________________________________________________________________________
B
Div WB
_____________________________________________________________________________

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WA 251
I. Ex-post Data: CovAB | rAB |σP2 | σP
WB 751
Year X DX = (X – 𝑿) DX2 Y DY = (Y – 𝒀) D Y2 DX × DY

1 15 4 16 9 7 49 28
2 10 1 1 14 2 4 2
3 8 3 9 25 9 81 27
33 26 48 134 53

Calculation of CovAB and rAB

Particulars A B

48 16
ECR EY 333 111 3

134
52 2
Edgy
44.66
dry 8.67 3

T 8.67 2.94 V44.66 6 681

2
COVA B daxdy 33 17.67
n

COYAB 17.67 0.90

RA.BY 6.68
TB 2.94

12.94 0.25 24 6 68 751

2x 294 0.25 6.68 0.75 0.9

19.01.01
1 9 01 4.36
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WA 251
II. Ex-ante Data: CovAB | rAB |σP2 | σP
WB 75.1
P X P×X DX = (X – 𝑿 ) P × DX2
20 101 2 6 7.2
50 16 8 0 0
30 20 6 4 4 8
16 12
Y P×Y DY = (Y – 𝒀) P × D Y2 P × DX × DY

15 3 2 0.8 2.4
14 7 0.5 0
10 3 13 2.7 3.6
66
13 4
Calculation of CovAB and rAB
Particulars A B

x̅ 13
ECR ElPxn 161
J ECpxy
22 E pxdn 12 E pxdy 4

12 3.46 MY 2

COVAB Pxdrxdy 6
COVAB 0.87
TAB TaxB
358 2
2
1346 0.2572 2 0.7572
2 3 46 0.25 2 0.75 C 0.87

0.75 85
0.75 0.87 Adish Jain CA CFA
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Portfolio Management YAE
III. Important points of consideration: E(RP) | Cov8AB | rABCOVAB
|σP2 | σP FABX TAX B
Calculating variance of the portfolio directly using covariance

In case of 2 securities in the portfolio:

TAWAY TB WB 2X TA WA TB WB JAB

TAWAY TB WB 2 WAUB COVAB

In case of 3 securities in the portfolio:

FAWA GWBP IF We
2X WAWBX COVAB 2X WBW CX COVBC

2x WC WAX COUCA

Special Case of σP of two securities, when r is equal to +1 and -1

Perfect Negative No Correlation Perfect Positive

r = -1 moderate r=0 r = +1
1 1 Margate
If we put r = +1 and -1 in the below formula of SD:

Tp TAWA TBWB Tp TAWA TB WB

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E RA 18.1
How does σP change with change in rAB and rest all remaining the same 241
E RB
σA σB WA WB

101 20 701 To
E(RP) = 18 50.1 24 701 21

Lysis rAB σP

+ 1.00

+ 0.50

0.00

- 0.50

- 1.00

Important Observations on rAB and σP:

 Expected return of the portfolio has nothing to do with correlation of its securities. It means
that in all above cases, expected return of the portfolio would be same i.e., weighted average
of expected return of individual securities.

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 With rest all inputs remaining the same, as the correlation between the securities reduces
from +1 to -1, risk of the portfolio reduces from highest to lowest. This is because, as
correlation reduces, securities offset the deviations of each other. It means that: lower the
correlation, lower the risk and better it is.
 As already read, at r = +1, risk of the portfolio is equal weighted average of risk of individual
security and this is also the case of its highest risk. Hence, we can conclude that:
 In all cases of correlation, except when r = +1, risk of the portfolio will be lower than
weighted average risk of individual securities.
 This is the central theme of Modern Portfolio Theory. It says: Return of the portfolio is
weighted average but risk of the portfolio is normally* less than weighted average.
(*except when r = +1, which is practically also a rare possibility).
 Hence, without sacrificing the expected return, we can reduce the risk by combing or
adding securities which are not perfectly positively correlated, to form a portfolio. This
process of combining or adding securities is called Diversification of the Portfolio
(discussed in detail later).
no
of digits after decimal points
Unit of measurement:
Units Return & Standard Deviation Variance & Covariance
Percentage 2 2
10 352
100 10022
Decimals 0.0352
4 9 10 6
3
Can weight of a security ever be negative? Concept of Short Selling
Selling the security, even when we don’t own it is called as Short Selling or Shorting. It is possible
through the scheme of Security Lending & Borrowing. In case of short selling, short position on
the asset gets created and is squared off when security is bought back in future.

Meaning as a:
Terms
Transaction Position
Having bought position
Long Buy the asset (i.e., bought the asset and not sold it yet)
Having sold position
Short Sell the asset (i.e., sold the asset and not bought it yet)

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Portfolio with Risk-free borrowing and lending

Risk free lending is equivalent to buying risk-free securities because technically what we do when
we buy a risk free asset is we lend money.
Similarly, risk free borrowing is equivalent to selling risk free securities because technically what
we do when we sell a risk free security is we borrow money.
Accordingly, in the calculation of risk and return, treat:

13 Risk Free Borrowing as SHORT position in RF securities

Risk free lending as LONG Postion in RF securities
Already discussed; just to bring everything at one place:

E(RRF)
RF
σRF
Zero
r Security, RF
Zero

Weight of a security with long and short positions in the portfolio

We know that weight of a security in the portfolio is calculated on its Value i.e., Price x Number
of security. Note that in case of a short position, number of securities held will be a negative
number and hence negative value of investment and negative weight in the portfolio.

Long Position
Weight
Short Position e

Weight
Following points are worth noting:
 Since, short position in a security will have its negative value, therefore, while calculating
the total value of the portfolio, it will not be added to long position rather it will be deducted
from long position.
 Total portfolio value will always be equal to the self-owned funds available with investor.
 Total of weights of security is always 1 which is equal to total portfolio value.
980

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with TRA WRA
Adish Jain CA CFA
Tp TRE WRF
RF
RA RA RI RI RI RA
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Portfolio Management
TRAX URA
Calculate E(RP) and σP for given examples using below data:
TCS Infosys GOI Bonds
E(R)
σ
r

Example 1: Mr. A has ₹ 8000 to invest. He shorts shares of TCS for ₹ 2000 and invest ₹ 10,000 in
the shares of Infosys.
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

Example 2: Mr. B has ₹ 12,000 to invest. He invests ₹ 8,000 in the shares of Infosys and balance
in Government of India bonds.
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

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Example 3: Mr. C finds share a TCS a multi-bagger but has just ₹ 3,000 to invest. He borrows a
sum of ₹ 9,000 and invest the entire amount available with him in the shares of Infosys.
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

Example 4: Mr. D is expecting that the share of TCS is going to do down. He shorts them for ₹
15,000 and lend the amount at risk free rate.
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

Example 5: Mr. E has ₹ 25000 to invest. He wants to invest the amount in the shares of SBI and
YES keeping weights as 1.2 and -0.2 respectively. Determine the amount and position of each of
the security.

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specifically
5) Coefficient of Variation Apply only ask for it
when ICAI
Practical Questions: _______________________ Practice Problems: _______________________

We should know that return is not the only factor to that helps us choose the best investment
option. Risk associated to the investment should also be considered in our analysis because risk
taken to earn that return is also important.
Example 1: Security E(R) σ Which Security looks better?

Example 2: Portfolio E(R) σ Which Security looks better?

Example 3: Security E(R) σ Which Security looks better?

Coefficient of variation (CV) is a measure of risk relative to return.

 It shows how much risk is taken to earn every

1% of return.
r
 It is used to compare securities or portfolios
to choose better. ECEA
 Lower it is, better it is.

CV of A: CV of B:

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6) Minimum Variance Portfolio of Two Securities

Risk
Practical Questions: _______________________ Practice Problems: _______________________

Based on our analysis of risk and return, suppose we selected two risky securities to be combined
to form a portfolio. But the next big question is:

?
 In what proportion, should they be combined to form the portfolio? Or
 What should be the weights of the securities in the portfolio? Or
 Of the total amount, how much should be invested in which security?
Suppose, we have selected securities A & B to be combined to form a portfolio.

E(RA) E(RB) σA σB rAB

15 1 201 121 16
With two securities, infinitely large number of portfolios can be created by keeping different
weight combinations of long and short positions. In our example below, we will consider a sample
of only eight such portfolios & calculate their return and risk:
σP
WA WB E(RP)
Case 1: r = 0.5 Case 2: r =

P 100 0 15 121
a 75 25 16.25 11.531
R 50 50 17.5
5 25 75 18.75 13 5
T
0 100 201 161

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soso.es I

19
5

18
R
17
i

16 tfoliom

15 P

F i iz u f Risk
10 s
Of all the portfolios with different weights combinations, there will be one portfolio with a specific
weights’ combination, whose risk will be minimum. That portfolio is called Minimum Variance
Portfolio. In our example:
 Case 1: ______________________________________________________________
portfolio m
 Case 2: ______________________________________________________________

Exact Weights of securities A & B in minimum variance portfolio:

Note:

VarB COVAB  It is possible that using this formula, we

WAE 2COVAB
might get the weight of one security more
Varat Vary than 1 and another security, a negative
number.
 Getting such weights would mean that
WB 1 WA minimum variance portfolio is such cases
can be constructed through short selling.

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Let’s calculate weights for both cases of our example:

Case 1: r = Case 2: r =

COVAB 8 TAX B
0.5 12 16
96
WA 162 96 76.92
122 16 2 96
1 72.961
WB
23.08
When short selling is not allowed, we can’t have negative
weights in our portfolio. In such cases, whether two
securities will be able to construct minimum variance
portfolio with only long position (i.e., positive weights) or
not, depends upon rAB.

It means that if above condition is not met:

 Then, minimum variance portfolio will compulsorily
include short selling. It can be verified in case 1.
 Then, risk of the portfolio created using only long position be more than risk of one of the
individual securities.

?
Can minimum variance be equal to even Zero? or
Can we create a risk-free portfolio with two risky securities?

Yes! When correlations between two

securities in the portfolio is perfectly WA B
negative, then risk of the minimum
variance portfolio is zero i.e., minimum Tat TB
variance portfolio created using two risky
securities will be risk free.
WB 1 WA
Mathematically: If rAB = -1, then at a specific _____________________________________
weight, σP2 and σP = 0
_____________________________________
Note that minimum variance portfolio in
case of three or more securities is beyond _____________________________________
the scope of our syllabus.

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7) Markowitz Model of Optimal Portfolio Selection or Risk Return

Optimization Model | Mean Variance Analysis | Efficient Frontier
This is the main model or technique laid down under MPT. The objective of this model is help
investor select the most optimal portfolio considering its risk-return characteristics. It focuses on
portfolio of only risky securities because risk-free securities have no risk to consider in the
analysis.

Which securities should be included in the portfolio, depends on their risk return characteristics.
Once the securities have been selected to form a portfolio, next obvious question is in what
proportion they should be combined. An infinite large number of possible portfolios can be
created by making different combinations of weights of selected securities. These possible
portfolios are called as feasible portfolios.

According to this model, a risk averse investor (which is an assumption of this theory) will always
choose an efficient portfolio from the feasible portfolios. A portfolio is efficient portfolio if:
 No other portfolio offers higher expected return for same risk, or,
 No other portfolio has lower risk for same expected return.
To find out efficient portfolios, we must do mean-variance analysis i.e., analyse the return
(means) and risk (variance) of all feasible portfolios.

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 Shaded region in the graph represents risk return combination of all the feasible portfolios.
In our case:
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________

 Among all feasible portfolios, we can identify the portfolios that satisfies the condition of
efficient portfolios. It would be all those portfolios lying on dark-bold line.
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________

 Efficient frontier is the dark-bold line containing all efficient portfolios. Portfolios laying
below this line are all inefficient portfolios because for the same risk as it, portfolio on
efficient frontier will offer higher return.
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________

 Investor’s Optimum Portfolio (best one for an investor) should be chosen from efficient
frontier. It would depend upon maximum risk that are willing to take, minimum return they
need, ratio of risk to return they are comfortable with, etc.
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________

Note that this concept is more important from understanding and theory question point of view
and less from practical question point of view.

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8) Capital Market Theory and Capital Market Line not

c
Modern Portfolio Theory considered only risky securities in the analysis of risk-return
characteristics of the portfolio, identification of efficient portfolios and selection of an optimum
one.
Capital Market Theory (CMT) is an extension of MPT that also considers risk free security to be
included in the portfolio. According to CMT, portfolios that can offer returns better than efficient
portfolios for same level of risk, can be created if risk free security is also added in it along with
risky securities.
Note that this concept is more important from understanding and theory question point of view
and less from practical question point of view.

Impact of including risk free security on the return and risk of the portfolio of risky securities.

Consider below details of risky securities- Particulars E(R) σ

‘RS’ and risk-free security- ‘RF’: RS
RF

We will construct the first portfolio with WRS = 100% and WRF = 0% and then construct every next
portfolio by shifting 20% weight from RS to RF and see the impact on its risk and return.

WRS : WRF E(R) σ

We can observe that as we add risk free security in the portfolio of risky securities, its E(R) and
σ change linearly because correlation between RS and RF is zero.
In other words, E(RP) and σP reduces proportionately in a straight line.

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Similar to MPT, the objective of CMT also is selection of optimal portfolio based on its risk and
return. It, however, goes beyond MPT. Let us understand it on risk - return space:

Below discussion will help us to understand CMT:

 Similar to MPT, an efficient frontier is determined on the basis of feasible portfolios. Note
that, in case of CMT, feasible portfolios will be all possible portfolios of all risky securities in
the market.

 A line is drawn between a portfolio of risk-free security and a portfolio on efficient frontier
such that the line is tangent to efficient frontier. So, let’s understand these three things:
a) Portfolio of risk-free security (Portfolio – RF) will have WRF = 100%. Expected return
of Portfolio – RF is Risk free rate of return (RF) and its risk is zero. In our case:
_____________________________________________________________________
_____________________________________________________________________

b) CMT is a special case of MPT in which the portfolio on the efficient frontier to which
the line is tangent, is a Market Portfolio (Portfolio – M).

99
Adish Jain CA CFA
Portfolio Management

Market Portfolio can be defined as a portfolio of all the risky securities in the market.
Since, practically no such portfolio exists, stock market index (like NIFTY, SENSEX) is
considered as a proxy of market portfolio.
Expected return of Portfolio – M is Expected return from market (E(RM)) and risk of the
Portfolio – M is Risk in the market (σM). In our case:
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________

c) The line between market portfolio and portfolio of risk-free security actually
represents the risk and return of various portfolios that can be made from the different
combinations these two portfolios. This line is called as Capital Market Line (CML).
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
________________________________________________________________

 The objective of CMT is to explain that the portfolios lying on Capital Market Line are more
efficient than portfolios lying on efficient frontier.
We can observe that, other than Portfolio – M (which is a common portfolio between CML
and efficient frontier), for any given amount of risk, portfolio lying on CML is offering higher
return than the one lying on efficient frontier. In our case:
__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________

Crux of the theory:

We know that the efficient frontier helps investor to select the optimum portfolio consisting
of only risky securities. CMT goes beyond it and says that by adding risk free securities to the
portfolio of risky securities, portfolios more efficient than even efficient frontier can be
created and optimum portfolio should be selected from the ones lying on CML.

100
Adish Jain CA CFA
Portfolio Management

 We know that in the Portfolio – M, WRS = 100% and WRF = 0%. Similarly, in the Portfolio – RF,
WRS = 0% and WRF = 100%. Hence, we can say that as we move from Portfolio – RF to portfolio
– M along the CML, WRF in the portfolio reduces to zero.
Moreover, as we move further to the right side beyond Portfolio – M, WRF starts becoming
negative and WRS starts becoming more than 1. Recollect positive weight of risk free security
means lending and negative weight means borrowing.

 Portfolios on CML lying on the left side of the

Portfolio – M i.e., between Portfolio – M and
Portfolio – RF can be created by lending a portion
of total self-owned funds at risk free rate and
investing another portion in Portfolio – M.

 Portfolios on CML lying on the right side of the

Portfolio – M can be created by borrowing at risk
free rate and investing the amount borrowed
amount along with self-owned funds in Portfolio –
M.

 Recollect that equation of a line: Y = a + bX and slope of line: , where:

Y Value of Dependent Variable

a Intercept of Y (i.e., value of Y, when X = 0)
b Slope of the line
X Value of Independent Variable

Accordingly, if we compare two points

RF and M, Slope of CML

Note that the slope arrived above is a ratio called as Sharpe Ratio to be discussed as in later
section. Since, in case of CML, Sharpe Ratio is calculated using risk and return of the market,
therefore we can say that Slope of CML is Sharpe ratio of the Market.

Accordingly,
Equation of CML

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Adish Jain CA CFA
Portfolio Management

B. Sharpe Index Model & CAPM

Total Risk

Systematic Risk Unsystematic Risk

 Non-diversifiable Risk  Diversifiable Risk

 Unavoidable risk  Avoidable Risk
 Market Risk  Specific risk
 Unique Risk
 Idiosyncratic Risk
 Residual Risk
 Random Variance
 Random Error

Systematic Risk is due to risk factors that

Unsystematic Risk is due to risk factors that
affect large number of companies in the
affect a specific company. These factors are
market. These factors are External to the
Internal to the company and Micro in nature.
company and Macro in nature.

Example: Demonetisation, change in Example: Airline Crash, CEO of the company

government, etc. resigning, etc.

This risk is faced by large number of This risk is faced by a specific company;
companies in the market; therefore, it cannot therefore, it can be avoided by diversification
be avoided by diversification of the portfolio. of the portfolio

Since it is unavoidable in nature, return is Since it is avoidable in nature, return is not

rewarded for taking this risk. rewarded for taking this risk.
It means that if an investor takes systematic It means that even if an investor takes
risk by investing in a well-diversified portfolio, unsystematic risk by investing in a non-
he can require a return from the portfolio that diversified portfolio, he cannot require any
is commensurate to the systematic risk taken. return from the portfolio for taking this risk.

(This logic will be used in CAPM; discussed in a later section)

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Adish Jain CA CFA
Portfolio Management

Diversification: Let’s now practically understand how does it happen!

We understood risk as deviation of Possible Return of a security. Possible returns that a security
can earn in future, are dependent on various external and internal factors as read above.
Co A Co B
Risk due to External factors Risk due to Internal factors
price price

iron
iron

51m Budget time time

6 Signed

Crux of the concept:

As seen above, due to systematic risk factors, security returns have high positive correlation and
due to unsystematic risk factors, security returns have no correlation.

So, as we diversify our portfolio,

Risk
systematic risk of the securities
continues to be there in the
portfolio because of their high
positive correlation but their
Total risk
unsystematic risk gets cancelled
out or eliminated or significantly
reduced at portfolio level because
of no correlation among them.
This is also called as unsystematic risk
Diversification or Diversification
of Unsystematic Risk. It can be systematic risk
better understood with the help seated
of above chart. I to n

The most diversified portfolio is portfolio of all the security in the market i.e., Market Portfolio,
commonly referred as Market. Observe that even market portfolio has systematic risk.
1 market portgio's toted risk
Index NiftySensex are is only its
systematics 103
used as proxyof what Adish Jain CA CFA
Which method to choose Future data Correlat method
Portfolio Management Past date only β cal regression
method
1) Systematic Risk: Beta - Individual Security B8 Cov Sys etc cal
correlation
method
17,18
Practical Questions: _______________________ Practice Problems: _______________________

Sensitivity of Rs w r.t Rm
Systematic risk is faced by all the securities in the market and also by market as a whole.
Therefore, Systematic risk of the security is measured relative to that of market. Systematic risk
of a security A is measured by a statistical measure called Beta (𝜷A).

Interpretation of Beta Direction and Unit of Beta

Δ in Return A Xx times
Ba in Return
1 Δ Mkt

𝛽A Riskiness Market moves ↑by 2% Market moves ↓ by 3%

2 more than mkt 41 61

1
equal to mkt 2 3

0 No risk Bearing 0 0

-0.5
less than mkt 1 1.5

mkt possible return

Security A possible rotor
Calculation of Beta

Correlation Method Regression Method

Eng n I J
PA Yam I Aim Ba
Ex n x̅
Tm Vorm
This formula can be used only when
historic data is given.

Note: Beta of cash and risk-free security is _________ 1

Zero and beta of Market or Index is _________
104
Adish Jain CA CFA
Jam CoV Am
Portfolio Management

2) Unsystematic Risk: Individual Security

19
Practical Questions: _______________________ Practice Problems: _______________________

Unsystematic risk is calculated by deducting systematic risk from total risk at variance level.
Systematic risk is converted from times to %2 so that it can be deducted from total risk.
Unsystematic Variance of Security A (σƐA2) and its Unsystematic Standard Deviation (σƐA):

Total Risk- Total Variance (σA2)

Total
systematic
Systematic Variance Unsystematic Variance (σƐA2)

FIBA fix β

TIM
8A m
1 85m
Systematic Standard Deviation Unsystematic Standard Deviation (σƐA)

Sys Var Unsys Var

Second formula of
systematic variance is
BA
In
Am
derived by modifying Tx PA JA.mx TA
the formula of beta.

Square of correlation (between security A &

market) is called as Coefficient of
Determination (rAM2). It can be interpreted 8ohm correlation m
Ka
as proportion of total variance that is
explained by the market.
square

105
Adish Jain CA CFA
Portfolio Management

3) Systematic Risk: Beta – Portfolio

020,21
Practical Questions: _______________________ Practice Problems: _______________________

Systematic Risk of the portfolio also is measured by beta. Beta of portfolio P (𝜷P) is weighted
average beta of individual securities in the portfolio.

Beta of the Portfolio (𝜷P): BAXWA BBXWB Box Wc

4) Unsystematic Risk: Portfolio

Practical Questions: _ Practice Problems: _

Unsystematic risk (Unsystematic Variance of portfolio P (σƐP2) and its Unsystematic Deviation
(σƐP)) can be calculated:
A. As a residual risk of the portfolio (similar to learnt in case unsystematic risk of a security).

Total Risk- Total Variance (σP2)

Systematic Variance Unsystematic Variance (σƐP2)

- ² -

β - 5m
β

²
⑤ 8km 1 Tp 1 - 8 my

Systematic Standard Deviation Unsystematic Standard Deviation (σƐP)

Vor
Sys var unsys
Note that breakup of systematic and unsystematic risk happens as variance level.

106
Adish Jain CA CFA
Portfolio Management

B. With the help of unsystematic

risk of individual securities in
the portfolio. This formula is
Tf EA WAY TB WB
TeA WATER WB JAB
similar to that of total risk of 2
the portfolio calculated from
risk of individual securities. 80

Note that: Top Unsys V08

 Two securities are not correlated on account of unsystematic risk, hence zero correlation
with respect to unsystematic risk.
 This formula can be used only when unsystematic risk of individual securities is given.

5) Return & Risk as per Sharpe Index Model

Practical Questions: _ Practice Problems: _

This model assumes that security prices are related to the market index and they move with it.
This relationship could be used to estimate the return & risk of a security or portfolio and
correlation between two securities.
A.Fetal
Risk of a security or portfolio
Systematic Variance Unsystematic Variance (σƐA2 or σƐP2)
Given in Q
mm β jp Ea
Given 08 Above formula
Tep
B of Te
Total Variance (σP2) Total Standard Deviation
(σP)
Oneys
88 t
Voy Total Vor

Notes:
 σƐA2 has to be given directly. σƐP2 may be given directly or calculated using σƐA2 (as per
alternative B above).
 Which model to be applied to calculate the portfolio risk has to be figured out by data
given and required part of the question.

107
Dependent slope Indeftie Adish Jain CA CFA

get
its'Istant
y
B km A
Portfolio Management
Pax
security Line
B. Expected return of a security or Portfolio determined by Characteristic
E(RA) or E(RP) can be determined with the help of Characteristic Line. It shows relationship
0229 between E(RM) (being independent variable) & E(RA) or E(RP) (being dependent variables).
create the eq
RA Y Steps to solve question:
1. Calculate 𝛽 A.
16 Take E(RM) and E(RA).
2. Calculate
14 3. By putting values of E(RM),
E(RA) and 𝛽 A in the
12
equation of Characteristic
10 Line, calculate αA.
by 4. In the final equation, put
8
calculated values of α and
6
ge
Slope
8 𝛽 A as constant & leave
E(RM) & E(RA) as variable.
8Eˢm βs Note: In case of portfolio,

apr replace values of security

with portfolio.
2 4 8 10 12 14 16 Rmd

Equation of Characteristic Line:

α
____________________________________
Intercept term Alpha
ECRA Bax ECRM a ____________________________________
it morkt ne zero return
p p p
____________________________________
tab PI ne
 Also called as Intercept Term, Alpha diga security
can be both positive or negative. ____________________________________
kitna return diga
 Note: αP = weighted average αA ____________________________________

C. Correlation between two securities

027 According to this model, two securities are correlated to market only due to market.

m
0.8 0 6
JAB 8am JBM
A B
9 98 8
108
Adish Jain CA CFA
Portfolio Management

6) Capital Asset Pricing Model | Security Market Line refer next page

49
Practical Questions: _______________________ Practice Problems: _______________________

Required Rate of Return is used in valuation of asset as a discounting rate. Required Rate of
Return for a security (Rj) can be determined with the help of Capital Asset Pricing Model (CAPM).
It shows the relationship between Rj (being dependent variable) and systematic Risk i.e., 𝛽 (being
independent variable).

Rm Re
Equation of CAPM: ___________________________________
Market Risk
Rj RF Bx Rm Re premium
___________________________________
Independent Security Risk
β Rm Rp
___________________________________
Depffate variable
Note that Rj and E(R ) are interchangeably
A ___________________________________
premium
used in the question.because security is assumed being valued Ipg 11
fair
Return
25 Graphical representation
R of CAPM equation is
Yanked Security Market Line
20
ECRA (SML).
Steps to solve SML question:
ECRB
1. From given data of Rj &
15 RM, create two linear
equations and solve
them for RF.
Rm 10
2. Create an equation with
overvalued RM & RF as constants
and Rj & 𝛽A as variable.
RF 5
Risk
Raffffle I 2 3 4 1H Rm 1011
m seca see see pm RF 5

II Jensen’s Alpha: Rj vs E(RA) Pricing Status Action Jenson’s Alpha

A ECRA Ri undervalued Buy

ECRA
Rj B ECRB KR overvalued sell

C ECRI Ri fatigued hold

109
Adish Jain CA CFA
me course asked by
Portfolio Management
50
1 12
7) Sharpe’s Optimal Portfolio

051
Practical Questions: _______________________ Practice Problems: _______________________

I in itI niiway
We have already leant to determine optimum portfolio based on Markowitz Theory. This is an unit of
alternative model to determine which securities should be included in the portfolio & in what
proportion. risken
Note that this is process driven & mechanical in nature.
learn this concept
through no 51 itself

____________________________________________________________________________________

D8
____________________________________________________________________________________

B08 5 08 H
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
compare
____________________________________________________________________________________
____________________________________________________________________________________

9 Reg Rate
____________________________________________________________________________________

we IV
____________________________________________________________________________________
____________________________________________________________________________________ DN
IF CMP
____________________________________________________________________________________

Expirate
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________

Cmp Exp Ret

____________________________________________________________________________________
30
033 Vs vs
____________________________________________________________________________________

34 IV Reg Return
____________________________________________________________________________________

110
portfolio mgmt
Adish Jain CA CFA Eq
Business
Portfolio Management

C. Other Important Topics Ri Re Ba I Rini RF

1) Arbitrage Pricing Theory MRP.EE I I IF
Practical Questions: _______________________ Practice Problems: _______________________

p 41
Arbitrage Pricing Theory is used as an alternative to CAPM in the calculation of Required Rate of
Return. CAPM considers systematic risk as a whole through a single measure i.e., market risk
premium & beta Extra return
ftp Ef.eftforr.is e Factor risk premium
APT on the other hand identifies various risk factors individually that can affect the returns of the
security like inflation, interest rates, etc and tries to factor them in separately through respective
Factor Risk Premium & Factor Sensitivities (Factor Beta).

Required Rate of Return:

FRP factor Risk premium
___________________________________

Rft Papp FRPapp BoppInflatin etc Risk

___________________________________
___________________________________
in
a security due to that
Bouflat FR Ponflation
porticialor relative
___________________________________
factor
Burst FRPontust to market
Note that for different factors, factor risk premium is common for all the securities (like market
risk premium), whereas, sensitivity to those factors is different for different securities.

2) Portfolio Performance Evaluation

Practical Questions: _ Practice Problems: _

These ratios help to evaluate performance of a securities or portfolio based on return & risk.

Expected Sharpe Ratio Treynor Ratio Jensen Alpha

(Reward to Variability) (Reward to Volatility)
Actual
TERM or Rp RF ECRpl or Rp Rp Rj
Tp Bp Apm
RF β RMRF
Note that for all of these, higher is better. Note that numerator is security risk premium.

Units or decimals or decimals hats 111

Adish Jain CA CFA
Portfolio Management

3) Portfolio Rebalancing Strategy 63

61,62
Practical Questions: _______________________ Practice Problems: _______________________

Graft pagefor concept

g
114
Constant Mix or Ratio Constant Proportion
Particulars Buy & Hold Policy
Plan Insurance Policy

Also called as ‘Do

Also called as ‘Do Under this strategy, an
Meaning something policy’, under
nothing policy’, under investor sets the floor
this strategy, an investor
this strategy, an investor value below which he
maintains the proportion
does not rebalance the does not what the value
of stock as a constant %
portfolio. of his portfolio to fall.
of total portfolio.

Balancing? No Yes Yes

Whose ability to take risk Whose ability to take risk Whose ability to take risk
increases (decreases) decreases (increases) increases (decreases)
Suitable to
linearly with the increase with the increase with the increase
investor…
(decrease) in the value of (decrease) in the value of (decrease) in the value of
portfolio. portfolio. portfolio.
Riskiness more most
Performs… less
Risk Risk Risk
n
PF EaE.se
dependency
on stock price
& diagram
y PF value

Calculations under CPPI: at

every Rebalancing Date
Value of Equity
Multillier
in portfolio: Value of PF Floor Value
Value of Bonds: Total value of PF Value of Equity
Note that Bond portfolio & Floor Value are assumed to grow at R f. If Rf is not given, it is assumed
to be constant.

112
Adish Jain CA CFA
I
βA BOVA Diva βDivB DVB
Portfolio Management

4) Beta of an Unlisted Entity | Proxy Beta 2

βA βF
1 total operation Asset
Practical Questions: _______________________ is to be borne
Practice Problems: _______________________
risk
by all capitalproviders firm
Since, unlisted companies are not publicly traded, data (history of share prices) required to
calculate beta of such companies is not available. Therefore, their beta is calculated using beta
of a listed company in the same line of business.
Even when two companies are in the same line of business (means their operating risk is same),
they might have different equity betas due to difference in their capital structure (means their
financial risk is different).
Note that unless otherwise specified, Beta of Debt is assumed to be zero.
Unlisted Co Itd
____________________________________________________________________________

Equity.BE WE Boiva
____________________________________________________________________________
DIV A WoivA
____________________________________________________________________________

Debt BD Div B
β DivB
____________________________________________________________________________
WD Wbivb
____________________________________________________________________________

Prism X equal to
____________________________________________________________________________
asset β
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________

A listed Co Lild B listed co Itd

____________________________________________________________________________
____________________________________________________________________________

BEV βa Equity BEV DIVB BB

____________________________________________________________________________
Equity Diva
____________________________________________________________________________
Dive Be
βD
____________________________________________________________________________
Debt
____________________________________________________________________________

βFirm XX BASSET βFirm

____________________________________________________________________________
ASSET β
____________________________________________________________________________
____________________________________________________________________________

113

BE 4
3
βF E at Box DCI
Et D t
Adish Jain CA CFA

H
I 1
we wo
Portfolio Management
CONSTANT RATIO PLAN debt Be βE
4 If no
____________________________________________________________________________________

I flac to invest
____________________________________________________________________________________

Risk appetite 701

____________________________________________________________________________________

30
Eq
Debt
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
on 3m 6M
____________________________________________________________________________________

I 1
____________________________________________________________________________________ I
70,000 90,000 70 84000 6800
70____________________________________________________________________________________
sell 6k
____________________________________________________________________________________

301 30.000 30000 30 36000 40.000

____________________________________________________________________________________
Buy 6k
____________________________________________________________________________________

120,000 1000
100,000 120,000
____________________________________________________________________________________
Rebal
____________________________________________________________________________________
again
Not tasper
not
____________________________________________________________________________________ type
ideal allocation
ideal allocation
____________________________________________________________________________________
to E D
to E4 D
____________________________________________________________________________________
____________________________________________________________________________________

Frequency of Relenting After way fix time interval say 3m

____________________________________________________________________________________

when to rebalance After evay fix to inc dec in value of PF

Inv Amount or value Possib

____________________________________________________________________________________
Decrease in
Equity Inv
Igf 80000
INC 501
____________________________________________________________________________________
____________________________________________________________________________________
Acceptable loss 20k
____________________________________________________________________________________
ÉfEÉ
Mei equity mein kitna invest karu ki uspe 50% ka loss ho bhi Jaye to loss ka amount 20,000 ke acceptable loss se
2
____________________________________________________________________________________
E
i ie
zyada na Ho
inv Eq
TOY
____________________________________________________________________________________
20,000
D 9 20,000 40k
114 Eq inv
got
Adish Jain CA CFA Alec 40,000 60,000
multiplied
5k TCS
units 500
skilled
Ellac GOI Bond
units 10K
Corp Bond
455,000
Cash
This.sk
Total 15 5 units Asset under
management
NAV CAUM
Yield 6
can
Mutual Fund

A. Types of Mutual Funds Plans

Dividend Dividend Bonus
Growth Reinvestment
Plan Postan Plan Plan
Growth in NAV D & CG
Income is in D & CG Bonus units are
Primarily (Capital (Reinvested & MF
the form of? (Received in cash) allotted
appreciation) units allotted)

Change in
No No Yes Yes
units?
Since opening and closing number of units

NAVI NAVO Dt G are different, return cannot be calculated

on per unit basis.
Return on
Mutual Fund NAVO NAVANI NAVO no

NAVO NO
Calm under
Example of Dividend Payout Plan v/s Dividend Reinvestment Plan:

NAVI 2T
NAVO IO
9800
15 19 i 25
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

units units counts reinvested

_____________________________________________________________________________
Closing Opening
_____________________________________________________________________________
chits 16.8 0 Total div to be reinvested
_____________________________________________________________________________
closing
NAV which div is reinvested
_____________________________________________________________________________
_____________________________________________________________________________

10,000 10.000 10x 20

_____________________________________________________________________________

25
_____________________________________________________________________________

10,000 800 10,800

Me 111
Adish Jain CA CFA
Mutual Fund

B. Calculations involved in Mutual Funds

1) Net Asset Value (NAV)

Practical Questions: _ Practice Problems: _

NAV means net assets of the

mutual funds calculated on
per unit basis. To calculate
All assets mv AM liabilities
units
NAV, think from the point of
view of Mutual Fund.
no
of n

Note that both NAV & Number of units (n) can be in fraction. n is calculated upto two decimal
points and NAV, upto two and four decimal points. For
any further calculation based
on NAV use a decimal points wala
2) Entry Load and Exit Load NAV

Practical Questions: _ Practice Problems: _

Entry Load (Front-end Load) is charged at the Exit Load (Back-end Load) is charged at the
time an investor purchases (or buys) the time an investor redeems (or sells) the mutual
mutual funds. funds.
Offer Redemption
Price: NAV I
Enterpad Price: NAV 1 Ex
ad
3) Expense Ratio
or
mgmt ER t
Practical Questions: _______________________ Practice Problems: _______________________

It is the expenses incurred to run a mutual fund

as a percentage of average NAV of the mutual EFP.p.fi Excluding trading
cost
funds. It includes various administrative and 100
management expenses incurred by mutual
funds but does not include brokerage costs for Ang Narpy
trading the portfolio

112
Adish Jain CA CFA
Mutual Fund

4) Return from Mutual Fund

Practical Questions: _ Practice Problems: _

unrealised seals
To calculate the return, think from the point of view of unitholder.

Return from NAV Δ Dividend G

Mutual Funds
08
earned by mF destitudtholder
Type of Plan: Growth or Dividend Payout Dividend Reinvestment or Bonus

NAVI NAVO D NAVIXMI NAVO

Nox 100
Holding Period
Return
NANO Yoo NAV no

Annualised Return
Or HPR 3650812
Effective Yield * n

where,
NAVIE 0 NAV end start of period
D Div distributed by MF As a 1 of FV ifi.mg

PG G i

n Holding period of mF

* For the purpose of this chapter, it is calculated by simple annualization of return, i.e., 12/n or
365/n.
Note that whenever question is silent, calculate both- holding period return and annualised
return. Also, Dividend paid is as a % of FV.

5) Tracking Error
Tracking error is the
d d
TELL
deviation of a fund’s return
from the benchmarks return n t
Note: Lower is better.
d RMF RBegygook ofevery period
113
Adish Jain CA CFA
Mutual Fund

C. Concept of Dividend Equalisation

Practical Questions: _______________________ Practice Problems: _______________________

2 unit issued I new unit issued

1 Jan 30June 31 dec
Total
NAV 24
n 22 z ygncomefqtLN.TV
Income 4 E 2p.cl

___________________________________________________________________________________________

___________________________________________________________________________________________
Issue price 12
___________________________________________________________________________________________
OpNAV diveat
___________________________________________________________________________________________
10 2p u
___________________________________________________________________________________________

___________________________________________________________________________________________

Total NAV 36 AT
___________________________________________________________________________________________
6 Income 42
n 3 n
___________________________________________________________________________________________ 3
Income 6 Income 12

114
Adish Jain CA CFA
Derivatives & Interest Rate Risk Management

TO Gold t
A. Basics of Derivatives RIL RICE

Derivative is a contract that derives its value from the value of the…

Asset stocks Commodity Currency

IEEIndex Sensex
Interest rate
Nifty
Refence Libor Repo
Rate …on which such contract is based.

contracts that talks about contracts that talks about

B 5 the asset on a future date B L me amount on a futuredate
Asset Derivatives (incl. Index) Interest Rate Derivatives

Forward Futures Options

FRA IRO IRF swaps

Basis Spot or Cash Market Derivatives Market

Market where assets itself are Market where derivative contracts are
Meaning
traded for immediate delivery. traded for future delivery or settlement.

Example Stocks, Currency, Commodity Stock Futures, Currency Options

Purpose Consumption or investment Hedging, Arbitrage or Speculation

Price spot price
HEDGING ARBITRAGE SPECULATION
Hedging means taking a Arbitrage means taking Speculation means taking a
position in Derivatives opposite positions in Cash position in Derivatives market
market with an intent to market and Derivatives market with an intent to earn risky
offset the possible losses on with an intent to earn risk-free profit from expected change in
a position in cash market. profit on account of mispricing. the price of the asset.

Tsition Golden Rule undervald Exp

119
priseAdish Jain CA CFA
mispricing
take Pg 129
pg 12 Yalued Mpg Fffing
nullify
Derivatives & Interest Rate Risk Management

Basic Terminologies:

Position
Transaction
Meaning as a:
Position
C C
How to square-
off the position?

Having bought position

Long Buy
(bought the asset and not sold it yet) sell
Having sold position
Short Sell
(sold the asset and not bought it yet) Buy
Fixed vs Floating Interest rates

Fixed Interest Rate

________________________________ ________________________________
Floating variable Antrate
This rate of interest does not change This rate of interest may change during the
during the tenure of borrowing or lending tenure of borrowing or lending
Example: Loan taken or given @ 8% pa Example: Loan taken or given @ LIBOR

No risk of change in Interest Rates Risk of change in Interest Rates

Ex 6m libor
30 Jun 1 Jul 31 Dec
Resetperiod
F y e
6m 6008 51Pa Gmlibor 6.1 p.ae

L ftp.igeiii tst
decidedhere ftpde
Spot vs Forward Interest rates (as learnt in Fixed Income Securities)
1 2
34

I 51 51Pa FR 1 2

FR 1 3

52 5.21 p 9 FR 2 3

53 5.51
p a

120 spot rate

Adish Jain CA CFA Food rate
Derivatives & Interest Rate Risk Management

Stock Index
A stock Market Index is an indicator of overall performance of the stock exchange. Out of
thousands of shares listed on an exchange, top few shares (based on M-cap) lead the
performance of the exchange. To measure that performance, an index (i.e., a notional portfolio)
of these top few shares is created. This is Stock Market Index referred casually as Market.

Sensex
Nifty
NSE BSE

B. Forward and Futures Contract

contacted here contracted h td

Go Price s 60.000 3M
expiry date

you
Buy
Fu
what Gold underlying
contract Asset
B S when 3m
much
Forward Price 62,000 Fwd Futures price
Futures
entering into a contract today
Meaning:
Buy or Long
YOU LONG to Buy the asset on a date
______________________________________________________________
future
Sell or short in me SHORT sell
____________________________________________________
Food futures
A Forward Contract is an agreement to buy or sell an asset of specified quality and quantity on
a specified future date at a price agreed today. A Futures Contract is a standardised forward
contract; standardised in terms of: Quality, Date and Quantity.

Difference between: Forward Futures

Market Over the counter market Exchange traded

Dataset
Standardisation Fully tailored Standardised
customized
Margin Not required Required

generally cash
Settlement Generallydelivery 121
till
on exipy date anytime
Adish Jain CA CFA
expiry
Derivatives & Interest Rate Risk Management

1) Pricing of Forward or Futures: Cost of Carry Model

Practical Questions: _ Practice Problems: __

Interpretation of A forward or futures contract can be entered today at

Forwards or Futures Price its price of ₹ 500. The transaction will be executed on
of today say ₹ 500 its maturity at that contracted price of ₹ 500.

Basis:
S F
Contango Market Backwardation Market
generaly 1st
SEF
___________________________ SDF
___________________________

Basis Hue
___________________________ Basis It ve
___________________________

Actual Forward or Future Price Fair Forward or Future Price

What
______________________________
is thepriie of what should be the
_____________________________

Food Futures actually

______________________________ 11
_____________________________
price
there in the mkt
Fair or Theoretical Price:
Spot out lost storage
Price cost till AMEY
expiry coffeniens

Fo So go II

F 5 COST OF CARRY

122
Adish Jain CA CFA

Typesof Rate Comp frequency

pa compounded annually
II semiannually 12
monthly 12 & Interest Rate Risk Management
Derivatives

1. Treatment of Interest:
Sot tut FV 50
Identify the nature of compounding and ‘Spot + Interest’ can be calculated as:

Discrete Compounding Continuous Compounding Question is Silent

(Compounding annually, semi- (Compounding continuously (Calculate assuming simple
annually, quarterly, monthly) or daily) interest rate)

5 1 87
F 5
CITY f Sx est F
FVF

É where,
8 Rate f interest p.ae I compounding treq.p.a.ie
t n Time till expiry of contract
no
of compounding igng
in terms of
years
I Note that whenever, question is silent about the type of compounding and values of e x are given,
question is to be solved using continuous compounding formula.

EE
E
Illustration: The current market price of the share is ₹ 70 and the risk-free rate of interest is 6%
p.a. Calculate the 3 month forward contract price based on that share. e
1.0151
g Re 6 Re 6 16 8 8 RF
stiff
Biffing
2 3
70 3 705 F 704 F 70 1 0.06
F 1 2
Fox 6.015 s
I 71.04
70 1.0151 7T
2. Treatment of Income
a) If income is given in absolute terms: Calculate the PV of the ‘Income’, deduct it from ‘Spot’
& then calculate the FV of ‘Spot – Income’:
the income
on 2m 3m If
1 is already on
5 xx Intome the expiry of con
PV Il then don't do PV
S PV II
f xxx
Rathed do
Interest INCSPOH I
925
days If e't value 123
n Dates days 365 doesn't match Adish Jain CA CFA
months months 12
silent it's p.a
Even
if Q is
Derivatives & Interest Rate Risk Management

Illustration: A 6-month forward contract on 100 shares with a price of ₹ 38 each is available.
The risk-free rate of interest is 10%. The share is expected to yield a dividend of ₹ 1.50 in 4
months from now. Determine the forward price. pay

in
am
9m
________________________________________________________________________________________

15
________________________________________________________________________________________
5 38
________________________________________________________________________________________
PV I
________________________________________________________________________________________
________________________________________________________________________________________
F XXX
________________________________________________________________________________________
________________________________________________________________________________________

F S PVCI 1 8 n
________________________________________________________________________________________
________________________________________________________________________________________
6
38 1 010
________________________________________________________________________________________
12
µ
________________________________________________________________________________________
________________________________________________________________________________________

238 38
________________________________________________________________________________________

b) If income is given in % terms (i.e., when dividend yield p.a. (y) is given): ‘Spot + Interest –
Income’ will be directly calculated as: as a i
of
MPs i e Spot

t
Cry
Sx
4 F Sx 1 n
F 1
F Sx

Illustration: Consider a 6-month forward on a security with 4% p.a. dividend yield. The risk-
free rate of interest is 10%. The asset’s current price is ₹ 25. Determine the forward price.
Re 10 Re 1 Re
B.im Euy 1 88 is.ie
2
2
F
F
S e
t
F 5 11 18 y n
25 6.10 0045 6
11 2 25 2010 0047 12
25 101 0.04 6 12

F 25.75 25 C 25.75
25 1 03045
25.76
124
Adish Jain CA CFA
Derivatives & Interest Rate Risk Management

3. Treatment of Storage Cost: Calculate the PV of ‘Storage Cost’, add it to ‘Spot – Income’ and
then calculate the FV of ‘Spot – Income + Storage Cost’:
am 6m 12m
im
Sxx Sexx IXX
PV II
PV SC
F XXX

Interest
4. Treatment of convinience yield: Treat it exacly same as income

5. Calculation of ex:
0.7
Calculating ex using interpolation:

1 21 22 m
1 2 3

002
It 0 21 0.022 8
2 1 8 1
1 02020

Action today by on speculator market

_____________________________________________________________________________
in Spot
to make profits based on expected price movement
_____________________________________________________________________________
_____________________________________________________________________________
200
_____________________________________________________________________________
sell
_____________________________________________________________________________
Buy Long of
_____________________________________________________________________________

Spot 1000 IF Bay

_____________________________________________________________________________
sell Short gain 300.8700
_____________________________________________________________________________
_____________________________________________________________________________
p
om 3m
spot price exp spot price 125
Adish Jain CA CFA
Which method to choose
for settlement
Derivatives & Interest Rate Risk Management
Since gain or loss is calculated under net settlement. Therefore, whether
it is arbitrage or hedge, this settlement can be applied only when closing
prices of future contract is given to calculate the gain loss..
Hence
2) Settlement of Futures and Forward Contract go.fgn.priieoffahefettiementc10fi
Not
Delivery girch settlement
Practical Questions: _______________________ Practice Problems: ________________________

Settlement by Contract is settled on maturity date by taking or giving the delivery of the
Delivery asset by paying or receiving the contracted price.

gain loss
Settlement in Contract is settled on maturity date by squaring off the position and paying
Cash or receiving the difference between contracted price & settlement price
(i.e., closing price) as shown below:
Anett TCS spot priic
Entices ice

f
1200
8Effs'e of
zzzzzzzzzzzzzzzzz

100
IT
Basis costofcarry for 6m

Basis on 6m
cost ofcarry 1 Jan 12m ex
30 Jun 31 Dec
for 12m
future
Case A Case B Case A Case B

Spot 2 1000 125.0 800 1500 600

Futures NOT GIVEN
If I 1200 1310 890
Position in Futures Profit or loss after 6 months Profit or loss after 1 year
Long
G 110 2310 9300 4600
Short 110 6310 L 300 G 600
Spot Price & Futures price converge over the expiry period & are same on expiry date. In other
words, Basis approaches Zero. This is called as Convergence.

126 Futures has standard quanity Jelitement is done lie

such futures position is calculated contractwi
Adish Jain CA CFA
gain lost on
not individual futukewise
912 pafuture pyfqf.cat of
p future contracts
IF OF
Derivatives & Interest Rate Risk Management

3) Arbitrage using Futures and Forwards

Practical Questions: _ Practice Problems: __

Arbitrage opportunity exists when price at which Futures is trading in

the market (Actual Future Price) is different from its Fair Future Price. AFP FFP
Arbitrage profit with be the amount of mispricing i.e., equals to the
price difference. Diff AFP FFP

Steps of arbitrage:
1. Calculate FFP
2. Compare & decide action today: If AFP is… (always comment on actual)

More than FFP, then Less than FFP, then

Files overvalued
____________________________________
are Elles undervalued
____________________________________
are
Cash & Carry Arbitrage Reverse Cash & Carry Arbitrage

I Buy Futures

aaysp.LY
I Sell Futures
2 Sell Spot
3 Borrow 3 Invest

3. Settle or square off the positions at the expiry of the contract

Presentation of Practical Questions:

Particulars
Today
7
Athis table simply will rheve cash
After 3 m
IFS

Action Amount Action Amount F

Future settle
spot
Borr 9Invest
Arpjtj.ie
127
08.9.12 Delivery Settlet Adish Jain CA CFA

910,13 Cash settlet

Derivatives & Interest Rate Risk Management Bank
TCS
in using
Short selling
market
spotSecurity p.fr
Lending-Borrowing Scheme (SLBS)
share
Borrow 5s seu Tes
Om
Bankguirantee high get
2m Dividend

Repay Buy
3m
E low
Lending charges
Long Term Investor Borrower & Normal buyer
& Lender Short Seller & seller

When share price of a company is expected to go down, profit can be made by selling it at higher
price & then buying back at a lower price. Short Selling means selling a share that a seller does
not own. Short selling can be done by borrowing the share and selling it. This entire process
happens under the mechanism called as SLBS:
1. Short Seller will borrow the shares from Lender by providing collateral or bank guarantee
against it.
2. Short Seller will then, sell the shares in the market with the expectation that its price will fall.
3. On a later date, Short Seller will buy the shares back so that it can be returned back to the
Lender.
4. Short Seller will return the shares back to the lender along with the Lending Charges.
Note that, if any dividend is declared on the share during the period of borrowing, the buyer of
the share will have the right over it and he will actually receive it. To compensate the lender for
loss of dividend, the borrower will pay the amount of dividend from his pocket to the lender.
Longposition short position
Normal Buying Short Selling
Bullish View: Buy today & sell later
Toast
89125
Bearish View: Sell today & buy later
Profit:
IF sale price OF Buyprice
Dividend is received from the company Dividend is to be paid to the lender
No charges applicable Collateral & Lending charges applicable

128
Adish Jain CA CFA
Derivatives & Interest Rate Risk Management

4) Speculation using Forward & Futures:

Speculation using Futures & Forward involves buying & selling it such that the expected change
in price of underlying assets, gives us profit. Accordingly, a trader who thinks that price of the
underlying (or Future or Forward itself) is expected to:

Move up
LONG
Move down
SHORT
Profit or loss on account of speculation can be calculated simply by applying the concept learnt
under heading: 2) Settlement of Futures and Forward Contract.

5) Hedging using Forward & Futures: Golden Rule of Hedging

Hedging using Forward & Futures Contract involves taking position in these contracts to
safeguard against loss on an asset in cash market. Two situations of losses we can hedge:
 Actual Loss: This is the actual loss that may occur on the position already taken in any asset.
For example: You have a long position on the shares of TCS which you plan to sell after a year.
If price of share of TCS goes down during the year, you will actually incur this loss.
 Opportunity Loss: This is the opportunity loss that may occur on the position that you plan to
take in any asset. For example: You plan to take a long position the shares of TCS after a year.
If price of share of TCS goes up during the year, you will lose profit that you could have earned.

Position (long or short) to be taken in Futures or Forward for Hedging:

To start whoa hedging
hedging i
is over The position to be taken depends
0M
periodof 3m upon the position we have or we
Hedging want to take in Cash Market.
Take position system S Golden Rule: Do in derivatives,
today
what you will do in spot. mkt on a

indaivafp.si
Position in Cash Market:
gy today
Action in Derivatives Market to hedge:
that

we already have is: Long Short sell

(Actual Loss) Short
long Buy
Long
We want to take is:
(Opportunity Loss) Short
Long Buy
Short sell
129
Adish Jain CA CFA
Derivatives & Interest Rate Risk Management

6) Beta Adjustment or Hedging through Stock Index Futures and RF securities

Practical Questions: _______________________ Practice Problems: ________________________

Basics of Beta of Portfolio (𝜷P) from Portfolio Management

 𝛽 P means: Δ in PF
Δ in mkt index
 𝛽 P is calculated as:

Without
futures in
Pp Pax WACH BBXWB.fi
portfolio
BAX MVA BBX MVB
Pp MVA MVB it total PF value

With
futures in
portfolio

 08
Beta of any security can be both _______________

 Beta of cash and risk-free security is ______ & Beta of Market (Index) and Index
1
Futures is ______


wight
Short position in any security is taken as _____________________
Ve
08 ve mV 021
Adjusting 𝜷P means using Risk-free Securities & Index Futures

𝛽 P represents the systematic risk of the portfolio. Higher the beta, higher is the risk & vice-
versa. To increase or decrease the risk of the portfolio, beta can be increased or decreased
using Risk-Free Securities or Index Futures as discussed below:

130
Adish Jain CA CFA
Derivatives & Interest Rate Risk Management

1. Using risk-free securities

Including Risk-free securities (RF) in the portfolio of Risky Assets (RA) helps to adjust its
𝛽 P. By using Target Beta (𝜷T) given in the question, we can calculate the desired WRF &
WRA in the portfolio using below formula:

BRAX WRA PRE WRF

βT 1380
Igiven given
Steps Solve for Wra WRF 1 1
Steps find out the amount of RA RF
If W = +ve : ______________________ If W = -ve : ______________________
SHORT position
LONG position

2. Using Index Futures

Don't
apply Golden rule of hedging
Just like there are Futures Contract on the stocks (say TCS Futures), there are Futures Contract
on the Stock Index also. The underlying of these Stock Index Futures is Stock Index. If someone
wants to take a position in Index, then in derivatives market it can be taken through Index
Futures.
To adjust the 𝛽 P, (where reducing 𝛽 P is also called as hedging), we can keep the portfolio of RA
intact & include Index Futures in it. Amount of Futures & position can be determined as below:

Value of PT PP
Index Futures
VP Pp β of the
____________________________________
portfolio
to be hedged
____________________________________

Bt Target
If Beta
____________________________________
No of Vpx Bp Bp Pe Actual price
____________________________________
per
contracts
PEX M Index futures
____________________________________

M multiplies i e Lot size

LONG
If answer is +ve: ____________________ SHORT
If answer is -ve: ____________________
FEET
Important points to consider:
1. VP is the net portfolio value i.e., net of long & short positions. 021
2. Both 𝛽 P & 𝛽 T can be positive or negative. Therefore, apply maths carefully.
3. Number of contracts are to be rounded off.

4 complete hedge Perfect hodge Question is silent 131

then
β 0 Adish Jain CA CFA
HEDGING USING RF SECURITIES
PF risky assets 100,000
Bra 2 times

Bt 1 times
50
Accordingly Target Wpa
WRF 50

option KEEP TOTAL PF VALUE OF

EILAC INTACT

change the composition with the PF

501 50 Target achieved

50,000 50,000 Bp D

Option 2 KEEP RA OF E 1 LAC INTACT

Add new RF security in the PF

100,000
50
50 Target achieved
100.000
βp

Tip to To chis INTACT hai

proceed further uske percentage se stark kor
to
find out amount of RA RF

Which method to Apply Language of the Oustion

HEDGING USING INDEX FUTURES

LONG I 100.000

TCS RIL Index mkt

PAYTM etc Futures

Bp 2 times SHORT position

Value of Futures 1 lacx 2times
Zlac

10 20 5 10

loss Ilac profit Ilac 26C loss 26C

profit
101 5 101
20
10k 20k 10k 20k
A A
Δ Δ

Loss PF cashposition
profit in the

is getting offset by Profit loss in the

Affaires derivations on
Derivatives & Interest Rate Risk Management

7) Margin on Futures

Practical Questions: _ Practice Problems: __

1. Initial Margin: It is the amount to be deposited with exchange as a security against probable
future losses on Futures Position. Such Gain or loss is adjusted from this margin on daily basis.
This is called as Mark to Market.
If question is silent, it is calculated as: Mt 35
where, µ = Daily Absolute Change
σ = Standard Deviation

2. Maintenance Margin: It is the lower limit to which margin cannot cross. Due to adjustment of
daily mark to market, if margin falls below this limit, it is brought back to the level of initial
margin by putting in money in margin account.
If question is silent, it is calculated as: 75 of Gutial margin
refer next page
Number of Future Contract: Multiplier:
Daily Change:
Standard Deviation:
Date Index Level Gain or loss Margin Call Margin Balance

8) Optimal or Minimum Variance Hedge Ratio Vp PT BP

Hedge Ratio is similar to Beta of the security and is used in same way as beta to calculate value
of contract or number of contracts:
Hedge Ratio:
RAF
Ba 8AM
σS = SD of Spot price
σF = SD of Futures price
r(s,f) = Correlation between Δ S and Δ F

132 Value of
futures Vpx CHR HRP
hedge
Adish Jain CA CFA
to
MARK TO MARKET
Daily
Initial margin 20.0
maintainance margin 50

settlement
price of Futures L
1000 short
Long Day
200 7200

100 9 2 1100 L 100

300 100

20 L 3 1080 G 20

280 120

80 G 4 1160 L 80

360 Below mm 40

Morgin Call 160

Margin Initial 200

Balance margin
40 L 5 1120 G 40

320 240

Till expiry of
the contract
Derivatives & Interest Rate Risk Management

C. Options: Call & Put

value of option
Practical Questions: _______________________ Practice Problems: ________________________

Om 3m expiry date
Premium so 60.000 underlying

Esset St V15
β
After
GOLD
3M
fifth Beneficial
10 Exercise
Quantity gm
65000 Option Contract Lapse Non Beneficial

Call Option Put Option

___________________________
Option underlying option
asset the underlying
____________________________
Is __ the
Long Call Short Call Long Put Short Put
Has the option Has given the Has the option Has given the
to
Buy the option to other to sell the option to otherthe
buy to the
party to sell
underlying asset party asset underlying asset
underlying underlying asset
cases
Exercise STDE LAPSE STZE
150
9888645018
100
10 53 150 90 10
40 L 4.0 L 210 G 10

E= 0
Premium = 10
LAPSE E SEE
95 STEEL g g
g
10 98
L 10 G 10 G 30 L 30
case 2

133
Adish Jain CA CFA
Derivatives & Interest Rate Risk Management

An Option Contract gives its owner the right, but not the obligation
 to buy or sell an underlying asset
 on a pre-determined future date (the exercise date)
 and at a pre-determined price i.e., the exercise price or strike price (E or X)
LONG
Option holder
Option Buyer
Pays the premium
Option Seller
Option write Receives the premium
SHORT
Gross Pay-off
5 E or Net Pay-off 6 1 Premium
on expiry CE STI P bit 8 6
Atpt
Types of Options:
Execrite Exercise only on
American Option Anytime European Option Expiry Date

Moneyness of options:
In the Money Out of the Money At the Money
Options When it makes sense When it does not make When we are
to exercise sense to exercise indifferent
Call
SSE SEE S E
Put
SEE STE
Breaking up the Option Premium

Calloption E
E 120 sure 140 120
Spot 140 Value of option if it is
exercised immediately 20
Value of an Option

30
____________________
Time
prem 30 20
value
Value over and above
the Intrinsic Value 10
B F
134
Adish Jain CA CFA
the an option
Finding premium on

g
Derivatives & Interest Rate Risk Management

1) Valuation of Option: Binomial Model and Risk-Neutral Method

n time period till expiry in termsofyears
Bt for aperiod Binomial model it time
is
Practical Questions: _______________________ Practice Problems: ________________________
Pp s L ftp.t.gs

Single Period Binomial Tree CALL PUT

20
10 Po 0
8 50 120 f
so 00 p
E 2110 20 80 Cd 0 Pd 30
24
femi.hn Épify date
Rate of Interest to Calculate PV R Future Value Factor
Discrete Continuous Silent

e't 1 rn

lets assume n 1g R
8 12
pa It 2
1212
Calculation of Probability 1 12

Risk Neutral Method Binomial Model

120 xp 80 1 0 1 12 08
100 D 1.2 0.8
Rie 1 12
80
P 80.1
So so 2 1.2
U 00
11 P1 20
d Sd 8
00 0.8
go
Important Note: To calculate the value of an option, probabilities given in the question won’t be
used, rather probabilities calculated above will be used. However, to calculate expected return
from the options, probabilities given in the question will be used.

ifto Question is silent use Binomial model 135

calculate probabilities Adish Jain CA CFA
Derivatives & Interest Rate Risk Management

Value of the Option Present value of future cash flows…

Value of Call Value of Put

Corp Cdx 1 p Po xp Pdx 1 p

Ve up R
R
10 0.8 0 0.2 0 0.8 30 0.2
1 12 1.12
7.14 2 5 36
Delta (∆) of an Option

∆ of an Option ∆ of Call ∆ of Put

Δ in Payoff 30
Δ
go
up
Δ in spot prile go 120 80
of asset 0.25 075
Creating Risk-free Portfolio using Delta As per the golden rule of hedging, a long spot
position inspot
can be hedged:
Using Call Option Using Put Option

ex 5 C 7 ΔpxS PIT
0.25 Spot long 1 Call short 0 75 spot long 1 Put long
4 it 3 4 it
1 11 f it
Proof of Hedged or Risk-free Portfolio
H hedging gets over
Risk-free Portfolio created using Call Option: f on expifffact
Today After 1 year, if spot price turns out to be:
Particulars
Action Amount Action
120 80
Share 100.7 sell 120 80
1
Buy
4 Call Sell 28.56 Settle 40
E 110
Off 71.44 I F 80 80
136
Adish Jain CA CFA
12 RF
means no situation Jaha contract expiry period Ke
dauran spot that upside downside
prices mei 2Derivatives ggay
& Interest Rate Risk Management

Risk-free Portfolio created using Put Option:

Today After 1 year, if spot price turns out to be:

Particulars
Action Amount Action 120 80
3 Share 300 Sell 360 240
Buy
4 Put 21.44 Settle 0 120
E 110 Bay
O F 321.44 IF 360 360
Two-period Binomial Model
European option
12 RF Put E 110

Poo 0
Node got 500 144
2
80.1 Pud 14
Node Sud 96
50 100
Node 80
Sdu 96 Pdu 14

Sd 80
Sdd 64 Pdd 46
Ly
on
premium pitjdate
pep is iuting.E
Note: Probabilities depend upon R, u & d; therefore, whenever these factors are same for both
the periods, their probabilities will also be the same.

Ox 80 14 201 22.5
value
Node So 1012
Value 14 80 46 201 18.21
Node Sd 1.12
2.5 80 18.21 201
Value I 5.04
Node So 1.12
137
Adish Jain CA CFA
Derivatives & Interest Rate Risk Management

American Option Two-period Binomial

Model

Value of option at Exercise

any given node Max I Value
value if sited at that
exercised on
expiry node
80 14 201
Value Max 1 12
0
Node
50 2.5

4 80 46 201 80
Value Max I 110
1.12
Node
Sd 30
75 80 30 201 110
Value Max 1 12 100
Node
So 10

2) Call-Put Parity Theorem

According to CPPT,
Vet Vp 50
Actions when options are mispriced:

Option Under-priced Over-priced

Call

Put

138
Adish Jain CA CFA
step 1 Step 2 sep 3 step 4
D1 NCI Vc
D2 N D2
Vp
Derivatives & Interest Rate Risk Management

3) Valuation of Option: Black-Scholes Model

Practical Questions: _ Practice Problems: __

where,
Value of
5 NCD N D2
Et
X
Call option: NCDA N D2
Area from Normal
distibut 2 value
for
DIED
D1:
i
E F t
Ln
L
N TE t time period till
expiry in terms

TF of years
D2:
D1

Using call-put parity,

value of Put Option: Vct _So
Notes:
1. Spot price used in the formula is ex-dividend. Therefore, if details of dividend are given in the
question, then its PV is deducted from the spot price (S) to make it ex-dividend.
2. To calculate N(D1) & N(D2), area till left tail is used:

t h
D2 When question is silent,
3. Interest Rate (r) used in the formula is continuously compounded.
we can assume CCRRI.
ofreturnsof spot price
4. Rate (r) and standard deviation (σ) used in the formula are annualized and in decimals.

Note: Real Options (new topic as per SM 2024) is discussed in chapter ‘Advanced Capital Budgeting Decision’.

139
Adish Jain CA CFA
Derivatives & Interest Rate Risk Management

D. Forward Rate Agreement

Practical Questions: _______________________ Practice Problems: ________________________
settlemetdate
1) Basics and Settlement of FRA Expiry date
contract contract
entered here settled here
Om 3m 9 m

Lend 6 6m
Borrow FRA
3 9 Short
Long I t.ae
Notional principal
3m
After
For 6m
Forward Rate 6 1 p.a
Reference Rate Reporate 7 or 4
underlying Rate
FRA is a contract under which one party enters into a contract to notionally borrow or lend a
specified amount at a specified rate of interest for a specified time after a specified time.

Positions in FRA: Long or Buy is contract to Borrow | Short or Sell is contract to Lend

6M
for
If spot RR on settlement FRA Position
Understanding:
Gain or Loss on date turns out to be: Long Short
FRA:
Gain 11 1 loss 111
Higher than FR
7
Lower than FR
4 1055 2 1 gain 121.1
Calculating:
N P X RR FR h periodof
CaseySettlement Amount
Borrowing
or Gain or Loss on
RRA
FRA:
Note: Rate used to calculate the PV is spot RR on settlement date.
IEEE
Calculation related to adjustment of time period are to be made as:
 If period is in months or days: months/12 or days/365 simple interest based
 If period is in years: annual compounding formula

140
Adish Jain CA CFA
t.skftd hff fftffci
N
If
someone to do with Tum
has Rate Risk Management
nothing
Derivatives & Interest
who want
Bfrow on a
future date
2) Hedging through FRA

In order to hedge, _______________________________________________________________

Accordingly, Borrower LONG in FRA Lender SHORT in FRA

today today
Example: 6x9 FRA Rate is 8%. After 6 months, 3 months RR turns out to be: 6% or 11%
LONG SHORT
Borrower Lender
Particulars
6% 11% 6% 11%
Interest as per spot RR
16 11.1 6 11
Gain or (Loss) under FRA
2 3 2 3 7
Net or Effective Interest
8 8.1 8 8 1
Note: For hedging questions, present value of gain or loss on FRA is not calculated. 058
3) Pricing of FRA and Arbitrage using FRA income securities
fixed
para
6 is 3
Ey
12
on spot
10 pia Fair
Eftc PV
spot 12 p.a FV
FRA

Path

Since PV under Path 1 & Path 2 is same, therefore FV as per Path 1 = FV as per Path 2

FR 12
It 01 6 1 It 0 12 12
12
Fair FR 13 33

141
Adish Jain CA CFA
8s short period ka spot rate
rate
L Long period Ka spot
Derivatives & Interest Rate Risk Management

Pricing: To calculate the fair FR, solve below equations:

If time period is in
months or days
1 8s n xn t 8in

If time period is in
years 1 8s 1
EY 1 8

Arbitrage: If actual FR (quoted by the bank) is different from the Fair FR (as calculated above),
then there is mispricing. Accordingly, follow below steps to make arbitrage profit.

When, actual FR is

is _________
111 i.e., less than Fair FR. is _________
15 i.e., more than Fair FR.

FRA is undervalued
Then, __________________________ overvalued
Then, __________________________
FRA is
Steps of Arbitrage: Steps of Arbitrage:

if
step Borrow 12
for
step 1 Borrow 1601 for 12m

FRA
É y
18 steps
Invest 10.1 for 6m

5M FRA 6 12 15

If sep 2 Invest
12m
12 108
If
_____________________________________________________________________________
_____________________________________________________________________________

3 Settle the above Borrowing Invest

_____________________________________________________________________________
Step 5
will be
steps
b w TIF 0 F
_____________________________________________________________________________
diff
S
_____________________________________________________________________________
arbitrage gain S
142
Adish Jain CA CFA
Derivatives & Interest Rate Risk Management

E. Interest Rate Option or Guarantee: Cap & Floor

Practical Questions: _______________________ Practice Problems: ________________________

Interest rate option gives its buyer, the right but not the legal obligation to notionally borrow or
lend an agreed amount at an agreed rate for a series of agreed time period.
Premium settlement date cie at the end ofrespegy.gg
of gross payoff
Notional Principital on 6m 12 18m
Duration 18m
111 10 9
Ref rate 6m Libor p 6mL 6mL 6m L
settle centfreq
Will you exercise?

Cap @ E =
10 Exercise Lapse
Option to Borrow
Spot RR Erate

Floor @ E = 10 Lapse exercise

Option to Lend
Spot RR E rate

Positions & Pay-offs:

Position we have: Long Position Short Position

We have the option to

has given
Other party has the option
an obligation
to
Cap
borrow @ E % (cap rate) otherto
party to borrow
lend @ E% (cap rate)
We have the option to lend has
Othergiven theanoption
party has to
obligation
party@toE%lend
Floor other
@ E% (floor rate) to borrow (floor rate)

N.P 1 spot RR Erate I h

Gross
Payoff
Receives Pays
Premium Receives
Pay
143
ement
Sef
Adish Jain CA CFA
08 005
n months 2 365
Derivatives & Interest Rate Risk Management

Important Notes: 1. Premium is paid at the initiation of the contract for all reset periods.
2. Settlement for each period takes place at the end of respective period.

Example on Cap: Below are the spot interest rates for 4 quarters during the year. Calculate the
payoff of a long cap @ exercise rate of 8% and net interest on a borrowing of ₹1,000.
Net or
Interest Option Defffs
Option Pay SPEE
Interest on
Net 08
Effective Effective
Quarter
Rate exercised? off in (₹) borrowing (₹) interest (₹) interest (%)

Jan- Mar 7.5 % NO 118.75 18.751 7.5

Apr- Jun 8% No 20 120 8.1
Jul- Sep 9% Yes 2.5 22.5 20 81
Oct- Dec 10 %
Yes 55 125 20 811
Example on Floor: Same question with floor option and lending of ₹1,000.

Interest Option Option Pay Interest on Effective Effective

Quarter
Rate exercised? off in (₹) lending (₹) interest (₹) interest (%)

Jan- Mar 7.5 % Yes 1.25 18.75 20 811

Apr- Jun 8%
No 20 20 8
Jul- Sep 9%
NO 22 5 22.5 9.1
Oct- Dec 7% 20 8.1
ieedg.ly eiiye 7pisihiontolonghilenge
Hedging Position: In order to hedge:
asper golden rule
Borrower
Long CAP
Lender
Long FLOOR

Collar
Long Position
Long Cop Short Floor
IStrategy
cottination Short Position Floor Short cop
of
1008
Long
cop Premium
Note: paid on long position is reduced by premium received on short position.

144
Adish Jain CA CFA
Derivatives & Interest Rate Risk Management

F. Interest Rate Futures

Practical Questions: _______________________ Practice Problems: ________________________

Interest Rate Future (IRF) is a contract to buy or sell a Fixed Income Security (like T-Bill or
Government Bonds) of specified Quality on a specified Date at a specified Price.
Note that, underlying of an IRF can be a Fixed Income Security or an Interest Rate (just like FRA).

Long Position ____________________________________________________________

Short Position __________________________________________________

Understanding quotations & Settlement of IRF

The underlying of an IRF is: 58
Quotation:
Interest Rate for 10.000
Ex 36m
___________________________________________________
futures in 3m is
____________
Libor Repo
expiring
95.5
___________________________________________________
quoted
ok
___________________________________________________
Contract to borrow send 10k
Think as contract Interpretation
to borrow dead
quoted futures
Settlement: 4 037.1 4 7
if Spot RR turns out to be 5
___________________________________________________
rate
___________________________________________________
10.000 25
5 4.5 6112
Interest rates are on p.a. basis and therefore, so are futures price. Hence, calculation of
gain or loss on settlement is to be adjusted as per the period of IRF i.e., n/365 or n/12.

145
Adish Jain CA CFA
o underlying is a Fixed Income security
i IRF here is contract to Buy sell that FI security
Derivatives & Interest Rate Risk Management

Quotation:
expirtyoffutures
Capital Market
Debt Security
similar to Ex
_____________________________________________________
3m futures
futures
Got Bonds
_____________ on 71 Got Bond FV 000 Quoted
_____________________________________________________
_ underlying fffy.ge
aᵈ Settlement: securing
Note that the underlying asset of an IRF is a notional bond (which does not exist in reality

EE.si & is created only for the purpose of IRF) with a coupon of say 7%. When a trader buys or
sell an IRF, he is actually entering into a contract to buy or sell this notional bond on the
expiry date.

Settlement of these IRF is done at two levels:

• Cash settlement done on a daily basis: (Recollect concept of margin on Futures) For
this purpose, gain or loss based on respective day’s settlement price (i.e., closing price)
of IRF is calculated and adjusted from margin in parties’ account.
• Physical delivery which happens on any day in the expiry month: Assuming our short
position, now we need to deliver the underlying notional bond to the long. Since it does
not exist in reality, Short has the right to choose the bond to be delivered from the
Deliverable Bonds to physically settle the contract. Therefore, he will buy the bond
from the spot market & deliver it to the long which is Cheapest to Deliver i.e., the bond
which is most beneficial calculated as below:
I F Derivatics O F
what
Profit / (Loss) Amount received from Amount paid to buy the
long against delivery bond from spot market

Invoice price
Settlement price ofFutures Spot price
X X of the
day when delively in spot mkt
is being done
of bond being
Conversion factor delivered
of Bond beingdelivered
Conversion Factor makes the given deliverable bond equivalent to 7% notional bond
for which contract was entered. Hence, irrespective of which bond is chosen by short
for delivery, long will receive the bond with correct value on settlement. Conversion
Factor will be given in the question.
Note: The bond which maximises the profit or minimises the loss is cheapest to deliver
& should be chosen for delivery.

146
Adish Jain CA CFA
Derivatives & Interest Rate Risk Management

Hedging interest rate risk using IRF

Recollect from ‘Valuation of Bonds’ that prevailing interest rate affects price of the bond. From
the below discussion, we can say that interest rates ultimately affect IRF.

Position to be taken to hedge:

So, as per our rule of hedging, in order to hedge:

Borrower means someone who will

short sell the bonds

Lender means someone who will

buy the bonds

147
Adish Jain CA CFA
Derivatives & Interest Rate Risk Management

G. Swaps
Practical Questions: _______________________ Practice Problems: ________________________

Swap means exchange. In context to finance, Swap is an agreement to exchange cash flows.
Three types of swaps have been covered in our syllabus:

Interest Rate Swaps Currency Swaps Equity Swaps

Net Settlement Amount: Principal amount of the swap is not exchanged and is called as Notional
Principal. Swaps are settled on net basis & settlement amount is calculated as:

Duration 8 Em'ÉÑ
p c
A B
Eff.IE ae
rate
settlement Aunt
NP
notional
Principal 1lac Ey BE n

Swtp vis Refese

suppose Iyear libor for year 1 2 turns out be

_____________________________________________________________________________
to
2
1 Year 10 B to A
_____________________________________________________________________________
Ilac 10 28 i 12 2000
2
2 Year 7 A to B
_____________________________________________________________________________
flex 8 7 1 12 1,000
Calculation related to adjustment of time period are to be made as months/12 or days/365

Net Interest Cost: It means the effective interest cost that a firm has to incur after adjusting
effect of swap transaction. Derivatives mkt
l
spot mkt spot mkt

10
A B
Banks
2 Banks
Payfix g Pay floating

Net Int cost

_____________________________________________________________________________
net net of all three arrows
A 10 81
_____________________________________________________________________________
L 2
B Lt 1 L 8 9
_____________________________________________________________________________

148
Adish Jain CA CFA
Derivatives & Interest Rate Risk Management

1) Interest Rate Swaps

Interest Rate Swap is an agreement to exchange cash flows linked to different interest rates.
Major focus in the syllabus, under interest rate swaps, has been on Fixed vs. Floating Swaps.
Fixed vs. Floating Swap (also called as Plain Vanilla Swap) is an agreement between two parties
to exchange interest rate payment where one party agrees to pay interest based on pre-decided
fixed rate of interest and another party agrees to pay interest based on floating rate (based on
say LIBOR, etc) prevailing in the market.
Interest rate swap is arranged to solve any of below two purposes:
1. Convert fixed rate loan to floating rate loan or vice-versa.
2. Save interest cost incurred by the parties (more important).

a) Construction of Swap without Financial Intermediary

Construction of swap involves simple process of making party to borrow opposite to their desire
and then arranging the swap such that they get their desired position.
Make sure that, at the end of the solution, construction of swap is explained in words also along
with diagram. Exact thought process depends on the purpose for which swap is arranged:
1. Conversion of fixed to floating and vice-versa
Example: Rigid Ltd wants to borrow at a fixed rate & Flexible Ltd at floating rate. But banks are ready
to give loan to Rigid Ltd at floating rate (Libor + 1%) and to Flexible Ltd as fixed rate (8%). In this case,
assuming they agree under the swap to reimburse each other the actual interest cost incurred, below
swap can be constructed:

Fixed Desire Floating

Fig
Rigid Flexible
8
Bank 1 11 Bank
riding
Floating Actual Fixed
Net Interest Cost:
Rigid Ltd 1 4 1 8.1 8
Flexible Ltd 8 8 2 1 1 11

1 deciding who
pay fix who
pay floating 149
Ans Rigid Back to floating de rua hai no swap kiAdish Jain CA CFA
me floating receive Korega so that uski flooding position
cancel to fooge no fixed ban poaye
Derivatives & Interest Rate Risk Management

2. Saving the interest cost:

Example Rigid Ltd wants to borrow at a fixed rate & Flexible Ltd at floating rate. Following banks
quotations are available:

Company Fixed Rate Floating rate

A problem
Rigid Ltd 121 1T 10
L 5 extra
Lt 15 payment du
to desised
Flexible Ltd
9.1 4 3
A
Note that a gainful swap can be constructed only when total interest cost under Actual is less
than Desired.
tredka
Situation 1: When question specifies the payments to be exchanged under the swap: opposite borro
Continued example: Say, payments agreed under the swap were 8% vs. LIBOR flat (i.e., party koro
paying fir usse
fixed agrees to pay 8% and party paying floating agrees to pay LIBOR) swap
dcised P

Fixed Desire Floating

Rigida Flexible g
41
Frothing
Actual Fixed
Floating
Net Interest Cost i.e., cost under ‘Actual + Swap’:

Rigid Ltd
2 1 L 8 9
Flexible Ltd
91 81 L 2 1.1
Savings i.e., Cost under Desired – Net Interest Cost

Rigid Ltd
91 3 5
121
facto
Flexible Ltd
31 FL 1 2 both the parties
150
Adish Jain CA CFA
Derivatives & Interest Rate Risk Management

Situation 2: When question specifies how the saving in ‘total interest cost’ because of swap
will be distributed between parties:
Continued example: Say, parties agree to share the gain (savings) on account of swap in the ratio 2:3.
4
mehangi
Fixed Disise Floating
ulated
9
Rigid Flexible
Utd assumed did
Floating
Actual Fixed
Floating sastri
Savings in Total Interest Cost & Share of Parties (%):

Particulars (%)

Total Interest Cost Desiredposition 1 3 12 2 15 1

Actual position 1 1 9 101
Gross savings 51
Less:
NA
Net 5
Savings
Distributed as: 3
2
FEEL 1 1
Note: If question is silent on distribution of savings in interest cost between the parties,
assume that to happen equally.

Asolute Comparative
____________________________________________________________________________

Advantage
____________________________________________________________________________
Advantage
Fixed ed
____________________________________________________________________________
Flating0 Flating
a
A 2 3 A Lt
____________________________________________________________________________
8 8
B lot 21A B 101
____________________________________________________________________________
D
ekhico.RO
____________________________________________________________________________
co Ko ek mkt mei done
Sasha dussiko dusse mkt mkt me sastad151
be
me Sastay Beneficial swap
arranged in
can
both types of
Adish Jain CA CFA
eg

Derivatives & Interest Rate Risk Management

Now, follow the process of situation 1 in reverse order as below. Make below calculations only
for one of the parties to the swap.

Calculating Net Interest Cost from Savings:

Starting with Rigid Ltd Starting with Flexible Ltd

Cost under desired Net Interest Cost Gain Savings

12 NIC 4
____________________________________ 4 3 NIC
____________________________________

NIC 8
____________________________________ NIC 4 21
____________________________________

Note that when question ask only to calculate the net interest cost, there is no need to
construct a swap.

Calculating Fixed payment under the swap (by assuming Floating payment as LIBOR) using Net
Interest Cost:

Fixed 8
____________________________________
1 9 Fixed L 2 21
____________________________________

Fixed 7
____________________________________ Fixed 7
____________________________________

Above two calculations can be directly performed in a single step as below:

Cost undel desired NIC Savings

Ettatid 4 1 3 9i Fixed 1
____________________________________ ____________________________________
12
____________________________________ ____________________________________

Fixed 7
____________________________________ Fixed 7
____________________________________

Verification (not for exams): We can verify the correctness of Fixed rate calculated above by
calculating the gain of other party to the swap as below:

gain field NIC gain 884528 NIC

7
9 7 4 12 4 1 4
13 4

152
Adish Jain CA CFA
Derivatives & Interest Rate Risk Management

b) Construction of Swap with Financial Intermediary

In case of financial swap with a financial intermediary, thought process is similar with a small
extra calculation at the end.

1. Conversion of fixed to floating and vice-versa

2. Saving the interest cost:
Situation 1: When question specifies the payments to be exchanged:
Situation 2: When question specifies how the saving in ‘total interest cost’ because of swap
will be distributed between parties:
Continued example: Say, parties agree share the gain (savings) on account of swap in the ratio 2:3
after deducting intermediary’s commission of 1%.

Fixed Desised Floating

rigid
I FI
flexion

1 Itd g 1
assumed
411 Cassini
eating
eating
Floating Actual Fixed

Savings in Total Interest Cost & Share of Parties (%):

Particulars (%)

Total Interest Cost Desised 1 15

Actual 2 10
Gross savings 51
Less:
Commoission 1
Net 41
savings
Distributed as: 2 3 Rigid 215
Flexbile 35
153
Adish Jain CA CFA
Derivatives & Interest Rate Risk Management

Point of difference: Here we would need to calculate the fixed leg for one party first & then
for another party in the next step:
Calculating Fixed payment under the swap for any one party:
Starting with Rigid Ltd Starting with Flexible Ltd

Cost under desired NIC gain

121 Lt Fixed 16
____________________________________
v1 4 3 9 Fixed
____________________________________2.4
9.4
____________________________________ ____________________________________
er effie.in j4
____________________________________ ____________________________________

Calculating Fixed payment under the swap for the other party:

rigid EE.im
____________________________________
fEIdEkyYmmn
____________________________________
Effie rgiftz
____________________________________
4 g 1 8
____________________________________
8 4 0 g.it
Verification (not for exams): We can verify the correctness of Fixed rate calculated above by
calculating the gain of other party to the swap as below:

GET 19s L NIC

9ft 18s L NIC
2 9.4
9 12 1
11 64 1 3
2
584 Rigid 1 6
verified
Verified
SWAP
____________________________________________________________________________
Understang QUOTATION
____________________________________________________________________________

Ex An All in cost
____________________________________________________________________________
sy swap for
Elolacs is quoted at
7 5
____________________________________________________________________________
81
V15 6m libor Flat
____________________________________________________________________________

Duration settlement Freq

____________________________________________________________________________
Interpreation Sy 6M
Ref Rate Gm Libor Notional princible 10 ae
____________________________________________________________________________

Libor Flat Flat means nothingis

____________________________________________________________________________
LEG
P Floating added in the
to be
154
S fixed leg floating rate over 9 abo
Adish Jain CA CFA of
it is inclusive 608
IF customer
t.in PAY Fixed Rate 8 Receives Fix RATE 7.54
Receive lie rate
a ng py f ng

Derivatives & Interest Rate Risk Management

LONG
SHORT
c) Various types of Interest Rate Swaps

Practical Questions: _ Practice Problems: __

1. Generic Swaps or Coupon Swap

 It involves the exchange of a fixed rate loan to a floating rate loan.
 Fixed interest payments are calculated on 30 days/360 days basis.
 Floating interest payment is calculated on actual number of days/360 days basis.

2. Overnight Index Swap

 It involves the exchange of a fixed rate loan to a floating rate loan where floating rate is
an overnight reference rate i.e., 1-day LIBOR, MIBOR, etc.
 Floating interest payment is calculated daily since overnight floating rate is reset daily.
Since, it is an overnight rate (i.e., rate for loan of one day), therefore interest is
compounded daily, if swap is for more than one day and is calculated considering 365
days.
 Fixed interest payments are calculated without compounding on actual number of
days/365 days basis.

d) Pricing of Interest Rate Swaps

068
Pricing the swap means determining the Fair Fixed Rate of a Fixed vs. Floating Swap at which it
can be entered. It is determined with the help of Term structure of interest rates i.e., spot
floating rates available for different periods.

Example:
Period Libor Spot

155
Adish Jain CA CFA
Derivatives & Interest Rate Risk Management

2) Currency Swaps
Currency swap is an agreement to exchange on cash-flows on account of borrowing in two
different currencies. It takes place at three levels:
1. A spot exchange of principal
kid
2. Continuing exchange of interest payments during the term of the swap
3. Re-exchange of principal on maturity

f
Similar to interest rate swap, in this case also, companies borrow in currency other than currency
of their desire. But, with the help of swap, they ultimately incur outflows in their desired currency.
Note that from the point of view of practical questions on swaps, only 2nd part above i.e.,
continuing exchange of interest payment is relevant & thought process is same as interest rate
swaps.

3) Equity Swaps
An Equity Swap is an arrangement in which total return on equity or equity index in the form of
dividend and capital is exchanged with either a fixed or floating rate of interest.

NP
Net settlement rxfat.FI ig
Altel Betd

Equity
Return
settlement
Periods L Eq return
____________________________________________________________________________

1 81 7.1 A B 11
____________________________________________________________________________

2 7.5 101 B A 2.501

____________________________________________________________________________

3 71 21 A B 9
____________________________________________________________________________
____________________________________________________________________________

case of return
____________________________________________________________________________
negative equity
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________

156
Adish Jain CA CFA
Refer after 164
pg

For B
Essin Food
Rate 1 Rate
1 misgin Alc Eckhart
Feed Inter Ensign
Spf ty Back
Foreign Exchange & International Financial Management

A. Basics of Forex
Practical Questions: _______________________ Practice Problems: ________________________

Home Currency (HC) Foreign Currency (HC)

Currency of one’s own country Currencies other than home currency

For someone in:

India- I E E
US-
E t E
HC Transactions FC Transactions

Transactions denominated in HC. Ex: Transactions denominated in FC. Ex:

 Goods imported by India Ltd for ₹ 5,000.  Goods imported by India Ltd for £ 3,000.
 Goods exported by USA Ltd for $ 1000  Goods exported by USA Ltd for € 2000

How does it matter whether the transaction is HC or FC?

One would always want to know the amount of inflows, outflows, gain or losses on account of
any FC transaction in terms of HC since that is the ultimate resultant that matters. Since these
transactions are not denominated in HC, we need to apply certain concepts to be read ahead.
mkt where one currency 1 E
Transactions by different participants in Forex Market: can be bought or sold agains
another currency
Participant Transaction Type

Importer, Exporter, Borrower,

No need to to
forex mkt
Investor in HC
go
Importer in FC
FC
Exporter in FC
Pay FC
Buy
Recive FC Sell FC
Borrower of FC
at the Receive FC Sell FC
Investor in FC
time of
borrowing Pay FC Bug FC
investing
157
I
Adish Jain CA CFA
Foreign Exchange & International Financial Management

1. Exchange Rates
In order to buy or sell the FC, we will need to exchange i.e., pay or receive the HC. The amount of
HC to be exchanged can be calculated with the help of Exchange Rates. It is the price of one
currency in terms of another currency and the process of exchanging one currency to another
currency is called Conversion. to hai
Taise
ye Apple 9,4 ifeng.at's
16 50 60 50 I 50

É 1 70 80 70 70
8
waise ye ko BIS Karne
One-way Quote: Single rate for buying & selling the base currency dfmsknci
For any currency rate quoted as A/B = x

B Base Fiska
Rate
______________________________________________________________________
Currency diya hai
A
Price currency Fiski
______________________________________________________________________
terms mei dige hai
x = Rate at which one unit of B can be bought or sold

Two-way Quote: Bid - Ask: Different rate for buying & selling the base currency

For any currency rate quoted as A/B = x - y

Bid
x = _____________________________________________________________________________________
Rate Rate which Dealer Bank will Buy
the Base B
_____________________________________________________________________________________
currency
Ask
y = _____________________________________________________________________________________
Offer Rate Rate which Dealer Bank will sell
Base
the
currency B
_____________________________________________________________________________________

Notes:
 Rates are quoted as Bid/Ask from bank’s stand point. Kyuki Dukan
 Ask rate is always higher than Bid rate. base
currency
Ki hai and
date base
158 Ka hai
Adish Jain CA CFA
Foreign Exchange & International Financial Management

BIS one
currency
2. Conversion from one currency to another another
against
Given exchange rate:
50 60
Buy $ 100 100 60 6000 PAY OF

5000
Recife
Sell $ 100 100 50
Buy ₹ 100 100 50 2 PAY OF

Sell ₹ 100 100 60 1.67 Racing

F
Rules for conversion: Given exchange rate as: A/B = x - y

Amount to be
Multiply or Divide Rate used (x or y)
converted:

Buy B Multiply, when amount

4 Buy
to be converted is in B & Edukan
Since base currency is
Sell B rate is also given for B
y B, we need to think of
Buy A Divide, when amount to whether to buy or sell
be converted is in A but a from B’s point of view.
Sell A rate is given for B

3. Inverse of an Exchange Rate

y
One-way Quote Two-way Quote

Given Quote:
21 60 2 60 70
A B R

12 1 60 00167
12 470 1
60
Inverted Quote:
B
A
08H 9 87
Hence, even after inversion, Ask is higher than Bid.

159
Adish Jain CA CFA
Foreign Exchange & International Financial Management

4. Direct & Indirect Quote

Direct Quote Rate of FC in terms of HC i.e., base currency should be FC

Indirect Quote Rate of HC in terms of FC i.e., base currency should be HC

For someone in: Direct Quote Indirect Quote

India

London

Note: Direct quote can be converted to Indirect quote using concept of inversion learnt above.
BIS no
IB mkt Jan 2 Banks Dealer Kebich
5. Concept of Exchange Margin
Merchant mkt Jaha Customer Deald Ke
Interbank Rates Rate at which banks buy or sell currencies to each other Is no

Merchant Rates Rate at which banks buy or sell currencies to the customers

Interbank Rate:
Bid 1 48 Ask I 50
+/- Margin 1
Margin 1 Margin
Merchant Rate:
Bid 21 47 52 Ask 50.5
Note that exchange margin is not be applicable to interbank transactions.

6. Exchange Rates Presentations: Symbolic vs ISO Codes

or Swift codes
Rate in layman’s language Symbolic ISO Codes

1 60 21 60 USD INR 60
1 115 1.5 GBP USD 1.5
f
Note: Institute may not follow above rule every time, therefore we will apply common sense by
looking at the given rate.

160 E INR USD SPY

Adish Jain CA CFA EUR GBP 59 SGD
08

Foreign Exchange & International Financial Management

7. Gain or Loss on Foreign Currency Transactions

In this chapter, Gain or loss will normally be calculated in two ways:
 Inflow from selling the currency - Outflow from buying the currency
Example: You sold $100 at ₹65 and bought it later at ₹60, gain on the transactions = ₹500
 Inflow (or outflow) that could have happened - Inflow (or outflow) that has happened
Example: You want to buy $100 today at ₹65, but for some reason, you could not buy it today.
Next day, you could buy $ at an increased rate of ₹67, loss due to delay in buying = ₹200

Situation 1: When rate is given for the currency that has been bought & sold.
You bought $10,000 @ ₹/$ 65 & sold it @ ₹/$ 68. Gain or loss on the transaction:

fu
Net Basis Erality
Gross Basis

1 58 ÉÉ 10.000 99988 10988 EE

E 30,000 GAIN 30,000 GAIN

Situation 2: When rate is given for the currency other than what has been bought or sold.
You bought $10,000 @ $/₹ 0.015 & sold it @ $/₹ 0.017. Gain or loss on the transaction:

Net Basis Totality

Gross Basis
20 IF
10,000
No A 1000
0.015
017
588235 I 666666
Note that HC inflows & outflows are what ultimately matter to any business & hence, whenever
possible, final gain or loss outcome should be in terms of HC. 78431.2055
_____________________________________________________________________________
_____________________________________________________________________________
Indian want to buy 5
_____________________________________________________________________________

E
_____________________________________________________________________________
HC
FC t
_____________________________________________________________________________

Casse Casa Case 3

_____________________________________________________________________________

I 100 HE 001
5,1 161
Adish Jain CA CFA
5 5 0.01
HC E FC t
582 my
I
cimer or
I
Foreign Exchange & International Financial Management calculated
using
cross
B. Cross Rates currency

Practical Questions: _ Practice Problems: __

1. Calculation of Cross Rates

When One-way quotes are given:

A B B A
AIB R R
BIC Y GB y B
c Y
B A B
Al AB
d
c

y
B Ny Sf
Inverse of
GB BIA
Alps Bye
x.y

When two-way quotes are given:

A B x y A B ay BIA
Nos nor
B C P 9 B
p q c p q
A B B A B R Y BIC
f In
C
9 P.BA
xp y.q.CA Bid Ask Bid Ask

CIB P 9 BA 1 I
y T.p.am Y K B
c q p
Bid Ask Bid Ask
162
Adish Jain CA CFA
Incase of 2 way que
Refer note of Pg 409ft scanner
Foreign Exchange & International Financial Management

2. Transaction to Cover or Square-off a position

Long Position Short sell

To cover or square off
Short Position Long
Buy
Note that, gain or loss on above transactions will be calculated as learnt in basics.

3. Triangular arbitrage entire arbitrage in spot meat

60
E
PATHA
E
5000 2T

t 1.5 PATH
E 100

Find out whether the currency is undervalued or overvalued

Actual 100
Fair t 60 15 90 Elt

tis overvalued devalued

Conclusion: ________________________________________________________________________
against
Decision: t PATH 2
________________________________________________________________________
PETEGath 2sept t guy
sell
08
Choose the right path to follow I Buy
Above ‘decision’ will surely fall on one of the paths. Follow that path from the beginning.
Slept Sell 1000 141.5 step2 sell 666.67 t 100
100
666.67 666 67 100 66666.6
5

sep 3 sell 666.666.67 Steph Arbitrge PROFIT

21 60 1111 1000
66.666 67 1111.11 111.11
60
Examiner Batayega ki Hamare Paas, kaunsi currency Hai to start the arbitrage 163
process.however, Agar examiner, nahin Bataye to jis currency Pe comment kiya Hai Us Adish Jain CA CFA
currency say start kar Dena . t
Foreign Exchange & International Financial Management

C. Forward Contract
1. Forward Rate: Forward Premium and Discount
Practical Questions: _______________________ Practice Problems: ________________________

Spot exchange rate is for buying & selling the currency immediately in the spot market.
Forward Exchange Rate is decided today, for buying & selling the currency at a future date in
the derivatives market.
5 F
Today’s Spot rate: 1$ = ₹60 | Today’s 6m Forward Rate: 1$ = ₹66

is Food Premium E.is Food Discount

8 given rate of is more in
food what
Annualized Forward Premium or Discount:
Base Currency Price Currency

5 1208 365 S F 1208365

F n F n
15 4 66 80 100 54 60 66
60 1,2 66

20 Premium I 18.18 Discount

Note that formula is not for premium or discount, rather it is for base currency & price
currency. If answer to the formula is positive, it’s premium & if it is negative, it’s discount.

Calculation of Forward Rates using Forward Points, Forward Margin or Swap Points:
spread
Spot Rate xx
Premium Discount
Pfiffate
Question specifies Premium or Discount: Question is silent & format of swap points is:
Bid Ask
Premium: _____________ Low High: ____________
assume premium
Discount: _____________ High Low: ____________ assume

164
Adish Jain CA CFA
Foreign Exchange & International Financial Management

2. Expected Spot Rate: Expected Appreciation & Depreciation

on T 3m

So 60 21 66
E ST Relate it with PPP
$ is expected to _________________ &
Appreciate ₹ is expected to _________________ pg17
Depreciate
Expected Spot Rate is an estimate of spot rate that is expected to prevail on a future date.
Expected appreciation or depreciation of base & price currency can be calculated similar to
forward premium & discount.

Calculating expected spot rate:

 Using probability distribution:

inspot mkt
Possible Rates Probabilities Expected Spot

21 62 201
65 501
58 301
62 3
 Using expected appreciation or depreciation: So I 60
Cases Logical Solution What ICAI follows*

$ appreciates by 10%
60 1 101 66
$ depreciates by 10%
60 1 10 1 54
₹ appreciates by 10%

₹ depreciates by 10%
* Note: ICAI makes calculation presuming appreciation or depreciation of base currency,
even when question clearly specifies depreciation or appreciation of price currency
respectively. So, when question says ‘price currency will appreciate by 10%’, we will have to
interpret it as ‘base currency will depreciate by 10%’ and solve accordingly.

165
Adish Jain CA CFA
Foreign Exchange & International Financial Management

hedging starts hedgingover

3. Hedging through Forward Contract
Take popinjay
settle position delivery moshy
CashQQ 23
Practical Questions : _______________________ Practice Problems: ________________________

Exp Imp Refcipt paytment

on 3m.tl S0 = ______________________
Today's spot rate
So XX F =T ______________________
Today's fwd fatpfinf.xpiring
ECS E(ST) = ______________________
Exp spot 85am
IfHd
St
XX FoAD Actual
XX
ST =
spotratep.EE
______________________

Hedging Mechanism of Forwards: Since forward rate is known today with certainty, therefore
future HC cash flows, which will occur at this rate, are also certain. Hence, there will not be any
risk in FC exposures.
position to be
taken
Deciding Bid vs Ask Rate
depends upon position to FC receivable FC payable
be taken in the forward
contract. spPinittWould buy FC to pay
Would sell FC when received
Based on the golden rule of
hedging: In order to hedge,
do in derivatives market, Sell FC forward or Buy FC forward or
what you would do in spot buy HC forward today sell HC forward today
market.
derivatives
Approach for solving practical questions:
 Objective of practical questions on hedging will be to calculate HC inflow (in case of export)
or HC outflow (in case of import) on account of FC exposure.
 Whether to hedge an exposure (convert CFs using F) or leave it unhedged (convert CFs using
ST or E(ST)), depends on:
 In case of export i.e., HC inflows: Higher the better
 In case of import i.e., HC outflows: Lower the better
 Only by looking at the rate, we can’t comment on what would be better: F or ST or E(ST),
because given rates may be indirect quotes.
 Gain or loss due to forward contract will be same as learnt in basics.

166
Adish Jain CA CFA
Foreign Exchange & International Financial Management

D. Exchange Rate Theories used to calculate

sit
Practical Questions: _______________________ Practice Problems: ________________________

1. Interest Rate Parity CFood rate

date
844 99 jiffy
1 Us 5 1.05
So
21 62 86
21 60
260 India 10 66
51
Fair Fo 1
Actual Fo ly 21 65
IRP implies that exchange rate between two currencies is directly affected by the interest rates
in those countries. It states that forward premium or discount on any currency should be equal
to the interest rate differential of the two countries.
If India has higher interest rate (say 10%) than USA (say 5%), then:

Food discount
₹ will trade at ____________________________ approximately by _____________

FWD Premium
$ will trade at ____________________________ approximately by _____________

Fair Forward Rate

FoCT
Exact IRP equation to be used, depends upon the nature of compounding given in the question:
Discrete Compounding Continuous Compounding Question is Silent
(Compounding annually, semi- (Compounding continuously (Calculate assuming simple
annually, quarterly, monthly) or daily) interest rate)

K
1 80 Sox
ftp hn
e
Sox 1 Sox
1 86 k got
tin time period till
expiry of Adish Jain CA
167
terms of years CFA
food in
Foreign Exchange & International Financial Management

Fair Forward Premium or Discount: when question is silent on nature of compounding

We have already learnt calculation of actual forward premium or discount. Fair premium or
discount can be calculated either using the same formula learnt earlier or an alternative formula
discussed below.

Annualized premium or discount:

* Periodic interest of the country for which premium or discount is to be calculated

On ₹: On $:

Note that this formula of calculating premium or discount will be used only when exchange
rates are not given.

168
Adish Jain CA CFA
Because Rate used ty is Hedged Fixed Food
Ratel
Foreign Exchange & International Financial Management
so uncovered Arbitrage will be using ECS rather than
2. Covered Interest Arbitrage Food rate Q 34
Practical Questions: _______________________ Practice Problems: ________________________

Covered Interest Arbitrage involves earning risk free profit on account of mispricing of variables
used in IRP equation, i.e., interest rates of two countries or, spot or forward exchnage rates
between its currencies.
It involves borrowing in one currency & investing in another. In any given situation, there are two
ways in which we can borrow in one currency & invest in another.

Way 1: Borrow in $ & Invest in ₹ Feed expiry

Om
If
Borrow Repay
US 5
1 1.05 loss
sell 003
102
spot 2 Buy
Food 21 65
Recive
India 10 669
Invest poem

Way 2: Borrow in ₹ & Invest in $

on
If
Borrow Repay
60 India 10
66 gein
g I 2 25
6825
spot 2 Buy
Food 21 65
Recive
US 5 É
Invest redeem

169
Adish Jain CA CFA
Foreign Exchange & International Financial Management

Process of Abritrage
Step 1: Borrow Currency A and compute outflow on maturity
Step 2: Convert the borrowed amount of currency A to currency B at spot rate
Step 3: Invest currency B for the same time period and calculate inflow at maturity
Step 4: Sell currency B forward & receive currency A.
Step 5: Gain: Inflow in step 4 – Outflow in step 1

Deciding which currency to borrow 9

One-way Quote Two-way Quote

836
Try both the ways to see if there is profit on
Rule of Thumb: Borrow in
any of the ways. It is very well possible that
undervalued currency
both the ways give loss.

We know that one of the above two ways will give profit & another will give loss. We can figure
out which way will give profit by evaluating forward rates. We normally assume that all other
variables of IRP equation are correctly priced and forward rate may be mispriced:
1. Calculate fair forward rate using IRP equation.

Fair Food I 62.86

___________________________________________________________________________
___________________________________________________________________________

2. Compare actual forward rate to with it to determine whether actual base currency ($) is
undervalued or overvalued (always comment on actual).

8 Actual Food E 65 Fair Fwd E

___________________________________________________________________________
6286
is overvalued E
___________________________________________________________________________
against
3. If $ is undervalued, borrow in $. If $ is overvalued, means ₹ is undervalued, borrow in ₹.

is overvalued
___________________________________________________________________________

undervalued
___________________________________________________________________________
is
we will borrow in
170
Adish Jain CA CFA
cease without Derivatives.net
of hedge
Ñ
dg Foreign Exchange & International Financial Management

3. Money Market Hedge

Practical Questions: _______________________ Practice Problems: ________________________

Unlike forward hedge, money market hedge involves use of spot rate and FC & HC money market
(i.e., borrowing & investing). It involves creating a FC payable (through borrowing) or FC
receivable (through investing) against existing FC receivable or FC payable respectively.
Exported Imposter
FC Receivable FC Payable

14 o ly
1 1

PVCFI Borrow IPVCFIl Invest 1

ProfFC EE Proffe
spot Bug spot
2
9 2
FE

Invest Borrow
HC El HC El
Heracaved If E
Hctober
E

3 paid 3
Steps to solve practical questions:

1. Borrow PV of FC Receivable 1. Invest PV of FC Payable

2. Sell borrowed FC at spot rate & receive HC 2. Buy FC to be invested at spot rate & pay HC

3. Invest HC received 3. Borrow HC to be paid

Note As already discussed, objective of hedging based question will be to find out best tool to
hedge FC exposure. Best hedging tool is the one which gives:
 In case of exporter: most HC inflow
 In case of importer: least HC outflow
Note Steps of CIA & MMH are similar. Imagination on timeline is important to avoid confusion.

171
Adish Jain CA CFA
Foreign Exchange & International Financial Management

4. Purchasing Power Parity Exp Spot

Practical Questions: _______________________ Practice Problems: ________________________

It is based on ‘Law of one price’. It states that prices of similar products of two different countries
should be equal when measured in a common currency.
Absolute Form

1 16 260 21 60
Relative Form
Unlike absolute form (which talked about exchange rate at a particular point in time), relative
form talks about change in such exchange rates.

oy Ijn
1 US 5
1.05

rates
It Infation 21 62.86
z India 1 1
Go 66

Relative PPP states that exchange rate between two currencies is affected by the inflation rates
in those countries.
i
Expected Spot Rate: If inflation in India= 10% & US= 5%. Current spot ₹/$ 60.

ECS So
II p
60
1 5 5
Expected Appn/Depn in $: Base Currency Expected Appn/Depn in ₹:
price currency
ECS So 62 86 60 60 62.86
60 SELFISH 62 86
So
4 77 4.55
172
Apph
it
Adish Jain CA CFA

Depn
Foreign Exchange & International Financial Management

Real appreciation or depreciation: If actual spot rate after a year turns out to be:
71 65
Real appreciation in $: Real depreciation in ₹:

ST ELST 3.57
So
It is important to understand below differences between Forward rate & Expected spot rate.

Forward Rate Expected Spot Rate

Relation with Spot Rate Premium or Discount Appreciation or Depreciation
Market Derivatives Market Spot Market
Rate at which future cash Known today. Not known today.
flows will occur Hence, certain CFs Hence, uncertain CFs
Underlying Theory IRPT PPPT
Determined by Interest Rates Inflation Rates
:

5. International Fisher Effect

According to International Fisher Effect, interest rates are highly correlated with inflation rates.
This theory states that interest rate differential between two countries is equal to inflation rate
differential of those countries.

Mathematically: =

Accordingly, expected spot rate can be estimated with the help of interest rates also.

St 21
65
_____________________________________________________________________________

due to
_____________________________________________________________________________
factors
other than
_____________________________________________________________________________
inflation
ECS 62.86
_____________________________________________________________________________
_____________________________________________________________________________

50 2 60 4yÉn
_____________________________________________________________________________
_____________________________________________________________________________ 65
App 60
_ I 1 Deph
60
ty 173
Real Adish Jain CA CFA
65 286 6288560
APP
ep

Foreign Exchange & International Financial Management

E. Fate of Forward Contract

Practical Questions: _______________________ Practice Problems: ________________________

This topic of the chapter is governed less by logics and more by the provision of Foreign Exchange
Dealers Association of India (FEDAI) rules.
contract entered Date Automatic
Effigy Concalation
Oy

Possibility Before due date

On maturity forking
Till 3 days End of 3 days After 3
date (MD) from MD from MD days
Execute
Delivery
Early Delivery Estate
Cancel
cancellation Default
Extend
Extension
Important Notes:
 As per FEDAI Rules, exchange rates should be rounded off to the multiples of 0.0025.
 Think from whose point of view?

In case of: Think from the point of view of...

Cancellation
Extension
Customer
Early Delivery
Default
Bank Dealer

Concept of Swap Transaction

Buy – Sell Swap

Buy Spot Food sell
Sell – Buy Swap
sell spot Fwd Buy
174
Adish Jain CA CFA
Foreign Exchange & International Financial Management

1. Cancellation of Forward Contract

When a customer does not want to execute the forward contract (i.e., give or take delivery of the
currency), he ask the bank to cancel the contract. On the date of cancellation, he will have to pay
or receivce the loss or gain on account of cancellation (i.e., cancellation charges) to the bank.

Cancellation Rate: To cancel a 3 month forward:

Date on which AC
3m
forward contract
is cancelled: on
in 2m
3m 337
D
Rate to be used
for cancellation: Fwd Fid Fed Fate

Bid Rate vs Ask

Impoyted
Long Position Selling rate of customer i.e., Bid Rate
Rate for To cancel
cancellation: Short Position Buying rate of customer i.e., Ask Rate

Exported

Cancellation Charges: Customa will

Gain
From the point of view receive
from bank
of customer, gain or loss IF OF
from above long & short
Loss Customer will pay
transaction
to Bank

2. Extension of Forward Contract

Extension means delaying the date for executing the forward contract.

Extension: cancellation New contract

lofexsiting
Cancellation is the same as read above. Question may ask us to calculate the rate applicable for
new forward contract.

175
Adish Jain CA CFA
Foreign Exchange & International Financial Management

3. Early delivery under forward contract

When a customer wants to execute the forward contract before due date (called as early
delivery), the bank can get or give early delivery under the contract on payment or receipt of
early delivery charges from the customer.
On the date of early delivery of forward contract, payment or receipt from the customer will be
adjusted by the amount of early delivery charges calculated below:

Imported papers
Fwd
sell 1
Em 3m
g on
Bank
Buy Spot mcr
4m go.gs
Food sell XX

Bank
a xx

Component of early delivery charges:

S. No. Component Treatment

1
Swap (on the date): Gain:
Bank will passon to customde
84th
______________________
custogges
Loss: Bank will recover from customer
Net cash Inflow: Bank
2 Interest on outlay of funds
will pass on to customer

Net I
Net cash Outflow: Bank will recover from
OF customch
Interbank Mkt
Swap transaction to be entered by bank: 1 no exchange margin
Importer
Buy sell Swap
Sell Buy swap
Exporter

176
Adish Jain CA CFA
Foreign Exchange & International Financial Management

4. Default of Forward Contract

When a customer does not execute the contract till its due date, it becomes the case of default.
The contract does not become void immediately after the due date, it gets automatically
cancelled after 3 days.
Note: When customer comes to the bank, below components are compulsorily recovered from
the customer, irrespective of whether he has come to execute the contract, cancel or extend it.

Imported papas ftp9f Automatic cancellation

Fwd on 3m 3d
sell 3m
2d
Bank
Spot sell CANCE OG
M
t 2 CONTRACT

Food Buy
STIEFengaturity
Bank
Canterbank
meicover
BEEF xx

Component of default charges:

S. No. Component Gain or Net cash Inflow Loss or Net cash Outflow

Swap (on the date):

TP
1
______________________
when contract expires
DON'T RECOVER
2 Cancellation Charges PAY to from
Rexchange diff customer customer
3 Interest on outlay of funds
of in interbank mkt
Swap transaction to be entered by bank:
IS
Importer sell
Buy Swap
Exporter
Buy sell
swap
Interest is charged from expiry date till the date customer arrives. However, if the customer
177
doesn’t arrive till the date of automatic cancellation, then interest is charged only till that day Adish Jain CA CFA
that is only for a period of three days.
Foreign Exchange & International Financial Management

F. Foreign Currency Exposures

1. Types of Currency Exposures
Practical Questions: _______________________ Practice Problems: ________________________

An Exposure can be defined as a future cash receipt or payments whose magnitude is not certain
at the moment.

 Translation or Accounting Exposure: It refers uncertainty regarding HC equivalent amount of

certain FC receivable or payable caused because of its translation at a different exchange
rates that may prevail on reporting date. It arises because the exchange rate on the date
when transaction was recorded was different from the exchange rate on the date when
financial statement reporting is done. It also included translation of assets and liabilities of
subsidiary company into the currency of parent company.
Example: An exporter has sold goods worth $100 and exchange rate is ₹/$ 65. Now, at year
end (reporting rate) exchange rate changes to ₹/$ 60. Loss due to Translation Exposure is (65-
60)*500= ₹ 2,500.

 Transaction Exposure: It refers uncertainty regarding HC equivalent amount of a certain FC

receivable or payable caused because of its realisation at a different exchange rates that may
prevail on settlement date. It arises due to change in exchange rates when a transaction was
entered into and when a transaction is settled.
Example: An imported purchased goods worth $100 and exchange rate is ₹/$ 55. Now, at the
time of payment, exchange rate changes to ₹/$ 60. Loss due to Transaction Exposure is (65-
60)*100= ₹ 500.

 Operating or Economic Exposure: It 51 refers uncertainty regarding economic value of a

company that can decline due to change in exchange rates. Even if the company is not directly
dealing in transaction denominated in foreign currency, it is exposed to economic risk. The
exposure is on account of macro level factors such as:
o Change in the prices of inputs used or output sold by competitors (giving them competitive
advantage).
o Reduction in demand by the foreign importer due to depreciation of his currency (elasticity
of demand- as, if the transaction is denominated in exporters home currency, he may not
have transaction exposure, but is economically affected by the reduced demand).
o Change in interest rate in order to control exchange rates might affect all the domestic
firms.

178
Adish Jain CA CFA
Foreign Exchange & International Financial Management

2. Techniques of Hedging Transaction Exposure

Hedging transaction exposure means eliminating or reducing uncertainty regarding HC
conversion of certain FC receivable or payable. It can either be achieved internally by changing
FC transaction related decisions or externally with the help of tools available in the market.

Internal Hedging Techniques External Hedging Techniques

o Invoicing in HC 025 o Forward Cover

o Leading & Lagging o Money Market Cover
o Netting 057 o Future Cover
o Matching o Options Cover
o Price Variation o Currency Cover
swap
o Asset & Liability Management iii iii is

3. Leading & Lagging

Leading means advancing the timing of FC payments and receipts. Lagging means delaying the
timing of FC payments and receipts. The one which gives higher HC inflows or lower HC outflows
should be chosen.

on 3M Inflow HC
Discount FC XX
FC xx higher is
food better

21 spot MC Exx
Outflow HC
lower is
shut better
HSE xx He Exx

179
Adish Jain CA CFA
Foreign Exchange & International Financial Management

4. Hedging through Futures

This page has summary of Basics
of Futures settlement of futures
futures
using
Practical Questions: _______________________ Practice Problems: ________________________
nudging
learnt in derivatives
Unlike forward, (which are settled through delivery), futures have their own market price through
which profit and loss for cash settlement is calculated. Accordingly, hedging will involve:

in tugging
hedging starts here Hedging over
Take a position in futures contract Settlement of open positions

Identifying futures’ currency Diff Settle Futures cash settlement

Decide Position to take
spatt Settle FC exposure

Number of contracts Interest lost on margin

Points of consideration:
 Futures expiring after the due date of the exposure should be chosen for the purpose of
hedging. Not the one expiring before the due date.
 Futures given in the question is on the currency:
o that is the base currency of quoted futures price.
o for which contract size is given.
settlement
Neton futures on one currency is calculated in terms of other currency.
 Profit or loss
Today
Example: Position entered in ₹/$ future at 61.50

In this case:
given futures is on GIL on it will in
Position Long Position Short Position

Price increases to I62.75 G 21.25

E 1.255 L
24 Price increases to 59.50
L E 2 G 2

sdtqm.cat date
Expiry
180
Adish Jain CA CFA
Foreign Exchange & International Financial Management

Foreign Currency Futures Home Currency Futures

FC MMCin 3m. OF OF
ITC Ltd has $110000 payable ITC Ltd hasPFC AMC
$110000 payable in 3m.
₹/$ Spot Price 3m Futures Price $/₹ Spot Price 3m Futures Price
Today 64 65 Today 0.020 0.021
After 3m 67 68 After 3m 0.023 0.024
Margin: ₹ 10000 Margin: ₹ 10000
Contract size: $20000 Contract size: ₹200000
Interest rate 12% Interest rate 12%

Take a position in Futures today:

1. Identify the currency on which futures are given.

Given futures is on: EC Given futures is on: E HE

Because: ___________________________ Because: ___________________________
Ethnegates 9s ftp.cfatsf a.se
contract size
___________________________ in ___________________________
contract size in E

2. Decide the position to be taken.

Based on the golden rule of hedging:

FC Receivable FC Payable FC Receivable FC Payable

in spot in spot
in spot in spot

Would sell FC Would buy FC Would sell FC Would buy FC

in spot latch in spot latch
in spot latch in spot latch

sell FC futures Buy FC futures it Would buy HC Would sell HC

inspot later inspot latch
today Lives toddhinitives
Buy no futures sell He Futures
today in deities today in derivatives

Buy
In this case: ____________________________
futures sell
In this case: ____________________________
futures
21 65 2 0.021
181
Adish Jain CA CFA
Foreign Exchange & International Financial Management

3. Determine the number of contracts to take position in:

Exposure HC Equivalent Exposure

No. of Contracts = No. of Contracts =
Contract Size Contract Size
Exposure
HC Equivalent Exposure =
Futures Price

 Numr and Denr should be in sameopt currency

 Numr and Denr should be in same currency
 No. of contracts to be rounded off  No. of contracts to be rounded off

Effects 110,000 No of 11000010.021

20.000 contact 200,000
5.55 26.19
6 contract long ie 26 contract
short
Settle the open positions on maturity:

Final HC inflow or outflow on expiry will consist of: Remember to convert to

Component Foreign Currency Futures Home Currency Futures CSI

0021 0.024 x E 200,000
Dash butement
Gain or loss on futures
6 65 20,000 26 contract
Relevant rates: F0 & FT 6 contracts 15600 1 F
E 3.60.000 IF E 1560010.023 I 6,7862
Spot met
1,10000 67 110.000 0.023
Settlement of FC
receivable or payable
I 7370,000 OF OF
Relevant rate: ST or E(ST)
I 47,82 609
210,000 6 121 X 210.000 26 121
3112
Interest lost on margin 3 12
Always an outflow
7800 OF
I 1800 OF
Net of
Total HC inflow or outflow 800 of 5468,670
Exfortes Iportee
182
Adish Jain CA CFA
Foreign Exchange & International Financial Management

option to sell the underlying

5. Hedging through Options buy E
assets ie exercise price
Practical Questions: _______________________ Practice Problems: ________________________

Hedging through option can be done by buying Call or Put options (i.e., only long positions). For
the purpose of hedging, options are assumed to be settled by delivery.

on
Expiry date ofoptions
3m
Hedging starts hedging over
Take a position in option contract Settle the open positions

Identify option’s currency Hedged & unhedged exposure

Decide between call & put Derivatives Settle hedged exposure Delivery
settlement
Number of contracts SPLIT Settle unhedged exposure

Premium on call or put option

Points of consideration:
 Option given in the question is on the currency:
o for which lot size is given
o that is the base currency of exercise price (E)
o other than the currency in which premium is quoted
Lot Size $20000 NA
Exercise ₹ 50/$ €/¥ 0.008
Premium ₹ 0.05 € 0.0002
Option is on:

 Premium on option on one currency is in terms of other currency.

 When is call & put exercised:
Call
STD E
Put
ST SE
183
Adish Jain CA CFA
Foreign Exchange & International Financial Management

Foreign Currency Options Home Currency Options

AFC payable in COF OF
ITC Ltd has $105000 3m.
I
ITC Ltd has $105000 payable in 3m.
₹/$ Spot Price 3m Fwd Price $/₹ Spot Price 3m Fwd Price
Today 64 68 Today 0.016 0.017
After 3m 67
33 NA After 3m 0.018 NA
Exercise Price: ₹ 65 Exercise Price: $0.019
Contract size: $20,000 Contract size: ₹1,00,000
Premium: Call: ₹0.8 Premium: Call: $0.002
Put: ₹0.7 Put: $0.003

Take a position in Options today:

1. Identify the currency on which options are given.

Given option is on: Given option is on:

Because: ___________________________
E Rate is of
Because: E Rate is
___________________________
of
is contract size is
___________________________ ___________________________
Contract size
___________________________ ___________________________
premium in teeny of premium in terms of
2. Decide between call or put option.

Note that hedging can be done only using long position. Based on the golden rule of hedging:

FC Receivable FC Payable FC Receivable FC Payable

Would sell Would buy Would sell FC Would buy FC

FC in ot FC Ffp or buy HC or sell HC

long POT long CALL

long call long PUT
will call today
In this case: ____________________________ Will Put
In this case: ____________________________
Buy today
buy
E 65 0.019
21
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Adish Jain CA CFA
Foreign Exchange & International Financial Management

3. Determine the number of contracts to take position in:

Exposure HC Equivalent Exposure

No. of Contracts = No. of Contracts =
Contract Size Contract Size
Exposure
HC Equivalent Exposure =
Exercise Price

 Numr and Denr should be in same currency  Numr and Denr should be in same currency
 No. of contracts to be rounded off  No. of contracts to be rounded off

No of 105.000 105000080.019
contracts 20,000
Etihad
2100000
5 25
55.26
ie 5 21 call option
contractilong
it 55 HE put
contract long
Settle the open positions on maturity:
1. Bifurcate the total exposure into hedged & unhedged (i.e., under-hedged & over-hedged) based on
the number of contracts taken

Foreign Currency Options Home Currency Options

= No. of lots x size per lot = No. of contracts x size per lot x E

Hedged exposure 5x 20.000 55 700.000 0.019

100.000 1.04.55.00

= Total Exposure – Hedged exposure = Total Exposure – Hedged exposure

Under or over
hedged 105.000 100000 1 05,000 1,04500
exposure: Under- 5000 500
hedging means
hedging less than Settlement of unhedged exposure will lead to:
exposure & Over-
hedging means Under-hedged Over-hedged
hedging more Call Option
than exposure.
Put Option

185
Adish Jain CA CFA
Foreign Exchange & International Financial Management

2. Final inflow or outflow on maturity will consist of:

a. When ST or E(ST) are given in the question:

Component Foreign Currency Options Home Currency Options

Settlement of hedged Call not exercise
exposure 100000 63
Relevant rate: E or E(ST),
depends on exercise of option E 63.00.000 OF

Settlement of unhedged 7000 63

exposure I 315,000 OF
Relevant rate: ST or E(ST)

Premium Paid* Scontract 20,000

Relevant rate: S0 0.8
Always an outflow
80,000 107

Total HC inflow or outflow 6695000 OF

expt ftp OR

b. When ST or E(ST) are not given in the question:

Settlement of hedged compulsory Exercise compulsory Exercise

exposure 1 00,000 X 65 1,04500 0.019
Relevant rate: E
OF OF
65,00000 I 5,500,000
Settlement of unhedged 5000 68 500 0.017
exposure
Relevant rate: Forward Rate# I 3.40.000 OF 29412 10K

Premium Paid* contract 20,000 55 1,00000 0 003

Relevant rate: S0 0.8 16500
Always an outflow
280,000 1 F
161090.016 10
t.FI
69.20.000 OF
Total HC inflow or outflow
I 65606621017
Remember to convert to
#
Recollect that according to PET, E(ST)=F.
*Note that interest lost on premium can be ignored by putting a note at the end of the question.
186 pHexpection theory because premium is
Adish Jain CA CFA
paid opt
Foreign Exchange & International Financial Management

G. Important Residual Topics

1. Foreign Currency Accounts Pg 267 also
Practical Questions: _______________________ Practice Problems: ________________________

 Nostro (Our account with you): This is a current account maintained by a domestic bank or
dealer with a foreign bank in the foreign currency.

Banks or Dealer maintain two types of books for its transactions:

1. Exchange Position: All the transactions that the bank has entered, whether for immediate
delivery (spot transactions) or delivery on a future date (forward transactions), are
recorded in this book.
2. Cash Position (Nostro Account): Only transactions with actual delivery are recorded in this
account.

 Vostro (Your account with us): This is a current account maintained by a foreign bank with a
domestic bank in our home currency.

 Loro Account (Their account with you): This is a current account maintained by one domestic
bank on behalf of other domestic bank with the foreign bank in the foreign currency.

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Adish Jain CA CFA
Foreign Exchange & International Financial Management

2. FC Borrowing and Investment Decision

Practical Questions: _______________________ Practice Problems: ________________________

As compared to investment or borrowing in HC, investment or borrowing in FC involves an

addition risk of exchange rate fluctuation that can significantly impact the return on investment
or cost of borrowing.

Borrowing in FC Investment in FC

on 3m on 2
3m

Int
Borrow petty Invest red
y
Spattie 38 spattie 38
HEE HEE
IF 4 OF effective
Example: Cost of borrowing in FC ($) is 10%. Example: Rate of return in FC ($) is 10%.
If Then, cost in HC (₹) If Then, return in HC (₹) 74
FC ↑ by 5% FC ↑ by 5%
1 1 1.05 1 155 1 1 1.05 1 15.5
FC ↓ by 5% 1 1 0 95 1 4.5 FC ↓ by 5% 1 1 0 95 1 4.5

HC ↑ by 5% HC ↑ by 5%

HC ↓ by 5% HC ↓ by 5%

Note that if forward rate is given in place of E(ST), then replace appreciation & depreciation with
forward premium & discount respectively. Calculation of cost of borrowing or return on
investment will remain same.

Deciding the currency of investment or borrowing:

Borrow in the currency that results in lower outflow of HC at maturity.

Invest in the currency that results in higher inflow of HC at maturity

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Adish Jain CA CFA
Foreign Exchange & International Financial Management

3. International Cash Management

Practical Questions: _______________________ Practice Problems: ________________________

Cash Management Systems in MNCs aims to optimize cash flow movement & utilize cash balance
optimally. If it is surplus we will sell the amount
Centralized CMS It deficit we will Buy the amount
pay
Excess cash balances of subsidiaries are pooled together with parent & cash deficit
requirements are met by the parent.

I ty

Parent India I
subs I 2 Interest
london me

I
NY
spfate
Decentralized CMS
Each subsidiary is viewed as separate undertaking from the parent and cash positions are
managed independently.

og ly

I Intrust E
India
attest t
london I me
antest
Ny
bulate
08 E ST
189
Adish Jain CA CFA
Foreign Exchange & International Financial Management

4. International Capital Budgeting

Practical Questions: _______________________ Practice Problems: ________________________

Evaluation of an investment proposal in a project in foreign country involves additional

complexities of converting CFs from one currency to another and determining the appropriate
discount rate to calculate the NPV. There are two approach with which NPV of a project in foreign
country can be calculated:

Home Currency Approach Foreign Currency Approach

l l l

Bag

E E E NPV DR i
E E
So
I
1C ENPV
DR E ENPV HC

Relationship between DRFC & DRHC

DRFC 1 REC 1 Risk premium

Riska
1 DRAC 1 RE premium

Note that
 Final answer should be in terms of HC.
 CFs in FC & HC should be discounted by DRFC & DRHC respectively.
 Conversion of CFs from FC to HC may be done at forward rate or expected spot rate, given
directly or calculated using IRPT or PPPT.

190
Adish Jain CA CFA
also
Tfiid Budging
Foreign Exchange & International Financial Management

5. Adjusted Present value

095
The APV or Adjusted NPV model of capital budgeting process considers each cashflow individually
and discounts at a rate consistent with risk involved in that cash flow. First, NPV is calculated
assuming that the project is fully financed by equity (called as base case NPV) then adjustment
regarding effect of financing is done.
2 3
Baste P.V of TAX
Adjusted SAVINGS 7T
Coffey ion
NPV outcast
COST
on Debt

Relevant Discounting Rate:

Cash Flow Discounting Rate

1 Base Case NPV Ke

2 Tax saving of Int
Pretax Kd
3 FC

6. Issue of ADRs, GDRs & IDRs

96
Depository receipt is a negotiable certificate that represents the company's publicly traded equity
shares. DRs are issued in a country & currency, not native to issuer. When such DRs are issued in
USA, it’s called ADR; in India, it’s called IDR & in rest of the cases called as GDR.
Example: If RIL wants to raise money through equity shares in USA, it will have to issue ADR in
USA denominated in USD.

Issue Price: FP go.ge Distount Net Proceeds

per DR: Issueprite
r
21 Flaation Gst
Number of Dost of DR: DI
DRs to be i Fund to be (like we have Ke) g
issued: Raised fiteeds
Net proceed
191
RIL shares.IE Adish Jain CA CFA
Depository
go
DR I go
India El USA 1
Foreign Exchange & International Financial Management

192
Adish Jain CA CFA
Advanced Capital Budgeting
Decisions
Advanced Capital Budgeting Decisions

A. Basics of Capital Budgeting

Capital Budgeting decisions are investment decisions related to expansion of operations,
replacement of an asset or diversification into a new product or market.
Let’s recollect important basics:
 What matters is cash flow and not profit.
 Opportunity cost is relevant if any benefit is forgone because of the project.
 Working capital is OF today and IF at the end.
 Both cashflows and discounting rate should be post-tax.
 Sunk cost is irrelevant.
 Allocated overheads are irrelevant.
 Recollect from ‘Basics of SFM’: Discounting rate used to calculate PV of future cashflows is
the required rate of return by the financers from the project. Hence, whether the discounting
rate would be Ke or Ko would depend on:
If cashflow belong to: Then discounting rate:

All capital providers

Ko
Only Equity
ke
Note that in case of all equity financed project, we don’t need to think on this point.
 Recollect from ‘Basics of AFM’: Discounting rate used to calculate PV of future cashflows
depends on the nature of cashflows. Hence, cashflows and discounting rate should be
aligned:
Nature of cashflow Real Nominal

Real Riskfree Rate Nominal Risk repate

Risk-free

Risky
Real Risky Rate Nominal Resky Rate

193
Adish Jain CA CFA
Advanced Capital Budgeting Decisions

 Conversion of CFs and Rate from Real to Nominal and viceversa. 17 189

Nominal Fm Real CFa 81 Inftal

1 nominal rate 1
reef 1 Inflation
premium
Techniques of incorporating Risk in Capital Budgeting Decisions

 Probability
Statistical Techniques  Variance or Standard Deviation
 Coefficient of Variation

 Risk-adjusted Discount Rate

Conventional Techniques  Certainty Equivalent Approach

 Sensitivity Analysis
 Scenario Analysis
Other Techniques  Simulation Analysis
 Decision Tree

194
Adish Jain CA CFA
Advanced Capital Budgeting Decisions

A. Statistical Techniques
1) Probability
Calculate the NPV of the project if initial investment is ₹ 10,000, discounting rate is 10% and
inflows are expected as follows:

Year 1 Year 2 Year 3

Probability Cashflows Probability Cashflows Probability Cashflows

0.2 4,000 0.1 6,000 0.3 8,000
0.5 5,000 0.6 7,000 0.5 9,000
0.3 6,000 0.3 8,000 0.2 10,000

Step 1 Calculate Expected Inflows for all the years:

E CFI 0.2 5000 0 tt 6000 0.3

_______________________________________________________________________
4000
25100
_______________________________________________________________________

E
_______________________________________________________________________
RFR
_______________________________________________________________________
7200
ERCF3
_______________________________________________________________________

8900
_______________________________________________________________________

Step 2 Calculate NPV using above expected inflows and given initial outflow:

Year ECCF D8 DCF

I 5100 0909 4635.9
2 7200 0.826 5947.2
3 8900 0.751 6683 9
PV of ECCFs 17267
1 PV of OF 10,000
Expected NDV I 7267

195
Adish Jain CA CFA
Advanced Capital Budgeting Decisions

2) Variance, Standard Deviation and Coefficient of Variation

In this method, the decision of investment in a project is based on the risk involved in the project.
Risk of cashflows from the project is calculated using statistical measures like Variance, Standard
Deviation and Coefficient of Variation.

Below are the inflows of two projects for a given year:

Project A Project B
Probability Cashflows Probability Cashflows
pa pa
0.2 2,000 0.1 12,000
0.5 3,000 0.6 14,000
0.3 4,000 0.3 16,000

Step 1 Calculate Expected Inflows of both the project:

E 0.2 4000 0.3

_______________________________________________________________________
CFA 2000 3000 0.5
3100
_______________________________________________________________________

E
_______________________________________________________________________
CFB
_______________________________________________________________________
14400
Step 2 Calculate Variance (σ 2) of the cashflows:
2
2000 3100
02 3100 3000
_______________________________________________________________________
0.5
4000 3100 24.90.000
_______________________________________________________________________
x 0.3
TÉ 552 2000 1440077 01 14000 14400
_______________________________________________________________________ 0.6
16000 14400
_______________________________________________________________________
0 3 1440,000
Step 3 Calculate Standard Deviation (σ ) of the cashflows:

2490000 700
_______________________________________________________________________
TA Avg fluctuation
1440.000 1200 About
_______________________________________________________________________
TB in E
terms
Step 4 Calculate Coefficient of the Variation of the cashflows:
1 1 Ecr
in
_______________________________________________________________________
Ang fluctuation
Relates
CV 700 1200
CVB
_______________________________________________________________________
A
3100 14400
_______________________________________________________________________

196 22.581 8.331

Adish Jain CA CFA
highes Risk lower Risk
for Pg 514
loncept If EL 5 off expected NPV
Advanced Capital Budgeting Decisions

B. Conventional Techniques
1) Risk Adjusted Discount Rate
15,16
This method involves using NPV for taking investment decision. As we know that the discount
rate used to calculate PV of cashflows from the project is the required rate of return from the
project. And the rate of return required depends on the risk involved.
Proiect
Reg Rate of Retor RF Rate Risk prem.mn
________________________________________________________________________________________

of a project
________________________________________________________________________________________
Add 9 return for
used to calculate taking additional risk
________________________________________________________________________________________

NPV
2) Certainty Equivalent Approach 14
CE method involves using NPV for taking investment decision. In this method, cash flows from
the project are adjusted to remove the effect of risk involved in them and the discounting rate
used has no effect of risk premium included into it.
 Equivalent Certain CFs are calculated by multiplying Risky CFs with CE Coefficient (α).
 Rate used to discount the CFs is a Risk-free Rate

Below are the CFs of a project:

RF rate 1011
Year Cashflows CE Coefficient
0 -40,000
I No Risk
1 20,000 0.90
2 25,000 0.85
3 45,000 0.75

Steps Calculate Equivalent Certain CFs and calculate NPV using Rf

Years REET Eff Certain CF PVF DCF

_______________________________________________________________________

4019 40.000
_______________________________________________________________________

2019 18000
_______________________________________________________________________
1
2 25k 0.85 21250
_______________________________________________________________________

3 45k 0.75 33750

_______________________________________________________________________
I 19260.7J
NPV
_______________________________________________________________________

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Adish Jain CA CFA
Advanced Capital Budgeting Decisions

C. Other Techniques
1) Sensitivity Analysis
This method involves analyzing the % changes in NPV (or IRR in certain cases) of a project by
making the a particular % change in different variables (or inputs like initial cost, life of the
project, sales price, costs, etc.) that were used in calculating that NPV. This helps in identifying
the most crucial variable for which the project is most sensitive.

Details of a project having 3 years of life and 10% discounting rate:Ringwove dep D
Variables Particulars Amount
1 Initial Cost
I 1,00 000
E 50
2 Sales Price
3 Units Sold p.a. 2000
4 Fixed costs p.a.
30.000
Step 1 Calculate NPV of the project:

NII PV of Casey PV of
cash

50 2000 30,000 50 2000 39000

t
II II

50 2000
3
39000 1.00.000
II
74080

adversely
Step 2 Change all the variables one by one by a particular rate (%) and calculate revised NPVs.
A
Assumed
101
Initial Gst
_______________________________________________________________________

cost
If
_______________________________________________________________________
increase
101
by
Revised
Jutiial Cost Ilars 104
_______________________________________________________________________
gff
110.000
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Adish Jain CA CFA
Advanced Capital Budgeting Decisions

Revised NPV
_______________________________________________________________________
150 150
_______________________________________________________________________
39000
211 2219239000 1
_______________________________________________________________________
150 1.10.000 64080
_______________________________________________________________________
21195.39000
_______________________________________________________________________
in NPV 64080 74080 13.5
_______________________________________________________________________
due to 10 74080
_______________________________________________________________________
Δ in initial cost
_______________________________________________________________________

Think what should be the initial cost

_______________________________________________________________________
for
if NPV to 280
_______________________________________________________________________
be
50 2000 30,000 150 2000 30,000
_______________________________________________________________________
II t II
_______________________________________________________________________
Ét 150 20007 30,000 0
_______________________________________________________________________
1173
_______________________________________________________________________

174080
_______________________________________________________________________
_______________________________________________________________________
Δin Initial 174080 100000
_______________________________________________________________________
Cost to make
1.00.000
_______________________________________________________________________
NPV zero
ie 1001 negative 74 08
_______________________________________________________________________
Δ
_______________________________________________________________________
_______________________________________________________________________
Sale
price
Revised sale price
_______________________________________________________________________
50 10 45
Revised NPV
_______________________________________________________________________

145 145
_______________________________________________________________________
39000
212 2129239000 1
_______________________________________________________________________

145 190.000 49211

_______________________________________________________________________
22295.39000
_______________________________________________________________________
in NPV 49211 74080 33057
_______________________________________________________________________
due to 10 74080
Δ in Salesprile
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Adish Jain CA CFA
Advanced Capital Budgeting Decisions

2) Scenario Analysis 931,20

This technique involved analyzing the NPV (or even IRR) calculated under different possible
scenarios of CF Inflows, useful life, etc.
Details of a project having initial outflow of ₹ 50,000 and 10% discounting rate:
Scenario Cash Inflows Project Life
Best
22000
Base
Worst
20.000
15000
Ff
Steps
Yy
Calculate NPV of the project under different scenarios:

Scenario Best Case Base Case Worst Case

Inflows p.a. 15000
27,000 20.000
 PVAF (10%, n years) 4 355 3 791 3170
PV (IF)
95810 75820 47550
- PV (OF)
50,000 50000 5,0000
NPV
45.810 25,820 2450

Prob 10 50.1
_______________________________________________________________________
40.1
_______________________________________________________________________

Exp NPV 16511

_______________________________________________________________________

3) Simulation Analysis
Simulation Analysis is a technique, in which infinite calculations are made to obtain the possible
outcomes and probabilities for any given action.
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

200
Adish Jain CA CFA
Advanced Capital Budgeting Decisions

4) Decision Tree analysis

Decision tree is a graphic display of the relationship between a present decision and future
events, future decision, and their consequences.
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

201
Adish Jain CA CFA
Advanced Capital Budgeting Decisions

Existing machine
D. Replacement Decision new machie
1) Replacement of Existing Machine 23.29

1 2 3

30,000 30.000 30,000

58,800 SV O
BV O

600 400,000 100.000 100.000

Salvage value
50,000

Anc OF Inr Ias

_____________________________________________________________________________
Ifs p.at SV
70,000 50000
_____________________________________________________________________________
2,00000
_____________________________________________________________________________

Assume
_____________________________________________________________________________
2.487 8 10
I_____________________________________________________________________________
174090
0.751
_____________________________________________________________________________
37550
_____________________________________________________________________________

If Incremental NPV
_____________________________________________________________________________
11640
_____________________________________________________________________________
positive
5
_____________________________________________________________________________
Replace
_____________________________________________________________________________

This deals with Replace Krna

_____________________________________________________________________________
nahi
haiya
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

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Adish Jain CA CFA
Advanced Capital Budgeting Decisions

2) Optimum Replacement Cycle 22,26 27 28

deals with Kab Replace Krna Mai

_____________________________________________________________________________
This
_____________________________________________________________________________

Ophon Option
_____________________________________________________________________________
1 2
_____________________________________________________________________________
_____________________________________________________________________________

chaloo
_____________________________________________________________________________
chadao
By
_____________________________________________________________________________ 2y
PV
_____________________________________________________________________________
of
xx Initial cost
_____________________________________________________________________________
xx
XX maint'cost XX
_____________________________________________________________________________
operating
X
_____________________________________________________________________________
1 I
salvage value
xxx
_____________________________________________________________________________
x
NOT COMPARABLE PVAF
_____________________________________________________________________________
PVAF13y zy
_____________________________________________________________________________

Equivalent Annual Cost EAC X

_____________________________________________________________________________
_____________________________________________________________________________
COMPARABLE
E. Real Options
30,32 33,34
Real Options methodology is a technique of capital budgeting where projects are evaluated using
the approach learnt in Option Pricing Theory in Derivatives.
The methods used in valuation of real options are same as used in valuation of Financial Options
like call or put.
1. Binomial Model
same
2. Risk Neutral Method
3. Black-Scholes Model
Note that above concepts are already learnt in the chapter of Derivatives. They are now to be
applied from the point of view of Options available in real world investment projects & not in
financial securities.

Note: The concept of Adjusted Present Value has been discussed in the chapter of ‘Foreign Exchange’.
203
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Advanced Capital Budgeting Decisions

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________+_______________

204
Adish Jain CA CFA
Risk Management & Security Analysis

A. Risk Management
1) Value at Risk (VaR)

Practical Questions: _ Practice Problems: __

Value at Risk is a measure of risk. Given a normal market condition, it tells us the maximum loss
that an investment might suffer in a given period and at given confidence level.

2 0
_____________________________________________________________________________
_____________________________________________________________________________

x̅ Expected value of or portfio

_____________________________________________________________________________
generally
_____________________________________________________________________________

H minimum Value or return

of portfolio which
_____________________________________________________________________________

we can to have Cat

afford
_____________________________________________________________________________
given probability
or confidence level
_____________________________________________________________________________
_____________________________________________________________________________

x̅
x_____________________________________________________________________________
Max loss we can afford at a given probabity
or confidence level
_____________________________________________________________________________
_____________________________________________________________________________

6 5 Returns which
_____________________________________________________________________________
of the period for
maxloss
of
to be calcuted
_____________________________________________________________________________
_____________________________________________________________________________

205
Adish Jain CA CFA
we might need to solve for anyof these
Risk Management & Security Analysis

_____________________________________________________________________________
times Max loss
2 x x̅
_____________________________________________________________________________
_____________________________________________________________________________
r
_____________________________________________________________________________
prob from normal distribution
table
_____________________________________________________________________________
for this 2
_____________________________________________________________________________

B. Security Analysis
Practical Questions: _______________________ Practice Problems: ________________________

1) Arithmetic Moving Average (AMA) | Exponential Moving Average (EMA)

 AMA means the simple
average of prices of Pt Pet 11 Pat 2
last n period n
 EMA is weighted average price of last n period. Calculation of EMA is mechanical (process
driven)
 Exponent a
1
where n no
of dayof moving org
___________________________________________________________

 EMA ___________________________________________________________
t

Py X a EMA e e 11 91
___________________________________________________________

 Market Trends:
price

Time

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Adish Jain CA CFA
Risk Management & Security Analysis

2) Run - Test
used to test Weak Form
Efficiency
_____________________________________________________________________________
t T 21h2 2nd na ne N2
_____________________________________________________________________________
M 21,1122 ni the net 72 1
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
No
n of positive changes nz No of negative changes
_____________________________________________________________________________
_____________________________________________________________________________
Ut t 5 upper limit
_____________________________________________________________________________

If 8 is with
_____________________________________________________________________________
thisrange then
no
of chong
_____________________________________________________________________________
in direction
Frp
_____________________________________________________________________________
µ to lower limit
_____________________________________________________________________________
t degree
of freedom
3) Serial Correlation Test Auto Correlation Test

used test Weak Form

_____________________________________________________________________________
to
Efficiency
_____________________________________________________________________________

Price
_____________________________________________________________________________
data of 20
years
_____________________________________________________________________________
oy log 20g
_____________________________________________________________________________
1
_____________________________________________________________________________
Absolute change Absolute change
_____________________________________________________________________________
series
series 2
_____________________________________________________________________________

Correlation 8
_____________________________________________________________________________

w two series
_____________________________________________________________________________
b
Not even w F
_____________________________________________________________________________
is serial correlation
If f is Miss weak form
efficient 207
Adish Jain CA CFA
Risk Management & Security Analysis

208
Adish Jain CA CFA
Theory Topics

Table of content...
1. Financial Policy And Corporate Strategy ........................................................ 214
2. Risk Management ......................................................................................... 218
3. Advanced Capital Budgeting Decisions (Sm 2024) ......................................... 222
4. Security Analysis ............................................................................................ 224
5. Security Valuation ......................................................................................... 232
6. Portfolio Management .................................................................................. 235
7. Securitization ................................................................................................. 242
8. Mutual Funds ................................................................................................ 249
9. Derivatives Analysis And Valuation ............................................................... 257
10. Foreign Exchange Exposure And Risk Management ...................................... 264
11. International Financial Management ............................................................ 269
12. Interest Rate Risk Management .................................................................... 273
13. Business Valuation ........................................................................................ 275
14. Mergers, Acquisitions And Corporate Restructuring ...................................... 276
15. Start-Up Finance ............................................................................................ 279

209
Adish Jain CA CFA
Theory Topics

Theory Questions from Past Exam Papers, RTPs & MTPs

Startup Finance:
o Write a short note on Venture Capital Fund. (Nov 22)
o “A limited Partnership Entity, in India, is not recognised for the purpose of Venture Capital Fund” Do
you agree? Briefly explain the structure of Venture Capital Funds in India. (May 23)
o Discuss Bootstrapping as a mode of financing for startups and describe the various methods of
bootstrapping. (RTP, MTP)
o What is the mode of financing is called in Startups, when a person attempts to found & build a
company from personal finances or from the operating revenues of a new company. Explain briefly
the methods of this mode. (Dec 21)
o An individual attempts to found and build a company from personal finances or from the operating
revenues of the new company. What this method is called? Discuss any two methods. (Nov 20, Nov
22)
o Write the characteristics of Venture Capital Financing. (Nov 21)
o Peer - to - Peer Lending and Crowd funding are same and traditional methods of funding. Do you
agree? Justify your stand. (Nov 20, MTP Nov 23)
o Non-bank Financial Sources are becoming popular to finance Start-ups. Discuss. (Nov 20)
o Explain Indicative Risk Matrix of each stage of funding for Venture Capital Financing. (July 21)
o Venture Capital Funding passes through various stages. Discuss. (Nov 20)
o State briefly the basic characteristics of venture capital financing (Nov 19)
o What is a startup to avail the benefits of government scheme? (May 22, Nov 19)
o Explain Angel Investors. (May 22, Nov 18)
o Explain Pitch Presentation. List the methods for approaching a Pitch Presentation. (May 21)
o Explain briefly the sources for funding a Start-up. (May 23, May 19)
o Explain the advantages of bringing venture capital in the company. (May 18)
o Mr. R has completed his studies and wants to start his new online business. For a successful online
business there are various expenditure costs with regards to advertisement & application
development, to make the business successful he wants to raise funds. Explain some of the innovative
sources for funding a start-up. (RTP Nov 21)
o Compare and contrast start-ups and entrepreneurship. Describe the priorities and challenges which
start-ups in India are facing. (RTP Nov 19)
o EXPLAIN Startup India Initiative. (RTP Nov 18)
o ‘Venture Capital Financing is a unique way of financing Startup’. Discuss. (Answer: Characteristics of
Venture Capitals) (RTP May 21)
o Who are Angel Investors and how they are different from Venture Capitalists. (MTP Nov 21)

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o Explain alternatives available to offshore investors for making investments in Venture Capital Funds
in India. (MTP Nov 21)
o Explain the basic documents that are required to make up Financial Presentations during Pitch
Presentation. (MTP May 20)
o During Pitch Presentation to convince the investors to put money into the proposed business how
promoters deal with following points:
(i) Problem (ii) Solution (iii) Marketing/Sales (iv) Business Model (MTP Nov 23)
o NIYA Healthcare is a proprietary concern engaged in the manufacture and development of
pharmaceutical products since last five years. To scale up the business operations and increase the
present turnover which is hovering around 500 million, the proprietor decides to convert his existing
business into a Private Limited Company. He also wants to get access to various tax benefits, easier
compliances under the startup India initiative and get recognized as a startup company. Advise
whether NIYA Healthcare can be recognized as a startup company in view of the criteria considered
eligible for the startup recognition initiated by the Government of India? (Nov 23)
o "In Deal Structuring, in many structures to facilitate the exit, the Venture Capital may put a tag-along
clause". What do you mean by that clause? Explain Deal Structuring and Exit Plan to Venture Capital
Investment Process. (Nov 23)

Securitization
o What are the features of Securitization? (Nov 22)
o Explain the pricing of the securitized instruments. (Nov 21)
o Distinguish between Pass Through Certificates (PTC) and Pay Through Securities (PTS) (May 23)
o Participants are required for the success of the securitisation process. Discuss their roles. (Nov 21)
o The process of securitisation can be viewed as process of creation of additional financial product of
securities in the market backed by collaterals." What are the other features? Describe.
o Explain the benefits of Securitization from the perspective of both originator as well as the investor.
(May 18, Nov 19)
o State the main problems faced in Securitization in India? (Nov 19, May 21)
o Discuss about the Primary Participants in the process of Securitization. (Nov 18)
o Briefly explain the steps involved in Mechanism of Securitization. (May 19, May 18)
o Explain the Secondary Participants involved in the process of Securitization of Instruments. (RTP May
21)
o Distinguish between: Primary Participants and Secondary Participants in securitization. (RTP May 18)
o “While pricing the securitized instruments, it is important that it should be acceptable to both
originators as well as to the investors”. Explain. (MTP Nov 21)
o “Securitisation is the process of repackaging or rebundling of illiquid assets into marketable
securities”. EXPLAIN. (Answer: Steps of Securitization) (MTP May 22)
o Beside the primary participants other parties are too involved in the process of securitization. Explain
them briefly. (MTP Nov 23)
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o Not only Bundling and Unbundling is only feature of Securitisation, there are other features too of the
same. Explain. (MTP Nov 23)
o “Though in recent period of time the concept of securitisation has become popular in India as a source
of off-balance Sheet source of financing but its level of growth is still far behind” Explain. (Answer:
Problem faced by securitization in India) (MTP Nov 23)
o "Lack of existence of a well-developed debt market in India, is an obstacle that hinders the growth of
the Secondary Market of securitized or asset backed Securities". Is it true? What are the other
problems in Securitization Process (Nov 23)

Financial Policy & Corporate Strategy

o As a financial strategist you will depend on certain key financial decisions. Discuss. (Nov 20)
o Discuss briefly the key decisions which fall within the scope of financial strategy. (Nov 19)
o State the strategy at different hierarchy levels. (May 21)
o Explain the interface of Financial Policy and Strategic Management. (May 18)
o Explain the traits that an organisation should have to make itself financially sustainable. (May 23)
o How financial goals can be balanced vis-à-vis sustainable growth? (RTP May 20)
o Financial Resources, Financial Tools and Financial Goals are outcomes of Financial Planning. Do you
agree with this statement? (MTP Nov 21)
o “Sustainable growth is important to enterprise long-term development”. Explain this statement in
context of planning healthy corporate growth. (MTP Nov 20)
o Explain the specific steps that make an organisation sustainable. (MTP May 21)
o EXPLAIN outcomes of the Financial Planning. (Nov 22)
o Describe the main function of corporate level strategy and state which three basic questions it should
be able to answer. (Nov 23, MTP Nov 23)

Risk Management
o Briefly explain: (a) Compliance risk and (b) Operational risk (May 22)
o Which type of risk covers the default by the counterparty? List out the ways to manage this type of
risk. (Nov 21)
o What is Financial Risk. How different stakeholders view the financial risk? (Nov 18, MTP Nov 23)
o Describe the main features of Value-at-Risk (VAR). (May 21)
o List the main applications of Value at Risk (VAR). (Mov 22, May 19)
o Explain how an organization interested in making investment in foreign country can assess Country
Risk and mitigate this risk. (RTP May 21)
o EXPLAIN the main risk that can be faced by an overseas investor. (Answer: Political Risk) (MTP May
22)
o What do you mean by term “Counter Party Risk”. Explain various hints that may provide an indicator
of the same risk. (MTP Nov 23)
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o List out the four methods for Identification and Management of Financial Risk. What are the
parameters to identify the currency risk? (Nov 23, RTP Nov 19)

Security Analysis
o Describe briefly on which principles Technical Analysis is based. (Nov 21)
o In an efficient market, technical analysis may not work perfectly. However, with imperfections,
inefficiencies and irrationalities, which characterises the real world, technical analysis may be helpful.
Critically analyse the statement. (Nov 20)
o Explain various “Market Indicators”. (RTP Nov 20)
o EXPLAIN the challenges to Efficient Market Theory. (RTP Nov 18)
o Explain the factors affecting economic analysis. (RTP May 20)
o DESCRIBE the factors affecting Industry Analysis. (RTP May 19)
o EXPLAIN Dow Jones theory. (MTP Nov 18)
o Discuss the various techniques used in economic analysis. (MTP May 19)
o Describe the concept of ‘Evaluation of Technical Analysis’. (MTP May 19)
o Explain Random Walk theory. (MTP May 18)
o In a rational, well ordered and efficient market, technical analysis may not work very well". Is it true?
List out the reasons for this statement regarding Technical Analysis. (Nov 23)

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1. FINANCIAL POLICY AND CORPORATE STRATEGY

1. Strategic Financial Management & it’s Functions
SFM means application of financial management techniques to strategic decisions in order to help
achieve the decision-maker's objectives. It is basically about the identification of the possible
strategies capable of maximizing an organization's market value. It involves the allocation of scarce
capital resources among competing opportunities.
Investment and financial decisions involve the following functions:
a. Continual search for best investment opportunities;
b. Selection of the best profitable opportunities;
c. Determination of optimal mix of funds for the opportunities;
d. Establishment of systems for internal controls; and
e. Analysis of results for future decision-making.

2. Key Decisions falling within the Scope of Financial Strategy

1. Financing decisions: These decisions deal with the mode of financing and mix of equity and debt in
the capital structure.
2. Investment decisions: These decisions involve the profitable and optimum utilization of firm's funds
especially in long-term capital projects. Since the future benefits associated with such projects are
not known with certainty, investment decisions necessarily involve risk. The projects are therefore
evaluated in relation to their expected return and risk.
3. Dividend decisions: These decisions determine the division of earnings between payments to
shareholders as dividends and retention with the company for future reinvestment.
4. Portfolio decisions: These decisions involve evaluation of investments based on their contribution
to the aggregate performance of the entire company rather than on the characteristics of
individual investments (Just like we read in portfolio management that risk & return of entire
portfolio is to be considered rather than individual securities).

3. Strategy at different Hierarchy Levels

Let us take the example of Corporate Level Strategy

Reliance Industries Limited (RIL)...
RIL
Business Level Strategy
Oil Telecom
Business Business
Manufacturing

Operations
Marketing

Marketing

Functional Level Strategy

Finance
HR

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Corporate Level Strategy:

 Corporate level strategy fundamentally is concerned with selection of businesses in which a
company should compete. It also deals with the development and coordination of that
portfolio of such businesses. (Strategy at RIL level will come under this)
 Corporate level strategy should be able to answer three basic questions:
Suitability: Whether the strategy would work for the accomplishment of common
objective of the company.
Feasibility: Determines the kind and number of resources required to formulate and
implement the strategy.
Acceptability: It is concerned with the stakeholders’ satisfaction and can be financial and
non-financial.

Business Level Strategy

 Strategic Business Unit (SBO) is a profit centre that can be planned independently from the
other business units of a corporation. Strategies formed to accomplish objectives of SBOs are
Business Level Strategies. (Oil Business Unit or Telecom Business Unit is an SBO)
 Business Level Strategy deals with practical coordination of operating units and developing
and sustaining a competitive advantage for the products and services that are produced.
Functional Level Strategy
 Functional Level Strategies include strategies at the level of operating departments like R&D,
operations, manufacturing, marketing, finance, and human resources.
 Functional level strategies involve the development and coordination of resources through
which business unit level strategies can be executed effectively and efficiently.

4. Financial Planning & Outcomes of Financial Planning

Financial Planning = Financial Resources + Financial Tools + Financial Goal
Financial planning is a systematic approach to maximize his existing financial resources by utilizing
financial tools to achieve his financial goals. Financial planning is the backbone of the business
planning and corporate planning.

Outcome of Financial Planning = Financial Objective, Financial decision-making & Financial measures

Financial objectives are to be decided at the very beginning so that rest of the decisions can be taken
accordingly. The objectives need to be consistent with the corporate mission and corporate objectives.
Financial decision making helps in analysing the financial problems that are being faced by the
corporate and accordingly deciding the course of action to be taken by it.
Financial measures like ratio analysis, analysis of cash flow statement is used to evaluate the
performance of the Company.

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5. Interface of Financial Policy and Corporate Strategic Management

CORPORATE FINANCIAL
Interface
STRATEGY PLAN

The interface of strategic management and financial policy will be clearly understood if we appreciate
the fact that the starting point of an organization is money and the end point of that organization is
also money.
Dimensions of interface between Corporate Strategic Management and Financial Policy:
(Interface in general means point of connection between two things. Here, ‘Dimensions of interface
between Corporate Strategic Management and Financial Policy’ means in which all ways, Corporate
Strategic Management is connected to Financial Policy)
a) Sources of Finance and Capital Structure Decisions
 To support any expansion activity, funds may be mobilized (generated) through owner’s
capital (equity or preference shares) or borrowed capital (debt like debentures, public deposits,
etc.).
 Along with mobilization of funds, policy makers must also decide on the capital structure i.e.,
appropriate mix of equity and debt capital. This mix varies from industry to industry.
Investment and Fund Allocation Decisions
 A planner must frame policies for regulating investment in fixed and current assets.
 Planners task is to make best possible allocation under resource constraints.
 Investment proposals by different business units can be divided as:
 Addition of new product by the firm (i.e., diversification)
 Increasing the level of operation of an existing product (i.e., expansion)
 Cost reduction or efficient utilization of resource
Dividend Policy Decisions
 Dividend policy decision deals with the extent of earnings to be distributed as dividend and the
extent of earnings to be retained for future growth of the firm.
It may be noted from the above discussions that financial policy cannot be worked out in isolation of
corporate strategy. Since, financial planning and corporate strategy are interdependent of each other,
attention of the corporate strategy makers must be drawn while framing the financial plans not at a
later stage.

6. Sustainable Growth Rate

The sustainable growth rate (SGR) of a firm is the maximum rate of growth in sales that can be
achieved, given the firm's profitability, asset utilization, and desired dividend payout and debt
(financial leverage) ratios.

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SGR is a measure of how much a firm can grow without borrowing more money. After the firm has
passed this rate, it must borrow funds from another source to facilitate growth.
SGR is calculated as: ROE x (1- Dividend payment ratio)
Variables of SGR formula typically include:
1. Net profit margin on new and existing revenues;
2. Asset Turnover ratio,
3. Assets to equity ratio (Financial Leverage Ratio)
4. Retention rate
Sustainable growth models assume that the business wants to:
1. maintain a target capital structure without issuing new equity;
2. maintain a target dividend payment ratio; and
3. increase sales as rapidly as market conditions allow.

7. Financially Sustainability of an Organisation

To be financially sustainable, an organisation must:
 have more than one source of income (say, multiple businesses)
 have more than one way of generating income (say, both online and offline sales)
 do strategic, action and financial planning regularly
 have adequate financial systems
 have a good public image
 have financial autonomy (ability to take financial decisions independently)

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2. RISK MANAGEMENT
1. Types of Risks a Business Faces
Strategic Risk Compliance Risk Operational Risk Financial Risk

It is the risk that Every business needs to It refers to the risk It refers to the risk
company’s strategy comply with rules and that company of unexpected
might become less regulations. If the company might fail to changes in
effective and fails to comply with laws manage day to day financial conditions
company struggles related to an area or operational prevailing in an
to achieve its goals. industry or sector, it will problems. economy such as
pose a serious threat to its prices, interest
It could be due to This type of risk
survival. rates, inflation, etc.
technological relates to internal
reasons, new It refers to the risk that risk as risk relates All these factors
competitors, shift company might not be able to ‘people’ as well have direct impact
in customer’s to company with the rules as ‘process’. on the profitability
demand, etc. and regulation applicable to of the company.
the business.

Counter Party Risk

It refers to the risk of non-honouring of obligation by counterparty. It can be failure to deliver goods
against payment already made or failure to make payment against goods delivered. This risk also
covers the credit risk i.e., default by the counter party.
Hints used to identify this risk:
1. Failure to obtain necessary resources to complete the project.
2. Any regulatory restrictions from the Government.
3. Hostile action of foreign government.
4. Let down by third party.
5. Have become insolvent.
Techniques to manage this risk:
1. Carrying out Due Diligence before dealing with any third party.
2. Do not over commit to a single entity or group or connected entities.
3. Know your exposure limits.
4. Review the limits and procedure for credit approval regularly.
5. Rapid action in the event of any likelihood of defaults.
6. Use of performance guarantee, insurance or other instruments.

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Interest Rate Risk

It refers to the risk of change in interest rates which further leads to change in assets and liabilities.
This risk is more important to financial companies whose balance sheet items are sensitive to
interest rates.
Hints used to identify this risk:
1. Monetary Policy of the Government.
2. Any action by Government such as demonetization etc.
3. Economic Growth
4. Investment by foreign investors
5. Stock market changes
Techniques to manage this risk:
1. Traditional Methods:
a) Asset and Liability Management (ALM): It is the management of liabilities and assets in the
balance sheet in such a way that the net earnings from interest are maximized within the
overall risk preference.
b) Forward Rate Agreement (FRA): It is an agreement between two parties through which a
borrower or lender protects itself from the changes to the interest rate by agreeing to a
forward rate.
2. Modern Methods:
a) Interest Rate Futures (IRF): It is a contract between the buyer and seller agreeing to the
future delivery of any interest-bearing asset at a predetermined price.
b) Interest Rate Options (IRO): It is a right but not an obligation and acts as insurance by
allowing businesses to protect themselves against adverse interest rate movements while
allowing them to benefit from favourable movements.
c) Interest Rate Swaps: In this, the parties to it agree to exchange payments indexed to two
different interest rates.

Liquidity Risk
It refers to the inability of organization to meet it liabilities whenever they become due. This risk
arises when a firm is unable to generate adequate cash when needed. This type of risk is more
prevalent in banking business where there may be mismatch in maturities and receiving fresh
deposits pattern.

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Currency Risk
It refers to the risk of change in cash flows due to unfavourable changes in exchange rates. This risk
mainly affects the firms dealing in foreign currency denominated transactions. This risk can be
affected by cash flow adversely or favourably.
Hints used to identify this risk:
1. Government Action: The Government action of any country has impact on its currency, because
government has powers to enact laws and formulate policies that can affect flow to foreign
funds in an economy.
2. Nominal Interest Rate: As per interest rate parity (IRP), the currency exchange rate depends on
the nominal interest of that country.
3. Inflation Rate: As per Purchasing power parity theory, the currency exchange rate depends on
the inflation of that country.
4. Natural Calamities: Any natural calamity can have negative impact on the exchange rates.
5. War, Coup, Rebellion etc.: All these actions can have far reaching impact on currency’s exchange
rates (Coup means sudden change in government illegally & Rebellion means organised protest
against any authority).
6. Change of Government: The change of government and its attitude towards foreign investment
also helps to identify the currency risk.
Techniques to manage this risk:
Already covered in Foreign Exchange as Internal & External Hedging Techniques.

Political Risk
This type of risk is faced by and overseas investors, as the adverse action by the government of host
country may lead to huge loses.
Hints used to identify this risk:
1. Insistence on resident investors or labour.
2. Restriction on conversion of currency.
3. Confiscation of foreign assets by the local govt.
4. Price fixation of the products.
5. Restriction of remittance to home country.
Techniques to manage this risk:
1. Local sourcing of raw materials and labour.
2. Entering into joint ventures
3. Local financing
4. Prior negotiations

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2. Evaluation of Financial Risk from the point of view of Different

Stakeholders
1. From Shareholder’s point of view: Equity shareholders view financial risk as financial gearing i.e.
ratio of debt in capital structure of company since in event of winding up of a company they will be
given least priority in capital repayment.
2. From Lenders point of view: Lenders view risk as existing gearing ratio since company having high
gearing faces more risk of default of payment of interest and principal repayment.
3. From Company’s point of view: A company views risk from the point of view of company’s ability
to exist. If a company borrows excessively or lends someone who defaults, then it can be forced to
go into liquidation.
4. From Government’s point of view: Government views financial risk as failure of any bank or down
grading of any financial institution leading to spread of distrust among society at large.

3. Value at Risk (VaR)

VAR is a measure of risk of investment (just like standard deviation which is also a measure of risk).
Given the normal market condition, it estimates how much an investment might lose during a given
time period at a given confidence level.

Main Features of VaR:

1. Components: VaR Calculation is based on following three components:
 Maximum Loss
 Confidence Level
 Time Period
2. Statistical Method: VaR is a statistical method of measuring risk since it is based on standard
deviation
3. Time Horizon: It can be applied for different time periods say one day, week, month, etc.
4. Probability: It is based on assumption of normal probability distribution
5. Z-Score: Z-Score indicates how many standard deviation, value is away for means. Z-score
multiplied with Standard deviation gives the amount of maximum loss.
6. Control over Risk: It helps to control risk by setting limits of maximum loss.

4. Applications of Value at Risk

VaR can be applied:
 to measure the maximum possible loss on any portfolio or on a trading position.
 as a benchmark for performance measurement of any operation or trading.
 to fix limits for individuals dealing in front office of a treasury department.
 to enable the management to decide the trading strategies.
 as a tool for Asset and Liability Management especially in banks.

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3. ADVANCED CAPITAL BUDGETING DECISIONS (SM 2024)

1. Why is it important to analyse the impacts of change in technology
1. Change in technology can significantly alter production process.
2. Changes can also yield benefits such as improved quality, delivery time greater flexibility, etc.
3. Changed technology can also result in reduction in cost of capital
4. Improved cash inflows can be achieved through technological changes.
5. There may be need to incur additional cost in the form of additional capital expenditure.
6. The sale volume can be impacted as the anticipated life cycle of the product can be shortened
because of change in consumer preference.

2. Impact of changes in Government Policies on Capital Budgeting Decisions

A. Domestic Capital Budgeting Decisions
1. The change in interest rate is decided by government through its Monetary Policy. This can affect
the Cost of Capital because the Cost of Debt is normally dependent on the bank rate of interest.
2. The change in interest rate is decided by government through its Fiscal Policy. Since Fiscal Policy
deicides the tax rate and the Annual Cash Flows are dependent on the Tax Rate, change in tax
rate can change the cash flows significantly.
B. International Capital Budgeting Decision
1. In these decisions, the foreign exchange rate play a very important role. Since the change in bank
rate and money supply is decided as per Monetary Policy, the change in any of these two impacts
the rate of Foreign Exchange and ultimately the cashflows.
2. Change in Tax Rates relating to Foreign Income or changes in provisions of Double Tax Avoiding
Agreement (DTAA) as decided in Fiscal Policy may affect cashflows.

3. Risk Factors affecting Capital Budgeting Decisions:

A. Internal Factors:
1. Project Specific Risk: Risks which are related to a particular project and affects the project’s cash
flows. It includes completion of the project in scheduled time, error of estimation in resources and
allocation, estimation of cash flows etc.
2. Company Specific Risk: Risks which arise due to company specific factors like downgrading of
credit rating, changes in key managerial persons, cases for violation of intellectual property rights
(IPR) and other laws and regulations, etc.
B. External Factors
1. Industry-specific risk: These are the risks which effect the whole industry in which the company
operates. These risks include regulatory restrictions on industry, changes in technologies etc.
2. Market risk: The risk which arise due to market related conditions like entry of substitute, changes
in demand conditions, availability and access to resources etc.

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3. Competition risk: These are risks related with competition in the market in which a company
operates. These risks are risk of entry of rival, product dynamism and change in taste and
preference of consumers etc.
4. Risk due to Economic Conditions: These are the risks which are related with macro-economic
conditions like changes in monetary policies by central banks, changes in fiscal policies like
introduction of new taxes and cess, inflation, changes in GDP, etc.
5. International risk: These are risk which are related with conditions which are caused by global
economic conditions like restriction on free trade, restrictions on market access, recessions,
bilateral agreements, political and geographical conditions etc.

4. Differentiate Scenario Analysis vs Sensitivity Analysis

Sensitivity analysis and Scenario analysis both help to understand the impact of the change in input
variable on the outcome of the project. However, there are certain basic differences between the two.
 Sensitivity analysis calculates the impact of the change of a single input variable on the outcome
of the project viz., NPV or IRR. The sensitivity analysis thus enables to identify that single critical
variable which can impact the outcome in a huge way and the range of outcomes of the project
given the change in the input variable.
 Scenario analysis, on the other hand, is based on a scenario. For example, the scenario may be
recession or a boom wherein depending on the scenario, all input variables change. This analysis
calculates the outcome of the project considering a particular scenario where the variables have
changed simultaneously. Similarly, the outcome of the project would also be calculated for the
other scenarios.
Scenario analysis is far more complex than sensitivity analysis because in scenario analysis all inputs
are changed simultaneously, considering the situation in hand while in sensitivity analysis, only one
input is changed and others are kept constant.

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4. SECURITY ANALYSIS
1. Security Analysis and its approaches
Investment decision of securities to be bought, held or sold depends upon the return and risk profile
of that security. Security Analysis involves a systematic analysis of the risk-return profiles of various
securities to help a rational investor take an investment decision.
There are two approaches viz. fundamental analysis and technical analysis for carrying out Security
Analysis. In fundamental analysis, factors affecting risk-return characteristics of securities are looked
into while in technical analysis, demand and supply position of the securities along with prevalent
share price trends are examined.

2. Fundamental Analysis and its stages

Economic Analysis

Industry Analysis

Company Analysis

Fundamental analysis is based on the assumption that value of a share today is the present value of
future dividends expected by the shareholders, discounted at an appropriate discount rate and this
value is known as the 'intrinsic value of the share'(i.e., Fundamental Principal of Valuation). The
intrinsic value of a share, depicts the true value of a share. A share that is priced below the intrinsic
value must be bought, while a share quoting above the intrinsic value must be sold.
(Therefore, while calculating intrinsic value, we must analyse all those factors that can impact the
future revenue, earnings, cash flows or dividends of the company)

Stages of Fundamental Analysis:

a) Economic Analysis
Factors to be considered in Economic Analysis (It includes factors at economy level (say India as
an economy) that can affect the future cash flows or dividends of all the companies operating in
India):

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 Growth rate for National Income and GDP: The estimates of GDP growth rate further helps to
estimate growth rate of an industry and a company. For this purpose, it is also important to
know Real and Nominal GDP growth rates.
 Inflation: Inflation is a strong determinant of demand in some industries mainly in consumer
product industry. Estimating inflation in an economy helps to estimate the expected revenue
from the product. Inflation can be measured either in terms of Retail prices or Wholesale prices.
 Monsoon: Monsoon is also a key determinant of supply and demand of many products
therefore it is also of great concern to investors in stock market.
 Interest Rates: Interest rates in an economy helps in estimating the flow of cash and savings
& consumption patterns in an economy.
b) Industry Analysis
Factors to be considered in Industry Analysis (It includes factors at industry level (say Pharma or
telecom as an industry) that can affect the future cash flows or dividends of all the companies
operating in that industries):
 Product Life-Cycle: An industry usually exhibits high profitability in the initial and growth
stages, medium but steady profitability in the maturity stage and a sharp decline in
profitability in the last stage of growth. Therefore, understanding the product life-cycle is
important while estimating the future cash flows from any product.
 Demand Supply Gap: Excess supply relative to demand reduces the profitability of the industry
because of the decline in prices, while insufficient supply tends to improve the profitability
because of higher price.
 Barriers to Entry: Any industry with high profitability would attract new entrants. However,
the potential entrants to the industry face different types of barriers to entry. Restriction on
entry to new participants helps to analyse impact on the future revenues of the company
operating in that industry.
 Government Attitude: The attitude of the government towards an industry is a crucial
determinant of future prospects of an industry.
 Technology and Research: They play a vital role in the growth and survival of a particular
industry. Technology is subject to very fast change leading to obsolescence.
c) Company Analysis
Factors to be considered in Company Analysis (It includes company specific factors (say TCS or
Infosys as a company) that can affect the future cash flows or dividends of that company):
 Net Worth and Book Value: Net Worth is sum of equity & preference share capital and free
reserves less intangible assets and any carry forward of losses. The total net worth divided by
the number of shares is the much talked about book value of a share. Though, book value may
not be a true indicator of Intrinsic Value of share.
 Sources and Uses of Funds: The identification of sources and uses of funds is known as Funds
Flow Analysis. One of the major uses of funds flow analysis is to find out whether the firm has
used short-term sources of funds to finance long term assets. Since, financing long term assets

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using short term source of finance may create liquidity crunch to the firm while making
repayment of liabilities.
 Cross-Sectional and Time Series Analysis: Analysis of financial statement is important to
evaluate fundamental strength of a company. It involves comparing a firm against some
benchmark figures for its industry (Cross-sectional) and analysing the performance of a firm
over time (time-series). The techniques that are used to do such proper comparative analysis
are: common-sized statement, and financial ratio analysis.
 Growth Record: The growth in sales, net income, net capital employed and earnings per share
of the company in the past few years should be examined. Historical growth numbers are also
important to determine expected growth.
 Quality of Management: Quality of management has to be seen with reference to the
experience, skills and integrity (ethics) of the people involved at board and managerial level.
Quality of management decides the confidence of investors on the decisions and action of
management. Shares will good management quality trades at premium as compared to shares
with low management quality.

3. Techniques used in Economic Analysis

a) Anticipatory Surveys:
Anticipatory Surveys help investors to form an opinion about the future state of the economy. It
involves taking expert opinion on certain parameters that helps estimating the level of expected
economic activities. It involves construction activities, expenditure on plant and machinery, levels
of inventory.
b) Barometer/Indicator Approach
Various indicators are used to find out how the economy shall perform in the future. The
indicators have been classified as under:
1. Leading Indicators: They lead the economic activity in terms of their outcome. They relate to
the time series data of the variables that reach high or low points in advance of economic
activity. (It means, these indicators lead the economic event i.e., first they take place and then
economic event occurs. It means with the help of occurrence of such indicator, future economic
event which is going to take place can be estimated.)
2. Roughly Coincidental Indicators: They reach their peaks and troughs (i.e., high and lows) at
approximately the same time in the economy.
3. Lagging Indicators: They are time series data of variables that lag behind as a consequence of
economy activity. They reach their turning points after the economy has reached its own
already.
All these approaches suggest direction of change in the aggregate economic activity but nothing
about its magnitude. The various measures obtained from such indicators may give conflicting
signals about the future direction of the economy.

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c) Economic Model Building Approach

A precise and clear relationship between dependent and independent variables is determined
under this approach (This process is called as building Economic Model). It is the most scientific
and complex way of economic analysis requiring high skill set, time, data and efforts.

4. Technical Analysis | Assumptions | Principles

Technical Analysis is a method of estimating share price movements based on a study of price charts
on the assumption that share price trends are repetitive, that since investor psychology follows a
certain pattern, what has happened before is likely to be repeated.

Technical Analysis is based on the following FOUR assumptions:

1. The market value of stock depends on the supply and demand for a stock
2. The supply and demand is actually governed by several factors in the market. For instance, recent
initiatives taken by the Government to reduce the NPA of banks may actually increase the demand
for banking stocks.
3. Stock prices generally move in trends which continue for a substantial period of time. And there
is possibility that there will soon be a substantial correction which will provide an opportunity to
the investors to buy shares at that time.
4. Technical analysis relies upon chart analysis which shows the past trends in stock prices rather
than the information in the financial statements.

Technical analysis is based on the following THREE principals:

1. The market discounts everything: Many experts criticize technical analysis because it only
considers price movements and ignores fundamental factors. The argument against such criticism
is based on the Efficient Market Hypothesis, which states that a company’s share price already
reflects everything that has or could affect a company.
2. Price moves in trends: Technical analysts believe that prices move in trends. In other words, a
stock price is more likely to continue a past trend than move in a different direction.
3. History tends to repeat itself: Technical analysts believe that history tends to repeat itself.
Technical analysis uses chart patterns to analyse subsequent market movements to understand
trends.

5. Theories of Technical Analysis:

a) The Dow Theory
 It is one of the oldest and most famous technical theories. It can also be used as a barometer of
business.
 The Dow Theory is based upon the movements of two indices, Dow Jones Industrial Average (DJIA)
and Dow Jones Transportation Average (DJTA). These averages reflect the aggregate impact of
all kinds of information on the market.

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 The movements of the market (or these indices) are divided into three classifications (all
happening at the same time):
 The primary movement: It is the main trend of the market, which lasts from 1 year to 36
months or longer. This trend is commonly called bear or bull market.
 The secondary movement: It is shorter in duration than the primary movement, and is
opposite to primary movement in direction. It lasts from 2 weeks to 1 month or more.
 The daily fluctuations: They are the narrow day-to-day movements. These fluctuations are
also required to be studied thoroughly since they ultimately form the secondary and primary
movements.
 The Dow Theory’s purpose is to determine where the market is and where is it going. The theory
states that if the highs and lows of the stock market are successively higher, then the market
trend is up and a bullish market exists. Contrarily, if the successive highs and successive lows are
lower, then the direction of the market is down and a bearish market exists.
b) Elliot Wave Theory
 This theory was based on analysis of 75 years’ stock price movements and charts. Elliot found that
the markets exhibited certain repeated patterns or waves.
 He defined price movements in terms of waves. As per this theory wave is a movement of the
market price from one change in the direction to the next change in the direction.
 As per this theory, waves can be classified into two
parts:
 Impulsive Patterns (Basic Waves): In this pattern,
there will be 3 or 5 waves ((i) to (v) in figure 1) in
a given direction (going upward or downward).
These waves shall move in the direction of the
basic movement. This movement can indicate bull
phase or bear phase.
 Corrective Patterns (Reaction Waves): These 3
waves (a, b & c in figure 1) are against the
direction of the basic waves. Correction involves
correcting the earlier rise in case of bull market
and fall in case of bear market.
c) Random Walk Theory
 This theory states that the behaviour of stock market prices is unpredictable and that there is no
relationship between the present prices of the shares and their future prices.
 This theory says that the peaks and troughs in stock prices are just are statistical happening and
successive peaks and troughs are unconnected.
 In the layman's language, it may be said that prices on the stock exchange behave exactly the
way a drunk would behave while walking in a blind lane, i.e., up and down, with an unsteady way
going in any direction he likes (i.e., without following a fixed pattern and in a totally unpredictable
manner).
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6. Charting Techniques
Technical analysts use three types of charts for analysing data
1. Bar Chart: In a bar chart, a vertical line (bar) represents the lowest to the highest price, with a short
horizontal line protruding from the bar representing the closing price for the period. Since volume and
price data are often interpreted together, it is a common practice to plot the volume traded,
immediately below the line and the bar charts.
2. Line Chart: In a line chart, lines are used to connect successive day’s prices. The closing price for each
period is plotted as a point. These points are joined by a line to form the chart. The period may be a
day, a week or a month.
3. Japanese Candlestick Chat: Like Bar chart this chart also shows the same information i.e., Opening,
Closing, Highest and Lowest prices of any stock on any day but this chart more visualizes the trend as
change in the opening and closing prices is indicated by the colour of the candlestick. While Black
candlestick indicates closing price is lower than the opening price the white candlestick indicates its
opposite i.e., closing price is higher than the opening price.
4. Point and Figure Chart: Point and Figure charts are more complex than line or bar charts. They are
used to detect reversals in a trend. For plotting a point and figure chart, we have to first decide the
box size and the reversal criterion.

7. Market Indicators
1. Breadth Index: It is an index that covers all securities traded. It is computed by dividing the net
advances or declines in the market by the number of securities traded (‘advances’ & ‘declines’ means
number of securities whose price has moved up & down respectively during the relevant period & ‘net’
means net of up & down). The breadth index either supports or contradicts the movement of the Dow
Jones Averages. If it supports the movement of the Dow Jones Averages, this is considered sign of
technical strength and if it does not support the averages, it is a sign of technical weakness
2. Volume of Transaction: The volume of shares traded in the market provides useful clues on how the
market would behave in the near future. A rising index/price with increasing volume would signal buy
behaviour because the situation reflects an unsatisfied demand in the market. Similarly, a falling
market with increasing volume signals a bear market and the prices would be expected to fall further.
3. Confidence Index: It is supposed to reveal how willing the investors are to take a chance in the market
It is the ratio of high-grade bond yields to low-grade bond yields. rising confidence index is expected
to precede a rising stock market, and a fall in the index is expected to precede a drop in stock prices.
4. Relative Strength Analysis: The relative strength concept suggests that the prices of some securities
rise relatively faster in a bull market or decline more slowly in a bear market than other securities i.e.
some securities exhibit relative strength. Investors will earn higher returns by investing in securities
which have demonstrated relative strength in past.
5. Odd - Lot Theory: This theory is a contrary - opinion theory. It assumes that the average person is
usually wrong and that a wise course of action is to pursue strategies contrary to popular opinion. The
odd-lot theory is used primarily to predict tops in bull markets, but also to predict reversals in
individual securities.

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8. Evaluation of Technical Analysis

Advocates of technical analysis offer the following interrelated argument in their favour:
a. Under influence of crowd psychology, trend persist for some time. Tools of technical analysis help
in identifying these trends early and help in investment decision making.
b. Shift in demand and supply are gradual rather than instantaneous. Technical analysis helps in
detecting this shift rather early and hence provides clues to future price movements.
c. Fundamental information about a company is observed and assimilated by the market over a
period of time. Hence price movement tends to continue more or less in same direction till the
information is fully assimilated in the stock price.
Detractors of technical analysis believe that it is a useless exercise; their arguments are:
a. Most technical analysts are not able to offer a convincing explanation for the tools employed by
them.
b. Empirical evidence in support of random walk hypothesis cast its shadow over the usefulness of
technical analysis.
c. By the time an up-trend and down-trend may have been signalled by technical analysis it may
already have taken place.
In a nutshell, it may be concluded that in a rational, well ordered and efficient market, technical
analysis may not work very well. However, with imperfection, inefficiency and irrationalities that
characterizes the real world market, technical analysis may be helpful.

9. Efficient Market Theory or Efficient Market Hypothesis

 As per this theory, at any given point in time, all available price sensitive information is fully
reflected in share’s prices. Thus, this theory implies that no investor can consistently outperform
the market as every stock is appropriately priced based on available information.
 Level of market efficiency (i.e., how efficient is the market):
 Weak form efficiency: Price of a share reflect all information found in the record of past prices
and volumes.
 Semi-strong form efficiency: Price reflects not only all information found in the record of past
prices and volumes but also all other publicly available information.
 Strong form efficiency: Price reflects all available information public as well as private.

10. Challenges to Efficient Market Theory

1. Information Inadequacy: Information is neither freely available nor rapidly transmitted to all
participants in the stock market. There is a calculated attempt by many companies to circulate
misinformation.
2. Limited information processing capabilities: Human information processing capabilities are
sharply limited. According to great economist, every human organism lives in an environment
which generates millions of new bits of information every second, but we are able to take as input
and process very less of it.
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3. Irrational Behaviour: It is generally believed that investors’ rationality will ensure a close
correspondence between market prices and intrinsic values. But in practice this is not true. The
market seems to function largely on hit or miss tactics rather than on the basis of informed beliefs
about the long-term prospects of individual enterprises.
4. Monopolistic Influence: A market is regarded as highly competitive. No single buyer or seller is
supposed to have undue influence over prices. But in reality, powerful institutions and big operators
have influence over the market. The monopolistic power enjoyed by them diminishes the
competitiveness of the market.

11. Difference between Fundamental & Technical Analysis

Basis Fundamental Analysis Technical Analysis

Method It involves forecasting future cashflows of the Predicts future price & its
company by analysing: direction using purely
historical data of share price,
Economy’s Macro factors: GDP, Interest rates,
its volume, etc.
Inflation, etc.
Company’s Micro factors: Profitability, Solvency
position, Operational efficiency, etc.

Rule Price of share discounts everything. Price captures everything.

Usefulness For Long-term investing. For short term investing.

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5. SECURITY VALUATION
1. Immunization
 We know that when interest rate (or yield) goes up, value of bond falls but return on re-investment
(of coupon receipts) improves and vice versa. Thus, an investor in bonds has to face two types of
interest rate risks (i.e., change in interest rates affects an investor in two ways):
 Price Risk: Risk that price of bond will fall with the increase in interest rates and rise with its
decrease.
 Reinvestment Risk: Risk that coupon receipts will be reinvested at a lower rate if interest rate
falls and at higher rate if interest rate rise.
 We can see that, with the change in interest rates, two risks move in the opposite direction.
Through the process of immunization selection of bonds shall be in such manner that the effect of
above two risks shall offset each other. Duration of the bonds is that point where these two risks
exactly offset each other. If the duration of a bond is equal to its holding period, then we ensure
immunization of the same and hence, the bond is not having interest rate risk. It means that
immunization takes place when the changes in the YTM in market has no effect on the promised
rate of return on a bond.
 It means that if a bond is bought today and rate of interest in the market changes, then, value of
bond portfolio (including the reinvested coupons) at the end of its duration (not maturity; duration
here means Macaulay’s Duration) will not change. This is because the decrease (increase) in value
of bond due to increase (decrease) in interest rates will be equal to the increase (decrease) in
income on reinvested coupons received till the end of duration.
 Therefore, when a liability (say future planned cash outflow) is planned to be funded through the
sale of bond portfolio, duration of that bond portfolio (asset) should be made equals to the duration
of liability, so that even if the interest rates change, value of portfolio will not change and liability
can be fully funded through the sale of bond portfolio as planned.

2. Term Structure Theories

The term structure theories explain the relationship between interest rates or bond yields and different
terms or maturities.
1. Expectation Theory: As per this theory, the long-term interest rates can be used to forecast short-
term interest rates in the future as long-term interest rates are assumed to unbiased estimator of
the short term interest rate in future.
2. Liquidity Preference Theory: As per this theory, investors are risk averse and they want a premium
for taking risk. Long-term bonds have higher risk due to longer maturity. Hence, long-term interest
rates should have a premium for such a risk. Further, people prefer liquidity and if they are forced
to sacrifice the same for a longer period, they need a higher compensation for the same. Hence,
longer term bonds have higher interest rates and the normal shape of a yield curve is Positive
sloped one.
3. Preferred Habitat Theory (Market Segmentation Theory): This theory states that different
investors may have different preference for shorter and longer maturity periods and therefore, they
have their own preferred habitat. Hence, the interest rate structure depends on the demand and
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supply of fund for different maturity periods for different market segments. Accordingly, shape of
yield curve can be sloping upward, falling or flat.

3. Reverse Stock Split and its reasons

 Reverse Stock Split is a process whereby a company decreases the number of shares outstanding
by combining the shares into lesser number of shares. It can be also understood as opposite of stock
split.
 Although, reverse stock split does not result in change in Market value or Market Capitalization of
the company but it results in increase in price per share.
 Reasons for Reverse Split Up:
1. Avoid Delisting: Sometimes, as per the regulation of stock exchange, if the price of shares of
a company goes below a limit it can be delisted. To Avoid such delisting company may resort
to reverse stock split up.
2. To avoid tag of Penny Stock: If the price of shares of a company goes below a limit it may be
called as penny stock. In order to improve that image, company may opt reverse stock split.
3. To attract Institutional Investors: It might be possible that institutional investors may be
shying away from acquiring low value shares. To attract these investors, the company may
adopt the route of Reverse Stock Split.

4. Role of Valuers (SM 2024)

The role of Valuers has increased a lot due to increased statutory and information requirements. The
valuations made by a Valuers are required statutorily for the following purposes:
1. Mergers/Acquisitions/ De-Mergers/Takeovers: Valuation is mandated in cases of Mergers/
Acquisitions/ De-Mergers/ Takeovers by the Income Tax Act, 1961 for the purpose of determining
the tax payable in such cases.
2. Slump Sale/ Asset Sale/ IPR Sale: Valuation is required by Insolvency and Bankruptcy Code, 2016
in case of liquidation of company and sale of assets of corporate debtor for the purpose of
ascertaining fair value or liquidation value.
3. Conversion of Debt/ Security: Valuation is a necessitated by RBI for Inbound Foreign Investment,
Outbound Foreign Investment and other business transactions.
4. Capital Reduction: SEBI regulations such as ICDR/ LODR/ Preferential Allotment etc. also require
valuations to be made for listed securities for various purposes on a period basis.
5. Strategic Financial Restructuring: Various statutes such as Companies Act, 2013, SARFAESI Act,
2002, Arbitration and Conciliation Act 1996 etc., warrant valuations to be made for meeting
various statutory requirements.

5. Precautions for Valuer before accepting Valuation Assignment (SM 2024)

1. A good valuation does not provide a precise estimate of value. A valuation by necessity involves
many assumptions and is a professional estimate of value. The quality and veracity of a good
valuation model does not depend just on number crunching. The quality of a valuation will be

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directly proportional to the time spent in collecting the data and in understanding the firm being
valued.
2. Valuing a company is much more than evaluating the financial statements of a company and
estimating an intrinsic value based on numbers. This concept is getting more and more critical in
today’s day and age where most emerging business are valued not on their historical
performances captured in the financial statement but rather on a narrative driven factors like
scalability, growth potential, cross sell opportunities etc.
3. A lot of times, investors/users tend to focus on either numbers or the story without attempting to
reach a middle ground. In both these cases, investors will fail to capture opportunities that could
have been unlocked had they been willing to reach some middle ground between the two
concepts.
4. While it is true that a robust intrinsic value calculation using financial statements data and an
error-free model makes investing a more technical subject, in reality, emotions play a massive
role in moving stocks higher or lower.

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6. PORTFOLIO MANAGEMENT
1. Objectives of Portfolio Management
4. Security of Principal: Security of principal not only involves keeping the principal sum intact but
also its purchasing power (i.e., value of portfolio should increase atleast by the percentage of
inflation so that purchasing power of portfolio is maintained)
5. Capital Growth: It can be attained by investing in growth securities or by reinvesting the income
received on securities in the portfolio.
6. Stability of Income is important to facilitate planning of reinvestment or consumption of income
accurately and systematically.
7. Diversification (risk minimisation): The basic objective of building a portfolio is to reduce the risk
of loss by investing in various types of securities and over a wide range of industries.
8. Liquidity is desirable for the investor so as to take advantage of attractive opportunities upcoming
in the market.
9. Favourable Tax Status: The effective yield, an investor gets from his investment, depends on tax to
which it is subjected to. By minimising the tax burden, yield can be effectively improved.

2. Discretionary and Non-Discretionary Portfolio Management

1. Under Discretionary Portfolio Management:
 The portfolio manager has the full discretion and freedom of investment decisions of portfolio
of the client.
 Scope of discretion and freedom of portfolio manager is agreed and noted in Investment Policy
Statement.
 Degree of freedom is more as compared to non-discretionary portfolio management.
2. Under Non-Discretionary Portfolio Management:
 The portfolio manager manages the funds in accordance with the directions and instruction of
the client.
 He advices client based on available information and analysis but final decision is of client.
 Degree of freedom is less as compared to discretionary portfolio management.

3. Active and Passive Portfolio Strategy for Equity Portfolio

a) Active Portfolio Strategy
APS is followed by most investment professionals and aggressive investors, who strive to earn
superior return after adjustment for risk. This strategy involves finding investment opportunity to
beat the overall market. It involves researching individual companies, gathering extensive data
about financial performance, business strategies and management of the companies.
There are four principles of on active strategy:
1. Market Timing: This involves departing for normal long run strategy and forecast market
movement in near future. This involves taking entry and exit from the market at the right
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time by estimating market movements. A variety of tools are employed for market timing
analysis namely business cycle analysis, moving average analysis, advance-decline analysis,
Econometric models.
2. Sector Rotation: It involves shifting funds from one sector to another based on sector outlook.
If a sector is expected to perform well in future, the portfolio manager might overweigh that
sector relative to market and under-weigh if the sector is expected to perform poor. (For
example, if an index has 25% value of stock in technology sector and portfolio on the other
hand, has invested 28% of the funds in stock of technology sector, then portfolio is overweight
on technology sector.)
3. Security Selection: Security selection involves a search for under-priced security. If one has to
resort to active stock selection, he may employ fundamental and technical analysis to identify
stocks which seems to promise superior return relative to risk.
4. Use of Specialised Investment Concept: To achieve superior return, one has to employ a
specialised concept with respect to investment in stocks. The concept which have been
exploited successfully are growth stock, neglected stocks, asset stocks, technology stocks,
etc.
b) Passive Portfolio Strategy
Passive strategy, on the other hand, rests on the belief that the capital market is fairly efficient
with respect to the available information. Basically, passive strategy involves creating a well-
diversified portfolio at a predetermined level of risk and holding the portfolio relatively unchanged
over time unless it became adequately diversified or inconsistent with the investor risk-return
preference.

4. Active and Passive Portfolio Strategy for Fixed Income Portfolio

a) Passive Portfolio Strategy
As mentioned earlier Passive Strategy is based on the premise that securities are fairly priced
commensurate with the level of risk. Though investor does not try to outperform the market but
it does not imply they remain totally inactive.
Common strategies by passive investors of fixed income portfolio:
1. Buy and Hold Strategy: This technique is do nothing technique and investor continues with
initial selection and do not attempt to churn bond portfolio to increase return or reduce the
level of risk. However, sometime to control the interest rate risk, the investor may set the
duration of fixed income portfolio equal to benchmarked index.
2. Indexation Strategy: This strategy involves replication of a predetermined benchmark well
known bond index as closely as possible.
3. Immunization: This strategy cannot exactly be termed as purely passive strategy but a hybrid
strategy. This strategy is more popular among pension funds. Since pension funds promised
to pay fixed amount to retired people, any inverse movement in interest may threaten fund’s
ability to meet their liability timely.

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4. Matching Cash Flows: Another stable approach to immunize the portfolio is Cash Flow
Matching. This approach involves buying of Zero Coupon Bonds to meet the promised
payment out of the proceeds realized.
b) Active Portfolio Strategy
As mentioned earlier Active Strategy is usually adopted to outperform the market.
Common strategies by active investors of fixed income portfolio:
1. Forecasting Returns and Interest Rates: This strategy involves the estimation of return on
basis of change in interest rates. Since interest rate and bond values are inversely related, if
portfolio manager is expecting a fall in interest rate of bonds, he should buy with longer
maturity period. On the contrary, if he expected a fall in interest then he should sell bonds with
longer period.
Based on short term yield movement, three strategies can be followed:
a. Bullet Strategy: This strategy involves concentration of investment in one particular bond.
This type of strategy is suitable for meeting the fund after a point of time such as meeting
education expenses of children etc. For example, if 100% of fund meant for investing in
bonds is invested in 5-years Bond.
b. Barbell Strategy: As the name suggests this strategy involves investing equal amount in
short term and long term bonds. For example, half of fund meant for investment in bonds
is invested in 1-year Bond and balance half in 10-year Bonds.
c. Ladder Strategy: This strategy involves investment of equal amount in bonds with
different maturity periods. For example if 20% of fund meant for investment in bonds is
invested in Bonds of periods ranging from 1 year to 5 years.
2. Bond Swaps: This strategy involves regularly monitoring bond process to identify mispricing
and try to exploit this situation.
Some of the popular swap techniques are as follows:
a. Pure Yield Pickup Swap - This strategy involves switch from a lower yield bond to a higher
yield bonds of almost identical quantity and maturity. This strategy is suitable for portfolio
manager who is willing to assume interest rate risk as in switching from short term bond
to long term bonds to earn higher rate of interest, he may suffer a capital loss.
b. Substitution Swap - This swapping involves swapping with similar type of bonds in terms
of coupon rate, maturity period, credit rating, liquidity and call provision but with different
prices. This type of differences exits due to temporary imbalance in the market.
c. International Spread Swap – In this swap portfolio manager is of the belief that yield
spreads between two sectors is temporarily out of line and he tries to take benefit of this
mismatch. Since the spread depends on many factor and a portfolio manager can
anticipate appropriate strategy and can profit from these expected differentials.
d. Tax Swap – This is based on taking tax advantage by selling existing bond whose price
decreased at capital loss and set it off against capital gain in other securities and buying
another security which has features like that of disposed one.
3. Interest Rate Swap: Interest Rate Swap is another technique that is used by Portfolio Manager.

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5. Risk in holding a Security

Risk

Systematic Risk Unsystematic Risk

This risk is due to risk factors that affects all the This risk is due to risk factors that affects a specific
companies in the market, i.e., Macro Factors. company, i.e., Company Specific Factors.
Example: Demonetisation, change in Example: Fire in the factory, CEO of the company
government, etc. resigning, etc.
 Since, this risk is faced by all the companies in  Since this risk is faced by a specific company, it
the market, it cannot be avoided even by can be avoided by adding securities (shares of
adding more securities (shares of the the companies) in the portfolio (i.e., by
companies) in the portfolio (i.e., even if we diversifying the portfolio)
diversify)  Since, it is avoidable in nature, return is not
 Since, it is unavoidable in nature, return is rewarded for taking this risk.
rewarded for taking this risk.

 Interest Rate Risk: This arises due to variability  Business Risk: Business risk arises from
in the interest rates from time to time. Price of a variability in the operating profits of a company.
security has inverse relationship with interest Higher the variability in the operating profits of
rates. Discounting rate which is used to calculate a company, higher is the business risk. Such a risk
intrinsic value depends upon the interest rates. can be measured using operating leverage.
 Purchasing Power Risk: It is also known as  Financial Risk: It arises due to presence of debt
inflation risk. Inflation affects the purchasing in the capital structure of the company. It is also
power adversely which further affects the known as leveraged risk and expressed in terms
demand of a product. of debt-equity ratio. Excess of debt vis-à-vis
 Market Risk: This risk affects the prices of any equity in the capital structure indicates that the
share positively or negatively in line with the company is highly geared and hence, has higher
market. Bullish or bearish trend in the market financial risk.
also affect the price of security in the market.

6. Risk Aversion, Risk Appetite & Risk Premium

1. Risk Aversion is an inherent attribute (behavioural feature) of investor makes him avoid risk unless
adequate return is awarded for taking that risk.
2. Risk Appetite is willingness and ability to take risk. It helps an investor to decide the securities in
which funds can be invested based of the risk involved in the securities.
3. Risk premium is the additional return for taking the additional risk by investing into a risky security
rather than risk-free security.

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How does investor’s expectation vary with variation in level of risk appetite?
 Investor with high-risk appetite will invest in riskier securities such as Equity or Alternative
Investments and therefore they will seek higher returns.
 Similarly, investor with low-risk appetite invest in low risky securities such as debt instruments.
Therefore, they expect lower rate of return.
 Investor who wants to take moderate risk will invest in balanced funds and accordingly the return
they will expect will also be between the above two categories.

7. Assumptions of CAPM
1. Efficient market is the first assumption of CAPM. Efficient market refers to the existence of
competitive market where securities are bought and sold with full information of risk and return
available to all participants.
2. Investor has rational investment goals. Investors desire higher return for any acceptable level of
risk or the lowest risk for any desired level of return.
3. CAPM assumes that all assets are divisible and liquid.
4. Investors are able to borrow at a risk free rate of interest
5. Securities can be exchanged at no transaction cost like payment of brokerage, commissions or
taxes.
6. Securities or capital assets face no bankruptcy or insolvency.

8. Portfolio Rebalancing Strategies

Constant Proportion
Particulars Buy & Hold Policy Constant Mix
Insurance Policy
Also called as ‘Do Also called as ‘Do
Under this strategy, an
nothing policy’, under something policy’, under
Meaning investor sets the floor
this strategy, an this strategy, an investor
value below which he
investor does not maintains the proportion
does not what the value
rebalance the of stock as a constant % of
of his portfolio to fall.
portfolio. total portfolio.

Balancing? No Yes Yes

Whose ability to take

Whose ability to take
risk increases Whose ability to take risk
risk increases
Suitability to (decreases) linearly decreases (increases) with
(decreases) with the
investor with the increase the increase (decrease) in
increase (decrease) in
(decrease) in the value the value of portfolio.
the value of portfolio.
of portfolio.

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PF dependency
on stock price
(x axis: value of
share portfolio)
y axis: Value of Payoff Line: Linear Payoff Line: Concave
total portfolio) Payoff Line: Convex

9. Alternative Investment and its Features

Plainly speaking, Alternative Investments (AIs) are investments other than traditional investments
(stock, bond and cash). Over the time various types of AIs have been evolved but some of the
important AIs are Mutual Funds, Real Estates, Private Equity, Hedge Funds, Distressed Securities,
Commodities, etc.
Common Features of AIs:
1. High Fees: Being a specific nature product the transaction fees on AIs is quite high.
2. Limited Historical Rate: The data for historic return and risk is verity limited where data for equity
market for more than 100 years in available.
3. Illiquidity: The liquidity of AIs is not good as next buyer not be easily available due to limited
market.
4. Less Transparency: The level of transparency is not adequate due to limited public information
available about AIs.
5. Extensive Research Required: Due to limited availability of market information, the extensive
analysis is required by the Portfolio Managers.
6. Leveraged Buying: Generally, investment in alternative investments is highly leveraged.

10. Important Alternative Investments

1. Real Estates
Real estate is a tangible form of assets which can be seen or touched. Real Assets consists of land,
buildings, offices, warehouses, shops etc. Real Estate Funds invest in Real Assets.
Following characteristics of Real Estate make valuation of Real Estate Funds complex:
 Inefficient market: Information may not be as freely available as in case of financial securities.
 Illiquidity: Real Estates are not as liquid as that of financial instruments.
 Comparison: Real estates are only approximately comparable to other properties.
 High Transaction cost: In comparison to financial instruments, the transaction and management
cost of Real Estate is quite high.
 No Organized market: There is no such organized exchange or market as for equity shares and
bonds.

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2. Gold (SM 2024)

Being a real asset Gold is an attractive alternative form of investment by various categories of
investors. The most common avenue of making investment in the gold has been buying the jewellery.
However, with the passage of time other forms have been evolved some of which are as follows:
1. Gold Bars: Investors can buy physical gold coins or bar of different denominations. However,
similar to jewellery this form of investment suffers from the limitation of cost of physical storage.
2. Sovereign Gold Bonds (SGBs): SGBs are government securities denominated in grams of gold.
They are substitutes for holding physical gold. Investors have to pay the issue price in cash and
the bonds will be redeemed in cash on maturity. The quantity of gold for which the investor pays
is protected, since he receives the ongoing market price at the time of redemption. The risks and
costs of storage are eliminated.
3. Gold Exchange Traded Funds (ETFs): Gold ETFs can be considered as an investment avenue which
is a hybrid of flexibility of stock investment and the simplicity of gold investments. Like any other
company stock, they can be bought and sold continuously at market prices on Stock Exchanges.
Prices of Gold ETFs are based on gold prices and investment of fund amount is made in gold
bullion.
4. E-gold: Started in 2010 in India, E-gold is offered by the National Spot Exchange Ltd (NSEL). Each
unit of e-gold is equivalent to one gram of physical gold and is held in the Demat account. Like
Gold ETFs, e-gold units are fully backed by an equivalent quantity of gold kept with the custodian
and have less storage cost compared to physical gold. These units can be traded on the exchange.

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7. SECURITIZATION
1. Concept and Mechanism of Securitisation
The process of securitization typically involves the creation of pool of assets from the illiquid financial
assets, such as receivables or loans and their repackaging or rebundling into marketable securities.
These securities are then issued to investor. Example of such illiquid financial assets can be automobile
loans, credit card receivables, residential mortgages or any other form of future receivables.
Mechanism or steps involved in Securitisation process:
Step 1: Creation of Pool of Assets
The process of securitization begins with creation of pool of assets by originator (originator is the entity
who owns the illiquid financial assets). This involves segregating the assets backed by similar type of
mortgages in terms of interest rate, risk, maturity, etc.

Step 2: Transfer to Special Purpose Vehicle/Entity

Once the assets have been pooled, they are transferred by originator to SPV/SPE for consideration.
SPV/SPE is the entity especially created for the purpose of securitization.

Step 3: Sale of Securitized Papers

SPV designs the instruments (marketable securities) based on interest rate, risk, tenure etc. of pool of
assets. These instruments can be Pass Through Security or Pay Through Certificates. These certificates or
securities are issued to investors against consideration. (The amount raised through the issue is used by
SPV to pay the originator for the pool of asset bought from him.)

Step 4: Administration of Assets

The administration of assets in subcontracted back to originator which collects principal and interest from
underlying assets and transfer it to SPV.

Step 5: Recourse to Originator

Performance of securitized papers depends on the performance of securitised assets unless specified that,
in case of default, such illiquid assets will go back to originator from SPV.

Step 6: Repayment of funds

SPV will repay the amount to the investors in form of interest and principal, that are recovered by
originator and passed on to SPV.

Step 7: Credit Rating to Instruments

Sometime, before the sale of securitized instruments, credit rating can be done to help investors assess
the risk of the issuer.

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2. Participants in Securitisation Process and their Role

Role of Primary Participants:
1. Originator/Securitiser:
He is the initiator of the securitisation deal and also termed as Securitiser. It the entity that sells
the financial assets to the SPV and receive the funds from SPV. It transfers both legal and
beneficial interest in those assets to SPV. (The purpose of initiation of securitisation deal is to
release the amount blocked in illiquid financial assets).
2. SPV/SPE
SPVs are created especially for the purpose of deal i.e., converting illiquid financial assets into
marketable securities. For this purpose, it buys the financial assets to be securitised from the
originator by making an upfront payment. Then, they issue securities to the investors. SPV could
be in the form of company, firm or trust.
3. Investors
Investors are the buyer of securitized papers. They can be an individual or an institutional investor
like mutual funds, provident fund or insurance company. They acquire the securitised papers
initially and receive their money back at redemption in the form of interest and principal as per
the agreed terms.
Role of Secondary Participants:
1. Obligors
Actually, they are the main root of the whole securitization process. They are the parties who owe
money to the originators and are assets in the Balance Sheet of Originator. The amount due from
the obligor is transferred to SPV and hence they form the basis of securitization process.
2. Rating Agency
Since the securitization is based on the pools of assets rather than the originators, the assets have
to be assessed in terms of its credit quality and credit support available.
3. Receiving and Paying agent
Also, called Servicer or Administrator, it collects the payment due from obligors and passes it to
SPV. It also follows up with defaulting borrower and if required initiate appropriate legal action
against them.
4. Credit Enhancer
Since investors in securitized instruments are directly exposed to performance of the underlying
financial assets, they seek additional comfort in the form of credit enhancement.
5. Structurer
It brings together the originator, investors, credit enhancers and other parties to the deal of
securitization. Normally, these are investment bankers also called arranger of the deal.
6. Agent or Trustee
They take care of interest of investors who acquires the securities. They also make sure that all
the parties perform in true spirit.

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3. Features of Securitisation
1. Creation of Financial Instruments – The process of securities can be viewed as process of creation
of additional financial instruments in the market backed by collaterals.
2. Bundling and Unbundling – When all the assets are combined in one pool it is bundling and when
these are broken into instruments of fixed denomination it is unbundling.
3. Tool of Risk Management – In case of assets are securitized on non-recourse basis, then
securitization process acts as risk management as the risk of default is shifted from originator to
investor.
4. Structured Finance – In the process of securitization, financial instruments are structured in such
a way that they meet the risk and return profile of investors, and hence, these securitized
instruments are considered as best examples of structured finance.
5. Tranching – Portfolio of different receivable or loan or other illiquid asset is split into several parts
based on risk and return they carry, called ‘Tranche’.
6. Homogeneity – Under each tranche the securities issued are of homogenous nature and even
meant for small investors who can afford to invest in small amounts.

4. Benefits of Securitisation
From the point of Originator From the point of Investor

 Off-Balance Sheet Financing: When receivables are

securitized, it releases a portion of capital blocked in  Diversification of Risk: Purchase of
these assets resulting in off Balance Sheet financing securities backed by different types of
& improving liquidity position. assets provides the diversification of
portfolio resulting in reduction of risk.
 More specialization in main business: By
transferring the assets, the entity could concentrate  Regulatory requirement: Acquisition
more on core business as servicing of loan is of asset backed belonging to a
transferred to SPV. Further, in case of non-recourse particular industry say micro industry
arrangement even the burden of default is shifted. helps banks to meet regulatory
requirement of investment of fund in
 Helps to improve financial ratios: Especially in case industry specific.
of Financial Institutions and Banks, it helps to
manage financial position related ratios effectively.  Protection against default: In case of
recourse arrangement if there is any
 Reduced borrowing Cost: Since securitized papers default by any third party, then
are rated due to credit enhancement, they can also originator shall make good the least
be issued at reduced rate in case of debts resulting in amount.
reduced cost of borrowings.

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5. Risks in Securitization (SM 2024)

1. Credit risk or Counterparty risk: It is the prime risk wherein investors are prone to the risk of
bankruptcy and non-performance of the servicer.
2. Legal risks: Since in the Indian context it is a recently developed concept there is an absence of
conclusive judicial precedent or explicit statutory provisions on securitization transactions.
3. Market risks: It represent risks external to the transaction and include market-related factors that
impact the performance of the transaction.
a) Macroeconomic risks: The performance of the underlying loan contracts depends on
macroeconomic factors, such as industry downturns or adverse price movements of the
underlying assets. For example, downturn in economy will affect the production and revenue
generation in any industry which will affect the ability of a company to repay the loan.
b) Prepayment risks: A change in the market interest rate represents a difficult situation for
investors because it is a combination of prepayment risk and volatile interest rates. With a
reduction in interest rates generally prepayment of retail loans increases, resulting in
reinvestment risk for investors.
c) Interest rate risks: This risk is prominent where the loans in the pool are based on a floating
rate and investor pay-outs are based on a fixed rate or vice versa. It results in an interest rate
mismatch and can lead to a situation where the pool cash inflow, even at 100% collection
efficiency, is not sufficient to meet investor pay-outs.

6. Types of Securitization Instruments

1. Pass Through Certificate (PTC):
 As the title suggests, originator transfers (pass through) to SVP the entire receipt of cash in the
form of interest or principal repayment from the securitized assets. SPV further distributes it
to the investors.
 PTC securities represent direct claim of the investors on all the assets that has been securitized
through SPV and the investors carry proportional beneficial interest in the asset held in the
trust by SPV. (Just like how unitholders of any mutual fund have direct claim on the assets
owned by mutual fund).
 It should be noted that since it is a direct route, any prepayment of principal is also
proportionately distributed among the securities holders.
2. Pay Through Security (PTS)
 In case of PTS, securities are backed by financial asset of SVP (rather than having a direct claim
on the assets, these securities are secured these assets.)
 This structure permits desynchronization of ‘servicing of securities issued’ from ‘cash flow
generating from the financial asset’.
 Hence, it can restructure different tranches from varying maturities of receivables.
 Further, this structure also permits the SPV to reinvest surplus funds for short term as per their
requirement.

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3. Stripped Securities
 Stripped Securities are created by dividing the cash flows associated with underlying securities
into two or more new securities. Those two securities are as follows:
i. Interest Only (IO) Securities
ii. Principle Only (PO) Securities
 As each investor receives a combination of principal and interest, it can be stripped into two
portions as Principal and Interest.
 Accordingly, the holder of IO securities receives only interest while PO security holder receives
only principal. Being highly volatile in nature these securities are less preferred by investors.

7. Pricing of the Securitized Instruments

Pricing of securitized instruments in an important aspect of securitization. While pricing the
instruments, it is important that it should be acceptable to both originators as well as to the investors.
On the same basis pricing of securities can be divided into following two categories:
1. From Originator’s Angle
From originator’s point of view, the instruments can be priced at a rate at which originator has
to incur an outflow and if that outflow can be amortized over a period of time by investing the
amount raised through securitization.
2. From Investor’s Angle
From an investor’s angle security price can be determined by discounting best estimate of
expected future cash flows using rate of yield to maturity of a security of comparable security
with respect to credit quality and average life of the securities. This yield can also be estimated
by referring the yield curve available for marketable securities, though some adjustments is
needed on account of spread points, because of credit quality of the securitized instruments.

8. Problems Faced in Securitisation

1. Stamp Duty: Stamp Duty is one of the obstacle in India. Mortgage debt stamp duty which even
goes upto 12% in some states of India has impeded the growth of securitization in India.
2. Taxation: Taxation is another area of concern in India. In the absence of any specific provision
relating to securitized instruments in Income Tax Act, experts’ opinion differs a lot. Some are of
opinion that, SPV, as a trustee, is liable to be taxed in a representative capacity. While, others are
of view that instead of SPV, investors will be taxed on their share of income.
3. Accounting: Accounting and reporting of securitized assets in the books of originator is another
area of concern. Although, securitization is designated as an off-balance sheet instrument but in
true sense receivables are removed from originator’s balance sheet. Problem arises especially
when assets are transferred without recourse.
4. Lack of Standardisation: Every originator following his own format for documentation and
administration having lack of standardization is another obstacle in the growth of securitization.

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5. Inadequate Debt Market: Lack of existence of a well-developed debt market in India is another
obstacle that hinders the growth of secondary market of securitized assets.
6. Ineffective Foreclosure laws: For many years efforts are on for effective foreclosure but still
foreclosure laws are not supportive to lending institutions and this makes securitized instruments
less attractive.

9. Blockchain (SM 2024)

Blockchain, or Distributed Ledger Technology (DLT) is a shared, peer-to-peer and decentralized open
ledger of transactions system with no trusted third parties in between. This ledger database has every
entry as permanent as cannot be altered. All transactions are fully irreversible with any change in the
transaction being recorded as a new transaction. The decentralised network refers to the network
which is not controlled by any bank, corporation, or government.
A. Applications of Blockchain
a) Financial Services: Blockchain can be used to provide an automated trade lifecycle in terms of the
transaction log of any transaction of asset or property such as shares, automobiles, real estate,
etc. from one person to another.
b) Healthcare: Blockchain provides secure sharing of data in healthcare industry by increasing the
privacy, security, and interoperability of the data by eliminating the interference of third party.
c) Government: There are instances where the technical decentralization is necessary but politically
should be governed by governments like land registration, vehicle registration and management,
e-voting etc. Blockchain improves the transparency and provides a better way to monitor and
audit the transactions in these systems.
d) Travel Industry: Blockchain can be applied in money transactions and in storing important
documents like passports, reservations and managing travel insurance, etc.
e) Economic Forecasts: Blockchain makes possible the financial and economic forecasts based on
decentralized prediction markets, decentralized voting, and stock trading, thus enabling the
organizations to plan their businesses.
B. Risks associated with Blockchain
1. With the use of blockchain, organizations need to consider risks with a wider perspective because
different members of a particular blockchain may have different risk tolerances. There may be
questions about who is responsible for managing risks if no one party is in-charge, and how proper
accountability is to be achieved in a blockchain.
2. The reliability of financial transactions is dependent on the underlying technology and if this
underlying consensus mechanism has been tampered with, it could render the financial
information stored in the ledger to be inaccurate and unreliable.
3. In the absence of any central authority to administer, there could be a challenge in the
development and maintenance of process control activities and in such case, users of public
blockchains find difficult to obtain an understanding of the IT controls.
4. As blockchain involves humongous data getting updated frequently, risk related to information
overload could potentially challenge the level of monitoring required. Furthermore, to find

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competent people to design and perform effective monitoring controls may again prove to be
difficult.
C. Tokenization and its similarities with Securitization
Tokenization is a process of converting tangible and intangible assets into blockchain tokens. Digitally
representing anything has recently acquired a lot of traction. It can be effective in conventional
industries like real estate, artwork etc.
Since tokenization of illiquid assets attempts to convert illiquid assets into a product that is liquid and
tradable and hence to some extent it resembles the process of Securitization. Hence, following are
some similarities between Tokenization and Securitization:
a) Liquidity: First and foremost, both Securitization and Tokenization inject liquidity in the market for
the assets which are otherwise illiquid assets.
b) Diversification: Both help investors to diversify their portfolio thus managing risk and optimizing
returns.
c) Trading: Both are tradable hence helps to generate wealth.
d) New Opportunities: Both provide opportunities for financial institutions and related agencies to
earn income through collection of fees.

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8. MUTUAL FUNDS
1. Classification of Mutual Funds:
On the basis of:
1. Functions 2. Portfolio 3. Ownership
Open ended funds: Investor can make entry and exit Equity Funds: means Public Sector MF: are
any time directly with mutual fund. The capital of the the mutual funds that sponsored by
fund is unlimited and redemption period is indefinite. invest in stocks. companies of Public
Close ended Funds: Investor can buy directly from MF Debt Funds: means Sector.
during IPO or from the stock market after listing. the mutual funds that Private Sector MF: are
Similarly, redeem from MF at maturity or sell it in the invest in debt sponsored by
stock market before maturity. Capital is limited and securities. companies of Private
redemption is finite. Special Funds: Sector.
Interval Funds (SM 2024): It is a combination of an discussed below Foreign Mutual Funds
Open-Ended and a Close-Ended funds which can be are sponsored by
purchased or redeemed during pre-specified intervals foreign companies for
at prevailing NAVs. They are not required to be listed raising funds in India,
on the stock exchanges. They can make fresh issue of operate from India and
units during the specified interval period. Maturity invest in India.
period is not defined.

A. Equity Funds B. Debt Funds C. Special Funds

Growth Funds: invest in Bond Funds: They invest in fixed Index Funds: Every market has a stock Index
securities which have income securities e.g., government that measures the movement of the market.
long term capital bonds, corporate debentures, etc. Index funds follows the stock index and are
growth. These MF Bond funds are less volatile than stock low-cost funds. The investor will receive
provide long term funds and often produce regular whatever the market delivers.
capital appreciation to income. It has following risk: International Funds are located in India to
the investors. Interest Rate Risk: Risk of fluctuation raise money in India for investing globally.
Income Funds seek to in market value of bond due to Offshore Funds is a mutual fund located in
maximize present change in interest rate. India to raise money globally for investing in
income of investors by Credit Risk: Risk of default in India.
investing in safe stocks repayment of loans or interest by the Sector Funds: They invest their entire fund
paying high cash borrowers. in a particular sector say Technology,
dividends.
Prepayment Risk: Risk of repayment Pharma, etc.
Aggressive Funds look of money by the issuer of Bonds Quant Funds: works on a data-driven
for super normal returns before its maturity date. approach for stock selection and investment
for which investment is
Reinvestment Risk: Risk of investing decisions based on a pre-determined rules
made in start-ups, IPOs
the bond proceeds at a lower rate of using statistics or mathematics-based
and speculative shares.
interest. models. (discussed in details below)
Gilt Funds invest in Govt Securities.

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2. Benefits or Advantages of Mutual Fund

1. Professional Management: The funds are managed by skilled and professionally experienced
managers with a back-up of a Research team.
2. Diversification: Mutual Funds offer diversification in portfolio by investing in large number of
securities which reduces the risk.
3. Economies of Scale: The “pooled” money from a number of investors ensures that mutual funds
enjoy economies of scale. It is cheaper compared to investing directly in the capital markets which
involves higher charges.
4. Transparency: The SEBI Regulations now compel all the Mutual Funds to disclose their portfolios
on a half-yearly basis. However, many Mutual Funds disclose this on a quarterly or monthly basis
to their investors.
5. Flexibility: There are a lot of features in a mutual fund scheme, which imparts flexibility to the
scheme. An investor can opt for Systematic Investment Plan (SIP), Systematic Withdrawal Plan etc.
to plan his cash flow requirements as per his convenience.
6. Highly Regulated: Mutual Funds all over the world are highly regulated and in India all Mutual
Funds are registered with SEBI and are strictly regulated as per the Mutual Fund Regulations which
provide high level of investor protection.

3. Drawback of Mutual Funds

1. No guarantee of Return: There may be some Schemes who may underperform against the
benchmark index. A mutual fund may perform better than the stock market but this does not
necessarily lead to a similar gain for every investor. This is because of the different entry & exit
points for each investor.
2. Diversification – A mutual fund helps to create a diversified portfolio. Though diversification
minimizes risk, it does not ensure maximizing returns. The returns that mutual funds offer is at
times lesser than what an investor can earn from a single stock.
3. Selection of Proper Fund – It may be easy for someone to select the right share rather than the
right mutual fund scheme. For stocks, one can rely his selection on the parameters of economic,
industry and company analysis. In case of mutual funds, past performance is generally the criteria
but past does not guarantee future.
4. Cost Factor – Every Mutual Fund Scheme charges some fund management fees as a part of Annual
Recurring Expenses. This fees in no way related to performance of the funds. There might also be
entry & exit loads if the funds are withdrawn before specified time.

4. Short note of certain types of funds:

A. Exchange Traded Funds or Index Shares
 An ETF is a hybrid product that combines the features of an Index Mutual Fund and Shares,
therefore also called as Index Shares. Like Index Funds (see Mutual Fund Chapter), these funds
also follow (i.e., track) underlying index. Like Shares, these can be traded.

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 ETFs are listed on the stock exchanges and their prices are linked to underlying index. They can
be bought or sold any time during the market hours at a price which may be more or less than
its NAV. NAV of an ETF is the value of components of the benchmark index (i.e., the index that
ETF tracks).
 There is no paper work involved for investing in ETF and they can be bought and sold just like
any other stock. They are attractive as investments because of their low cost tradability and
stock-like features.
 Following types of ETF products are available:
a. Index ETFs - Most ETFs are index funds that hold securities and attempt to replicate the
performance of a stock market index.
b. Commodity ETFs - Commodity ETFs invest in commodities, such as precious metals and
futures.
c. Bond ETFs - Exchange-traded funds that invest in bonds are known as bond ETFs. They thrive
during economic recessions because investors pull their money out of the stock market and
into bonds.
d. Currency ETFs - The funds are total return products where the investor gets access to the FX
spot change, local institutional interest rates and a collateral yield.
B. Hedge Funds:
 Hedge fund is a lightly regulated investment fund that escapes most regulations by being a
private investment vehicle being offered to selected clients.
 It does not reveal anything about its operations and also charges performance fees.
 Hedge funds are aggressively managed portfolio of investments which use advanced
investment strategies such as leveraged, long & short and derivative positions in both domestic
and international markets with the goal of generating higher returns.
 Risk involved under hedge funds in higher than that under Mutual Funds
 It is important to note that hedging is actually the practice of attempting to reduce risk, but
the goal of most hedge funds is to maximize return on investment.
C. Quant Funds:
Quant Fund works on a data-driven approach for stock selection and investment decisions based
on a pre-determined rules or parameters using statistics or mathematics-based models.
While an active fund manager selects the volume and timing of investments (entry or exit) based
on his\her analysis and judgement, in this type of fund, complete reliance is placed on an
automated programme that decides making decision for volume and timings of investments and
concerned manager has to act accordingly.
However, it is to be noted it does not mean that in this type of Fund there is no human intervention
at all, because the Fund Manager usually focuses on the robustness of the Models being used and
also monitors their performance on continuous basis and if required some modification is done in
the same.

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The prime advantage of Quant Fund is that it eliminates the human biasness and subjectivity and
using model-based approach also ensures consistency in strategy across the market conditions.
Sometime the term ‘Quant Fund Manager’ is confused with the term ‘Index Fund Manager’ but it
should be noted that both terms are different. While the Index Fund Manager entirely hands off
the investment decision purely based on the concerned Index, the Quant Fund Manager designs
and monitors models and makes decisions based on the outcomes.
D. Fixed Maturity Plans
Fixed maturity plans (FMPs) are a debt mutual funds that mature after a pre-determined time
period. FMPs are closely ended mutual funds in which an investor can invest during a New Fund
Offer (NFO). FMPs, which are issued during NFO, are later traded on the stock exchange where
they are listed. But, the trading in FMPs is very less. So, basically FMPs are not liquid instruments.
FMPs usually invest in Certificates of Deposits (CDs), Commercial Papers (CPs), Money Market
Instruments and Non-Convertible Debentures over fixed investment period. Sometimes, they also
invest in Bank Fixed Deposits.
Presently, most of the FMPs are launched with tenure of three years to take the benefit of
indexation.
The main advantage of Fixed Maturity Plans is that they are free from any interest rate risk
because FMPs invest in debt instruments that have the same maturity as that of the fund.
However, they carry credit risk, as there is a possibility of default by the debt issuing company.
So, if the credit rating of an instrument is downgraded, the returns of FMP can come down.

5. Direct Plan in Mutual Funds

Direct plan means plans where an investor can directly invest in the mutual funds without involving
distributor or broker. This helps mutual funds to save the distribution charges they have to pay to
distributors. Mutual funds pass on this benefit to the investor by keeping the NAV of direct plan higher
than NAV of a distributor plan (plans that involve distributor, also called as regular plan) by the
amount of distribution charges.
Mutual Funds have been permitted to take direct investments in mutual fund schemes even before
2011. But there were no separate plans for these investments. These investments were made in
distributor plan itself and were tracked with single NAV i.e., NAV of the distributor plans. Therefore,
even when an investor bought direct mutual funds, he had to buy it based on the NAV of the
distributor plans.
However, things changed with introduction of direct plans by SEBI on January 1, 2013. Mutual fund
direct plans are the plans in which Asset Management Companies or mutual fund Houses do not
charge distributor expenses, trail fees and transaction charges. NAV of the direct plan are generally
higher in comparison to a regular plan. Studies have shown that the ‘Direct Plans’ have performed
better than the ‘Regular Plans’ for almost all the mutual fund schemes.

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6. Tracking Error
 Tracking error can be defined as the divergence or deviation of a fund’s return from the return of
benchmark it is tracking (following). In other words, it is the error made by MF while tracking an
index, i.e., difference between ‘return from fund’ and ‘return from index which it was following’.
 The passive fund managers design their investment strategy to closely track the benchmark index.
However, often it may not exactly replicate the index return. In such situation, there is possibility
of deviation between the returns.
 Higher the tracking error, higher is the risk profile of the fund. Whether the funds outperform or
underperform their benchmark indices, it clearly indicates that of fund managers are not following
the benchmark indices properly. In addition to the same, other primary reason for tracking error
are Transaction cost, Fees charged by AMCs, Fund expenses and Cash holdings.

7. Side Pocketing
Understanding the lengthy yet simple concept:
 Suppose, a mutual fund (say XYZ) has total investment of ₹1000 in the bonds of different
companies, out of which ₹200 is invested in a particular company (say Bad Ltd.). Now, if Bad Ltd
defaults in making the coupon payment or principal repayment on its bond, then, as per SEBI
norms, XYZ will have to write down such investment in its books and consequently NAV of the fund
will fall and also its credit ratings. Due to such event and out of fear, the unitholders might sell or
redeem their units at the reduced NAV which may be less than its true NAV because even if
investment in Bad Ltd is fully written down, there is possibility of recovering some amount from
Bad Ltd.
 In such a situation, both XYZ and its unitholders will suffer. XYZ might suffer liquidity issue, if large
number to unit holders come to redeem their units. And, unitholders might sell their units at a NAV
lower than its true NAV.
 To avoid such situations, XYZ will separate investment of ₹200 in Bad Ltd.’s bonds (now onwards
referred as risky or illiquid assets) from its other good investments of ₹800 and shift it in the SIDE
POCKET. So, now there are two categories of assets lying with XYZ- Good or liquid assets (of ₹800)
and risky or illiquid assets (of ₹200).
 Note that, since XYZ has side-pocketed illiquid investments, the NAV of the fund will now reflect the
value of only liquid assets of ₹800. Therefore, for illiquid assets, unitholders are issued units of a
new scheme of mutual fund (now onwards referred as ‘new units’) in addition to original units
already held by them. This new scheme will represent the claim of unitholders in the risky assets of
₹200.
 Hence, we can say that, unitholders will now have two types of units- original units (which represent
the claims in good or liquid assets) and new units (which represent the claim in risky assets)
 Original units of the fund can be bought and sold normally as they were done earlier, but investors
are not interested to sell them, since, now they represent only liquid assets. Whereas, with respect
to new units, there are certain restrictions its sale imposed by SEBI due to which, they cannot be
redeemed for some period.

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 Hence, side pocketing will help both XYZ and its unitholders to not suffer on the event of default by
any company.
Answer from exam point of view from Study Material:
 Side Pocketing in Mutual Funds means separation of risky or illiquid assets from other investments
and cash holdings.
 Whenever, the rating of a mutual fund decreases, the fund shifts the illiquid assets into a side
pocket so that unitholders can be benefitted atleast from the liquid assets held by the fund.
Consequently, the NAV of the fund will now reflect the value of only liquid assets.
 The purpose is to also make sure that money invested in MF, which is linked to illiquid asset, gets
locked, until the MF recovers the money from the company.
 Side Pocketing is beneficial for those investors who wish to hold the units of the original scheme for
long term. Therefore, the process of Side Pocketing ensures that liquidity is not the problem with
MF even in the circumstances of frequent allotments and redemptions of units.
 In India, recent case of IL&FS has led to many discussions on the concept of side pocketing as IL&FS
and its subsidiaries have failed to fulfil its repayments obligations due to severe liquidity crisis. The
MF had given negative returns because they have completely written off their exposure to IL&FS
instruments.

8. Evaluation of Mutual Funds (SM 2024)

A. Quantitative Parameters
1) Risk Adjusted Returns: Basically, it is the return of a Mutual Fund relative to the risk it assumed
as benchmarked against the market and industry risk.
2) Benchmark Returns: Benchmark can be defined as the quality or set of standards against which
performance of Mutual Fund can be measured. A good Mutual Fund performs over and above its
benchmark during all phases of market.
3) Comparison to Peers: The comparison of relative performance of fund with its peers (of same
category) is another quantitative method because evaluation of performance in isolation does
not have any meaning.
4) Comparison of Returns across different economic and market cycles: At the time of evaluating
performance of any Mutual Fund, it is not just looking across short term but performance during
different economic and market cycles also needs to be evaluated.
5) Financial Measures: There are some financial measures that help in evaluation of performance
of any Mutual Fund which are as follows:
 Expense Ratio: It is the percentage of the assets that were spent to run a mutual fund. Paying
close attention to the expense ratio is important as high ratio can seriously undermine the
performance of a mutual fund scheme.
 Sharpe Ratio: this ratio measures the Mutual Fund’s performance measured against the total
risk (both systematic and unsystematic) taken.

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 Treynor Ratio: Beta of a mutual fund measures volatility of a fund’s return to return from its
Benchmark i.e., systematic risk. Treynor Ratio measures performance of a mutual fund
against the systematic risk it has taken.
 Sortino Ratio: A variation of Sharpe Ratio that considers and uses downside deviation instead
of total standard deviation in denominator.
B. Qualitative Parameters
1) Quality of Portfolio: Quality of securities in the portfolio of the Mutual Funds is an important
qualitative parameter. The reason is that the quality of the portfolio plays a big role in achieving
superior returns.
 In Equity Funds, the quality of the portfolio is measured on the basis of allocation of funds in
top Blue-chip companies, how diversified is the portfolio or the style followed being followed.
 In Debt Funds, the quality of portfolio is measured on the basis of credit quality, average
maturity and modified duration of the securities.
Not only that it is necessary that Mutual Fund should hold good quality stocks or securities, but it
is also necessary the investment should be as per the objective of the Fund.
2) Track record and competence of Fund Manager: Since Fund Manager takes investment
decisions, his competence and conviction play a very big role. The competence of a Fund Manager
is assessed from his knowledge and ability to manage in addition to past performance.
3) Credibility of Fund House Team: Team of the mutual fund also plays a big role towards the
investors’ interest. There are some other administrative tasks such as redemption of units,
crediting of dividend, providing adequate information etc. which play a crucial role in qualitative
assessment of any mutual fund.

9. Role of Fund Managers in Mutual Funds (SM 2024)

A portfolio manager manages individual’s fund. Similarly, a fund manager is a gatekeeper of funds of
any Mutual Fund. While, the main responsibility is to ensure good performance of the fund, but there
are other roles as well. The exact Primary Role also depends on the fact that whether Fund is an
Actively Managed or a Passively Managed Fund.
1) Actively Managed Funds: In these funds, Fund Manager’s role is more crucial because with use of
his extensive research, judgement and due diligence, he has to outperform the market and
generate positive alpha. Right stock picking can help him to outperform.
2) Passively Managed Funds: In these funds, Fund Manager’s role is to match the return of the
underlying benchmark index with the minimum Tracking Error.
In addition to the abovementioned primary role, following are Other key roles of a Fund Manager:
1) Compliances: Because of numerous regulations in the Capital Market, the number of Regulatory
Compliances has increased multi-fold. Fund Manager must ensure that:
 Compliance of various Guidelines as laid down by SEBI, AMFI etc.
 Ensuring various reporting such as Expenses Ratio, redemption of funds etc.
 Ensuring that investors are aware of various required details and rules.

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2) Constant Monitoring the Fund Performance: The role of a Fund Manager is not only to select the
securities, but also to evaluate them on a continuous basis. It is Fund Manager’s decision to enter
or exit market that maximises the wealth of unit holders. The performance of a Fund Manager is
not only judged on the basis of return but also on growth achieved above inflation and interest
rate.
3) Creation of Wealth and Protection: This role is a fundamental role of a Fund Manager. Though
wealth creation for investors is very important but reckless assumption to risk should be avoided.
The investments should be made after thorough Fundamental Analysis and Technical Analysis.
4) Control over the works outsourced to third parties: In many cases some of the works of the Funds
are required to be outsourced to any third party. In such cases, it is the duty of the Fund Manager
to exercise proper control over functioning of the third party to ensure error free operations.

10. Role of Foreign Institutional Investors in Mutual funds (SM 2024)

The FIIs plays an important role for Indian Economy through their investment in Mutual Funds
because:
1. Enhanced Corporate Governance: Before making investment in any Mutual Fund, FII carries out
thorough due diligence of Corporate Governance. Hence, Corporate Governance is improved to a
great extent.
2. Improved Competition in Market: With the investment of FIIs in Mutual Funds, improvement in
the capital market takes place.
3. Improved Inflow of Capital in the economy: With the investment of funds in Mutual Funds in the
economy not only employment is generated but the position of Foreign Exchange also improves.

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9. DERIVATIVES ANALYSIS AND VALUATION

1. Difference between Spot/Cash Market and Derivatives Market
Basis Spot Or Cash Market Derivatives Market
Market where assets itself are traded Financial market where contracts based
Meaning
for immediate delivery. on such assets are traded.
Futures and options has minimum lot
Quantity Even one share can be purchased
size
Investment Full amount is required to be paid Only margin or premium is to be paid
Risk More risky than derivatives market Less risky than cash market
Purpose Consumption or investment Hedging, Arbitrage or Speculation
Example Example: shares, forex, commodity Example: stock futures, currency options

2. Difference between Futures and Forwards

Basis Forward Future
Forward are entered into on personal Futures are entered into by buying or
Contract type
basis through phone or meeting. selling on exchange.
Fully tailored. Not standardised Standardised in term of quality, quantity
Standardised
about quality, quantity or time. and time.
Market Over the counter market Exchange traded
Margin Not required Required
Credit Risk Risk of default Guarantee of performance
Liquidity Less Liquidity More liquidity

3. Difference between Futures or Forwards and Options

Basis Forwards / Futures Options
Performance of Obligation to buy or sell the asset In case of long position, choice to buy or
contract under the contract. sell the asset under the contract.
Forwards: No investment
Initial investment Premium is paid to buy the option
Futures: Margin is paid
Unlimited gain/loss on the In case of long position: Limited
Gain or Loss
contract gain/loss
Duration of the
Generally, longer than option Generally, shorter than futures/forwards
contract

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4. Physical Settlement and Cash Settlement of Derivatives Contract

 The physical settlement in case of derivative contracts means that underlying assets are actually
delivered on the specified delivery date. In other words, traders will have to take delivery of the
shares against position taken in the derivative contract.
 In case of cash settlement, the seller of the derivative contract does not deliver the underlying asset
but transfers the amount of gain or loss on the contract in cash. It is similar to Index Futures where
the trader, who wants to settle the contract in cash, will have to pay or receive the difference
between the Spot price of the asset on the settlement date and the Futures price agreed to.
 The main advantage of cash settlement in derivative contract is high liquidity because of more
derivative volume in cash settlement option, since traders can trade in derivatives segment without
taking position in spot market.
 Also, a liquid derivative market facilitates the traders to do speculation. The speculative trading
may worry the regulators but it is also true that without speculative trading, it will not be possible
for the derivative market to stay liquid.

5. Greeks- Factors affecting value of an option

Factors that affect the value of an option and Change in the value of option due to these
how they affect it... factors is measured by Greeks:

DELTA
1. PRICE: If price of the underlying asset:
It is the ratio by which value of an option will
Value of Call Option Put Option change due to change in price of underlying
Rises Increases Decreases asset. It is used for hedging through options.
 Delta of call option is Positive.
Falls Decreases Increases
 Delta of put option is Negative.

2. VOLATILITY: If volatility of price of VEGA

underlying asset: It indicates the change in value of option for a
 Increases: Value of option increases. one percent change in volatility. Like delta, Vega
 Decreases: Value of option decreases. is also used for hedging.

THETA
3. TIME: As the time passes and time period till
It indicates the change in the value of option for
expiry of the option reduces, price of call and
one day decrease in period till expiration. It is a
put option falls.
measure of time decay.

4. RISK FREE RATE: If risk free rate of interest: RHO

 Increases: Value of option decreases. It indicates the value of option for one percent
 Decreases: Value of option increases. change in risk free rate of interest.

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(there are only four factors, Gamma is an GAMMA

additional Greek used in calculations related to Measures how fast delta change due to small
options) change in price of underlying asset.

6. Intrinsic Value and Time Value of an Option

Intrinsic Value
o It is the value that an option would fetch if it is exercised today.
o It means, for call option it is the value by which today’s spot price is higher than exercise price and
for put option it is the value by which exercise price is higher than today’s spot price.
o The minimum intrinsic value of any option can be zero (i.e., it cannot be negative), since in case of
negative value, option will not be exercised.
Time Value
o It is the value of premium over and above the Intrinsic Value.
o It is the risk premium that option writer requires to give buyer the right to exercise the option.

7. Exotic Options (SM 2024)

Exotic options are the types of option contracts having a different structure and features from plain
vanilla options i.e. American and European options. We know that an American option can be
exercised at any time on or before expiry date whereas a European option can be exercised only on
expiry date. Exotic option is a type of hybrid of American and European options and hence falls
somewhere in between these options.
The most common types of Exotic options are as follows:
1. Chooser Options: This option provides a right to the buyer of option after a specified period of
time to decide whether purchased option is a call option or put option. It is to be noted that the
decision can be made within a specified period prior to the expiration of contracts.
2. Compound Options: Also called split fee option or ‘option on option’. As the name suggests this
option provides a right or choice not an obligation to buy another option at specific price on the
expiry of first maturity date. Thus, it can be said in this option the underlying is an option. Further
the payoff depends on the strike price of second option.
3. Barrier options: Though it is similar to plain vanilla call and put options, but unique feature of this
option is that contract will become activated only if the price of the underlying reaches a certain
price during a predetermined period.
4. Binary Options: Also known as ‘Digital Option’, this option contract guarantees the pay-off based
on the happening of a specific event. If the event has occurred, the pay-off shall be pre-decided
amount and if event it has not occurred then there will be no pay-off.
5. Asian Options: These are the option contracts whose pay off are determined by the average of
the prices of the underlying over a predetermined period during the lifetime of the option.

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6. Bermuda Option: It is somewhat a compromise between a European and American options.

Contrary to American option where it can be exercised at any point of time, the exercise of this
option is restricted to certain multiples dates on or before expiration.
7. Basket Options: In this type of contracts the value of option instead of one underlying depends
on the value of a portfolio i.e., a basket. Generally, this value is computed based on the weighted
average of underlying constituting the basket.
8. Spread Options: As the name suggests the payoff of these type of options depend on difference
between prices of two underlying.
9. Look back options: Unlike other type of options whose exercise prices are pre-decided, in this
option on maturity date the holder of the option is given a choice to choose a most favourable
strike price depending on the minimum and maximum price of an underlying achieved during the
life time of option.

8. Credit Derivatives (SM 2024)

Credit Derivatives is summation of two terms, Credit + Derivatives. As we know that derivative derives
its value from an underlying which can be stock, share, currency, interest etc.
Financial instruments are subject to following two types of risks:
a. Market Risk: Due to adverse movement of the stock market, interest rates and foreign exchange
rates.
b. Credit Risk: Also called counter party or default risk, this risk involves non-fulfilment of obligation
by the counter party.
While, financial derivatives can be used to hedge the market risk, credit derivatives emerged out to
mitigate the credit risk.
Types of credit derivatives: Collateralized Debt Obligation and Credit Default Swap.
A. Collateralized Debt Obligations
CDOs are similar to securitization. While, in securitization the securities issued by SPV are backed by
the loans and receivables, the CDOs are backed by pool of bonds, asset backed securities, REITs, and
other CDOs.
Types of CDOs:
1. Cash Flow CDOs: It is a CDO which is backed by cash market debt or securities which normally
have low risk weight. This structure mainly relies on the collateral’s risk weight and collateral’s
ability to generate sufficient cash to pay off the securities issued by SPV.
2. Synthetic CDOs: It is similar to Cash Flow CDOs but with the difference that instead of transferring
ownerships of collateral to SPV (a separate legal entity), synthetic CDOs are structured in such a
manner that credit risk is transferred by the originator without actual transfer of assets.
3. Arbitrage CDOs: In this CDOs, the issuer captures the spread between the return realized by
collateral underlying the CDO and cost of borrowing to purchase these collaterals. In addition to
this issuer also collects the fee for the management of CDOs.
Risks involved in CDOs

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1. Default Risk: Also called ‘credit risk’, it arises from the default of underlying party to the
instruments.
2. Interest Rate Risk: Also called Basis risk, it arises due to different basis of interest rates. For
example, asset may be based on floating interest rate but the liability may be based on fixed
interest rates. Commonly used techniques such as swaps, caps, floors, etc. can be used to mitigate
such risk.
3. Liquidity Risk: Another major type of risk by which CDOs are affected is liquidity risks as there
may be mismatch in coupon receipts and payments.
4. Prepayment Risk: This risk results from unscheduled or unexpected repayment of principal
amount underlying the security. Generally, this risk arises in case of falling interest rates as the
borrowers may pay back the money early.
5. Reinvestment Risk: This risk is generic in nature as the CDO manager may not find adequate
opportunity to reinvest the proceeds when allowed for substitutions.
6. Foreign Exchange Risk: Sometimes CDOs are comprised of debts and loans from countries other
than the country of issue. In such a case, in addition to above mentioned risks, CDOs are also
subject to the foreign exchange rate risk.
B. Credit Default Swaps
It is a combination of following 3 words:
Credit: Loan given
Default: Non payment
Swap: Exchange of Risk
Accordingly, CDS can be defined as an insurance (not in stricter sense) against the risk of default on a
debt security. Under this arrangement, one party (called buyer) needing protection against the default
pays a periodic premium to another party (called seller), who in turn takes the default risk if there is
any default on such debt security.
Main Features of CDS
1. CDS is a non-standardized private contract between the buyer and seller. Therefore, it is covered
in the category of Forward Contracts.
2. They are normally not traded on any exchange and hence remains free from the regulations of
Governing Body.
3. CDS can be purchased from third party to protect itself from default of borrowers.
4. An individual investor who is buying bonds from a company can purchase CDS to protect his
investment from insolvency of that company.
5. The cost or premium of CDS has a positive relationship with risk attached with loans. Therefore,
higher the risk attached to Bonds or loans, higher will be premium or cost of CDS.
6. If an investor buys a CDS without being exposed to credit risk of the underlying bond issuer, it is
called “naked CDS”.

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9. Difference between real option & financial option (SM 2024)

Basis Financial Options Real Options
Have underlying assets that are normally
Have underlying the projects that
Underlying traded in the market i.e. shares, stocks,
are not traded in the market.
bonds, commodity etc.
In most of the cases it is specified in the It is estimated from the project cash
Pay-off
contracts and hence is fixed. flows and hence can be varied.
Mostly the period of these options is The period of these options mostly
Exercise Period
short and can go maximum upto 1 year. starts with 1 year or more.
Since these options are normally traded Since these options are used to make
Approach
in the market they are “Priced”. decisions, they are “Valued”.

10. Weather Derivatives & Electricity Derivatives (SM 2024)

Weather Derivatives: Like other derivatives a Weather derivative is a contract between a buyer and
a seller wherein the seller of a weather derivative receives a premium from a buyer with the
understanding that the seller will provide a monetary amount in case the buyer suffers any financial
loss due to adverse weather conditions. In case no adverse weather condition occurs, then the seller
makes a profit through the premium received.
Pricing a Weather Derivative is quite challenging as it cannot be stored and following issues are
involved:
a. Data: The reliability of data is a big challenge as the availability of data quite differs from one
country to another and even agency to agency within a country.
b. Forecasting of weather: Though various models can be used to make predictions about evolving
weather conditions but it is difficult to predict the future weather behaviour. Generally, forecasts
address seasonal levels but not the daily levels of temperature.
c. Temperature Modelling: Temperature is one of the important underlying for weather derivatives.
The temperature normally remains quite constant across different months in a year. Hence, there
is no such Model that can claim perfection and universality.
Electricity Derivatives: Since electricity spot prices in India, are generally volatile, due various factors
such as change in fuel supply positions, weather conditions, transmission congestion and other
physical attributes of production and distribution, there is a need for hedging instruments that reduces
price risk exposures. Derivative contracts linked with spot electricity prices as underlying can help
market participants to hedge from price risk variations. This will help the buyer to pay a fixed price
irrespective of variation in spot electricity prices as variations are absorbed by derivative instruments.
a. Electricity Forward contracts represent the obligation to buy or sell a fixed amount of electricity at
a pre-specified contract price, known as the forward price, at a certain time in the future.
b. Electricity Futures are similar to forwards with the difference that Electricity futures contracts are
standardized contracts in terms of underlying quantity, trading locations, transaction requirements
and settlement procedures.

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c. Electricity Swaps are financial contracts that enable their holders to pay a fixed price for underlying
electricity, regardless of the floating electricity price, or vice versa, over the contracted time.

11. Explain Co-Location Facility or Proximity Hosting

 The co-location or proximity hosting is a facility which is offered by the stock exchanges to stock
brokers and data vendors, whereby, their trading or data-vending systems are allowed to be
located within or at close proximity to the premises of the stock exchanges. They are allowed to
connect to the trading platform of stock exchanges through direct and private network.
 Stock exchanges are advised to allow direct connectivity between co-location facility of one
recognized stock exchange and the co-location facility of other recognized stock exchanges.
 Stock exchanges are also advised to allow direct connectivity between servers of a stock broker
placed in colocation facility of a recognized stock exchange and servers of the same stock broker
placed in colocation facility of another recognized stock exchange.
 In order to facilitate small and medium sized members, who otherwise find it difficult to own and
maintain a co-location facility due to cost or other reasons, SEBI has directed the stock exchanges
to introduce ‘Managed Co-location Services’.
 Under this facility, some space in co-location facility shall be allotted to eligible vendors by the stock
exchange along with arrangement for receiving market data for its further dissemination to their
clients.

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10. FOREIGN EXCHANGE EXPOSURE AND RISK

MANAGEMENT
1. Interest Rate and Purchase Power Parity Theorem
1. Interest Rate Parity Theorem (IRPT)
 IRP Theorem defines the relationship between exchange rate between currencies of two
countries and interest rates of those countries.
 Interest rate parity is a theory which states that the forward premium (or discount) of any
currency with respect to another currency should be equal to the interest rate differential of
the two countries.
(1 + interest rate of price currency)
 According to IRPT, Forward rate: Spot rate ×
(1 + interest rate of base currency)
 Hence, currency of the country with higher interest rate will trade at forward discount and
currency of the country with lower interest rate will trade at forward premium.
 When IRPT holds true, covered interest arbitrage is not feasible.
2. Purchase Power Parity Theorem (PPPT)
 PPP is based on “Law of one price”. It says that price of same product in two different countries
should be equal when measured in common currency.
 Similar to IRP Theorem, PPPT defines the relationship between exchange rate between
currencies of two countries and inflation rates of those countries.
 According to PPPT, expected appreciation (or depreciation) of any currency with respect to
another currency should be equal to the inflation differential between the two countries.
(1 + inflation rate of price currency)
 According to PPPT, Expected Spot rate: Spot rate ×
(1 + inflation rate of base currency)
 Hence, currency of the country with higher inflation rate is expected to depreciate and currency
of the country with lower inflation rate is expected to appreciate.

2. Non-Deliverable Forward Contract

 As name says, NDFC is a forward contract where the profit/loss on the contract is settled in cash.
 Profit is calculated by taking the difference between the agreed upon exchange rate (i.e., the
forward rate) and the spot rate at the time of settlement, for an agreed upon notional amount of
currency. NDFs are commonly quoted for time periods of one month up to one year.

3. Types of currency exposures

A. Translation Exposure: Also known as ‘Accounting Exposure’, it refers to the gain/loss caused by
the translation of foreign currency asset or liability. It arises because ‘the exchange rate on the

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date when transaction was recorded’ was different from ‘the exchange rate on the date when
financial statements are reported.
Example: An exporter has sold goods worth $500 and exchange rate is ₹/$ 65. Now, at year end, if
exchange rate changes to ₹/$ 60. Loss due to Translation Exposure is (65-60)*500= ₹2,500.
B. Transaction Exposure: It refers to the gain/loss which arises due to difference in the exchange rates
on ‘the date when transaction was entered into’ and ‘the date when the transaction is settled’. It
deals with the higher or lower cash flows in home currency required to settle any obligation in
foreign currency.
Example: An importer purchased goods worth $100 and exchange rate is ₹/$ 55. Now, at the time
of payment, if exchange rate changes to ₹/$ 60. Loss due to Transaction Exposure is ₹500.
C. Economic Exposure: It refers to the extent to which economic value of a company can decline due
to change in exchange rates. Even if the company is not directly dealing in transactions
denominated in foreign currency, it is exposed to economic risk. The exposure is on account of
macro level factors such as:
 Change in the prices of inputs used or output sold by competitors (giving them advantage)
 Reduction in demand by the foreign importer due increased prices in his HC (if invoicing is done
in exporter’s HC, then importer will have to pay more in his HC to by same amount of FC)
Difference between Transaction and Economic Exposure:
Transaction Exposure Economic Exposure
 Is direct in Nature  Is indirect in Nature
 Amount of exposure is known  Amount of exposure in unknown

 Faced by only firms who have entered into  Faced by all the firms whether they have
FC transactions entered into FC transactions or not

 Easy to hedge  Difficult to hedge

4. Techniques of hedging transaction exposure or currency risk

Internal Hedging Techniques External Hedging Techniques

 Invoicing  Forward Cover

 Leading & Lagging  Money Market Cover
 Netting  Future Cover
 Matching  Options Cover
 Price Variation  Swap Cover
 Asset & Liability Management

 Invoicing: Companies engaged in export and import are concerned with decisions relating to the
currency in which goods and services are to be traded (invoiced). Trading in a foreign currency

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gives rise to transaction exposure whereas, trading purely in a company's home currency has no
currency risk.
 Leading & Lagging: Leading and Lagging refer to adjustments in the times of payments in
foreign currencies. Leading means advancing the timing of payments and receipts. Lagging
means postponing (delaying) the timing of payments and receipts. These techniques are aimed
at taking advantage of expected appreciation or depreciation of relevant currencies.
 Settlement Netting or (only) Netting: Netting means adjusting receivable and payables. Under
this technique, group companies merely settle inter affiliate indebtedness for the net amount
owing. The reduced number and amount of transaction leads to savings in transaction cost (such
as buy/sell spreads in the spot and forward markets) and administrative cost resulting from
currency conversion.
 Matching: Although, ‘netting’ and ‘matching’ are used interchangeably, there is a difference
between the two. Netting is a term applied to potential cash flows within group companies
whereas matching can be applied to both inter-company and to third-party balancing. Matching
is a mechanism whereby a company matches its foreign currency inflows with its foreign
currency outflows in respect of amount and approximate timing. Receipts in a particular
currency are used to make payments in that currency thereby reducing the need for a group of
companies to go to the foreign exchange markets only for the unmatched portion of foreign
currency cash flows.
 Price Variation: Price variation involves increasing selling prices to counter the adverse effects
of exchange rate change.
 Asset and liability management: can involve aggressive or defensive postures. In the aggressive
attitude, the firm increases exposure of inflows denominated in strong currencies or increases
exposure of outflows denominated in weak currencies. The defensive approach involves
matching cash inflows and outflows according to their currency of denomination, irrespective
of whether they are in strong or weak currencies.

5. Exposure Netting
 Exposure Netting refers to offsetting exposure in one currency with exposure in the same or another
currency, where exchange rates are expected to move in such a way that loses (or gains) on the first
exposed position are offset by gains (or losses) on position in the second currency.
 The objective of the exercise is to offset the likely loss in one exposure by likely gain in another.
 This is a method of hedging foreign exchange exposure is different from forward and option contracts.
This method is similar to portfolio approach in handling systematic risk. (Recollect that to reduce the
beta of the portfolio, position on index futures was taken such that loss (gain) on portfolio is offset by
gain (loss) on index futures).

6. Strategies for Exposure Management 68of Forex

There are four strategies of foreign exchange exposure management:

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1. High risk – High reward

These strategies can be remembered
2. Low risk – Reasonable reward easily by understanding below graph
3. Low risk – Low reward showing different combinations of risk
4. High risk – Low reward and reward.

 This strategy involves active trading in

 Perhaps the worst strategy is to leave the currency market through
all exposures unhedged. continuous booking and cancellations
High Risk
 The risk of destabilization of cash flows of forward contracts.
is very high,  In effect, this requires the trading
 The merit is zero investment of function to become a profit centre.
managerial time or effort. All  This strategy requires high skills to
exposure Active identify profit opportunities.
left Trading
unhedged
Low Reward High Reward
All
Selective
Exposure  This strategy requires selective hedging
 This option involves automatic hedging Hedging
Hedged
of exposures in the forward market as of exposures whenever forward rates
soon as they arise irrespective of the are attractive but keeping exposures
attractiveness or otherwise of the unhedged whenever they are not.
forward rate.  Successful pursuit of this strategy
 This option doesn't require any Low Risk requires quantification of expectations
investment of management time or about the future and the rewards
effort. would depend upon the accuracy of
the prediction.

7. Foreign Currency Accounts

Nostro (Our account with you): This is a current account maintained by a domestic bank with a foreign
bank in foreign currency.

Indian Bank Foreign Bank

(HDFC) (Swiss Bank)

HDFC will call its account with

Swiss Bank as Nostro Account.

Vostro (Your account with us): This is a current account maintained by a foreign bank with a domestic
bank in home currency.

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We can say that, in the given

case, the same account, if seen,
Indian Bank Foreign Bank from HDFC’s point of view, is
(HDFC) (Swiss Bank) Vostro account, whereas, from
Swiss Bank’s point of view, it is
HDFC will call, the account of Swiss Bank Nostro account.
maintained with it, as Vostro Account.

Loro Account (Their account with you): This is a current account maintained by one domestic bank
on behalf of other domestic bank in foreign bank in a foreign currency.

Indian Bank
(HDFC)
Foreign Bank
(Swiss Bank)

Indian Bank
SBI will call, the Nostro account of HDFC
(SBI)
maintained with Swiss bank, as Loro Account.

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11. INTERNATIONAL FINANCIAL MANAGEMENT

1. International or Multinational Cash Management
Cash Management Systems (CMS) in case of companies operating in multiple countries includes:

Centralized CMS: Each branch’s cash position Decentralized CMS: Each branch is viewed as
is managed by single centralized authority. separate undertaking and cash positions are managed
separately.

There is a Cash Management Centre. There is no Cash Management Centre.

Local borrowings & investments are not allowed. Local borrowings & investments are allowed.
Net cash requirement is lower. Net cash requirement is higher.
Involves flow of excess or deficit cash among
No such flows are involved.
branches.

2. Sources of International Finance

1. Foreign Bonds:
2. Euro Bonds:
Bond issued by any company native to the company not native to the
in a currency which is: company
native to the country where the
Domestic Bond Foreign Bond
bond is issued
not native to the country where the
Eurobond
bond is issued
Hence, we can say that:
Domestic Bond: Though, we can understand meaning of domestic bond from the above table,
but it is not a source of international finance, hence won’t form part of the answer here.
Foreign bonds are debt instrument denominated in a currency not native to borrower (borrower
means the company issuing the bonds) but native to the country where the bonds are issued. For
example: Rupee denominated bonds of Apple Inc. issued in India or Dollar denominated bonds of
TCS Ltd. issued in USA. These bonds have restrictions placed by government of the country where
they are issued.
Euro bonds are debt instrument denominated in a currency which is not native to the country
where the bonds are issued. For example: Dollar denominated bond of any company issued in
India or Yen denominated bond issued in USA. (Note that, its name ‘Euro Bond’ has no relation
with Europe or Euro currency).
3. Foreign Currency Convertible Bonds (FCCBs): Foreign bonds are debt instrument denominated in
a currency not native to borrower but native to the country where the bonds are issued. FCCB is

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a type of foreign bond which gives the bondholder an option to convert the bond into the stocks
of the company. It is a mix of debt and equity instrument, as it acts like a bond by making regular
coupon and principal payments and also gives the bondholder an option to convert it into stock.
 Benefit to investor: Buyer of this bond is benefitted by appreciation in the price of company’s
stock.
 Benefit to issuer: Due to attached equity option, coupon rate on such bonds is relatively lower.
4. Euro Convertible Bond: Euro bonds are debt instrument denominated in a currency which is not
native to the country where the bonds are issued. Euro Convertible bond is a type of euro bond
which has an option, attached to it, to convert it into the equity shares of the company. Euro
option may carry two options:
 Call option: Issuer has the option to call (buy) the bonds before redemption and issue equity
shares.
 Put option: Investor (holder) has the option to put (sell) the bonds before redemption and get
equity shares against such bonds.
5. ADR and GDR: Since ADR and GDR are similar instruments and also because it becomes easy to
remember, they have been explained together. But these concepts may be asked individually in
exams, in which case below answer to be made specific. Depository receipt is a negotiable
certificate denominated in currency not native to the company issuing it, representing its one or
more local currency equity shares publicly traded in its home country. When such receipt is issued
in:
in US it is called ADR

Outside of USA it is called GDR

Mechanism of DRs: Other Important Points:

Company issues local currency equity

 ADR is denominated in USD whereas, GDR
shares
can be denominated in USD, EUR or GBP.
 ADR and GDR trade in the same way as
any other security, either on stock
Such shares are kept with depository exchange or OTC market.
bank or depository’s local custodian
 Holders of ADR & GDR participate in the
banks
same economic benefits as an ordinary
shareholder; however, they do not have
Against which, ADRs/GDRs are issued to voting rights.
foreign investors.

3. International Financial Centre (SM 2024)

IFC is the financial centre that caters to the needs of the customers outside their own jurisdiction.
Broadly, speaking IFC is a hub that deals with flow of funds, financial products and financial services
even though in own land but with different set of regulations and laws.

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A. Benefits of IFC
1. Opportunity for qualified professionals working outside India come here and practice their
profession.
2. A platform for qualified and talented professionals to pursue global opportunities without leaving
their homeland.
3. Stops Brain Drain from India.
4. Bringing back those financial services transactions presently carried out abroad by overseas
financial institutions/entities or branches or subsidiaries of Indian Financial Market.
5. Trading of complicated financial derivative can be started from India.
B. Constituents of IFC
1. Highly developed Infrastructure: A leading edge infrastructure is a prerequisite for creating a
platform to offer internationally competitive financial services.
2. Stable Political Environment: Destabilized political environment brings country risk for investment
by foreign nationals. Hence, to accelerate foreign participation in growth of financial centre,
stable political environment is a prerequisite.
3. Strategic Location: The geographical location of the finance center should be strategic such as
near to airport, seaport and should have friendly weather.
4. Quality Life: The quality of life at the center should be good as center retains highly paid
professionals from own country as well from outside.
5. Rationale Regulatory Framework: Rationale legal regulatory framework is another prerequisite
of international finance center as it should be fair and transparent.
6. Sustainable Economy: The economy should be sustainable and should possess capacity to absorb
all the shocks as it will boost investors’ confidence.

4. Sovereign Funds (SM 2024)

A Sovereign Wealth Fund (SWF) is a state-owned investment fund comprised of money generated by
the government. This money is generally derived by Government from country's own surplus reserves.
SWFs provide a benefit for a country's economy and its citizens. Since it is created by the Government
the legal basis on which these are created varies from Government to Government.
The popular Sources for funding the SWF are:
 Surplus reserves from state-owned natural resource revenues and trade surpluses,
 Bank reserves that may accumulate from budgeting excesses,
 Foreign currency operations,
 Money from privatizations, and
 Governmental transfer payments.

Some Common Objectives of a SWF are:

 Protection & Stabilization of the budget and economy from volatility in revenues or exports
 Diversify from non-renewable commodity exports
 Earn better returns than returns on foreign exchange reserves
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 Assist monetary authorities dissipate unwanted liquidity

 Increase savings for future generations
 Fund social and economic development
 Ensuring Sustainable long term capital growth for target countries
 Political strategy

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12. INTEREST RATE RISK MANAGEMENT

1. Interest Rate Swaps
Interest Rate Swap is an agreement to exchange cash flows linked to different interest rates.
Types of interest rate swaps:
1. Plain Vanilla Swap: Also called as Generic Swap, it involves the exchange of interest on fixed rate
loan for interest on floating rate loan. Floating rate can be LIBOR, MIBOR, Prime Lending Rate
etc. Fixed interest payments are calculated on 30 days/360 days basis whereas, Floating interest
payment is calculated on actual number of days/360 days basis.
2. Basis Rate Swap: Also called as Non-Generic Swap, it is similar to plain vanilla swap with the
difference that payments to be exchanged under the swap are based on the two different variable
rates (variable rates means floating rates only). For example, 1 month LIBOR may be exchanged
for 3-months LIBOR. In other words, Both the legs of swap are floating but are measured against
different benchmarks.
3. Asset Swap: It is also like plain vanilla swaps, with the difference that it is an exchange of fixed
rate investments such as bonds which pay a guaranteed coupon rate with floating rate
investments such as an index.
4. Amortising Swap: It is an interest rate swap in which the notional principal, on which interest
payments are calculated, declines during the life of the swap. They are particularly useful for
borrowers who have issued redeemable bonds or debentures. It enables them to hedge interest
payments based on the redemption profile of bonds or debentures.

2. Swaption
An interest rate swaption is simply an option on interest rate swap. It gives the holder the right but
not the obligation to enter into an interest rate swap at a specific date in the future, at a particular
fixed rate and for a specified term.
 A 3-month into 5-year swaption would mean an option to enter into a 5-year interest rate swap
after 3 months.
 The swaption premium is expressed as basis points.
 There are two types of swaption contracts: -
 A fixed rate payer swaption gives the owner of the swaption the right but not the obligation
to enter into a swap where they pay the fixed leg and receive the floating leg.
 A fixed rate receiver swaption gives the owner of the swaption the right but not the
obligation to enter into a swap in which they will receive the fixed leg, and pay the floating
leg.

3. Benchmark Rates (SM 2024)

Benchmark interest is an interest rate that are used to determine other interest rates. These rates are
also known as ‘Reference Rates’. These rates are very important in any in financial transactions as

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they form the basis of financial contracts such as bank overdrafts, loans, mortgages and are also used
in other complex financial transactions.
The benchmark rates are widely used in interest rate derivative transactions such as Forward, Future,
Option or Swap Contracts. The Benchmark rate also forms the basis for floating rate loans.

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13. BUSINESS VALUATION

1. Enterprise Value
 Enterprise value is the true economic value of a company. It is the theoretical value of business of
target company under the takeover.
 It is calculated as:
Market Capitalization + Long Term Debt + Minority Interest - Cash and Cash Equivalents
 Enterprise value considers both equity and debt in its valuation of the firm, and therefore it is least
affected by the capital structure of the firm.
 Enterprise Value based multiples (such as EV/sales, EV/EBITDA, etc.) are more reliable than Equity
Value based multiples (such as P/E, P/B Ratio, etc.) because Equity Value based multiples focus only
on equity claim.

2. Impact Of ESG on Valuation (SM 2024)

Environmental, Social, Governance (ESG) is a framework designed to be embedded into an
organization's strategy that considers ways in which value should be generated for all organizational
stakeholders (such as employees, customers and suppliers and financiers).
The ESG performance and linked ratings have begun to play an influencing role for companies going
to market to raise funds for future growth.
Traditional belief was that ESG was ‘good to have’ in the area of business ethics, sustainability,
diversity and community. However, with the increased interests from different stakeholders groups, it
is now moving into the ‘must-to-have’ territory.

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14. MERGERS, ACQUISITIONS AND CORPORATE

RESTRUCTURING
1. Rationale behind Mergers | Benefits of Mergers
1. Synergy:
 Synergy means the combined value of two firms or companies is more than their individual
value.
 Cost saving due to non-duplication of functions and economics of large scale are few reasons
for synergy benefits.
 These economies can be real economies, which means reduction in factor input per unit of
output (means per unit fixed cost will reduce), or pecuniary economics which means actually
paying lower prices for factor inputs for bulk transactions.
2. Diversification: Merger between two unrelated companies would lead to reduction in business risk,
which in turn will increase the market value consequent upon the reduction in discount rate/
required rate of return. (meaning to say lower the risk, lower is the required rate of return).
3. Taxation: The provisions of set off and carry forward of losses as per Income Tax Act may be
another strong season for the merger and acquisition. Thus, there will be Tax saving or reduction
in tax liability of the merged firm.
4. Growth: Growth of any company by way of acquiring companies is called as inorganic growth.
Merger and acquisition mode enables the firm to grow at a rate faster than the other mode like
organic growth mode. The reason being the shortening of ‘Time to Market’.
5. Consolidation of Production Capacities and increasing market power: Due to reduced
competition, marketing power increases. Further, production capacity is increased by combining
of two or more plants.

2. Types of Mergers
1. Horizontal Merger: The two companies that merge, are in the same industry selling similar or
competing products. Normally the market share of the new consolidated company would be larger
and it is possible that it may move near monopoly to avoid competition.
2. Vertical Merger: This merger happens when two companies having buyer-seller relationship come
together to merge.
3. Conglomerate Mergers: Such mergers involve firms engaged in unrelated type of business
operations. In other words, the business activities of acquirer and the target are related neither
horizontally nor vertically.
4. Congeneric Merger: In these mergers, the acquirer and the target companies are related through
basic technologies, production processes or market. The acquired company represents an extension
of product-line or technologies of the acquirer.
5. Reverse Merger: Next question...

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3. Reverse Merger or Takeover by Reverse Bid

Normally, the company taken over is the smaller company than acquirer. But, in a 'reverse merger', a
smaller company gains control of a larger one.
Below three tests should be fulfilled before an arrangement can be termed as a reverse takeover:
1. the assets of the target company are greater than acquirer company,
2. equity capital to be issued by acquirer against acquisition exceeds its existing issued capital and
3. the change of control in the acquirer company through the introduction of a minority holder or
group of holders.
Such mergers normally involve acquisition of a public by a private company, as it helps private
company to by-pass lengthy and complex process required for public issue. This type of merger is also
known as back door listing.

4. Demerger or Disinvestment or Divestitures: Meaning and Reasons

It means a company selling one of its divisions or undertakings to another company or creating an
altogether separate company. It has following advantages:
 Attention on core areas of business
 Division not contributing to revenues
 Size of the firm may be too big to handle
 Need cash in for other investment opportunity

5. Types of Demerger
1. Sell-off: A sell off is the sale of an asset, factory, division or subsidiary by one entity to another for
a purchase consideration payable either in cash or in the form of securities.
2. Split-up: This involves breaking up of the entire firm into separate legal entities for each business
division. The parent firm no longer legally exists and only the newly created entities survive
individually.
3. Spin-off: In this case, a part of the business is separated and created as a separate firm. The existing
shareholders of the firm get proportionate ownership. So, there is no change in ownership and the
same shareholders continue to own the newly created entity.
4. Equity Carve Outs: This is like spin off, however, some shares of the new company are sold in the
market by making a public offer. This brings cash in the company.

6. Management Buy-outs (MBO) & Leveraged Buy-out (LBO)

1. Management Buy Outs: Since, management of the company has better understanding of the
business and operations of the company, they sometimes consider buying out a company facing
financial difficulties. Buyouts initiated by the management team of a company are known as a
management buyout. In this type of acquisition, the company is bought by its own management
team.
2. Leveraged Buyout:
 An acquisition of a company or a division of that company which is financed entirely or partially
(50% or more) using borrowed funds is termed as a leveraged buyout.
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 The target company no longer remains public after the leveraged buyout, hence the transaction
is also known as going private.
 After an LBO, the target entity is managed by private investors, which makes it easier to have a
close control of its operational activities. The intention behind LBO transaction is to improve
operational efficiency of a firm and increase sales volumes, which leads to improved cash flows.
 The extra cash flow generated will be used to pay back the debts in LBO transaction.
 The LBO does not stay permanent. Once the LBO is successful in increasing profit margins & cash
flows and debt is paid back, it will go public again.

7. Special Purpose Acquisition Companies (SM 2024)

It is an entity is set up with the objective to raise funds through an IPO to finance a merger or
acquisition of an unidentified target within a specific time. It is commonly known as a blank cheque
company.
The main objective of SPAC is to raise money, despite not having any operations or revenues. The
money raised from the public is kept in an escrow account, which can be used while making the
acquisition. Shareholders have the option to redeem their shares if they are not interested in
participating in the proposed merger.
Finally, if the merger is approved by shareholders, it is executed, and the target private company or
companies become public entities. However, in case the acquisition is not made within stipulated
period of the IPO, the SPAC is delisted, and the money is returned to the investors.
The current SPAC transactions are not supported by regulatory framework in India like the Companies
Act 2013 or SEBI Act.
SPAC approach offers several advantages over traditional IPO, such as providing companies access to
capital, even when market volatility and other conditions limit liquidity.
It is typically more expensive for a company to raise money through a SPAC than an IPO.

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15. Start-up Finance

1. Innovative ways of financing or Sources of funding a Start-up
1. Personal financing: Personal financing means investing one’s own money. It is important because
most of the investors will not put money in your start-up if they see that you have not contributed
any money from your personal sources.
2. Personal credit lines: One qualifies for personal credit line based on one’s personal credit efforts.
However, banks are very cautious while granting personal credit lines. They provide this facility
only when the business has enough cash flow to repay the line of credit.
3. Family and friends. These are the people who generally believe in you, without even thinking that
your idea works or not. However, the loan obligations to friends and relatives should always be in
writing as a promissory note.
4. Crowdfunding. Crowdfunding is the use of small amounts of capital from a large number of
individuals to finance a new business. Crowdfunding makes use of vast networks of people on social
media and crowdfunding websites to bring entrepreneurs and investors together.
5. Microloans. Microloans are small loans given by individuals at a lower interest to new business
ventures. These loans can be issued by a single individual or group of individuals who in aggregate
contribute to the total loan amount.
6. Peer-to-peer landing: In this process group of people come together and lend money to each other.
Many small and ethnic business groups having similar faith or interest generally support each other
in their start up endeavours.
7. Vendor Financing. Vendor financing is the form of financing in which a company lends money to
its customers so that he can buy products from the company itself. Vendor financing also takes
place when many manufacturers and distributors are convinced to defer payment until the goods
are sold. However, this depends on one’s credit worthiness.
8. Factoring accounts receivables. In this method, a facility is given to the seller who has sold the
good on credit to fund his receivables till the amount is fully received. So, when the goods are sold
on credit, the factor will pay most of the amount up front and rest of the amount later.
9. Purchase order financing: The start-ups not able to find a large new order because they don’t have
the necessary cash to produce and deliver the product. Purchase order financing companies often
advance the required funds directly to the supplier. This allows the transaction to complete and
profit to flow up to the new business.

2. Modes of Financing a Start-up

1. Angel Investors
 Angel investors are affluent individuals who inject capital for start-ups in exchange for
ownership equity or convertible debt.
 Angel investors invest in small start-ups. The capital that angel investors provide may be a one-
time investment to help the business propel or an ongoing injection of money to support and
carry the company through its difficult early stages.

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 Angel investors are focused on helping start-ups take their first steps, rather than the possible
profit they may get from the business.
 Angel Investors typically invest their own money, unlike venture capitalists who invest money
pooled from many investors.
 Angel investors are also called informal investors, angel funders, private investors, seed
investors or business angels. Angel Investors usually represent individuals, but the entity that
actually provides the funds may be an LLP, trust, an investment fund or some kinds of vehicle.
2. Venture Capital Funds
 Venture capital is the money provided by professionals who invest in young and rapidly
growing companies that have the potential to develop into significant economic contributors.
 Venture Capital Fund (just like a mutual fund) means investment vehicle that manage funds
of investors seeking to invest in startup and small businesses with exceptional growth
potential. Venture Capital funds invest in equity and debt instruments of these businesses.
 Venture Capital Funds generally
o Finance new and rapidly growing companies
o Purchase equity securities
o Assist in the development of new products or services
o Add value to the company through active participation.
 Investors in Venture Capital Funds include Financial Institutions, Banks, Pension Funds, HNIs,
etc.
3. Bootstrapping
English word ‘Bootstrap’ means ‘get oneself out a situation using existing resources’.
Bootstrapping means when an individual attempt to found and build a company from personal
finances or from the operating revenues of the new company.
Methods in which a start-up firm can bootstrap:
A. Trade Credit
 When a person is starting his business, suppliers are reluctant to give trade credit. They
insist to make upfront payment for the goods supplied.
 Preparing a well-crafted financial plan and convincing supplier about it can help to get
credit. For small business organization, the owner can be directly contacted and for big firm,
the Chief Financial Officer (CFO) can be contacted.
 Along with financial plan, the owner or the CFO has to be explained about the business and
the need to get the first order on credit in order to launch the venture.
B. Factoring
 This is a financing method where accounts receivable of a business organization is sold to a
commercial finance company to raise capital.
 Factoring frees up the money that would otherwise be tied to receivables. This money can
be used to generate profit through other avenues of the company.
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 It can also reduce costs associated with maintaining accounts receivable such as
bookkeeping, collections and credit verifications
C. Leasing
 This method of bootstrapping involves taking the equipment on lease rather than
purchasing.
 It reduces the amount of capital to be employed in the business along with reducing the risk
of incurring fixed capital expenditure.
 Both lessor and lessee enjoy the tax benefit, respectively on depreciation on fixed asset and
lease rentals under the agreement.

3. Pitch Presentation and its Approach

While raising funds from the investors like Angel Investors or Venture Capital Funds, a presentation is
required to be made to them; called as Pitch Presentation. Pitch deck presentation is a short and brief
presentation to investors explaining about the prospects of the company and why they should invest
into the start-up business. It is a quick overview of business plan and convincing the investors to put
some money into the business.
How to approach a pitch presentation?
1. Introduction: First step is to give a brief account of yourself i.e. who are you? What are you
doing? Use this opportunity to get your investors interested in your company.
2. Team: The next step is to introduce the team to the investors. The reason is that the investors
will want to know the people who are going to make the product or service successful.
3. Problem: In a pitch presentation, the promoter should be able to explain the problem he is going
to solve.
4. Solution: It is very important to describe how the company is planning to solve the problem and
the investors should be convinced that the newly introduced product or service will solve it.
5. Marketing or Sales: The market size of the product must be communicated to the investors.
Marketing strategy of the start-up is also required to be explained.
6. Projections or Milestones: Projected financial statements give a brief idea about where is the
business heading. It tells us that whether the business will be making profit or loss. Financial
projections include three basic documents that make up a business’s financial statements.
(covered specifically in the next heading...)
7. Competition: Every business organization has competition even if the product or service offered
is new and unique. It is necessary to highlight in the pitch presentation as to how the products
or services are different from their competitors.
8. Business Model: The term business model is a wide term denoting core aspects of a business
including operational process, offerings, target customers, strategies, infrastructure,
organizational structures, etc. It is important to explain investors about the business model to
generate revenues.
9. Financing: If a start-up has already raised money, it is preferable to talk about how much money
has been raised, who invested money into the business and what they did about it. If no money
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has been raised till date, an explanation can be made regarding how much work has been
accomplished with the help of limited funds available with the company.

4. Documents for Financial Projections during Pitch Presentation

1. Income statement: A projected income statement shows much money the business will generate
by projecting income and expenses, such as sales, cost of goods sold and expenses. For your first
year in business, you’ll want to create a monthly income statement. For the second year, quarterly
statements will suffice. For the following years, you’ll just need an annual income statement.
2. Cash flow statement: A projected cash flow statement will depict how much cash will be coming
into the business and out of that cash how much cash will be utilized into the business. At the end
of each period (e.g., monthly, quarterly, annually), one can tally it all up to show either a profit or
loss.
3. Balance sheet: The balance sheet shows the business’s overall finances including assets, liabilities
and equity. Typically, one will create an annual balance sheet for one’s financial projections.

5. Characteristics of Venture Capital Financing

1. Long time horizon: The VC fund would invest with a long-time horizon in mind. Minimum period of
investment would be 3 years and maximum period can be 10 years.
2. Lack of liquidity: When VC fund invests, it takes into account the liquidity factor. It assumes that
there would be less liquidity on the equity shares of business it invested in. They adjust this liquidity
premium against the price and required return. It will plan its investments into different businesses
accordingly.
3. High Risk: VC fund would not hesitate to take risk. It works on principle of high risk and high return.
So, high risk would not eliminate the investment choice for a venture capital, if it is commensurately
rewarded for taking high risk.
4. Equity Participation: Most of the time, VC fund would be investing in the form of equity of a
company. This would help the Venture Capitalist participate in the management and help the
company grow. This would also help them to supervise a lot of board decisions.

6. Advantages of bringing Venture Capital in the company:

1. VC brings long- term equity capital into the company which provides a solid capital base for future
growth.
2. The venture capitalist is a business partner, sharing both, the risks and rewards. Venture
capitalists are rewarded with business success and capital gain.
3. The venture capitalist is able to provide practical advice and assistance to the company based on
past experience with other companies which were in similar situations.
4. The venture capitalist also has a network of contacts in many areas that can add value to the
company.
5. The venture capitalist may be capable of providing additional rounds of funding which the
company would require to finance the growth.

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Theory Topics

6. Venture capitalists are experienced in the process of preparing a company for an initial public
offering (IPO) of its shares onto the stock exchanges.

7. Stages of Venture Capital Funding

Stage of Funding Risk Activity to be Financed
Seed Money Extreme Low level financing needed to prove a new idea.
Early stage firms that need funding for expenses
Start-up Very High
associated with marketing and product development.
First-Round High Early sales and manufacturing funds.
Working capital for early stage companies that are selling
Second-Round Sufficiently High
product, but not yet turning in a profit.
Expansion of a newly profitable company (also called as
Third Round Medium
Mezzanine financing)
Finance the "going public" process (also called as bridge
Fourth-Round Low
financing)

8. Venture Capital Investment Process

Deal VC operates directly or through intermediaries who get them deal. Start-up would
Origination give a detailed business plan to VC, called as Investment Memorandum which
consists of business model, financial plan and exit plan.

Screening Screening process would help to select the company for further processing. The
screening decision would take place based on the information provided by the
company.

Due Diligence Due diligence is the process by which the VC would try to verify the correctness of the
documents taken. This is generally handled by external bodies, mainly renowned
consultants.

Deal The deal is structured in such a way that both parties win. In many cases, the
Structuring convertible structure is brought in to ensure that the promoter retains the right to
buy back the share. Besides, in many structures to facilitate the exit, the VC may put
a condition that promoter must sell a part of his stake along with the VC. Such a
clause is called tag-along clause.

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Theory Topics

Post Investt In this section, the company has to adhere to certain guidelines like strong MIS,
Activity strong budgeting system, strong corporate governance and other covenants of the
VC and periodically keep the VC updated about certain milestones.

Exit plan Exit happens in two ways: one way is ‘sell to third party’. This sale can be in the form
of IPO or Private Placement to other VCs. The second way to exit is that promoter
would give a buy back commitment at a pre agreed rate.

9. Structure of Venture Capital Fund in India

Offshore Funds

Domestic Funds
Offshore Structure Unified Structure

Domestic Funds are the funds which Under this structure, an When both domestic and
raises money domestically. They are offshore investment vehicle offshore investors are
usually structured as: which is an LLC or LP expected to participate in
i) a domestic vehicle for the pooling registered outside India, the fund, a unified structure
of funds from the investor, and makes investments directly is used.
ii) a separate investment vehicle that into Indian portfolio
Overseas investors pool their
carries the duties of asset companies.
assets in an offshore vehicle
manager. The assets are managed by that invests in a locally
The choice of entity for the pooling the offshore manager, while managed trust, whereas
vehicle falls between a trust and a the investment advisor in domestic investors directly
company, with the trust form India carries out the due contribute to the trust.
prevailing due to its operational diligence and identifies
This trust makes the local
flexibility. deals.
portfolio investments with
Unlike most developed countries, the help of asset manager.
India does not recognize a LP.

10. Difference between start-ups and entrepreneurship. Priorities and

challenges which start-ups in India are facing
Start-ups are different from entrepreneurship in the following way:
1. Start- up is a part of entrepreneurship. Entrepreneurship is a broader concept and it includes
a start-up firm.
2. The main aim of start-up is to build a concern and conceptualize the idea into a reality and
build a product or service. On the other hand, the major objective of an already established

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Theory Topics

entrepreneurship concern is to attain opportunities with regard to the resources they currently
control.
3. A start-up generally does not have a major financial motive whereas an established
entrepreneurship concern mainly operates on financial motive.
Priority related to start-ups in India:
 The priority is on bringing more and more smaller firms into existence. The objective is to
encourage self-employment rather than large, scalable concerns.
 The focus is on need based, instead of opportunity based entrepreneurship.
Challenges related to start-ups in India:
 The main challenge with the start-up firms is in getting the right talent. Lack of skilled workforce
can hinder the chances of a start-up succeeding.
 Further, start-ups had to comply with numerous regulations which escalate its cost.

11. Definition of Start-up under Start-up India Initiative to avail benefits

Startup India scheme was initiated by the Government of India on 16th of January, 2016. As per GSR
Notification 127 (E) dated 19th February 2019, an entity shall be considered as a Startup:
1. Upto a period of ten years from the date of incorporation/ registration, if it is incorporated as a
private limited company (as defined in the Companies Act, 2013) or registered as a partnership
firm (registered under section 59 of the Partnership Act, 1932) or a limited liability partnership
(under the Limited Liability Partnership Act, 2008) in India.
2. Turnover of the entity for any of the financial years since incorporation/ registration has not
exceeded ₹ 100 crores.
3. Entity is working towards innovation, development or improvement of products or processes or
services, or if it is a scalable business model with a high potential of employment generation or
wealth creation.
Provided that an entity formed by splitting up or reconstruction of an existing business shall not be
considered a ‘Startup’.
Apart from the support from government, there are Other reasons why India has become a
sustainable environment for start-ups: (SM 2024)
1. The Pool of Talent: Our country has a big pool of talent. There are millions of students graduating
from colleges and B-schools every year. Many of these students use their knowledge and skills to
begin their own ventures, and that has contributed to the startup growth in India.
2. Cost Effective Workforce: India is a young country with over 10 million people joining the
workforce every year. The workforce is also cost effective. So, compared to some other countries,
the cost of setting up and running a business is comparatively lower.
3. Increasing use of the Internet: India has the world’s second-highest population, and after the
introduction of affordable telecom services, the usage of internet has increased significantly. It

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Theory Topics

has even reached the rural areas. India has the second-largest internet user base after China, and
companies as well as start-ups are leveraging this easy access to the internet.
4. Technology: Technology has made the various processes of business very quick, simple and
efficient. There have been major developments in software and hardware systems due to which
data storage and recording has become an easy task. Indian startups are now increasingly
working in areas of artificial intelligence and blockchain technologies which is adding to the
growth of businesses.
5. Variety of Funding Options Available: Earlier there were only some very traditional methods
available for funding a startup. Now, there are numerous options and opportunities available.
Start-up owners can approach angel investors, venture capitalists, seed funding stage investors,
etc.

12. Succession Planning in Business (SM 2024)

Succession planning is the process of identifying the critical positions within an organization and
developing action plans for individuals to take the charge of those positions. A succession plan
identifies future need of people with the skills and potential to perform leadership roles.
A. Need for succession planning
1. Risk mitigation: If existing leader quits, then searches can take six-nine months for suitable
candidate to close. Keeping an organization without leader can invite disruption, uncertainty,
conflict and endangers future competitiveness.
2. Cause removal: If the existing leader is culpable of gross negligence, fraud or misconduct
while discharging duties and has been barred from undertaking further activities by court,
arbitral tribunal, management, stakeholders or any other agency.
3. Talent pipeline: Succession planning keep employees motivated and determined as it can
help them obtaining more visibility around career paths expected, which would help in
retaining the knowledge bank created by company over a period of time and leverage upon
the same.
4. Conflict Resolution Mechanism: This planning is very helpful in promoting open and
transparent communication and settlement of conflicts.
5. Aligning: In family-owned business succession planning helps to align with the culture, vision,
direction and values of the business.
B. Business succession strategy
Step 1. Evaluate key leadership positions: To evaluate which roles are critical, risk or impact
assessment can be performed. Generally, these are such positions which would bring
transformation to the entire business or create strategic direction for the organization.
Step 2. Map competencies required for above positions: In this step, one needs to identify
qualifications, behavioural and technical competencies required to perform the role
successfully.
Step 3. Identify competencies of current workforce: Identifying what are possible internal options
that can deliver results as expected in Step-2, and also if there is a need for training and

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Theory Topics

development of certain skills required. The organization should also place weight on
whether is there a need to search outside the organization.
Step 4. Bridge Leader: In family-owned business appointment of an outsider as ‘bridge leader’ will
help to develop the business and prepare young family members for leadership role.
C. Challenges in implementing Succession Planning
1. Founder mindset might be different than the corporate mindset: The way founder’s brains
are wired is different from the way that a traditional corporate manager thinks, and this puts
off seasoned corporate leaders from joining even matured start-ups.
2. Premature for startups to implement business succession: Certain startups are at early
growth stage and too much of processes would lead to growth slow-down and hence they
are not in a current stage for implementing business succession planning.
3. Founders are the face of startups: One cannot imagine a startup without a founder who
initiated the idea and executed it and in his/ her absence succession planning can become
difficult.

287
Adish Jain CA CFA
Tables

Values of ex & Ln
X Ex ln (1+x) X Ex ln (1+x) X Ex ln (1+x)
0.01 1.01005 - 4.60517 0.51 1.66529 - 0.67334 1.01 2.74560 0.00995
0.02 1.02020 - 3.91202 0.52 1.68203 - 0.65393 1.02 2.77319 0.01980
0.03 1.03045 - 3.50656 0.53 1.69893 - 0.63488 1.03 2.80107 0.02956
0.04 1.04081 - 3.21888 0.54 1.71601 - 0.61619 1.04 2.82922 0.03922
0.05 1.05127 - 2.99573 0.55 1.73325 - 0.59784 1.05 2.85765 0.04879
0.06 1.06184 - 2.81341 0.56 1.75067 - 0.57982 1.06 2.88637 0.05827
0.07 1.07251 - 2.65926 0.57 1.76827 - 0.56212 1.07 2.91538 0.06766
0.08 1.08329 - 2.52573 0.58 1.78604 - 0.54473 1.08 2.94468 0.07696
0.09 1.09417 - 2.40795 0.59 1.80399 - 0.52763 1.09 2.97427 0.08618
0.10 1.10517 - 2.30259 0.60 1.82212 - 0.51083 1.10 3.00417 0.09531
0.11 1.11628 - 2.20727 0.61 1.84043 - 0.49430 1.11 3.03436 0.10436
0.12 1.12750 - 2.12026 0.62 1.85893 - 0.47804 1.12 3.06485 0.11333
0.13 1.13883 - 2.04022 0.63 1.87761 - 0.46204 1.13 3.09566 0.12222
0.14 1.15027 - 1.96611 0.64 1.89648 - 0.44629 1.14 3.12677 0.13103
0.15 1.16183 - 1.89712 0.65 1.91554 - 0.43078 1.15 3.15819 0.13976
0.16 1.17351 - 1.83258 0.66 1.93479 - 0.41552 1.16 3.18993 0.14842
0.17 1.18530 - 1.77196 0.67 1.95424 - 0.40048 1.17 3.22199 0.15700
0.18 1.19722 - 1.71480 0.68 1.97388 - 0.38566 1.18 3.25437 0.16551
0.19 1.20925 - 1.66073 0.69 1.99372 - 0.37106 1.19 3.28708 0.17395
0.20 1.22140 - 1.60944 0.70 2.01375 - 0.35667 1.20 3.32012 0.18232
0.21 1.23368 - 1.56065 0.71 2.03399 - 0.34249 1.21 3.35348 0.19062
0.22 1.24608 - 1.51413 0.72 2.05443 - 0.32850 1.22 3.38719 0.19885
0.23 1.25860 - 1.46968 0.73 2.07508 - 0.31471 1.23 3.42123 0.20701
0.24 1.27125 - 1.42712 0.74 2.09594 - 0.30111 1.24 3.45561 0.21511
0.25 1.28403 - 1.38629 0.75 2.11700 - 0.28768 1.25 3.49034 0.22314
0.26 1.29693 - 1.34707 0.76 2.13828 - 0.27444 1.26 3.52542 0.23111
0.27 1.30996 - 1.30933 0.77 2.15977 - 0.26136 1.27 3.56085 0.23902
0.28 1.32313 - 1.27297 0.78 2.18147 - 0.24846 1.28 3.59664 0.24686
0.29 1.33643 - 1.23787 0.79 2.20340 - 0.23572 1.29 3.63279 0.25464
0.30 1.34986 - 1.20397 0.80 2.22554 - 0.22314 1.30 3.66930 0.26236
0.31 1.36343 - 1.17118 0.81 2.24791 - 0.21072 1.31 3.70617 0.27003
0.32 1.37713 - 1.13943 0.82 2.27050 - 0.19845 1.32 3.74342 0.27763
0.33 1.39097 - 1.10866 0.83 2.29332 - 0.18633 1.33 3.78104 0.28518
0.34 1.40495 - 1.07881 0.84 2.31637 - 0.17435 1.34 3.81904 0.29267
0.35 1.41907 - 1.04982 0.85 2.33965 - 0.16252 1.35 3.85743 0.30010
0.36 1.43333 - 1.02165 0.86 2.36316 - 0.15082 1.36 3.89619 0.30748
0.37 1.44773 - 0.99425 0.87 2.38691 - 0.13926 1.37 3.93535 0.31481
0.38 1.46228 - 0.96758 0.88 2.41090 - 0.12783 1.38 3.97490 0.32208
0.39 1.47698 - 0.94161 0.89 2.43513 - 0.11653 1.39 4.01485 0.32930
0.40 1.49182 - 0.91629 0.90 2.45960 - 0.10536 1.40 4.05520 0.33647
0.41 1.50682 - 0.89160 0.91 2.48432 - 0.09431 1.41 4.09596 0.34359
0.42 1.52196 - 0.86750 0.92 2.50929 - 0.08338 1.42 4.13712 0.35066
0.43 1.53726 - 0.84397 0.93 2.53451 - 0.07257 1.43 4.17870 0.35767
0.44 1.55271 - 0.82098 0.94 2.55998 - 0.06188 1.44 4.22070 0.36464
0.45 1.56831 - 0.79851 0.95 2.58571 - 0.05129 1.45 4.26311 0.37156
0.46 1.58407 - 0.77653 0.96 2.61170 - 0.04082 1.46 4.30596 0.37844
0.47 1.59999 - 0.75502 0.97 2.63794 - 0.03046 1.47 4.34924 0.38526
0.48 1.61607 - 0.73397 0.98 2.66446 - 0.02020 1.48 4.39295 0.39204
0.49 1.63232 - 0.71335 0.99 2.69123 - 0.01005 1.49 4.43710 0.39878
0.50 1.64872 - 0.69315 1.00 2.71828 - 1.50 4.48169 0.40547

288
Adish Jain CA CFA
Tables

Z values between μ and X

z 00 01 02 03 04 05 06 07 80 09
- - 0.0040 0.0080 0.0120 0.0160 0.0199 0.0239 0.0279 0.0319 0.0359
0.10 0.0398 0.0438 0.0478 0.0517 0.0557 0.0596 0.0636 0.0675 0.0714 0.0753
0.20 0.0793 0.0832 0.0871 0.0910 0.0948 0.0987 0.1026 0.1064 0.1103 0.1141
0.30 0.1179 0.1217 0.1255 0.1293 0.1331 0.1368 0.1406 0.1443 0.1480 0.1517
0.40 0.1554 0.1591 0.1628 0.1664 0.1700 0.1736 0.1772 0.1808 0.1844 0.1879
0.50 0.1915 0.1950 0.1985 0.2019 0.2054 0.2088 0.2123 0.2157 0.2190 0.2224
0.60 0.2257 0.2291 0.2324 0.2357 0.2389 0.2422 0.2454 0.2486 0.2517 0.2549
0.70 0.2580 0.2611 0.2642 0.2673 0.2704 0.2734 0.2764 0.2794 0.2823 0.2852
0.80 0.2881 0.2910 0.2939 0.2967 0.2995 0.3023 0.3051 0.3078 0.3106 0.3133
0.90 0.3159 0.3186 0.3212 0.3238 0.3264 0.3289 0.3315 0.3340 0.3365 0.3389
1.00 0.3413 0.3438 0.3461 0.3485 0.3508 0.3531 0.3554 0.3577 0.3599 0.3621
1.10 0.3643 0.3665 0.3686 0.3708 0.3729 0.3749 0.3770 0.3790 0.3810 0.3830
1.20 0.3849 0.3869 0.3888 0.3907 0.3925 0.3944 0.3962 0.3980 0.3997 0.4015
1.30 0.4032 0.4049 0.4066 0.4082 0.4099 0.4115 0.4131 0.4147 0.4162 0.4177
1.40 0.4192 0.4207 0.4222 0.4236 0.4251 0.4265 0.4279 0.4292 0.4306 0.4319
1.50 0.4332 0.4345 0.4357 0.4370 0.4382 0.4394 0.4406 0.4418 0.4429 0.4441
1.60 0.4452 0.4463 0.4474 0.4484 0.4495 0.4505 0.4515 0.4525 0.4535 0.4545
1.70 0.4554 0.4564 0.4573 0.4582 0.4591 0.4599 0.4608 0.4616 0.4625 0.4633
1.80 0.4641 0.4649 0.4656 0.4664 0.4671 0.4678 0.4686 0.4693 0.4699 0.4706
1.90 0.4713 0.4719 0.4726 0.4732 0.4738 0.4744 0.4750 0.4756 0.4761 0.4767
2.00 0.4772 0.4778 0.4783 0.4788 0.4793 0.4798 0.4803 0.4808 0.4812 0.4817
2.10 0.4821 0.4826 0.4830 0.4834 0.4838 0.4842 0.4846 0.4850 0.4854 0.4857
2.20 0.4861 0.4864 0.4868 0.4871 0.4875 0.4878 0.4881 0.4884 0.4887 0.4890
2.30 0.4893 0.4896 0.4898 0.4901 0.4904 0.4906 0.4909 0.4911 0.4913 0.4916
2.40 0.4918 0.4920 0.4922 0.4925 0.4927 0.4929 0.4931 0.4932 0.4934 0.4936
2.50 0.4938 0.4940 0.4941 0.4943 0.4945 0.4946 0.4948 0.4949 0.4951 0.4952
2.60 0.4953 0.4955 0.4956 0.4957 0.4959 0.4960 0.4961 0.4962 0.4963 0.4964
2.70 0.4965 0.4966 0.4967 0.4968 0.4969 0.4970 0.4971 0.4972 0.4973 0.4974
2.80 0.4974 0.4975 0.4976 0.4977 0.4977 0.4978 0.4979 0.4979 0.4980 0.4981
2.90 0.4981 0.4982 0.4982 0.4983 0.4984 0.4984 0.4985 0.4985 0.4986 0.4986
3.00 0.4987 0.4987 0.4987 0.4988 0.4988 0.4989 0.4989 0.4989 0.4990 0.4990
3.10 0.4990 0.4991 0.4991 0.4991 0.4992 0.4992 0.4992 0.4992 0.4993 0.4993
3.20 0.4993 0.4993 0.4994 0.4994 0.4994 0.4994 0.4994 0.4995 0.4995 0.4995
3.30 0.4995 0.4995 0.4995 0.4996 0.4996 0.4996 0.4996 0.4996 0.4996 0.4997
3.40 0.4997 0.4997 0.4997 0.4997 0.4997 0.4997 0.4997 0.4997 0.4997 0.4998
3.50 0.4998 0.4998 0.4998 0.4998 0.4998 0.4998 0.4998 0.4998 0.4998 0.4998
3.60 0.4998 0.4998 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999
3.70 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999
3.80 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999
3.90 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000

289
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